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The Destructive Effects of Deflation on Debt

Updated on March 16, 2011

What is Deflation?

Deflation means a general price decrease in good and services, which is the exact opposite of what happens during inflation. Its effects can be thought of as an appreciation in the value of a nation's currency.

In many ways, deflation is much more destructive than inflation. Historically most economies have alternately experienced deflation and inflation.

However inflation have been more common especially last 50 years, probably due to bias in the central bank policies.

The Possible Causes of Deflation

Here's the shortlist of the key causes of deflation:

  • Recessions effects leading to shrinking demand
  • Decrease in Money Supply and/or the Velocity of Money.
  • Higher Interest Rates that causes the Collapse of an Asset Bubble.
  • Excessive Debt leading to Collapse of Asset Bubbles.

Many of the causes of deflation are the causes of inflation in reverse. Some examples are, general slow down of the economy leading to decreasing aggregate demand. Another example is a contractionary monetary policy or structural problems in the financial system leading to slow down in the velocity of money.  

An interesting explanation based in part on the dynamic nature of the economy is Fisher's theory. It states that under a condition of excessive debt, the bursting of asset bubbles can trigger a chain of events that can cause a deflationary spiral.

List of Deflationary Effects

"The effects of deflation are:

  1. Decreasing nominal prices for goods and services
  2. Increasing real value of cash money and all monetary items
  3. Discourages bank savings and decreases investment
  4. Enriches creditors at the expenses of debtors
  5. Benefits fixed-income earners
  6. Recessions and unemployment"

Why is Deflation So Destructive?

One of the most dangerous aspects of falling prices is when lower prices lead to lower production which then leads to lower wages, and in turn lower demand which leads to further decreases in prices. This vicious cycle that feeds upon itself is what is known as the Deflationary Spiral.

There is no general consensus on whether such an out of control price spiral can occur. It is believe by some economist that such a deflationary spiral did occur during the great depression of the 1930s. 

The more immediate effect will be the increase risk of loan defaults due to increase difficulties of loan repayments.

What Happen to Your Debt during the Deflationary Cycle?

So what happens to the debt you are holding during deflation? The answer is "it depends".

The value of your money is actually increasing under this condition. In the simpler case where your debt is in your local currency than you are effectively paying more in terms of the real value of your monthly repayments.

If your debt is in foreign currencies that are experiencing inflation then you will benefit because now you'll be able to use your stronger local currency to pay these foreign dollars denominated debt.

Wages will usually be falling in a deflationary cycle. This will unfortunately shrink your disposable , forcing you to repay your debts with a larger portion of your income. Decreasing asset values, might also lead to the force liquidations of asset back loans. Which can in turn downward spirals of asset prices. This also lead to wealth destruction for people which are asset rich.

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