Inflation Induced Debt Destruction: How it Works, Consequences

What Is Debt Deflation?

Debt deflation is an economic theory suggesting that a general downturn in the economy can occur when prices fall and the value of currency rises, causing a climb in the real value of debt. The theory originated with 20th century economist Irving Fisher.

The essence of debt deflation is that when prices and wages fall with the price level, but the nominal size of debts and interest payments are fixed, then borrowers face increasing pressure on their ability to repay. This in turn leads to a leap in loan defaults, which in turn can cause bank insolvencies. The commonly assumed danger of debt deflation is that it can lead to a deflationary spiral, as defaulted debts lead to write-downs by banks and other creditors, which constitute a reduction in the overall volume of money and credit in the economy, which spurs further price and debt deflation in a vicious cycle.

How Does Debt Deflation Work?

In contrast to inflation, which is a period of rising prices, deflation is characterized as a period of falling prices. As a result, money’s purchasing power rises over time. On its face, deflation benefits consumers because they can purchase more goods and services with the same nominal income over time.

Debt deflation occurs when the fall in prices increases debt-servicing pressure on businesses and consumers who have borrowed money to finance their business operations, capital purchases, homes, and personal property. In deflation, the prices that businesses are able to charge for their products fall and the market value of their assets may decrease, but the principal and interest payments on their fixed debts do not.

Similarly, workers may also see cuts to wages and hours in deflation, but the principal and interest payments of their home mortgages and other personal debts are often fixed. This creates intense pressure on the budgets of both businesses and households and increases the default rate and the number of bankruptcies and foreclosures as a result.

Consequences of Debt Deflation

Some economists and analysts feel that debt deflation represents no more than a redistribution of funds from one group (debtors) to another (creditors). “Absent implausibly large differences in marginal spending propensities among the groups…pure redistributions should have no significant macroeconomic effects,” as Ben Bernanke summarized this viewpoint in a 1995 Journal of Money, Credit and Banking article.

However, another school of economic thought sees more dire consequences to debt deflation. They argue that it raises the risk of an economy-wide downturn if it creates a positive-feedback loop in defaults through the process known as a deflationary spiral. In this case, because the liquidation of defaulting business and consumer debts involves lenders writing down loans and wiping the corresponding liabilities (bank deposits) off their books, the total volume of credit in the economy contracts. This contraction in the volume of credit in the economy then feeds back into more downward pressure on prices and wages, which puts more borrowers in distress, renewing the cycle.

The economic upshot can be a decrease in consumer and business spending, rising unemployment (as companies try to cut costs), and rising interest rates. All of these factors can lead to a nation plunging into a recession or even a depression.

Fisher’s Formulation of Debt Deflation

The economic-disaster scenario was the economic consequence of debt deflation envisioned by aforementioned economist Irving Fisher. Fisher developed the concept of debt deflation in 1933, as an explanation of the Great Depression that the United States and much of Europe were experiencing at the time.

Fisher’s theory begins with an overextension of credit in the first place, leading to a buildup of unsustainable debt in some market or several markets. This “state of over-indebtedness…will tend to lead to liquidation, through the alarm either of debtors or creditors or both,” the economist wrote. The ensuring losses, write-downs, and even defaults trigger the debt deflation in a nine-step process that goes like this:

1. Debt liquidation leads to distress selling and to
2. Contraction of deposit currency, as bank loans are paid off, and to a slowdown of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
3. A fall in the level of prices—in other words, a swelling of the dollar. Assuming, as stated above, that this fall of prices is not interfered with by reflation or otherwise, there must be
4. A still greater fall in the net worth of business, precipitating bankruptcies, and
5. A like fall in profits, which in a “capitalistic”—that is, a private-profit—society, leads the concerns that are running at a loss to make
6. A reduction in output, in trade, and in employment of labor. These losses, bankruptcies, and unemployment lead to
7. Pessimism and loss of confidence, which in turn lead to
8. Hoarding and slowing down still more the velocity of circulation. These eight changes cause
9. Complicated disturbances in the rates of interest—in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.

However, it may be possible for a negative real economic shock or a sudden increase in market pessimism to trigger debt deflation as well, even when the initial extension of debt was sound given market fundamentals at the time. 

How Debt Deflation Affects Mortgages

The mortgage market is one area highly prone to debt deflation, since it encompasses a large portion of the total debt outstanding. In a debt-deflation cycle, borrowers can struggle with paying their mortgage debt and see a decrease in the property value of the collateral used to secure their debt in a mortgage loan. 

Lower collateral values, in turn, can lead to underwater mortgages, losses in net worth, and limits to available credit. These can all be problems for a borrower with activities pertaining to their real estate collateral.

In an underwater mortgage, for example, the borrower’s loan balance is higher than the secured property’s value, which requires them to stay in the home until the balance can be paid down enough to match the value of the property. This also gives a homeowner no equity in their home for which to obtain a home equity loan or other credit products tied to the collateral’s equity value. If the borrower must sell, they would be required to take a loss and would owe the lender more than the cost of the proceeds from a sale.

If a borrower finds that their mortgage is underwater, and they are nearing foreclosure, then they also may have other considerations beyond just the loss of their property, specifically if their mortgage has a full-recourse provision. Full-recourse provisions require borrowers to pay additional capital to the bank if the value of their collateral does not cover its credit balance. A full-recourse provision benefits a lender in an underwater mortgage, since it also gives the lender additional rights to other assets to account for the difference in property value.