Thursday 19 May 2022
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Deflation And Debt Bad For Economy

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[dropcap]I[/dropcap]nflation to the lay refers to the rate of increase in prices while deflation refers to the opposite, i.e. rate of decrease in prices. Now if you are a normal person (not an economist), you would tend to believe that deflation is good while inflation is bad. Unfortunately, economists are abnormal people, particularly those belonging to mainstream economics.

Since the 2008 crisis, the US Central Bank, (Federal reserve) has printed 4.5 trillion dollars in order to give a boost to its economy. One of the many objectives of the Fed while pursuing this policy was to fight deflation. The US Fed Chairman during the 2008 crisis, Ben Bernanke is considered to be an expert on the Great Depression of 1930. Bernanke considers deflation to be a grave threat. In 2002, Ben Bernanke gave a speech titled “Deflation: Making Sure ‘It’ Doesn’t Happen Here”.

Sustained deflation can be highly destructive to a modern economy and should be strongly resisted.

The US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation. (Link)

Human nature: money illusion

For a long time, I never understood the widespread fear of deflation, it just seemed unreasonable. Why would low prices be a threat? I finally seemed to figure out a satisfactory reason after I recently read the book Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism. The answer is surprisingly very simple and lies in us, human nature.

Humans suffer from money illusion. Money illusion occurs when decisions are influenced by nominal dollar amounts and not real value. Human nature is agnostic to inflation. This means humans do not consider inflation, so when prices go down, they don’t accept wage cuts. Experiments have shown that people generally perceive an approximate 2% cut in nominal income with no change in monetary value as unfair, but see a 2% rise in nominal income where there is 4% inflation as fair, despite them being almost rational equivalents. (Source)

This might seem simple but this can have a profound impact on the economy. As Nobel Laureates George Akerlof and Robert Shiller write in their book Animal Spirits… about the Great Depression of 1929:

The early year of the Great Depression were marked by sharp deflation. The US Consumer Price Index fell 27% from the month of the stock market crash, October 1929, until it hit bottom in March 1933. The deflation meant that profits were squeezed: firms revenues from sales were declining sharply and yet their payments to workers would remain the same if wages were not reduced.

The need for wage cuts was articulated by many. “If food and clothing have been reduced 28%, wherein will it hurt if any government employee receives 25% pay cut? However, the public never fully accepted the argument for nominal wage cuts. Thanks to money illusion, people who experienced nominal wage cuts felt hurt. Labor union leaders did not endorse wage cuts. American Federation of Labor issued a statement declaring that “Our object from now on should be to raise wages, not to reduce them”.

Thus, when real wages are not adjusting to deflation, it meant profits of firms get squeezed. As a result, firms retrench workers. As unemployment rises, the demand in the economy reduces, which makes even more firms out of business. Thus starts the deflationary spiral.


Modern day courses on economics in universities teach little about the history of economic thought. A century ago, money illusion was widely acknowledged by economists. Irving Fisher, the great classical economist, for example, spent a lot of time on devising a perfect price index as he believed that individuals made a lot of bad decisions because they were unaware of inflation. John Maynard Keynes also believed that workers failed to negotiate increases in wages to offset inflation.

In the 1960s, economists suddenly reversed their view on money illusion and rational behaviour was born. In 1967, Milton Friedman argued that workers negotiated on real wages and not nominal wages. This view largely holds true even today even though evidence suggests otherwise.

Deflation usually follows an asset price inflation

The Great Depression of 1929-33 was preceded by the Roaring 1920s when stock and real estate prices began to skyrocket. Same happened before the 2008 crisis. Deflation is thus a natural process of creative destruction of the bubble economy and rebuilding it.

The role of government is important too because governments tend to favour inflationary policies. As RBI Governor Raghuram Rajan wrote in 2014:

If lower rates generate higher demand and higher inflation, people may produce more, believing that they are getting more revenues, not realizing that high inflation reduces what they can buy out of the revenues. Following the saying, “You can fool all the people some of the time,” bursts of inflation can generate growth for some time. Thus, in the short run, the argument goes, higher inflation leads to higher growth. As the public gets used to the higher level of inflation, the only way to fool the public again is to generate yet higher inflation. The result is an inflationary spiral which creates tremendous costs for the public. (Source)

As Vivek Kaul writes,

The larger point is that any government has only got a period of five years to show its performance and in that period it has to do whatever it takes. If that means turning on inflation to create growth, then so be it. (Source)

What this means is that a more prudent policy would be a hawking policy targeted at controlling inflation, thereby minimizing the possibility of deflation. This is precisely the reason I supported Rajan. Beware of any politician, economist or policy-maker who tries to argue for too high growth. One such person is India’s current Finance Minister Arun Jaitley.

Four-letter word d-e-b-t

Worried couple doing their accounts in the living room at home

While modern economists may not agree to money illusion, they simply cannot deny the role of debt. Suppose you have taken a home loan of 50 lakhs to purchase a house and the economy suddenly goes into a recession. As prices reduce due to deflation, your cost of living may go down, but your debt installments would not. Would you be willing to take a pay cut? More debt makes people even less likely to accept wage cuts, thus making deflation even more dangerous.

Another important point about private debt (that is often ignored) is that it goes against the very nature of capitalism. Private debt makes people more conservative, less risk-taking and it constrains all the creative elements of capitalism. If you have an education or home loan, you have to get a job, whether you like it or not. You are extremely unlikely to quit your job and start a business. Thus, higher private debt encourages people to become job doers rather than job creators, thus stifling the dynamism at the heart of capitalism.

Role of banks

Mainstream economics considers the financial industry as intermediaries that get funds from savers and lends it to borrowers. Nothing can be farther from the truth. What this theory ignores is that banks are themselves interested in making profits.

Banks earn their profits by creating debts. This means that they would always want to create more debt and more debt, much more than what society needs. I have experienced this first hand when I used to work in a software product company that had a loan processing solution. My job was to sell the software to banks and NBFCs. The banks wanted to reduce their turnaround time (TAT) for loans (time to process a loan application). One claimed their TAT was barely 2 min. Can you imagine lending money to someone in such a short time?

Such behaviour is true also in micro-finance institutions. Micro-finance institutions charge rates as high 20-24%. This is much higher than the rate of other loans. Capital automatically flows into sectors giving higher returns and this encourages MFIs to give more loans than people actually want, mostly by temptation. The usual tactic of MFIs is thus to identify individuals with better credit history.

Multiple MFIs compete and try to poach such individuals by offering more and more credit. Individuals from rural backgrounds usually cannot handle such large amount of money and tend to spend them on wasteful consumption. Thus more credit leads to even good customers turn delinquent.

Home and education loans

While I have already discussed consumer finance and MFIs, these two sets of loans that require a special mention. There are two reasons: one, these loans tend to be of a much longer duration, thus more dangerous; two, governments tend to encourage people to take these loans by offering tax credits, lower rates and even guarantees.

Food, clothing and shelter have been the basic needs of man since time immemorial. With growth in economy, the first two have been taken care of. The third basic need, home, is still unfulfilled for a large percentage of the population even in the West. Housing is unlike any other commodity.

Home is one of the biggest purchases that individuals make in their entire lifetime. Most buy one or maximum two homes. This essentially means that they are vastly inexperienced at doing so. If you visit a restaurant with a bad service, you will learn and get better at it next time. But that won’t be the case with homes. Thirdly, search costs are substantial in the case of homes. No two homes would be the same; there are simply so many parameters in comparing your options that it makes it even more difficult for individuals. Then there is an emotional factor.

All this adds up and an individual mostly does not quite make a rational decision while buying a house. Government too encourages people to buy homes by cheaper credit that tends to push up home prices, which encourages speculating individuals to buy property and profit from rising prices. More credit to home loans crowds out credit businesses and SMEs, which actually make investments into the economy.

Education loan

As Ruchir Sharma writes in his book, The Rise and Fall of Nation:

Investing in education is often seen as a sacred obligation, like defending motherhood, and that too few questions are asked about whether it is getting the job done.

Delhi’s Chief Minister Arvind Kejriwal has launched a scheme of education loans of up to Rs 10 lakh to every applicant student. Government guarantees will be given on these loans. This is the popular position on education. But as this article points out, more loans to students does not really help as it leads to higher tuition fees. A bulk of the increases is captured by administrators in colleges.

Further, the gestation period from higher spending on education is much longer.

Economist Eric Hanushek found in a 2010 report that a 20-year education reform programme could result in an economy one-third larger, but that increase would register 75 years after the reform programme began.

All this means that higher loans are not going to result in better pay to the students. It further means that many of these students are going to spend a substantial amount of time in debt, which probably they did not need to take in the first place. Such debt slaves are not likely to take risks of starting a new business.

Thus, less private debt would be much more useful for society. The Western culture of encouraging private debt is not sustainable and India must guard against it. It further illustrates how important it is for governments to make sure that house prices and rents don’t go too high. Instead of encouraging people to buy homes, the state should encourage people to go for rented accommodation by providing better legal rights to tenants and faster dispute resolution.

People living on rent are more likely to be flexible and move to a new city in search of work. Home ownership in Germany is barely 43% (2013). This is one of the lowest in the OECD and a huge outlier when compared to its relative prosperity. Countries with highest rates of home ownership in OECD are Spain (83 %), Ireland (81.4%), Greece(73.2%). Coincidentally, all these countries have faced massive economic problems ever since 2008 crisis while German economy has strongly bounced back. (Source)

Less money to SMEs

As more capital flows into private debt, it means much less is available for businesses , in particular to SMEs.

According to a new paper by Oscar Jorda, Moritz Schularick and Alan Taylor, the traditional view that banks primarily lend to businesses is out of date. In 1900, only 30% of bank lending was to buy residential property; now that figure is around 60% (refer to the chart on the linked page at the end of this paragraph). Since the 1970s, virtually the entire increase in the ratio of private-sector debt to GDP around the world has been caused by rising levels of mortgage lending. Corporate borrowing has remained flat. Far from channelling money to companies, modern banks resemble “real-estate funds”, the authors claim, in which long-term mortgage lending is funded by short-term borrowing from the public (Source)

The statistics compiled in the fourth census of SME sector revealed that only 5.18% of the units (both registered and unregistered) had availed finance through institutional sources; 2.05% had finance from non-institutional sources and the majority of units. That is, 92.77% had no finance or depended on self-finance. (Source)

All this essentially means that SMEs usually do not get finance or, at best, are offered LAP (Loan Against Property). Thus, the whole financial system is against the very nature of capitalism. It constrains the inherent dynamism of capitalism.

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Sandeep Bansal
Sandeep Bansal
IT consultant with a special interest in economic theories

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