Debt Deflation

The workshop in our opening tries to survive by selling a machine. If many indebted businesses sell at once, buyers may offer less. Lower prices shrink assets net of debts, while weaker sales make repayments harder. Businesses then cut production and jobs, potentially weakening other people’s incomes. Economist Irving Fisher explored this mechanism in 1933 while studying the Great Depression. Events need not follow a set order: changes in prices, incomes and debt feed back into one another. The theory explains a possible connection; it does not predict the date of the next crisis. [1]

Take our own simplified calculation, leaving interest aside. We track principal, the loan amount still owed. A debt of 100 and a price index of 100 give D/P = 1. D means the debt in money, P the price level. The borrower repays 10, leaving 90, but the price index meanwhile falls to 80. That gives 90/80 = 1.125: debt relative to the price level is 12.5 % higher than initially. Yet contractual principal has fallen to 90; the lender has added nothing to the agreement. Each currency unit now buys more goods: its Purchasing Power has risen. How difficult repayment becomes also depends on the borrower’s income. A price index alone cannot describe their budget. [1]

When taking out a loan, people have expectations about incomes and prices. The Bank of England, the UK’s central bank, explains that unexpectedly lower inflation can change the real burden of an existing debt in the creditor’s favour. Disinflation means slower price increases; negative inflation is not required for this effect. Prices may still rise, just less than the contracting parties expected. A fixed interest rate stays unchanged for the agreed period; with a floating rate, the way the rate adjusts matters. The consumption effect therefore differs between households. We need to know the contract, expectations when it was signed and what actually happened to incomes. [2]

Collateral is property securing a loan. In our example it is worth 100 against a debt of 60. LTV, the loan-to-value ratio, is 60 %; subtracting debt leaves equity of 40. When the property falls to 75, debt stays unchanged, but LTV rises to 80 % and equity falls to 15. That is a loss of 62.5 % of the original equity. A falling house price does not tell us how much food or services have become cheaper. Whether additional collateral or a sale is required depends on the contract and ability to repay. A lower valuation alone does not trigger immediate eviction or sale under every loan. [2]

Selling a machine and repaying bank-loan principal are different events. Not every payment destroys money: a buyer may simply transfer a deposit to the seller, provided both are non-bank holders within the same monetary aggregate, a defined grouping of money. But if the seller uses the deposit to repay bank-loan principal, both deposit and loan shrink. Bank of England explains this destruction of deposit money. New bank loans, conversely, create deposits. Widespread repayment can therefore reinforce Monetary Deflation, a decline in the measured quantity of money, unless other money creation offsets it. The net result matters, not an isolated repayment. [3]

A 2015 study by the Bank for International Settlements, BIS, compared more than 140 years across up to 38 economies. In its data, the association between falling goods and services prices and weaker economic growth was relatively weak; the Great Depression played a substantial role. The authors found a stronger association with weaker growth when falling property prices coincided with high private debt. This is a historical finding with data limitations, not proof that a debt spiral cannot occur. Cheaper production through better methods and asset sales caused by a cash shortage can look similar on a price chart while leaving people in very different situations. [4]

Every sale has a buyer on the other side. In a model published by BIS in 2005, economist Goetz von Peter shows how buyers without prior debts or losses can cushion falling asset prices. In the model, they can borrow to buy because they expect prices to recover. If everyone wants to reduce debt, or banks stop providing the necessary finance, that stabilising effect weakens and the process can become unstable. This is the result of a particular model, not a guarantee that every market quickly recovers by itself. We need to ask not only who must sell, but also who can still buy and how they will pay. [5]

The creation of new bitcoin units (BTC) is limited. Its market price still changes with supply and demand, as the educational website Bitcoin.org explains. Consider our own model: collateral of 1 BTC is worth 100 000 and a loan is 50 000 in the same fiat currency, meaning a conventional government-issued currency such as the dollar or euro. LTV is 50 %. If BTC falls to 60 000, LTV rises to approximately 83.33 %, although the pledged quantity stays unchanged. This is not a current exchange rate. The loan’s terms may require more collateral or a forced sale. The limit on bitcoin supply neither cancels debt nor makes a repayment. Understanding the debt currency, forced-sale threshold and available repayment funds matters alongside any long-term view of Bitcoin. [6]