Debt deflation

[6] The following decades saw occasional mention of deflationary spirals due to debt in the mainstream, notably in The Great Crash, 1929 of John Kenneth Galbraith in 1954, and the credit cycle has occasionally been cited as a leading cause of economic cycles in the post-WWII era, as in (Eckstein & Sinai 1990), but private debt remained absent from mainstream macroeconomic models.

Debt-deflation theory has been studied since the 1930s but was largely ignored by neoclassical economists, and has only recently begun to gain popular interest, although it remains somewhat at the fringe in U.S.

According to Bernanke a small decline in the price level simply reallocates wealth from debtors to creditors without doing damage to the economy.

A credit crunch lowers investment and consumption, which leads to declining aggregate demand, which additionally contributes to the deflationary spiral.

The financial instability hypothesis of Hyman Minsky, developed in the 1980s, complements Fisher's theory in providing an explanation of how credit bubbles form: the financial instability hypothesis explains how bubbles form, while debt deflation explains how they burst and the resulting economic effects.

In the absence of reflation, he predicted an end only after "needless and cruel bankruptcy, unemployment, and starvation",[12] followed by "a new boom-depression sequence":[13] Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years.

Indeed, some argue that this is the mechanism by which Keynesian economics actually works in a depression – "fiscal stimulus" simply meaning growth in government debt, hence boosting aggregate demand.

Several studies prove that the empirical support for the validity of the debt deflation hypothesis as laid down by Fisher and Bernanke is substantial, especially against the background of the Great Depression.

But, past and present U.S. authorities have failed to adequately restore the balance sheets of over-leveraged banks, firms, and households.

"[17] After the financial crisis of 2007-2008, Janet Yellen in her speech acknowledged Minsky's contribution to understanding how credit bubbles emerge, burst and lead to deflationary asset sales.

"[19] Kenneth Rogoff and Carmen Reinhart's works published since 2009[20] have addressed the causes of financial collapses both in recent modern times and throughout history, with a particular focus on the idea of debt overhangs.