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Debt deflation
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:
— (Fisher 1933)
Prior to his theory of debt deflation, Fisher had subscribed to the then-prevailing, and still mainstream, theory of general equilibrium. In order to apply this to financial markets, which involve transactions across time in the form of debt – receiving money now in exchange for something in future – he made two further assumptions:
In view of the Depression, he rejected equilibrium, and noted that in fact debts might not be paid, but instead defaulted on:
It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will "stay put," in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.
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Debt deflation
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:
— (Fisher 1933)
Prior to his theory of debt deflation, Fisher had subscribed to the then-prevailing, and still mainstream, theory of general equilibrium. In order to apply this to financial markets, which involve transactions across time in the form of debt – receiving money now in exchange for something in future – he made two further assumptions:
In view of the Depression, he rejected equilibrium, and noted that in fact debts might not be paid, but instead defaulted on:
It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will "stay put," in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.