Can Japan climb out of this debt-deflation spiral?

In an article written on this blog entitled ‘Comparing the financial crisis mechanisms of Fisher, Minsky and Woodford’[1], Fisher’s debt-deflation spiral was explained. This article will describe this mechanism and then apply it to current conditions in Japan.

Start: Assumption of initial over-indebtedness due to speculation of future profits and/or due to low interest rates would increase the incentive to borrow and then speculate 

  1. Debt liquidation
  2. Contraction of deposit currency as bank loans are paid off which will decrease the velocity of money. This will lead to distress selling as over-indebtedness has set in.
  3. Distress selling leads to deflation (the money supply is decreased due to paying off loans). The paradoxical situation arises where the more people try to pay off their debts, the more the debt grows (because the real value of money has increased)
  4. An increase in bankruptcies due to a decrease in the net worth of businesses
  5. Decrease in profits
  6. Decrease in output, trade and employment
  7. Pessimism runs through the economy
  8. So hoarding increases and so the velocity of money decreases further.
  9. Complicated changes in nominal (money) and real (commodity) interest rates

Given the assumption that it is the expansion and availability of credit fuelled by the temptation of large future profits and low interest rates, Fisher highlights two possible policy implications: 1. the “natural” way out of depression and; 2. reflating the price level.

The natural way relates to bankruptcy which will slow the indebtedness rate. However, this is opposed to the social values an economy has – people are jobless with the potential to fall into poverty over time. Therefore the only alternative is to try and reflate prices, often done through quantitative easing.

Figures published today show an unexpected rise in unemployment and a decrease in household spending despite several attempts by the Bank of Japan to re-energise the economy. With unemployment rising and household consumption falling, deflationary fears are spreading once again.

Despite positive results in the increase of exports, Japan is widely regarded as over-reliant on them. Moreover, the problems faced in Europe have led to the yen to strengthen; exports have become more expensive and so threaten this key area of the economy.

However, if this can generate employment and then, subsequently, facilitate domestic demand improvements then there is a strong case for inflation to return.

With deflation still present people will continue to refrain from spending as the goods next month are cheaper than they are now.

Employment is the key; with an increase in employment comes inflation due to the connection with wages and prices and consumer spending should increase. However, given the current woes, will Japan be able to break free of this debt-deflation spiral through government expenditure on job creation? As elsewhere, however, this will be tempered by record public debt levels.

[1] See


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