Definition of debt deflation
What is debt deflation?
Debt deflation is a theory based on the principle of the correlation between the debt burden and the price level in a country. Deflation has the effect of significantly reducing the debt burden. Conversely, a price increase leads to an increase in the debt burden. This is the theory put forward by its creator Irving Fisher in 1933. In his opinion, debt deflation explains all major economic crises.
Mechanism of debt deflation
When a country has economic growth, the confidence of economic agents (households, companies, the State, etc.) is high. Households consume more and part of their consumption is financed by debt. At the corporate level, this growth drives investment financed by debt. The stronger the (GDP) growth, the more willing the agents are to go into debt.
At first, debt fuels growth, it helps to accelerate it. But in the long term, this excessive debt drives prices down and leads to deflation. Effectively, by repaying their debts, economic agents gradually lose purchasing power. Cases of over-indebtedness are more and more frequent and there is a desire to reduce debt. Household consumption ends up gradually decreasing. With lower demand for goods and services, prices fall. This is the mechanism of Fisher's debt deflation.
Debt deflation and unemployment
Debt deflation is a dangerous mechanism.
Faced with the decline in activity, companies do not react immediately. It may take several months for the productive system to adapt to the drop in demand. During this time, companies see their inventories increase. They lower their prices to sell off their stocks, which reduces their margins and therefore their profits.
If demand remains low, companies must adapt and reduce their costs. This requires a reduction in wages and numerous redundancies. Debt deflation therefore leads to an increase in unemployment.
Deflation and the debt burden
When there is deflation in a country, its currency gains value. A smaller amount of money is needed to buy goods and services, as prices are falling. From a debt perspective, deflation is beneficial for lenders and penalizing for borrowers. For borrowers, debt repayment becomes increasingly expensive, as money gains value over time. They need to pay back more than before.
For economic agents, deflation therefore has a strong impact on their debt level. This forces some agents to sell some of their assets to cover this increase in the cost of debt. The massive sale of assets lowers their prices and fuels deflation. This is an additional loss for economic agents. Deflation is self-sustaining and that is why it is very difficult to get out of it.
For Fisher, this theory of debt deflation explains all economic crises.