Tuesday, 9 September 2008

A quick hat tip to the importance of debt deflation

Sadly I don't have time to address this properly, but I do want to make a quick connection between Ben Bernanke's favourite theory of the Great Depression - Irving Fisher's idea of debt deflation - and the current situation. Krugman is insightful here:
when highly indebted individuals and businesses get into financial trouble, they usually sell assets and use the proceeds to pay down their debt. What Fisher pointed out, however, was that such selloffs are self-defeating when everyone does it: if everyone tries to sell assets at the same time, the resulting plunge in market prices undermines debtors’ financial positions faster than debt can be paid off. So deflation in asset prices can turn into a vicious circle. And one consequence of what he called a “stampede to liquidate” is a severe economic slump.

That’s what’s happening now, with debt deflation made especially ugly by the fact that key financial players are highly leveraged — their assets were mainly bought with borrowed money.
For more historical context and comment, see The London Banker.



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