Debt deflation theory is the idea that deflation causes recession because it makes debt servicing expensive, leading to default, a liquidity crisis, and money supply destruction. This in turn leads to a collapse of consumer spending, and widespread recession and unemployment.
Debt deflation occurs when, for whatever reason, an over-indebted economy enters a recession severe enough to cause:
This is the 9-point process described by Irving Fisher, but he did not intend it to be an exhaustive list, nor is the order of these points fixed. Fisher, in fact, was open and honest about the incomplete nature of his work.
Another point to note is that the process described assumes that the government lies idle (or is unable) to reflate the economy via expansive monetary and fiscal policy.
Nevertheless, debt deflation theory has been gaining popularity in recent years.
Debt Deflation Theory was, until after the 2008 financial crisis, one of the lesser known theories about the root causes of economic recessions, but it seems quite appropriate for analyzing the aftermath of the 2008 financial crisis and for making predictions about the coming crisis in the 2020s.
The theory was developed by Irving Fisher in his book 'The Debt Deflation Theory of Great Depressions' as a way of explaining the great depression of the 1930s (much of modern economic theory has its roots in the great depression).
The central idea is that an increase in the cost of repaying loans occurs in a deflationary period because loans are fixed in terms of the amount borrowed, but the underlying assets that were purchased with those loans do fall in value as the general level of prices falls. This then causes people to renege on their obligations to repay those loans, and that leads to a fall in asset values for the banking system.
With regard to the 2008 financial crisis, that would mean that significant numbers of bank customers (who took out large mortgages to buy real estate prior to 2008) defaulted on their mortgages either because it became cheaper to allow the bank to foreclose, or because their mortgage repayments simply became unaffordable.
This is precisely the problem that the banks had with their deflated assets (mortgage backed securities), and their scramble to get rid of those assets only caused further asset depreciation, which made the problem even worse.
When the music stopped, many financial institutions were left holding so many parcels of garbage assets that they were effectively insolvent. Their customers, sensing danger, started withdrawing what money they could until these institutions ran out of cash. The financial institutions then had to run to the Federal Reserve for emergency bailout money. Had the Fed refused there would have been widespread chaos because one bank after another would have collapsed, causing widespread destruction of the money supply in the process.
As it was, Lehman Brothers in the US and Northern Rock in the UK were the two most notable financial institutions to collapse, but many more were seriously affected and were only able to survive because of the quantitative easing bailout money.
Had the Fed not intervened, something akin to the Great Depression of the 1930s would have unfolded, when around 30% of the money supply in the US was destroyed, leading to a collapse of consumer spending and unemployment that peaked at almost 25%.
A common argument against debt deflation theory is that debt default should not make that big an economic impact on the aggregate level, because it merely transfers wealth from one person to another. In other words, a debtor gains from default in a way that offsets the creditor's loss.
This is a silly argument, because any gains that the non-banking sector receive from defaulting on loans will cannot mitigate the losses suffered by the banking sector in terms of credit creation via the money multiplier.
The debt deflation cycle described by Fisher dates back to 1933, a time before Keynes contributed his 'General Theory', and many mainstream economists regard Keynes' work as superseding that of Fisher.
For one thing, Debt Deflation Theory has little to say about how an economy can become over-indebted in the first place, or when a recession will occur that is deep enough to generate deflation. Keynes' liquidity preference theory does a better job of at least attempting to explain where the demand for money (and loans) comes from.
What debt deflation theory does do is simply state that over-indebtedness combined with deflation are the two most common precursors to a great depression.
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