“Assessment code:
ECN109-5
Registration no:
200136710
Title:
Explain why Irving Fisher’s debt deflation theory is still relevant today.
Word count:
360
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Debt deflation is where the prices of good in a market decreases due to the large amount
of outstanding debt and people liquidating assets to try and reduce what they owe. Fisher
believed that in order to help borrowers, inflation was needed as it weakened the real
value of what they owed and passed on some of the cost to the lenders.
Part of Fisher’s debt deflation theory that is still relevant today is in the mortgage market. If
a buyer is struggling to pay off their debt amongst debt deflation, the collateral (usually the
house) that they are backing their loan with will begin to decrease in value making it harder
to pay back the original sum. Bonds are bought by private real estate companies and
when a percentage of these mortgages go unpaid, buying the bond becomes a debt to
companies meaning they will not lend as there is not enough return. In 2008 this was due
to lax lending standards of the ‘real estate bubble’ as people who were not able to pay
back loans were granted mortgages.
Fisher’s theory of debt deflation also suggests that one individual trying to reduce his debt
will often work however if there are many trying to do this it will cause deflation as the
supply to the market will increase which brings the overall price down. This technically
increases the real value of debt as the cost of borrowing is calculated by the nominal
interest rate minus the inflation rate, so when there is deflation the cost is actually
increasing. This is relevant to the current economic climate as a lot of people may have
taken out loans or mortgage their house due to the coronavirus pandemic meaning there is
a large amount of the population in debt. The government could rectify this by using
monetary policy to manipulate the interest rates as when they are low inflation increases.
According to the Phillips curve, low unemployment causes
increase to the inflation rate. The furlough scheme currently being
used to keep people employed could also help keep inflation
rates higher to help reduce the real value of debt to the borrower.
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