DEBT DEFLATION - THEORY AND EVIDENCE

In the early 1990s the most severe recessions occurred in those countries which had experienced the largest increases in private debt burdens. Was this an accident of history or did it reflect deeper forces affecting market economies? The paper comprises three parts. First, it presents three 'stylised facts' about debt and its impact on consumption growth in the 1930s and the 1990s. Second, it discusses the reception of Irving Fisher's work on debt deflation by his contemporaries, and argues that it is helpful to think of debt deflation as a real business cycle phenomenon. Third, there is a theoretical discussion of the reaction of debt and consumption to shocks in the context of a model of precautionary saving. Central to the model is the role of distributional shocks which implies that aggregate demand may be a nonmonotonic function of the price of assets in terms of the consumption good. Multiple equilibria may exist, leading to the possibility of financial instability. The analysis of debt deflation requires the construction of real business cycle models without a representative consumer.