The Debt Deflation Theory: Why We Should Worry and What We Should Do About It

What really scares me about deflation [these days] isn’t just aggregate demand, it’s more about debt deflation because the theory, as developed by Irving Fisher, is that when debt shrinks, so does the economic cycle. Words: 453

Lorimer Wilson, editor of www.FinancialArticleSummariesToday.com, provides below further reformatted and edited excerpts from Steve Heller’s (http://blog.theprogressivetrader.com/) original article* for the sake of clarity and brevity to ensure a fast and easy read. Heller goes on to say:

Fisher set out the sequence of nine events that determine the deflation of debt levels from asset bubbles as follows:
1. Debt liquidation and distress selling.
2. Contraction of the money supply as bank loans are paid off.
3. A fall in the level of asset prices.
4. A still greater fall in the net worth of businesses, precipitating bankruptcies.
5. A fall in profits.
6. A reduction in output, in trade and in employment.
7. Pessimism and loss of confidence.
8. Hoarding of money.
9. A fall in nominal interest rates and a rise in deflation adjusted interest rates.

The above sounds a lot like of what we just went through and what I think Europe is currently heading towards. The problem is, however, that it could further deflate things here, and the dollar could be the star.

What got my attention was that palladium has been plummeting lately. It is used in auto manufacturers and aerospace, so is this the tell-tale sign that the developed economies of the world are headed towards a deflationary period?

Oil, too, has shared a similar fate. I don’t think oil goes from $85 to below $70 simply because of a strengthened dollar, on top of the most disastrous oil spill in American history. I think there is real fear out there that Europe will have another deep recession, possibly even a depression. Greece will go through one, will the rest of Europe?

It remains to be seen if we will experience a deflationary period, but if we do, obviously cash will be king. Always remember: the best have cash at tops and bottoms of markets. [Are you one of ‘the best’?]

*http://seekingalpha.com/article/206251-deflation-the-dirty-d-word?source=email

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