Debt Deflation

What Is Debt Deflation?

Debt deflation is an economic theory that a general downturn in the economy can occur due to a rise in loan defaults and bank insolvencies because of a rise in the real value of debt when the value of the currency unit rises and the price level falls. This 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 what they have borrowed. The commonly assumed danger of debt deflation is that it can lead to a deflationary spiral, as defaulted debts lead to writedowns by banks and other creditors, which constitute a reduction in the overall volume of money and credit in the economy, which spurs further price deflation leading to even more debt deflation in a vicious cycle.

Understanding Debt Deflation

In contrast to inflation, which is a period of rising prices, deflation is characterized as a period of falling prices. 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. 

This 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.

Indeed, Fisher’s theory begins with an overextension of credit in the first place, leading to a build up of unsustainable debt in some market or markets. The losses and write-downs that result when the unsustainable debts default, trigger the initial process of debt deflation in this theory. However, it may be possible for a negative real economic shock or a sudden increase in market pessimism to trigger such a process debt deflation as well, even when the initial extension of debt was sound given market fundamentals at the time. 

Example of Debt Deflation

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

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 themselves in an underwater mortgage in distress and nearing foreclosure then they may also have other considerations beyond just the loss of their property, specifically if their mortgage has a full-recourse provision. Non-recourse provisions can help a borrower in distress while full recourse provisions require them 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.