What Is Debt Deflation and How Does It Affect the Economy?

The theory of debt deflation is a macroeconomics concept pertaining to rising debt levels and their negative impact on the economy. The theory proposes that when the level of prices across consumer goods and services continuously drops, debt levels increase, and a period of financial instability results, eventually leading to a recession.

Debt deflation can occur when any of a number of economic factors leads to a lack of growth and loss of confidence in financial markets:

• Oversupply of goods and services: Supply typically rises to meet demand, and eventually, supply can rise so much it begins to outweigh demand. Businesses respond by lowering the prices of their goods in order to entice more buyers, but with more goods in circulation, the value of those goods as a whole declines. Knowing that prices will only continue to drop, consumers hold onto their money. Without stimulation from consumers, economic activity slows, contributing to debt deflation and leading to a loss of confidence in the market.
• Overinflation of assets: When the Federal Reserve, the central bank of the United States, lowers interest rates, it encourages borrowing (via bank loans and credit) and investment. Consumers will respond by taking on debt to purchase valuable assets at affordable rates, as they did during the 2008 real estate bubble. At the time, housing was overvalued, leading consumers to believe purchasing property was a safe, long-term investment. When the mortgage market eventually reverted back to standard interest rates, a large number of homeowners were unable to pay back creditors. Foreclosures, defaults, and bankruptcy pushed real estate values into a greater fall, causing consumers to panic and sell their properties at a loss (known as distress selling) in an effort to recoup as much of their investment as possible.
• Increase in productivity: Advancements in technology have made it easier than ever for businesses to become production machines. When a company becomes more efficient in their business, it lessens the cost of production, which in turn allows it to lower prices on goods. However, low prices for too long can lead to stagnancy and a slowing of the economy.

The effects of debt deflation are cyclical, feeding into itself and making it difficult to break the spiral the longer it continues. There are a number of things that can happen when an economy experiences debt deflation:

• Decreased spending: With a reduction in the velocity of circulation, money supply tightens. This increases the value of the dollar, but it also increases the real value of debt. Consumers, now faced with the dual problem of expecting greater gains from future spending, while also dealing with a greater debt in real terms, begin money hoarding and reduce their spending. This fear and lack of confidence among consumers can further slow growth and worsen deflation as the fall of prices continues.
• Rising unemployment: During deflation, businesses will cut costs to mitigate debt and often lay off staff and decrease wages. Some companies go out of business completely. These changes make employment more scarce, which means fewer people will be in the workforce earning income. During this time, those struggling to stay afloat financially may default on their debts—like credit cards or mortgages—which sends a negative ripple effect through the economy. Learn more about unemployment here.
• Rising interest rates: An increase in interest rates makes it harder for consumers to pay off their principal. Deflation reduces the value of collateral held by financial institutions, which raises the real cost of borrowing. Higher interest rates mean the amount a debtor pays back will be larger than the amount borrowed. Consumers work harder and pay more out of pocket to ease their debt, leaving them with less income. Many consumers will look to refinance their debt rather than attempt to pay it off, and fewer consumers will be inclined to borrow.
• Recession and depression: Eventually, an economy can become so inundated with over-indebtedness that economic growth slows to a near halt, leading to a financial crisis. If this recession continues long enough, it eventually turns into a depression, much like the one the United States experienced during the 1930s.

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