Debt deflation
Debt deflation is a theory that recessions and depressions are due to the overall level of debt rising in real value because of deflation, causing people to default on their consumer loans and mortgages. Bank assets fall because of the defaults and because the value of their collateral falls, leading to a surge in bank insolvencies, a reduction in lending and by extension, a reduction in spending.
The theory was developed by Irving Fisher following the Wall Street Crash of 1929 and the ensuing Great Depression. The debt deflation theory was familiar to John Maynard Keynes prior to Fisher's discussion of it, but he found it lacking in comparison to what would become his theory of liquidity preference.[1] The theory, however, has enjoyed a resurgence of interest since the 1980s, both in mainstream economics and in the heterodox school of post-Keynesian economics, and has subsequently been developed by such post-Keynesian economists as Hyman Minsky[2] and by the neo-classical mainstream economist Ben Bernanke.[3]
Post-Keynesian interpretation[edit]
Debt deflation has been studied and developed largely in the post-Keynesian school.
The financial instability hypothesis of Hyman Minsky, developed in the 1980s, complements Fisher's theory in providing an explanation of how credit bubbles form: the financial instability hypothesis explains how bubbles form, while debt deflation explains how they burst and the resulting economic effects. Mathematical models of debt deflation have recently been developed by post-Keynesian economist Steve Keen.