Velocity (turnover of money) is going down for most major economies. This means that people and businesses are saving rather than spending. Consumers across advanced economies consider that the best strategy to withstand the next pandemic or the second wave of the coronavirus is to increase savings and to reduce household debt.
Negative interest rates on UK government bonds provide additional information from markets in support of deflation rather than inflation in the medium term in accordance with the Fisher equation. Deflation increases the real value of debt, however. We know how highly leveraged businesses and households in many advanced economies are. The global outstanding stock of non-financial corporate bonds is particularly a concern, as it stood at all-time high of $13.5tn at the end of December. Over-indebtedness and deflation are two major factors that lead to a depression rather than a recession, through a “debt-deflationary spiral”, first described by Irving Fisher in 1933.
With higher debt in real terms, consumers and corporations may struggle to stay afloat financially and may default on their debts, which will lead to a repeating cycle of consequences. Consumers who are defaulting will also reduce their spending, which will decrease prices further. Businesses that are making a loss will reduce their output and their employment of labour, which will send additional negative ripple effects through the economy. Once the economy is trapped inside a debt-deflationary spiral, it is very hard to emerge from it. Confidence must be restored, which is an even harder task in the state we are in, given the psychological scars of the pandemic and lockdowns.
The conventional policy recommendation to address deflation would be quantitative easing (QE), which implies the continuation of “helicopter money” programs and other forms of government support programs. Yet, we know the QE effect on growth recovery in the aftermath the Great Recession was modest at best, if not controversial. This suggests that governments should also consider implementing policies that address structural problems. For instance, implementing debt restructuring programs could allow “bad” credit to wash out of the system, encouraging new, innovative entrants instead of creating zombie firms and companies. Economic growth cannot be generated from a system that keeps running on bad operating capacity.