Need enlightenment: Does Credit Crunch mean Deflation?

Economics Economics Questions
1

I have seen people like Bob Prechter saying that since so many people are defaulting on their loans, that means deflation is coming.

I assume that by deflation he means lower prices for things.

  1. Is what he is saying true, at least in theory? Meaning, is it true all other things being equal?

  2. What is the reason that it is true or false?

As always, I ask for an explanation in layman’s language, if possible.

TY.

2

Credit contraction is monetary deflation, and a side effect of this may be a fall in prices.

3

is people defaulting on debts one way to have a credit contraction?

also, WHY does the fact that I didn’t pay my mortgage mean that prices of things will go down? How does one thing cause the other.

4

Smiling Dave,

Yes, debt defaults causes deflation (monetary) in our current banking organization. We assume that this loan is made with fiduciary media. As such, a loan of amount X represents X amount of money added to the money supply (which is perfectly in tune with Austrian business cycle theory, since this method of fractional reserves is a cause of inflation [monetary]). A default on a loan represents the liqudation of this loan, and as such represents the liqudation of the amount of fiduciary media with the dollar-value of X.

5

Jonathan, I appreciate someone with your knowledge answering my question. But I need a bit more help. Here is what’s bothering me;

Jones gets a loan from the bank that increases the money supply. He goes out and buys beer with all the money. At the time he spends it is when it has its inflationary impact, right? And he spent it by handing some paper of some kind over to the grocer. That paper does not disappear from the world just because Jones refuses to repay the bank. So how is there a decrease in the money supply?

6

Smiling Dave,

In your example the money remains in circulation, so ceteris paribus there is no deflation. But, we are talking about the extension and contraction of fiduciary media within our current banking organization. Let’s say that the original loan consisted of credit valued at $1,000. The debtor now had an additional $1,000 at his disposal which did not originate as real savings. Credit expansion deccelerates and the economy contracts, and now the debtor realizes that his investment is not returning a profit and he can no longer repay his loan. The debtor defaults, and those $1,000 are no longer in circulation (the money malinvested ceases to be in circulation).

The same remains true of repayment of loans made from fiduciary media. What we are dealing with are not physical dollars, but credit. Credit can only be kept in circulation if a loan of equal value in credit to the one repaid is made. Otherwise, it represents “credit contraction”, which is synonymous to a fall in the supply of money. This is why a contraction of outstanding loans is the same as credit contraction, or a fall in the supply of money.

7

Someone defaulting on a credit from a bank it is not directly deflationary. But the bank now has a “hole” in its balance sheet that has to cover with part of his earnings. In general the bank will start to be more cautious lending, and at when it reaches the point that the bank is being repaid more money than it is lending, deflation will happen.

So defaulting on a loan is not directly deflationary, but will make the bank more cautious lending, which most of the time will lead to a deflationary situation.