Most of us alive today have not lived through a period of debt-deflation. On the contrary the global economy has been dominated over these last three decades by creditors and creditor interests. These have made inflation the No. 1 Threat to civilisation, and so we are overly concerned about inflation, and relatively ignorant about deflation.
The reason that creditors or moneylenders or bankers hate inflation is that it erodes the value of their assets – in particular loans. It erodes the value of debt. So that a loan of $100 today is worth only say, $80 when it is finally repaid. Creditors hate that.
On the other hand deflation inflates the value of debt. It increases the value of debt. A loan of $100 today may be worth $120 when it is repaid. Creditors love deflation as it increases the value of their assets, in particular loans.
This is a very important distinction. Particularly important for borrowers.
Irving Fisher clearly identified the phenomenon of ‘debt-deflation’. A famous economist, he published his seminal work in 1933: “The Debt-Deflation Theory of Great Depressions,”
In this he argued that if we assumed a state of excessive indebtedness – such as the state we are in – then we must assume liquidation of that debt, through the alarm of either debtors or creditors or both. This would lead to a chain of consequences. In order to liquidate their debts (think of a homeowner about to plunge into negative equity) the borrower tries to sell his/her asset. Given their circumstances, they are ‘distressed sellers’ – in other words, they will take any sum likely to cover their debts, and allow them to escape from under their creditors.
As loans are paid off there is a contraction of deposits in banks – which slows down the velocity of the circulation of money. This contraction of deposits leads to a fall in prices.
A fall in prices leads to a fall in the net worth of a business, and in profits, which in turn leads to bankruptcies. Businesses that are making a loss, reduce their output, their trade and their employment of labour.
Losses, bankruptcies and unemployment lead to pessimism and a loss of confidence.
This in turn leads to hoarding and cutting back, and even more of a ‘credit crunch’
These various changes cause complicated changes to real rates of interest. Nominal interest rates might fall, but real rates might rise.
This is because interest rates cannot fall below zero (otherwise the bank is paying you take away the money!). However, the prices of goods (think of tomatoes during a glut and trainers from China) can fall below the cost of producing them. So while prices can fall below zero, because interest rates can’t, the real rate of interest rises, as prices fall.
Scary stuff. Which is why it is so important to get interest rates – all rates, safe and risky, short-term and long-term – down to zero effectively in a deflationary environment – such as the one we are living through now.
And scary too, because once trapped inside a debt-deflationary spiral, it is very hard for an economy to emerge from it….confidence has to be restored; consumers have to be persuaded to spend and not hoard their precious savings; interest rates have to be very low; debts have to be written off. Getting all this done is really tough in the midst of a Depression – which is why no government should allow their economy to spin into a debt-deflationary spiral…..