Debt Deflation

Figure 1. Normalized data.

The U.S. National Home Price Index declined in the third quarter of 2010, showing home prices 1.5 percent below last year, according to Standard & Poor’s.

To investigate the possibility of debt deflation destabilizing the American economy, which the Federal Reserve is trying to stimulate through a second round of quantitative easing (QE2), a case study was conducted for further analysis of the decline in home prices.

Case Study

In January 2006, inflation (CPI) and home prices decreased, while credit card debt and the M3 money supply increased (Figure 1, “Jan-06”).  Increases in credit card debt and M3 money supply could be related to low interest rates from a pro-growth monetary policy in the wake of Islamic jihadist terrorist attacks five years earlier on September 11.

Economic historian Charles Kindleberger defined the start of a war, such as the September 11 terrorist attacks, as “displacement.” Economic displacement and monetary expansion that characteristically follows are the first and second phases, respectively, of a typical financial crisis.

Although inflation began increasing with an inflection point in the middle of 2006, leaving home prices alone to decrease, consumer prices peaked soon after the stock market in late 2007. It was an economic moment of “distress,” or the third phase of a financial crisis, characterized by speculation at a maximum (Figure 1, “Jan-08”).

Despite the short inside lags arising from opportunities for the central bank to adjust monetary policy every six weeks, as when the Fed began increasing interest rates in 2004 to adjust against the threat of rising inflation, the long outside lags characteristic of monetary policy didn’t begin to decrease M3 money supply nor credit card debt until the latter half of 2008 (Figure 1, “May-08”; Figure 2).

But making economic policy adjustments more difficult for the Bush administration and the Fed was that by 2008 the American economy was then progressing into the fourth phase of “crisis,” with the potential for a panic and crash that could have resulted in a third Great Depression by the year 2009 without the Fed to function as lender of last resort.
The United States economy hasn’t followed a classic pattern of debt deflation, with successive decreases in (1) home prices, (2) M3, (3) credit card debt, and lastly, (4) CPI. But statistical analysis confirms a close correlation between credit card debt and the broad money supply measured (Table 1 and Figure 1).

Figure 2. Interest rates were increased until financial distress in late 2007.


If customary time frames for inside and outside lags in monetary policy continue to hold, Americans may not observe a significant increase in aggregate demand from QE2 until 2012, when positive inflection points could then be observed in data for credit card debt and M3.

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Table 1. Correlation coefficients (R) Home prices        CPI    Credit cards M3 money supply
Home prices        1.00       0.37      -0.16           -0.42
CPI         1.00       0.19            0.09
Credit cards           1.00            0.95
M3 money supply                  1.00



Housing –

M3 and Credit –

Federal Funds Target Rate –


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