A public debt crisis in Japan (as the combination of recession, deflation, and high deficits drove up the debt GDP ratio).

Deflation increases the real (inflation adjusted) debt burden, as well as the real interest rate. Though there is little evidence of the importance of small changes in real interest rates, the effect of even mild deflation on real debt, year after year, can be significant.

And that's basically deflation 50 percent deflation.

A five year cumulative 30 deflation in prices and wages in Greece, for example which would mean five years of deepening and socially unacceptable depression even if feasible, this amount of deflation would exacerbate insolvency, given a 30 increase in the real value of debt.

Deflation Doldrums?

Policymakers will have to worry about a strange beast called stag deflation (a combination of economic stagnation recession and deflation) about liquidity traps (when official interest rates become so close to zero that traditional monetary policy loses effectiveness) and about debt deflation (the rise in the real value of nominal debts, increasing the risk of bankruptcy for distressed households, firms, financial institutions, and governments).

But that is logically flawed even with deflation, real purchasing power would fall, and the real value of debts would rise (debt deflation), as the real depreciation occurs. More importantly, the exit path would restore growth right away, via nominal and real depreciation, avoiding a decade long depression.

Putting Deflation First

The Deflation Bogeyman

Deflation and Democracy

Inflation or Deflation?

Irving Fisher s prescient warning in 1933 about such a debt deflation spiral resonates strongly today, given that public and private debt levels are at or near historic highs in many countries. Especially instructive is the 2.2 price decline in Greece for the 12 months ending in July the most severe example of ongoing deflation in the advanced countries and counterproductive to an orderly solution to the country s problems.

Can China Beat Deflation?

Can China Avoid Deflation?

nbsp nbsp nbsp nbsp nbsp nbsp nbsp nbsp A five year cumulative 30 deflation in prices and wages in Greece, for example which would mean five years of deepening and socially unacceptable depression even if feasible, this amount of deflation would exacerbate insolvency, given a 30 increase in the real value of debt.

Southern Europe could enforce deflation.

Deflation in many advanced economies.

Has Global Stag Deflation Arrived?

The main reason for the new dose of transatlantic drift is that the crisis is being experienced differently. America fears deflation Europe driven by its largest economy, Germany fears national debt and inflation.

That's a 50 percent deflation rate.

Why Deflation is Good News for Europe

Moreover, the extremes of collapse were amplified by unnecessarily tight monetary policies which deepened the debt deflation process, served to depress output and employment and caused serious dislocations in the corporate and financial sectors (Stiglitz, 2002).

Inflation and deflation of debts produce very different outcomes. Inflation reduces the value of debt, which for many people and companies feels like slowly sipping champagne, producing a nice buzz of light headed excitement as they are unburdened.

According to Bernanke s debt deflation theory, the collapse in consumer prices was one of the causes of the Great Depression, since deflation raised the real value of debts, making it difficult to repay loans. As Bernanke pointed out, 45 of US farms were behind on mortgage payments in 1933, and in 1934, default rates on home mortgages exceeded 38 in half of US cities.

There is a strong case for monetization two in the eurozone, which faces zero growth and deflation. Indeed, while the QE program unveiled by the European Central Bank in January consists mainly of sovereign debt purchases, the ECB will also buy debt issued by the European Commission and the European Investment Bank key elements of monetization two.

In addition to this increase in the real cost of debt service, deflation would mean higher loan to value ratios for homeowners, leading to increased mortgage defaults, especially in the US. A lower price level would also increase the real value of business debt, weakening balance sheets and thus making it harder for companies to get additional credit.

Clearly, the eurozone s muddle through approach no longer works. Unless the eurozone moves toward greater economic, fiscal, and political integration (on a path consistent with short term restoration of growth, competitiveness, and debt sustainability, which are needed to resolve unsustainable debt and reduce chronic fiscal and external deficits), recessionary deflation will certainly lead to a disorderly break up.

Unfortunately, the main advanced economies are following a divergent path which, in some cases, will lead them in the opposite direction in 2011. As a result, the risks of debt deflation and eventual disorderly sovereign and private sector defaults are rising.

To be sure, China overcame a similar challenge in its public sector from 1998 to 2001. It pursued growth boosting investment in infrastructure and real estate development to eliminate deflation, while maintaining artificially low interest rates to contain the rise of public debt.

Given this, China s current deflation should motivate its policymakers to pursue monetary easing, reducing real interest rates to a much lower level, even zero. Such a move for which China has plenty of room would not only enable the reduction of existing debt burdens perhaps more important, it would also allow for the rollover of debt as the economy accelerates.

Its inadequacy may lead to the formulation of a much older answer revulsion against the market economy, accompanied by indiscriminate condemnation of debt and debt instruments. Indeed, as governments scramble to respond to the current crisis, we should remember that deflation tends to produce not only radical anti capitalism, but also a profound hostility to any kind of economic or political organization.

If China s government is to prevent a debt deflation spiral from causing a hard landing, it should shift its focus to targeted expansionary fiscal policy. With a budget deficit of 2.3 of GDP, China can certainly afford to increase government expenditure and reduce taxes.

Nominal interest rates for periphery countries sovereign debt have remained extremely low, and, even when taking into account expectations of very low inflation (or even deflation), real interest rates are low. The eurozone now is facing not only a financial crisis, but a stagnation crisis.

Worse, rather than being an anchor of stability for the eurozone, as Schäuble claims, Germany spreads instability. Its banks poor approach to lending their surplus savings inflated asset price bubbles in the run up to the financial crisis, and have imposed debt deflation since then.

Japan s deflation and economic stagnation over the last two decades stemmed largely from a dysfunctional financial system and a lack of private demand. The collapse of asset bubbles in the 1990 s left Japan s financial system and private sector saddled with a huge debt overhang.

In terms of price performance, that's a 40 to 50 percent deflation rate.

Because many contracts are sticky (that is, not easily revised) in monetary terms, inflation and deflation would both inflict damage on the economy. Rising prices reduce the value of savings and pensions, while falling prices reduce profit expectations, encourage hoarding, and increase the real burden of debt.

But that does not make it any less risky. In fact, if overcapacity is allowed to continue putting downward pressure on prices, China s economic growth will not stabilize at a rate consistent with its potential instead, the economy will be pushed into a vicious spiral of debt deflation.

Making matters worse, weak demand and debt overhangs are fueling concerns about deflation in the eurozone and Japan. Anticipating falling prices, households could postpone their consumption decisions, and companies could defer investment, pushing the economy into a downward spiral from which it would be very difficult to escape.

DIJON With all of the problems afflicting the world economy nowadays, inflation seems to be the least of our worries. In addressing the post 2008 economic malaise, which stems from over indebtedness, policymakers are correct to focus on the threat of debt deflation, which can lead to depression.

Deflationary pressures eased in Japan but firm evidence that deflation has ended is still awaited.

Debt sustainability and debt relief

But these countries real economies would benefit from a furlough from the eurozone. Depreciation inside the eurozone in the form of deflation, on the other hand, would drive large parts of the real economy into excessive debt, because only the value of assets, not that of bank debts, would decline.

Price deflation is far more likely in the near term. But temporary deflation need not be the terror that central bankers fear, at least if the banking system is recapitalized and if interest rates in the industrial countries fall sharply.

In 2003, then Fed Chairman Ben Bernanke argued that Japan, facing deflation, should increase public expenditure or cut taxes, funding the operation by printing money rather than issuing bonds. This, he argued, was bound to increase national income, because the direct stimulative effect would not be offset by concern about future debt burdens.