Imagine all prices were to fall. Your income now buys an extra week worth of widgets, and everyone is better off. But you can only consume so many widgets now, and if you were to save a bit, tomorrow’s prices are certainly lower. So you save, and your neighbor, and their neighbors, and so on… Next month, your boss makes you an offer you can’t refuse —a new haircut for your wallet. You wake up, this nightmare you had was a standard deflation. But recently you had a slightly different dream, of debt deflation.
What is debt deflation?
You woke up with a shock, and such the details of the deflation nightmare are a bit hazy. You do not quite remember how it all started, but the story might go as follows.
For some reason, let it be a government stimulus program, or deregulation of the financial sector, everyone seams to be able to buy an extra house. Some spent their holiday in it, other rent it to university students, the next one lives in it. Everyone rejoices about their new-found wealth, weren’t it build on easy credit. After a while, one gets used to the spending, and asset prices rise. The weather is clear, the prospects are prosperous, and today’s party is paid by tomorrow’s hangover.
One day, a risk manager gets cold feet, and remembers the last crisis. He wants you to post more margin or denies the home equity loan. So you have to sell. First at prevailing market prices, then to willing buyers, at last so that we (you and the bank) may survive. The bank got its share, but you still got a mortgage to pay —without any house. It is easy to see that this could lead to financial crisis, with one seller driving the next one to sell at lower prices, making the initial problem worse. Luckily the bank agrees, and you can keep your house if you do not sell, but in return your payment did go up, and your budget became tight. You are not alone, and so the shelves start to fill, and general prices fall.
Why debt deflation is dangerous
Putting these two stories together, you see how well they interact. The exuberant asset prices justified an overhanging debt, which has to be paid, or else… Everybody’s budget now goes to the bank, instead of consuming or investing. As a result, prices fall, including on your house that backs the debt, so you can leave the house behind to get a cheaper more appropriate one. This alone can be overcome, if it weren’t for the accompanying fall in wages and other forms of income. Now it is a race to the bottom, between income and prices, so that the budget holds. If we just weren’t in such a debt, we could borrow to buy all those cheap assets and employ that cheap labor.
How to get out of debt deflation
The primary problem is budget shortfall from a debt overhang, which drives a positive feedback loop.
- Budget shortfall
- lower consumption and investment
- which is less demand
- leads to falling prices (including assets backing debt)
- with a lower debt capacity, which require
- a relative increase in debt payment as part of
- further budget shortfalls
The first (naive) way to break the cycle would be to inject cash into the economy to cover the budget shortfall. However, too much debt started the debt deflation, and the plumbing of getting the cash where it needs to be is messy, who gets how much, and how, under which conditions, with all the politics included. And who could lend at last resort?
The second-worst option (often used with excessive inflation) would be price controls. Set minimum prices for goods and assets, and voilà, with magic everyone can borrow against their assets and their budgets can balance without price decreases! Well, magic works only if you do not pay attention to the magician’s hand, as your creditor is sure to do, and the spending side of your budget increased as well. An unsatisfying prestige drowning the economy further.
How about forgiving the debt? Decrease the debt payments, and consumption as well as investment is going to increase demand and prices! This might work, if you could coordinate the creditors like a J.P. Morgan did. Otherwise, you face the coalition dilemma, where every member has the incentive to free ride, but cooperation is required for success. Even then, debtors themselves depend on the payments for they borrowed too, or are foreigners with no interest in your particular country.
What made America great again
What worked in the American case was a big increase in demand, coupled with public spending during the 1940s. Taking up slack capacity, raising prices, and remuneration (although not completely monetary, more in form of fringe benefits). To some extent the newly recovered economy could grow out of its debts, but the bigger burden bore bonds, by inflation.
Conclusion
Once you are in debt deflation, it is hard to get out of it. Too much debt stifles economic activity, which feeds into a greater real debt burden, starting the cycle anew. The important lesson is that you cannot save yourself out of the debt deflation, you also need economic growth. To encourage the economy, the signal —and trust— that you will do whatever it takes, to overcome the cycle is a good start. In fact, central banks understand by heart the importance of inflation expectations for a stable monetary environment.
