Many economic commentators regard high level of debt relative to GDP as a major risk factor as far as economic health is concerned. This way of thinking has its origins in the writings of the famous American economist Irving Fisher. According to Irving Fisher, a high level of debt relative to GDP runs the risk of setting in motion deflation and in turn a severe economic slump. On this way of thinking, the high level of debt sets in motion the following sequence of events that culminate in a severe economic slump.
Stage 1: The debt liquidation process is set in motion because of some random shock. For instance a sudden large fall in the stock market. The act of debt liquidation forces individuals into distressed selling of assets.
Stage 2: Because of the debt liquidation, the money stock starts shrinking and this in turn slows down the velocity of money.
Stage 3: A fall in money leads to a decline in the price level.
Stage 4: The value of people’s assets falls whilst the value of their liabilities remains intact. This results in a fall in the net worth, which precipitates bankruptcies.
Stage 5: Profits start to decline and losses emerge.
Stage 6: Production, trade and employment are curtailed.
Stage7: All this leads to growing pessimism and a loss of confidence.
Stage 8: This in turn leads to the hoarding of money and a further slowing in the velocity of money.
Stage 9: Nominal interest rates fall, however, because of a fall in prices real interest rates rise.
Note that the critical stage in this story is the stage 2 i.e. debt liquidation results in a decline in the money stock. However, why should debt liquidation cause a decline in the money stock?
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