5 minDéflation: short series (3)
Dieter Hein In the first instalment of this series, we considered how to define deflation and what might cause it. In the second instalment, we took a look back at history, at the supposedly “good phases of deflation” and, above all, at deflation during the Great Depression of the 1930s. In particular, I went into the two main theories, “Keynesianism” “monetarism”. Both theories explained some causes of the Great Depression and also provided some tips on how another depression could be avoided in the future.
A spectre is haunting the world, the spectre of deflation
However, neither theory can explain why the deflation of the 1930s – unlike the deflation phases of the second half of the 19th century – had such dramatic socio-economic consequences. One explanation was provided in the “debt deflation” (1) theory published in 1933 by Irving Fisher.
The basis of this theory is that debtors are the real losers in deflation and a decline in real incomes. The reason is that amidst deflation, outstanding debt and interest rates do not change in nominal terms but as incomes fall, the real debt burden rises. Those who took on heavy debt before deflation (“starting debt stock”) could find themselves in a situation of excess debt. In a situation like this, each person will try to pay back his debt. But this can only happen by reducing expenditure; this, in turn, leads to weaker demand and further price declines.
Based on this assumption, Irving Fisher listed the following chain of interactive circumstances that can lead to debt deflation and to a recession:
- Debt is liquidated through forced sales.
- As debt is paid off, the money supply shrinks and the velocity of money in circulation slows. (2)
- This raises the value of money, i.e., the prices of goods and services falls further.
- Demand shrinks, which reduces companies’ net value.
- Corporate profits fall, and fear of losses increases.
- Output, trade and employment shrink.
- An increasing number of bankruptcies and rising joblessness cause a further loss in confidence.
- Money and goods are hoarded; reluctance in making economic transactions of any type leads to a slowing of goods transactions, which, in turn, slows the velocity of money in circulation.
- All the above affect the capital markets, especially interest rates: nominal rates fall but real rates rise, as Inflation becomes negative. So the real debt burden expands further. (3)
If end debt stock is high enough, debt reduction cannot keep up with the fall in prices described above. This results in a downward spiral. The combination of deflation and excess debt leads to an economic disaster. (4)
The question here is how high starting debt stock must be for this process to lead to a downward spiral.
The following chart shows the trend in total US debt (private and government debt) in relation to economic output since 1870. In the late 19th century the debt burden was apparently low enough to forestall the process of debt deflation. By the start of the 1930s, the debt level had doubled in relation to economic output, and starting debt stock was then apparently so high that it led to the Great Depression.
U.S. Debt as a % of GDP (annual)
Source : Bureau of Economic Analysis, Federal Reserve (Q1 2011)
Much has changed since then. Industrial economies like the US have developed into service- and consumer-driven societies; debt management and financial products have become more sophisticated and differentiated; the social safety net has become more robust. Some economists have thus come to believe that national economies can not only tolerate heavier debt but actually need it urgently. However, despite much research in this area (5), it is still not clear how high the debt ratio and the debt structure must be, i.e., from what point the stock of debt becomes critical.
This seems quite clear to me, but there is still the matter that individual regions and countries must be regarded differently. Emerging markets or countries with under-diversified economies can be over-indebted even with apparently low debt ratios. On the other hand, past experience seems to have shown that in countries such as Japan the debt structure is such that, despite deflation and high debt ratios, a debt deflation spiral with dramatic social consequences can fail to occur.
In early 2015, the McKinsey Global Institute (6) published a study on debt trends in 47 countries, particularly since the financial crisis. It shows that the global debt ratio is very high and has even expanded further in spite of bad experiences during the financial crisis.
In my view, weak global growth in recent years in spite of rising debt burdens is, at the very least, a clear indication that debt ratios have in the meantime risen higher than is necessary or healthy for national economies. I even believe that debt ratios have risen so high that there is a real danger of debt deflation in many national economies. Recent turmoil on the financial markets seems to bear this out.
Apparently, central banks share this view increasingly. More and more of them are easing their monetary policy. For example, the Bank of Japan just recently moved its interest rate into negative territory for certain deposits. Even the US Federal Reserve, from whom successive hikes in interest rates had been expected, now seems to be thinking about starting back down the path of expansion.
In the next (and last) instalment of this series I will examine the consequences for the financial markets and explain what consequences this could have for investors.
(1) https://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf
(2) circulation. In extending credit, commercial banks create new money. When loans are paid off, money is pulled back out of the business cycle. On money creaation, see, e.g.: http://www.bankofengland.co.uk/publications/Document/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf For Velocity of money in circulation, see, among others https://www.bundesbank.de/Navigation/DE/Service/Glossar/_functions/glossar.html?lv2=32056&lv3=61806
(3) The implicit assumption here is that interest rates cannot fall below zero. We are currently experiencing how this is no longer the case of major segments of the financial economy. In the real economy interest rates are so fare overwhelming not negative.
(4) Remarkably, debt defaltion depens only on the debt burden in real terms. no distinction is made betweein types of debt. the last major finacial crisis almost triggered debt delation, judging from the US real estate sectore. Here is the commonly accepted belief in "good" real estate loans and "bad" consumer loans.
(5) See e.g.: Stepehn G. Cecchetti, M. S. Mohanty, and Fabrizio Zampolli, The real effects of debt, BIS working paper number 352, September 2011; Kenneth S. Rogoff, "Public debt overhangs: Advanced economy episodes since 1800" volume 26, number 3, Journal of Economic Perspectives, Summer 2012
(6) www.mckinsey.com/insights/economic_studies/debt_and_not_much_deleveraging
