Deflationary spiral
The deflationary spiral is best
explained by expanding our discussion of the effects
of deflation.
Some people are beginning to see how a deflationary
spiral works. As explained in Robert Prechter’s best-seller
Conquer the Crash, debtors are forced
to sell all they can, even their best assets, to raise
cash and satisfy creditors. That’s one reason why
gold and silver prices do not rise in a deflationary
spiral. When the sub-prime mortgage market crashed,
guess what: other bonds, including supposedly safe
municipal and corporate bonds, also fell.
Even if most price declines are due to forced selling,
that selling in turn will decrease the total value
of investments, which will curtail individuals’ and
companies’ economic activity, which leads to an economic
contraction, which will stress the issuers of such
bonds to the point that they cannot make interest
payments or return principal.
Despite this description, a deflationary spiral is
not linear. When the debt burden becomes too great
for the economy to support and the trend reverses,
reductions in lending, spending and production cause
debtors to earn less money. Defaults rise because
they can't pay off their debts. Default and the fear
of default exacerbate the new trend in psychology,
which in turn causes creditors to reduce lending further.
Just as the previous boom fed on optimism, a deflationary
spiral feeds on pessimism. The resulting cascade of
debt liquidation often results in deflationary
depression. To raise cash to pay off loans, borrowers
will desperately try to sell everything that’s not
nailed down, including stocks, bonds, commodities,
real estate, even art and collectibles. Prices for
these assets plummet.
When major world stock indexes turned down in late
2007 followed by commodities throughout 2008, it became
obvious a deflationary spiral had begun.
For more on deflation, Download Robert Prechter's FREE 60-page eBook, The Guide to Understanding Deflation.
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