Thursday, July 15, 2010

What does a debt deflation entail and are we headed for one?

The process of debt deflation goes a little something like this:
Unemployment increases this leads to a sudden drop in income and more people filing for unemployment insurance.  Suddenly people feel poorer and both home spending and consumer spending decline.  Producer Prices then fall because business are cutting back on inventories.  Furthermore, lower import prices also puts downward pressure on consumer and producer prices.  Last but not least home prices continue to fall.  Consumer prices then decrease due to lower input costs (via producer price index declines and import price declines) -  this lower price level causes the real value of the debt burden to increase.  This increased financial strain will lead to the next round of defaults and further reduction in consumer spending. This leads to more unemployment and even worse some unemployed 27 weeks or longer are no longer eligible for unemployment insurance.  This leads to a further decline in incomes leading to more cash strapped households on the brink of desperation and another round of defaults as some (newly unemployed or uninsured laborers) are unable to make their debt payments.
Debt Deflation in the Economy:

Recession Hits ----> Unemployment (Increases) + Unemployment Insurance (Increases) ---> Income (Falls) -----> Spending (Falls)([Consumer Spending (Falls) + Home Spending (Falls)] )------>  Price Level (Falls) ([ Producer Prices (Fall) + Import and Export prices (Fall) + Home Prices (Fall)]-----> Consumer Prices (Fall)] ) --> Real Debt Burden (Increases) --> Defaults (Increase) ---> Consumer Spending (Falls) --> Further Unemployment (Increases) + Unemployment Insurance (Fall)]---> Income (Falls) ----> Defaults (Increase) + Consumer Spending (Falls)---> and on and on

Lets look at the most recent evidence:

 Unemployment has increased and those receiving unemployment insurance has decreased:

This is surely to have some more effects on the already depressed consumer and home spending:

The Producer Price Index has declined as of late to reflect the sharp cut back in production from businesses reaction to the lamesauce consumer demand:

Import prices have fallen recently:

Home spending and home prices continue to be trending downward:

Price deflation leads to an increased real debt burden and as we have seen defaults continue to be on the rise.  As we have just seen some data suggest that this may be occurring and the fact that severe financial crisis do sometimes lead to debt deflation leaves me very worried.  We would be experiencing a full-blown debt deflation right now if it wasn't for two things: sticky wages and unemployment insurance.  The inflexible nature of wages allows those who do have jobs to keep spending.  This - in addition to unemployment benefits - has prevented the severity of the crises from reaching the debt deflation stage.  The governments ballooning debt has not been the work of bailouts but of unemployment insurance payments.  This has represented a massive transfer of debt from the private to the public sector and the extension of these benefits have proved undeniably important for keeping our economy afloat.

1 comment:

  1. Everyone talks about deflation like its the worst thing that can happen. Its Hyperinflation thats the worse thing that can happen.