Deflation

Falling prices sound good to consumers struggling to buy groceries or gas, but the work of Yale University economist Irving Fisher, whose theories were formed during the Great Depression, shows the negative effects of deflation.But broadly falling prices would be bad news for a country up to its ears in debt. Consumers and businesses have to pay back debt with money that is worth less than the original credit, essentially increasing the debt.
He outlines the problems of over-consumption, over-spending and over-indebtedness, and what their effects can be. He might as well be talking about the recent housing bubble when he writes: “Easy money is the great cause of over-borrowing. When an investor thinks he can make over 100% per annum by borrowing at 6%, he will be tempted to borrow, and to invest or speculate with the borrowed money. This was a prime cause leading to the over-indebtedness of 1929. Inventions and technological improvements created wonderful investment opportunities, and so caused big debts… The public psychology of going into debt for gain passes through several more or less distinct phases: (a) the lure of big prospective dividends or gains in income in the remote future; (b) the hope of selling at a profit, and realizing a capital gain in the immediate future; (c) the vogue of reckless promotions, taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud, imposing on a public which had grown credulous and gullible”

Irving points to a chain of nine events that can be triggered by too much debt.

“Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation.

“The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.”