The Definition of Debt Deflation

Debt deflation seems like a dense term you might hear in your Economics 101 class, something that you must study but has no relevance in real life. However, debt deflation can have serious consequences on your investments and has real relevance both in history and in modern everyday life.

Definition

Debt deflation, according to the Contrary Investing Report, occurs when there is an abundance of outstanding debt that goes unpaid. Values of that debt plummet and, if you are still paying down that debt, you are left with an asset that is worth less than what you are paying down.

Concerns

Both lenders and borrowers alike worry about debt deflation since deflating values can lessen an investment. One of the greatest examples of debt deflation occurred during the Great Depression and one of the era's premier thinkers, professor Irving Fisher of Yale, explained how debt depression was responsible for much of the financial woes. Fisher explained how debt deflation leads to financial stressors such as "debt liquidation," "fall in the level of prices" and, worse still, the loss of value (both personal and in business) as well as a loss of net profits. You might think the lowering of prices might be a good thing, but, if you own property, real estate or assets depending on a strong market, deflation could ruin the value of your business or personal assets.

Japan's Debt Deflation

Japan is a prime example of a nation crippled by debt deflation. According to the Research Institute of Economy, Trade, and Industry, as late as 2002, Japan was struggling with the effects of debt deflation. Debt deflation hit the nation's banks and businesses hard, forcing companies and institutions to sell assets at a loss, forcing down profits, wages and salaries. Banks were left with excessive debt and the call was for the Bank of Japan to provide relief measures by not only relieving debt but allowing for a free flow of funding. As of 2010, the debt problem still had not been solved, with the BBC reporting that Japan's gross national debt is approaching 200 percent of its economic output, with hopes of recovery resting on new industries and changing demographics.

U.S. Housing Market

The U.S. housing market also shows signs of bearing debt deflation. In 2011, according to the Home Buying Institute, home prices are predicted to fall 6 percent to 9 percent, and foreclosures increasing by 20 percent. As home values fall, lenders and mortgage holders alike are exposed to risk, from defaults for the lenders and for owing more than the home is worth for homeowners. Debt deflation in the housing market is a particularly toxic mix since much of a consumer's wealth and spending power is tied to their home value. The fall of that value, and wealth, can drag other areas of the economy down as well, leading to more deflation and loss of profit.