Can price inflation occur in the midst of debt deflation?

February 26th, 2009

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Right now, major economies like the US and UK are undergoing debt deflation. Large swathes of Europe is also going through this malaise. According to Professor Steve Keen, Australia, with its debt levels in the 3rd position behind US and UK, will suffer the same fate soon. Indeed, in the month of December 2008, Australia’s credit growth turned negative. Year-on-year credit growth in the second half of 2008 was decelerating. This is a worrying sign for Australia because as we explained before in Will Australia?s own pump-priming work?,

According to Professor Steve Keen, Australians? increased debt last year added $250 billion in spending into the economy. Currently, Australia?s credit growth is decelerating very rapidly. Should credit growth stagnate (or worse still, contract), this $250 billion (or more) in spending will go up in smoke.

So, there is plenty of scope for de-leveraging in the Australian economy, which will lead to debt deflation. Under such a scenario, asset prices will fall. As the theory goes, consumer prices should follow as well.

But is it possible for price inflation to rise in the midst of debt deflation? We were thinking of that possibility in What will happen if RBA cuts to zero?. The most likely culprit to blame for such a disturbing scenario will be the trashing of the Australian dollar. Debt deflation theory says that such a scenario is impossible. But there is a real-life example that shows that this can happen- Iceland. Today, Iceland is suffering sky-rocketing unemployment as well as price inflation. From the Icelandic central bank’s web site, you can see their price inflation rate has gone to the moon at 18.6% in January 2009.

How can both debt deflation and price inflation be possible? As someone in Professor Steve Keen’s blog site asked,

I?m wondering about what?s happening to Iceland now and going forward. When no one has a job, no one has savings and no one can sell a single thing. Everyone has no money. If no one has money, no one can buy things. If no one can buy things the shops must drop price further and further. This is monetary deflation and price deflation. More businesses fail and unemployment continues to rise. Where does the future inflation come from?

So, how can we explain Iceland?

Well, under the conventional demand-supply equilibrium model, prices should come down. But in this case, the system is out of equilibrium and cannot return to equilibrium. If there?s no money to buy imported things, it does not mean that the prices must come down. What will happen is (1) demand destruction and/or (2) the seller goes out of business (and contributes to higher unemployment). The remaining few sellers that survive will most likely sell to the richer Icelanders who can cough out the higher prices.

Furthermore, as we explained with an example in What will happen if RBA cuts to zero?, even locally produced goods can rise in price too.

Can this happen to Australia? Fingers crossed. The inflation part depends on the Aussie dollar.

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