The Debt-Deflation Conundrum
With asset values dropping, consumers who felt stable financially a few years ago are now facing a new reality. The unemployment rate is almost 10%, the underemployment rate around 18%- job insecurity is the new current norm. With a fall in the value of assets and less job security, consumers are realizing that too much debt is not a good thing- and are working on getting out of debt.
The most valuable asset for many consumers is their home, and many consumers feel like they can no longer afford to keep their current home and are downsizing. While it’s a good idea to tighten the belt buckle, what happens when everyone does this at the same time? Prices decline even faster.
Imagine a community with 100 homes, each that sold for $250,000. A homeowner in the community decides to put their home on the market, and is the only home for sale in the community. A buyer who wants to live in the community will pay the lowest price that the seller will accept. However, if there are two homes in the development for sale, then buyers have more options and can negotiate the prices of each further down. What if there are 20 homes for sale? This will precipitate a much larger drop in prices.
Consumers are trying to get out of debt. This is a responsible way of thinking, but not if everyone does this at once. From the New York Times on 9/25/2010:
“We see deleveraging of the consumer,” said Jerry Dubrowski, a spokesman for Bank of America, adding that a frugal consumer, decreasing demand for credit and declining balances were also factors. “As they work the balances down, they are not replenishing that with new debt,” he added.
However, as we saw from the above housing example, everyone trying to get out of debt at once causes bad things for the economy. Here’s an example of what could happen:
- Distress selling as consumers try to sell assets for whatever price they can get for them. This lowers the prices of assets even further which leads to:
- A general lowering of prices
- Still greater fall in net worth of companies leading to bankruptcies.
- Which leads to a fall in consumer confidence
- Which leads to more unemployment and more consumers needing to deleverage.
- And back to Step 1, until we are in a deflationary cycle.
Sound scary? The above cycle is based on Irving Fisher’s Theory of Debt Deflation. Irving Fisher was an economist during the Great Depression who then studied the causes of the Depression. He found that consumer de-leveraging was a major cause (as the above cycle explains)
The way we get out of this cycle is through Quantitative easing: increasing the supply of money. This can be done through lowering short term interest rates, but at 0-.25% the fed has lowered short term interest rates as much as they can. The fed can also lower long term interest rates by buying 30 year government treasuries, which they have said they will do if economic growth continues to disappoint.
Even if we avoid deflation, if we have years of high inflation, the recovery will likely be prolonged, and painful.
