Debt deflation

Date posted: May 15, 2013

Like most disciplines, economics has its own vocabulary, and over the years you’ve taught your listeners many of the terms.  But today you have a new one, debt deflation.  Should we be scared of this term or elated? N.C. State University economist Mike Walden answers.

You should be scared.  This refers to a situation where if you are a debtor and you have debt  normally what happens is that you pay back that debt in terms of a certain fixed amount of dollars – say, per month or per year.  For example, if you have a home mortgage and it’s for $600 a month, you’re going to pay back $600 a month to the bank — to the lender — as long as you have that mortgage.

Now, actually in this case inflation is the debtor’s friend, because as inflation rises, dollars are worth less.  So, if you’re a debtor and you’re paying back a fixed amount of dollars and you have inflation, those dollars in the future are worth less in purchasing power.  So, you actually win from that deal.

However, if we have deflation, which means that prices are going down and the value of each dollar is going up, that means exactly the opposite.  The dollars you are paying back in the future are actually worth more.  And debt deflation — which is the term for this whole process — is something that economists and particularly central bankers like our central bankers at the Federal Reserve worry a lot about, because if you have debt deflation that means that people who have debt, which is virtually all of us, are finding that the cost of that debt is going up over time.

So we’re going to have to cut back on our spending of goods and services, and that can propel the economy into a deep recession if not depression like we had in the 1930s. So this is one of the reasons I think it might be a little easier to understand what our Federal Reserve has been doing in terms of printing more money and actually trying to generate some inflation because they have been very worried about debt deflation occurring and hurting virtually everyone.

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