Ann Pettifor

A debt-deflationary spiral

Ann Pettifor: 28th February 2009

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…..


4 thoughts on “A debt-deflationary spiral”

  1. “consumers have to be persuaded to spend and not hoard their precious savings…”

    What savings? From the point of view of a well informed

    non expert it seems that its not a matter of confidence that is keeping most people from spending. They simply cannot take on more debt and they

    don’t have any real savings.

    I don’t understand why I don’t hear anything about the demand side of the credit crunch. Perhaps I’m just

    missing discussions of it. No matter how healthy our banks are the borrowing rate is not going to go back to where it was anytime soon. People

    were living unsustainably relative to their income and now realize they shouldn’t/can’t do that. Not only was what they were doing before

    unsustainable but they can’t go back to a reasonably healthy borrowing rate until they are able to get rid of the debt they already have. As far

    as I can tell the really serious liquidity crisis is in the finances of individual households and businesses. People consider themselves lucky if

    they can afford necessities and loan payments on a monthly basis. Consumers and businesses cannot and will not be a serious part of the solution

    to the debt deflationary spiral unless their debts evaporate or their incomes soar. At least thats how it looks from my vantage point.

  2. Very interesting stuff Ann. What is the solution? Stephen Zarlenga gives a great account of

    deflationary crises in the 19th century in chapter 18 of his book “The Lost Science of Money”.

    Echoing your observations, he explains that

    delationary episodes across Europe, the US and Japan were “opportunities for bankers to reduce the money supply and increase the value of the

    nation’s currency units which were owed to them”.

    I can’t help noticing that any mention of increasing the money supply is met by cries of

    anquish, immediately inviting comparison with the hyper-inflationary events in Zimbabwe/ post-war Germany, etc. As if bank-created credit is less

    inflationay than government-created money!

  3. “creditors or moneylenders or bankers hate inflation … Creditors love deflation”

    It’s important to distinguish between

    expected and unexpected changes in price level. If everyone knows that $100 today is worth the same in terms of actual goods as $110 next year,

    then the interest rates on loans will reflect that by being about ten percentage points above the real rate people are willing to pay to borrow.

    So neither lenders nor borrowers would care about perfectly-anticipated inflation, at least as lenders and borrowers. Everyone benefits

    (albeit unequally) when the economy works well. Conventional wisdom says that’s when inflation is moderately low and more or less constant.


  4. “As loans are paid off there is a contraction of deposits in banks – which slows down the velocity of the circulation of money.”

    ??? All other things equal, surely it would increase it (measured as so many times).

Leave a Comment

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.