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Japan experienced a deflation in recent years because the bursting of its asset-price bubble in the early 1990s created huge losses in its banking system. The Japanese banks had financed the asset-price bubble. When it burst, the debtors could not keep current on their loans to the banks and therefore were forced to turn back the collateral to the banks. The market value of the collateral, of course, was less than the amount of the loans outstanding, thereby inflicting huge losses of capital to the Japanese banks. With the decline in bank capital, the Japanese banks could not extend new credit to the private sector even though the Bank of Japan was offering credit to the banks at very low nominal rates of interest.

Banks are an important transmission mechanism between the central bank and the private economy. If the banks are unable or unwilling to extend the cheap credit being offered to them by the central bank, then the economy grows very slowly, if at all. This happened in the U.S. during the early 1930s.

U.S. banks currently hold record amounts of mortgage-related assets on their books. If the housing market were to go into a deep recession resulting in massive mortgage defaults, the U.S. banking system could sustain huge losses similar to what the Japanese banks experienced in the 1990s. If this were to occur, the Fed could cut interest rates to zero but it would have little positive effect on economic activity or inflation.

Short of the Fed depositing newly-created money directly into private sector accounts, I suspect that a deflation would occur under these circumstances. Again, crippled banking systems tend to bring on deflations. And crippled banking systems seem to result from the bursting of asset bubbles because of the sharp decline in the value of the collateral backing bank loans.

Paul L. Kasriel
Sr. V.P. and Director of Economic Research

 

And if the over-indebtedness with which we started was great enough, the liquidation of debt cannot keep up with the fall of prices which is causes. In that case, liquidation defeats itself.  While it diminishes the number of dollar owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to lessen their burden of debts increase it because of the mass effect of the stamped to liquidate in swelling each dollar owed.  Then we have the great paradox which, I submit, is the chief secret of most all, great depressions: The more the debtors pay, the more they owe.  The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing. But the over-indedbetness is not sufficent great to make liqudate this defeat itself, the situation is different and simpler. It is then more analogous to a stable equilibrium; the more the boat rocks the more it will tend to right itself.

Irving Fisher

(1933) The debt deflation theory of Great Depressions.