Debt Deflation And Its Economic Impacts

Inflation can be a detriment to your bottom line, because prices can rise so fast that it makes the money currently in your possession worth less relative to when you earned it. Falling prices, on the other hand, may sound like a real win for the consumer, but they can also pose their own set of problems. The one some economists are most scared of is debt deflation.

What Is Debt Deflation?

Debt deflation is the idea that a decline in wages, asset worth and prices of consumer goods can make it harder for borrowers to pay off their debts, potentially leading to an economic recession. In 1933 during the Great Depression, American economist Irving Fisher introduced this basic concept with what’s known as the Debt-Deflation Theory of Great Depressions.

In theory, debt deflation says that as prices fall, businesses may actually cut wages with the rationale that employees don’t need as much money to afford the same lifestyle. When this happens, consumers reduce spending, which can lead to further deflation as businesses lower prices to try and find a new demand equilibrium.

As lower prices erode profit margins, companies may lay off workers to save money. Because these newly unemployed workers need to save the money they have, they spend less and further deflation occurs. Meanwhile, banks hesitate to lend except at very high interest rates because a deflationary cycle makes the dollar more valuable as currency becomes scarce.

How Does Debt Deflation Work?

Inflation refers to an environment of rising prices. By contrast, deflation refers to falling prices. If the price of a basket of goods and services goes up by 3% over the course of a year, we say that the rate of annual inflation is 3%. If prices go down by 3%, that’s a 3% deflation rate.

Debt deflation occurs when prices have fallen to the point where the asset securing a debt you took on ends up being worth less than the balance of the debt.

The real estate industry is prone to debt deflation because the market is so interest rate sensitive. It’s also an asset where a significant portion of people getting mortgages rely on the sale of the home to eventually pay off the loan.

Let’s look at a practical example of how this might happen. You bought a house when interest rates were around 4% with a $260,000 loan amount. Interest rates then went up to about 7%. Because higher interest rates mean less buying power, assuming wages stay the same, the value of the home when you go to sell is around $230,000. The cost of the mortgage is too high relative to the value of the asset, and there’s a higher default risk.

When Does Debt Deflation Happen?

In order for debt deflation to happen, prices have to fall significantly enough that the market changes for the types of assets people often take on debt to afford.

An example of this happening would be the last U.S. financial crisis. When interest rates started to rise and people were less likely to qualify to refinance adjustable-rate mortgages, foreclosures went up and many houses hit the market.

But the sudden increase in supply also devalued the homes of those who could still pay their mortgages, sometimes dropping the value of the home below the balance of the debt for many and making the cost of that debt relative to values untenable for many Americans. The Home Affordable Refinance Program (HARP) was created to provide some relief.

5 Possible Effects Of Debt Deflation

The effects of debt deflation look different depending on where you’re standing. For some, debt deflation can cause trouble for your budget. For others, they see it as more of a movement of value across the economy rather than a net negative. For them, money isn’t necessarily taken out of the economy, but rather transferred from consumers to lenders and creditors.

1. Reduced Spending

In a debt deflation scenario, one of the things you’re likely to see is that people reduce their spending because money is more valuable in the bank. More of what they spend goes toward paying off debt because the payment on the mortgage or car doesn’t get lower even if you’re making less. This could lead to further deflation as businesses look for demand.

Even if wages remain relatively stable, you’re less likely to spend money today if you think the price is going to go down tomorrow. That has downstream impacts on employment.

2. Higher Interest Rates

Debt deflation can result from deflation in general and deflation can be the result of efforts to curb inflation that have gone a bit too far. When central banks around the world try to get inflation under control, they do so by curbing the money supply. This is done by raising interest rates to encourage people to keep money in the bank. So, debt deflation and high interest rates often go together.

3. Rising Unemployment Levels

When the value of assets falls and it’s more expensive to service the debt associated with those assets, businesses will look for other places to save money. One of the places that often takes a hit is employment and payroll. When people no longer have jobs, that has a major dampening effect on spending. Prices may fall further as a result and the spiral starts.

4. Defaulting On Debts

If reduced spending across the economy has led to the loss of your job, you may have a hard time making payments on things like mortgages and credit cards. Moreover, if your property value has fallen significantly, you may not be able to refinance to try to make the debt more affordable.

These conditions may lead people to default in the face of significant financial trouble.

5. Recession Or Depression

If there’s a long period of debt deflation, it could lead to a recession or even an economic depression. If people are defaulting on debts and there’s rising unemployment, lenders would likely tighten the purse strings, potentially making it harder for everyone to qualify for loans. If money and investment become too scarce, that could cause a significant downturn.

However, it’s worth noting that while debt deflation is often a result of a recession or depression, it’s not necessarily a cause. Just because some debt deflation is happening doesn’t mean either a recession or depression will follow.

Debt Deflation FAQs

Now that we’ve touched on debt deflation and the factors that can lead to it, let’s touch on a few more questions you might have.

Is deflation worse than inflation?

It’s really two sides of the same coin, but if you have to pick one, it might be a good idea to pick inflation. The Federal Reserve ideally wants inflation to rise at 2% annually because it encourages people to buy now and keep the economy going without prices getting out of control.

How does deflation affect debt?

Deflation makes debt less manageable because the price of the underlying asset goes down. If you’ve taken on debt, often at a fixed rate, for an asset that’s no longer holding its value, you are feeling the impact of deflation on your debt.

Is debt deflation the same as inflation-induced debt destruction?

Debt deflation is the idea that assets lose value while you pay the same fixed rate on the initial balance. On the other hand, inflation-induced debt destruction says that if both your asset value and wages continue to rise with inflation and you pay the same fixed rate on the same amount of money, the loan gets more affordable over time.

What is the Debt-Deflation Theory of Great Depressions?

In explaining his debt-deflation theory, Irving Fisher said in 1933 that the combination of lower wages as well as falling prices for major assets and consumer goods could make it burdensome for people to pay off their debts. In turn, this could cause defaults and a major tightening of the financial system, potentially leading to an economic recession or depression.

The Bottom Line

Debt deflation occurs when the value of having a debt is dragged down by a decline in the value of the underlying asset, such as a home or car. Debt deflation is often a side effect of overall price deflation within the economy. Debt deflation itself can lead to issues as minor as reduced discretionary spending or as serious as rising unemployment, recession or depression.

While you can be aware of it, an issue like debt deflation is beyond the control of any individual. The best we can hope for is to keep ourselves in the best financial shape possible. Download the Rocket Money^SM app to track your budget and spending.