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Concept
Debt deflation
Summary
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. 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.
The theory was developed by Irving Fisher following the Wall Street Crash of 1929 and the ensuing Great Depression. 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. 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 and by the neo-classical mainstream economist Ben Bernanke.
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. Then we may deduce the following chain of consequences in nine links:
Debt liquidation leads to distress selling and to
Contraction of the money supply, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of the money supply and its velocity, precipitated by distress selling, causes
A fall in the level of prices, in other words, a swelling of the dollar. 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.
Official source
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