Debt deflation

Debt deflation can occur if falling prices raise the real costs of repaying loans, thereby boosting the costs of debt service and leading to higher bankruptcy rates and debt defaults. Rising debt defaults then produce increasingly weaker business conditions, further fueling the downward spiral and leading to a vicious circle that the economist Irving Fisher believed to be an important element prolonging and deepening the Great Depression of the 1930s in the United States. Fisher’s perspective represented a sharp departure fromthe earlier conventionalwisdomthat occasional deflation was a natural result of productivity gains and, as such, was to be more welcomed than feared. Such was clearly not the case with the contracting economy of the early 1930s, for which Fisher’s mechanismemphasized the link between declines in goods prices and declines in asset prices. Although economists often discount the role played by the October 1929Wall Street crash, under Fisher’s debtdeflation mechanism an event like this serves as a catalyst for defaults that could, ifwidespread enough, induce deflation in the economy as a whole.

The role of balance sheet effects is also important in fueling a debt-deflation process (Bernanke 1983). Debtors who default forfeit their assets to banks. Sudden, large drops in the prices of the forfeited assets then hurt bank balance sheets and potentially threaten the solvency of the banking sector. If banks curtail lending as a result, firms dependent on bank credit could face a credit crunch that leads to further production cutbacks and intensifies the deflationary spiral. Firms’ borrowing difficulties may be further exacerbated if declines in asset prices reduce the value of their loan collateral.

Country Experiences with Deflation

During Japan’s slide into deflation after 1989, land and equity price declines hurt firms’ loan collateral at the same time that the banks’ own direct exposure to the stock market weakened their balance sheets. Together, these factors made firms less creditworthy at the same time that banks became more reluctant to lend at all. Japan in 1989, like the United States in 1929, clearly suffered from a sudden decline in asset prices as the stock market crashed. In the U.S. case, the unprecedented debt buildup during the 1920s, coupled with a sudden shift from a stable price environment to a deflationary environment at the beginning of the 1930s, meant that firms and households may have faced an unexpected rise in their debt service costs at the very time that their ability to fund their debt diminished. The unanticipated nature of the rising real debt burden at the beginning of the 1930s would have been a key factor in the operation of a debt-deflation process during the Great Depression in the United States (Fackler and Parker 2005). The agricultural sector was especially vulnerable in the U.S. case, and as falling prices made it harder and harder for farmers to repay loans, banks dependent on farm credit suffered as well. It is much harder to make a case for the importance of the debt-deflation process outside the United States, however, given that other major economies such as the United Kingdom did not appear to face any such dramatic debt buildup during the 1920s.

In addition to the more familiar U.S. and Japanese experiences, a debt-deflation mechanism may have been at work in late 20th-century emerging market crises such as those experienced in Mexico, Russia, and Southeast Asia. Output declines can be fueled by credit constraints that limit firms’ access to working capital. These binding credit constraints in turn trigger debt deflation under this approach, leading to the dumping of assets and falling asset prices that further tighten the existing credit constraints. Once under way, deflation then lowers the marginal product of and real rates of return on factors of production. Vulnerability to this process increases with leverage, and economist Enrique Mendoza (2006) points to a surge in leverage ratios (as reflected in the ratios of debt to firm sales, book value of firmequity, andmarket value of firm equity) of listed corporations in Indonesia, Korea,Malaysia, and Thailand in the period leading up to the 1997 Asian financial crisis. As with the earlier debt-deflation literature, the unfolding of this process requires a high debt buildup. Otherwise the binding collateral constraint would not come into play.

While the actual prevalence of debt deflation remains a subject of debate among economists, almost all would consider the potential triggers, or facilitating factors, for such a process undesirable. That is, it is hard to see how sudden asset price declines, the sudden onset of deflation, or high debt levels and leverage ratios could be considered desirable policy goals.The Federal Reserve in the 1920s and theBank of Japan in the 1980s, in arguably fostering an extended period of easy credit policies followed by sudden tightening,maywell have played amajor role in producing these very conditions. The pattern of sudden collapse following an extended period of excess liquidity seems to have been repeated in Southeast Asia in the 1990s. Unfortunately, such patterns often become more obvious after the fact than they were before the declines began.

Moreover, even though sudden tightening may trigger a debt-deflation process, expansionary monetary and fiscal policy will not necessarily reverse it in the absence of expectations of recovery on the part of consumers, businesses, and banks. Consumer and business unwillingness to spend, and bank unwillingness to lend, may well become ingrained among survivors of a debt-deflation process. In the Japanese case, for example, the bad debt problems of many Japanese corporations and the risks of future loan defaults help to explain why, even with ample zerointerest- rate money available, banks remained reluctant to lend. At the same time, Japanese banks were seeking to bolster their own balance sheets, which had been hurt not only by nonperforming loans but also by the sharp drop inthemarket value of their equityholdings.The banks’ reducedwillingness to lend and to circulate the newmoney being created by the Bank of Japan meant that these funds were often simply heldwithin the banking system, thereby doing little to fuel new spending and combat ongoing deflation in the second half of the 1990s.

Prevention May Be Easier Than Cure

Debtdeflation concerns only add to the argument that the most effective way to fight deflation is to keep it from starting, or at least to keep it fromlasting long enough to become entrenched in expectations. Indeed, once consumers come to anticipate continued falls in prices, they have an incentive to postpone nonessential purchases, to save now and consume later. Anticipation of deflation also encourages people to accumulate cash balances in the hope that their purchasing power will grow over time. All this further reduces the current demand for goods and services, adding to the problems that businesses face. And, once deflation has set in, even a zero nominal interest rate policy, as the Bank of Japanmaintained for some years, cannot prevent real borrowing costs from rising in the face of further price declines. This reflects the fact that the purchasing power of the funds borrowed increases over the course of the loan, producing a gain for the lender and a loss for the borrower even if no nominal interest payment is collected. Indeed, the worse the deflation gets, the more the automatic rise in the real interest rate is likely to further curtail business spending and exacerbate the downward pressures on economic activity.

There certainly are a number of reasons for authorities in low-inflation environments to balance the risks of deflation against those of accelerating inflation. The onset of declining prices can be particularly dangerous for a highly indebted economy vulnerable to debt deflation. Sudden interruption of a long period of easy credit and rising asset prices certainly had dire consequences for the United States at the end of the 1920s and Japan at the end of the 1980s. The somewhat analogous boom-bust cycle in the emergingmarket economies of Southeast Asia in the 1990s, although it did not produce sustained deflation of goods prices, nevertheless led to an extended period of decline in both output and asset prices following the outbreak of the Asian financial crisis in 1997. See also balance sheet approach/effects; currency crisis; Federal Reserve Board; financial crisis; hot money and sudden stops; liquidity trap, the; money supply; seigniorage