The Effects of Debt on the Economy

Posted by ProTradingIndicators on

Debt in a glance

We all know that the world today is drowning in debt. Private sector debt, government debt, the numbers are huge. Nonetheless, the world is still growing and the standard of living keeps rising, hyper-inflation? looks like it is still far away. So what does debt mean for the wide global economy?  To answer this question we need to look at micro economics, and follow up.

 

Rise in  Debt

A private household that has big debts – lives in a different matter than one with savings. While the one with savings can consume, invest and ramp up his living standard, the one with  debt needs to pay it back. When he pays it back, the money spent on paying debt creates a deflationary effect. Following up we see that during big debt payments/bankrupts ,usually in times of crisis – currency goes up , for example the big real-estate debt bubble of 2006, that deflated together with a very sharp rise in the US dollar in 2008.

Why does debt paying and bankruptcies – creates a deflationary effect? because it lowers the money supply significantly. The process is called De leveraging.

the circulating credit contracts, and that causes less money to be available in the economy and banking system. When that happens, fewer loans are available and creditors become very hawkish, afraid to loan or take risks in a deflating environment, where asset prices go down, and loans go bankrupt or payed back.

Euro Declines sharply in 2008 vs US dollar

Macro Effects of debt

That also explains why the Hyper-Inflation scenario caused by all the money printing around the world hasn’t kicked off. The debt is so big, that even after printing hundreds of billions of dollars, still the deflationary effect is so massive that the economy just CANT go into hyper inflation.

In Europe – the euro Declined while going through the debt crisis. and the question is why? Unlike the American crisis of 2008 – European banks didn’t go bankrupt. the ECB pumped them up with money, and prevented their failure, although they where broke at the time. that means that loans mostly didn’t go bad, and were never payed off until today, which makes the currency trade on confidence, rather than on economics. Also a lot of funds transferred from Europe to America, looking for better investments.

That effect is also easy to see when looking at government bonds yields. while in Europe money rushed out of bonds during the crisis, in the USA money rushed INTO bonds, looking for safety. rates went ballistic in Europe while they sank in America.

Conclusions

Debt paybacks and bankruptcies are Deflationary overall. the effect is contraction of the money supply, and strength in currency. in cases where Central banks prevent that from happening, the deflationary effect will be delayed, until loans are finally payed or written off. than and only than , the deflationary liquidity trap will cease to exist.


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