% This also gives a homeowner no equity in their home for which to obtain a home equity loan or other credit products tied to the collateral’s equity value. Debt deflation is a theory that recessions and depressions are due to the overall level of debt rising in real value because of deflation, causing people to default on their consumer loans and mortgages. "The Financial Instability Hypothesis". See more. Economists generally believe t In order to apply this to financial markets, which involve transactions across time in the form of debt – receiving money now in exchange for something in future – he made two further assumptions:[4]. Devaluation of the dollar is the third option. This page was last edited on 24 October 2020, at 02:16. In view of the Depression, he rejected equilibrium, and noted that in fact debts might not be paid, but instead defaulted on: It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will "stay put," in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave. You don’t get a reduction in your nominal debt because the value of … Ultimately, of course, but only after almost universal bankruptcy, the indebtedness must cease to grow greater and begin to grow less. debt deflation meaning: the situation in which collateral (= property that will be sold or collected to make certain a debt…. Non-recourse provisions can help a borrower in distress while full recourse provisions require them to pay additional capital to the bank if the value of their collateral does not cover its credit balance. The following decades saw occasional mention of deflationary spirals due to debt in the mainstream, notably in The Great Crash, 1929 of John Kenneth Galbraith in 1954, and the credit cycle has occasionally been cited as a leading cause of economic cycles in the post-WWII era, as in (Eckstein & Sinai 1990), but private debt remained absent from mainstream macroeconomic models. Debt deflation, which often occurs after a debt bubble has burst, happens when too much debt depresses the value of properties, goods, or services. % [1] The theory, however, has enjoyed a resurgence of interest since the 1980s, both in mainstream economics and in the heterodox school of post-Keynesian economics, and has subsequently been developed by such post-Keynesian economists as Hyman Minsky[2] and by the mainstream economist Ben Bernanke.[3]. In Fisher's formulation of debt deflation, when the debt bubble bursts the following sequence of events occurs: Assuming, accordingly, that, at some point in time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. The effect of inflation is more pronounced the higher the debt to GDP ratio is: at a 50% ratio, one year of 10% inflation reduces the ratio by approximately But, past and present U.S. authorities have failed to adequately restore the balance sheets of over-leveraged banks, firms, and households. The lack of influence of Fisher's debt-deflation in academic economics is thus described by Ben Bernanke in Bernanke (1995, p. 17): Building on both the monetary hypothesis of Milton Friedman and Anna Schwartz as well as the debt deflation hypothesis of Irving Fisher, Bernanke developed an alternative way in which the financial crisis affected output. The true definition of “deflation” is a contraction in the total supply of money and credit in an economy. Sales dry up, so profits dry up, and businesses go under. In the broad market, debt deflation generally refers to a theory that identifies total outstanding debts as a catalyst for price decreases across a country’s economy. 300 In real estate, a short sale is when a homeowner in financial distress sells their property for less than the amount due on the mortgage. A reader writes to observe that the concept of debt deflation is gradually leaking out into the mainstream discourse: I found a little snippet that NeonRevolt posted from Reddit's Wallstreetbets concerning Debt Deflation. The offers that appear in this table are from partnerships from which Investopedia receives compensation. = Innovation can cause good deflation. That should terrify us. There is then no tendency of the boat to stop tipping until it has capsized. Several studies prove that the empirical support for the validity of the debt deflation hypothesis as laid down by Fisher and Bernanke is substantial, especially against the background of the Great Depression. Declining property values can lead to underwater mortgages, even foreclosures, when debt deflation strikes the mortgage industry. The Home Affordable Refinance Program (HARP) is a mortgage refinancing program offered to borrowers who are currently underwater on their mortgages. Steve Keen (1995). An underwater mortgage is a home purchase loan with a higher principal than the free-market value of the home. China’s central bank is likely to look through the first deflation in consumer prices in over a decade, economists said, as it keeps its focus on bringing debt under control. The cumulative impact of deflation on corporate and personal finances and credit profiles could be catastrophic and long-lasting. = {\displaystyle 300\%\times 10\%=30\%,} In the context of this quote and the development of his theory and the central role it places on debt, it is of note that Fisher was personally ruined due to his having assumed debt due to his over-confidence prior to the crash, by buying stocks on margin. Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest. At the moment however, its sole use is as a host for my blog on Australia's private debt bubble. % Comments (73) Sort: Oldest. That reduces demand and slows growth. The Mechanisms of the Business Cycle in the Postwar Period", https://en.wikipedia.org/w/index.php?title=Debt_deflation&oldid=985119861, Creative Commons Attribution-ShareAlike License, Debt liquidation leads to distress selling and to, Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. Deflation expectations make consumers wait for future lower prices. By reducing household and corporate income in dollar terms, deflation would increase the real debt burden. During deflation, the unemployment rate will rise. Hoarding and slowing down still more the velocity of circulation. 73. As lower prices make it harder for businesses to pay back a record corporate debt bubble, deflation will trap the economy in a vicious cycle. This gives … Increase in the real value of debt. In a debt-deflation cycle borrowers can struggle with paying their mortgage debt and decreasing property value of the collateral used to secure their debt in a mortgage loan. That in turn leads to a credit crunch that does serious harm to the economy. Please click on the link to go there. If prices and wages are falling, then deflation causes the real value of debt to increase. It can lead to higher rates of foreclosure. Debt is an important component of an economy that can help to stimulate growth for both consumers and businesses. The theory proposes that when the level of prices across consumer goods and services continuously drops, debt levels increase, and a period of financial instability results, eventually leading to a recession. But when the deflation is severe, falling asset prices along with debtor bankruptcies lead to a decline in the nominal value of assets on bank balance sheets. When this occurs, the lendermay find it necessary to adjust the terms and provisions of the loan in order to keep his or her degree of risk within an acceptable range. This could drive the economy into a vicious cycle. As debt issuance increases, the risk for default rates are also higher. The deflation is masked by the inflationary parts of the economy, such as housing and college education, which are artificial creations and distract attention. In the Keynesian tradition, some suggest that the fall in aggregate demand caused by falling private debt can be compensated for, at least temporarily, by growth in public debt – "swap private debt for government debt", or more evocatively, a government credit bubble replacing the private credit bubble. This allows more goods and services to be bought than before with the same amount of currency. (1933) "The Debt-Deflation Theory of Great Depressions," Econometrica 1 (4): 337-57, Grant, J. × This … Deflation is when the prices of goods and services fall. In options markets, the "Greeks" refer to various measurements of how valuations move. High volumes of debt and high rates of default have a deflationary effect on a borrower’s secured mortgage collateral. Banks will react by tightening their credit conditions. In economics, deflation is a decrease in the general price level of goods and services. While this might sound like a good thing, it really isn't. 10 A similar situation could be developing now … Steve Keen's Debt Deflation Page. Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. For example, real estate and specifically property values can be highly susceptible to debt deflation, which can cause distress for mortgage borrowers. He builds on Fisher's argument that dramatic declines in the price level and nominal incomes lead to increasing real debt burdens, which in turn leads to debtor insolvency, thus leading to lowered aggregate demand and further decline in the price level, which develops into a debt deflation spiral. Deflation is worse than inflation because interest rates can only be lowered to zero. Borrowers will typically experience decreasing property values from debt deflation, which can lead to an array of other negative repercussions. media.[7][8][9][10]. , These can all be problems for a borrower with activities pertaining to their real estate collateral. This puts companies at risk because they eventually will be unable to pay their debts. Debt is an important component that can help to stimulate economic growth for both businesses and consumers. Inflation results in a wealth transfer from creditors to debtors, since creditors are not repaid as much in real terms as was expected, and on this basis this solution is criticized and politically contentious. According to Bernanke a small decline in the price level simply reallocates wealth from debtors to creditors without doing damage to the economy. Deflation is a relatively simple thing It refers to falling prices. This is the so-called "natural" way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation. % Eventually this site will support my book Finance and Economic Breakdown. Empirical support and modern mainstream interest, harv error: no target: CITEREFFisher1930 (, Pilkington, Philip (February 24, 2014). Debt deflation has been studied and developed largely in the post-Keynesian school. Steve Keen's Debtwatch. This contraction of deposits and of their velocity, precipitated by distress selling, causes, A fall in the level of prices, in other words, a swelling of the dollar. This is generally a negative end result. Bank assets fall because of the defaults and because the value of their collateral falls, leading to a surge in bank insolvencies, a reduction in lending and by extension, a reduction in spending. That means money that a borrower owes to the bank is worth more to the bank, leaving the borrower in further debt. debt deflation the reduction in aggregate demand arising from the increase in the real burden of outstanding debt caused by deflation; occurs because borrowers, whose real debt rises as a result of deflation, are likely to cut spending sharply, and lenders, whose real assets are now more valuable, are less likely to increase spending. Then comes recovery and a tendency for a new boom-depression sequence. Since price levels are decreasing, producers tend to cut their costs by laying off their employees. A 24/7 chat room where veteran traders from around the world share opportunities and actionable ideas in real time One of the biggest problems with it is that it effectively increases the cost of your debts. It often causes the loan issuer to insist on a restructure of the loan agreement. It typically occurs when property values drop. {\displaystyle 50\%\times 10\%=5\%,} In the absence of reflation, he predicted an end only after "needless and cruel bankruptcy, unemployment, and starvation",[12] followed by "a new boom-depression sequence":[13]. 42: The economic case against Bernanke, "Why You Should Love Government Deficits", Irving Fisher on Debt, Deflation, and Depression, "The Great Crash of 2008: Causes and Consequences,", https://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2009/april/yellen-minsky-meltdown-central-bankers/, "Rethinking Economics for a New Era of Financial Regulation: The Political Economy of Hyman Minsky,", http://scholar.harvard.edu/rogoff/publications, "The Macroeconomics of the Great Depression: A Comparative Approach", "The Debt-Deflation Theory of Great Depressions", "1. Debt-deflation theory has been studied since the 1930s but was largely ignored by neoclassical economists, and has only recently begun to gain popular interest, although it remains somewhat at the fringe in U.S. When asset bubbles burst, debt deflation results. Fisher viewed the solution to debt deflation as reflation – returning the price level to the level it was prior to deflation – followed by price stability, which would break the "vicious spiral" of debt deflation. If the borrower must sell they would be required to take a loss and would owe the lender more than the cost of the proceeds from a sale. The Primary Precondition of Deflation: Met Then we may deduce the following chain of consequences in nine links: Prior to his theory of debt deflation, Fisher had subscribed to the then-prevailing, and still mainstream, theory of general equilibrium. The Massive Debt Deflation Risk Murray Gunn • February 18, 2020. James Tobin cited Fisher as instrumental in his theory of economic instability. Given the perceived political difficulties in debt relief and the suggested inefficacy of alternative courses of action, proponents of debt deflation are either pessimistic about solutions, expecting extended, possibly decades-long depressions, or believe that private debt relief (and related public debt relief – de facto sovereign debt repudiation) will result from an extended period of inflation. 1-26. (2007) "Learn From the Fall of Rome, U.S. The theory of debt deflation is a macroeconomics concept pertaining to rising debt levels and their negative impact on the economy. If the dollar is devalued, then the real value of the debt declines. In other cases, they may be able to … Following Hyman Minsky, some argue that the debts assumed at the height of the bubble simply cannot be repaid – that they are based on the assumption of rising asset prices, rather than stable asset prices: the so-called "Ponzi units". In terms of foreign exchange, particularly of sovereign debt, inflation corresponds to currency devaluation. Debt deflation is a concept that pertains to the effects of debt on the price of properties, goods, and services. Deflation occurs when the inflation rate falls below 0%. Debt repayments will become a bigger percentage of income. 5 × Given the level of government debt growth required, some proponents of debt deflation such as Steve Keen are pessimistic about these Keynesian suggestions.[14]. Rates and bond yields structurally collapsed there in the 1990s, but that was also accompanied by the beginning of private sector debt deflation, a trend that existed for a couple of decades thereafter. Debt Deflation refers to the scenario where the loan collateral (or any other type of debt) sees a decrease in value. Debt deflation is a theory of economic cycles, which holds that recessions and depressions are due to the overall level of debt shrinking (deflating): the credit cycle is the cause of the economic cycle.. [6], In 2008, Deepak Lal wrote, "Bernanke has made sure that the second leg of a Fisherian debt deflation will not occur. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be, A still greater fall in the net worths of business, precipitating bankruptcies and, A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make, A reduction in output, in trade and in employment of labor. However, deflation increases the economic power of … Inflation reduces the value of currency over time, but sudden deflation increases it. Such debts cannot be repaid in a stable price environment, much less a deflationary environment, and instead must either be defaulted on, forgiven, or restructured. to 270%. Here we go again as Hyperinflationists Come Out of the Woodwork Again. The financial instability hypothesis of Hyman Minsky, developed in the 1980s, complements Fisher's theory in providing an explanation of how credit bubbles form: the financial instability hypothesis explains how bubbles form, while debt deflation explains how they burst and the resulting economic effects. Debt deflation is a concept that pertains to the effects of debt on the price of properties, goods, and services. In contrast to inflation, which is a period of rising prices, deflation is characterized as a period of falling prices. Learn more. % Consumer and producer prices generally fall during periods of deflation, but they can fall for other reasons as well, such as a production glut. 30 Debt deflation occurs when a debt bubble has burst and prices fall. Conversely, a price increase leads to an increase in the debt burden. Mathematical models of debt deflation have recently been developed by post-Keynesian economist Steve Keen. In the preface, I stated that the results "seem largely new," I spoke thus cautiously because of my unfamiliarity with the vast Debt deflation is a theory that recessions and depressions are due to the overall level of debt rising in real value because of deflation, causing people to default on their consumer loans and mortgages. Deflation makes debt payments more difficult each year since they become more expensive. Also known as collateraldeflationor worst deflation, debt deflation is a situation where the value of the asset that is used as collateral for a loan decreases in value. The theory was developed by Irving Fisher following the Wall Street Crash of 1929 and the ensuing Great Depression. to 45%, while at a 300% ratio, one year of 10% inflation reduces the ratio by approximately Indeed, some argue that this is the mechanism by which Keynesian economics actually works in a depression – "fiscal stimulus" simply meaning growth in government debt, hence boosting aggregate demand. , U.S. consumer debt hits an all-time high as it costs even less to service it. Empirical support for the Bernanke transmission mechanism in the post–World War II economic activity is weaker. Deflation has the effect of significantly reducing the debt burden. Debt deflation is a theory that recessions and depressions are due to the overall level of debt rising in real value because of deflation, causing people to default on their consumer loans and mortgages. A short refinance is the refinancing of a mortgage by a lender for a borrower currently in default on payments. 50 | Source: corlaffra/Shutterstock.com ING warns that deflation is going to strike the U.S. economy. Later commentators do not in general believe that reflation is sufficient, and primarily propose two solutions: debt relief – particularly via inflation – and fiscal stimulus. Other debt deflation theories do not assume that debts must be paid, noting the role that default, bankruptcy, and foreclosure play in modern economies. Widespread debt relief either requires government action or individual negotiations between every debtor and creditor, and is thus politically contentious or requires much labor. Deflation also makes the burden of debt heavier, as the same fixed dollar amount of a loan … Deflation definition, the act of deflating or the state of being deflated. [5], Initially Fisher's work was largely ignored, in favor of the work of Keynes.[6]. Deflation isn't necessarily positive for corporate bonds, especially those in companies that aren't blue-chip stocks. "[17] After the financial crisis of 2007-2008, Janet Yellen in her speech acknowledged Minsky's contribution to understanding how credit bubbles emerge, burst and lead to deflationary asset sales. Debt is an important component of an economy that can help to stimulate growth for both consumers and businesses. Kenneth Rogoff and Carmen Reinhart's works published since 2009[20] have addressed the causes of financial collapses both in recent modern times and throughout history, with a particular focus on the idea of debt overhangs. The mortgage market is one area highly prone to debt deflation since it encompasses a large portion of the total debt outstanding overall. These losses, bankruptcies and unemployment, lead to, pessimism and loss of confidence, which in turn lead to. If you have a debt of $1000, and the value of money increases by 5% (outright deflation), you still have to pay $1000. Deflation makes it less economical for governments, businesses, and consumers to use debt financing. Bank assets fall because of the defaults and because the value of their collateral falls, leading to a surge in bank insolvencies, a reduction in lending and by extension, a reduction in spending. A categorical method of debt relief is inflation, which reduces the real debt burden, as debts are generally nominally denominated: if wages and prices double, but debts remain the same, the debt level drops in half. THE DEBT-DEFLATION THEORY OF GREAT DEPRESSIONS BY IRVING FISHER INTRODUCTORY IN Booms and Depressions, I have developed, theoretically and sta-tistically, what may be called a debt-deflation theory of great depres-sions. Full-recourse debt grants lenders the right to tap a borrower's assets in excess of the specified secured collateral if a borrower defaults on its loan obligation. The debt deflation theory was familiar to John Maynard Keynes prior to Fisher's discussion of it, but he found it lacking in comparison to what would become his theory of liquidity preference. This amounts to a debt per citizen figure of $64,485 and a debt per taxpayer of $174,029. A full recourse provision benefits a lender in an underwater mortgage since it also gives the lender additional rights to other assets to account for the difference in property value. when inflation declines to a lower rate but is still positive. Mike "Mish" Shedlock. Minsky, Hyman (1992). A strategic default is a deliberate decision by a borrower to stop payments on a mortgage debt. ". Debt deflation is a theory based on the principle of the correlation between the debt burden and the price level in a country. It generally goes through cycles that influence the amount of debt issued and the categories of debt in high demand. Another way to think of deflation is that the real value of debt increases. He further rejected the notion that over-confidence alone, rather than the resulting debt, was a significant factor in the Depression: I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt. Deflation is distinct from disinflation, a slow-down in the inflation rate, i.e. [15], There was a renewal of interest in debt deflation in academia in the 1980s and 1990s,[16] and a further renewal of interest in debt deflation due to the financial crisis of 2007–2010 and the ensuing Great Recession. If a borrower finds themselves in an underwater mortgage in distress and nearing foreclosure then they may also have other considerations beyond just the loss of their property, specifically if their mortgage has a full-recourse provision. In an underwater mortgage, for example, the borrower’s loan balance is higher than the secured property’s value, which requires them to stay in the home until the balance can be paid down enough to match the value of the property. Warned," Financial Times (14 August), Compare: "Let us beware of this dangerous theory of, Causes of the Great Depression: Debt deflation, Keynes' Liquidity Preference Trumps Debt Deflation in 1931 and 2008, Debtwatch No. Lower collateral values, in turn, can lead to underwater mortgages, losses in property return on investment, and limits to available equity. When debt issuance reaches new peaks, it can deflate the value of real currency. Similarly invoking Minsky, in 2011 Charles J. Whalen wrote, "the global economy has recently experienced a classic Minsky crisis - one with intertwined cyclical and institutional (structural) dimensions."[19]. Consider that US federal tax revenue is $3,371,025,229 +/-, or $27,746 revenue per taxpayer – there is a significant shortfall of around $17.8 trillion. 10 % On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged. "Finance and economic breakdown: modelling Minsky’s Financial Instability Hypothesis", Fisher, I. Deflation is associated with an increase in interest rates, which will cause an increase in the real value of debt. It can have broad-ranging market and economic effects. No. [18] She described how a process of balance sheet deleveraging ensued while consumers cut back on their spending to be able to service their debt. 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