In Germany, when the state was forced to pay enormous war reparations after WWI, the public debt grew too rapidly to remain serviceable, resulting in hyperinflation. More recently, war-torn Zimbabwe has suffered from hyperinflation as a result of overwhelming government debt.
In contrast, massive private debt in Japan, fueled by a real estate bubble bursting, led to deflation. In the US, during the Great Depression, excessive private debt, caused by a stock market collapse, also led to deflation.
While the US government does have a large national debt, it is still manageable, at least over the next decade or so. As a percentage of GDP, our national debt is not at record levels. However, private debt, largely fueled by the housing bubble, is at astronomical levels that are no longer serviceable. When the credit market collapses, we will indeed experience deflation, just like Japan.
Consider the reasons cited for deflation in Japan and notice how they all currently apply to the US:
- Fallen asset prices: There was a classic price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.
- Insolvent banks: Banks with a large percentage of "non-performing" loans, that is to say they are not receiving payments on them but have not yet written them off, cannot lend more money; they must increase their cash reserves to cover the bad loans.
- Insolvent companies: Banks lent to companies and individuals that invested in real estate. When real estate values dropped, these loans could not be paid. The banks could try to repossess, but this wouldn't pay off the loan. Banks delayed foreclosures, hoping asset prices would improve. National banking regulators endorsed these delays. Some banks made additional loans to these companies that were used to service the existing debt levels. This continuing process is known as maintaining an "unrealized loss," until the assets are completely revalued and/or sold off (and the loss realized).
- Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods, due to lower wages and fast growth in those countries. Thus, prices of imported products are decreasing. Domestic producers must match these prices in order to remain competitive.
Notably, there are some key differences between the Japanese economy and US. Japan was a nation of savers, and we are a nation of consumers. That will likely cause the deflation to be felt even more sharply here. The US population is younger, which should help us recover from a deflation faster. The US economy is more diversified, which may also prove helpful.
Deflation can not be countered easily by a central bank. Public money creation (by the Federal Reserve and the Treasury) is very small relative to amount created by commercial banks which the Fed may influence, and other institutions which the Fed has no control over. Currently, less than 5% of money supply is made out of central bank money. This occurs because credit, which anyone can issue, has become a substitute for money. All sorts of institutions from large investment banks such as Goldman Sachs, to small payday loan shops are creating credit in unprecedented amounts. These institutions are not members of the Fed, and therefore their credit creation is only controlled by their level of capitalization. Once these capitalization levels are exceeded, businesses will be forced to withdraw credit, decreasing the money supply.
It is impossible to replace private money by public money overnight, and generally private agents resent any attempt as spoliation. The problem we face currently is that the ratio of public/private money has never been so small. Once a credit collapse in the trillions of dollars begins, the Treasury and the Fed will be powerless to stop it.
