The debt deflation debate

In the recent public debate on problems of the world economy, ‘deflation’, or more specifically ‘debt deflation’, has again become an important topic. The possible role of debt deflation in triggering the Great Depression of the 1930s has come back into academic studies as well as into the writings of economic and financial journalists. It has been observed that there are similarities between recent global trends and the 1930s, namely the joint occurrence of high levels of debt and falling prices, the dangerous downside of cheaper cars and TVs when debt is high. Debt deflation thus concerns the interaction of high nominal debt of firms, households and countries and shrinking economic activity due to falling output prices and increasing real debt.

There is often another mechanism accompanying the one just mentioned. That other mechanism involves how large debt may exert an impact on macroeconomic activity and works through the asset market. Asset price inflation during economic expansions normally gives rise to generous credit expansion and lending booms. Assets with inflated prices serve as collateral for borrowing by firms, households or countries. In contrast when asset prices fall the borrowing capacity of economic agents shrinks, financial failures may set in, macroeconomic activity decreases and consequently large output losses may occur.

Countries that have gone through such booms and busts are some Asian countries (in particular Japan), Russia and Brazil in 1998 and 1999.