Thursday, 13 November 2008

Debt deflation

Gavin Davies has a nice summary in the Guardian of Irving Fisher's debt deflation theory. I'll edit slightly:
Deflation is defined as a pervasive decline in the general price level... When such a decline starts, three very dangerous things can happen.

First, real (inflation-adjusted) interest rates rise, and the central bank becomes powerless to prevent this, because it cannot reduce the level of nominal interest rates below zero. As the rate of deflation gets larger, the real rate of interest actually increases, and this perversely tightens the stance of monetary policy.

Second, the real level of debt in the economy also rises. Most debt is denominated in fixed nominal quantities (£100 for instance), so when the price of goods declines, more goods are needed to pay down the same quantity of debt.

Third, consumers - expecting price declines to continue - delay purchases because the real value of cash is likely to be higher in the future. This reduces demand, pushing the economy further into depression.
Monetary policy does not work in this regime: a fiscal stimulus is needed. Thus the central bank prints money (inflation not being a concern) and the government spends it on something, ideally something useful. Green Keynes anyone?

Update. Krugman has more on the same topic in the NYT here. As he says, to pull us out of this downward spiral, the federal government will have to provide economic stimulus in the form of higher spending and greater aid to those in distress.

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