Beijing stadium.

China in the Debt-Deflation Trap

In the wake of a global stock market sell-off triggered by economic turmoil in China, the US Federal Reserve has decided to postpone raising interest rates. And, indeed, China is facing huge challenges, with the risk of a global debt-deflation trap being a major one.

HONG KONG – In the wake of a global stock-market sell-off triggered by economic turmoil in China, the US Federal Reserve has just decided to postpone raising interest rates. Indeed, China is facing the huge challenge of dealing with the risk of a global debt-deflation trap.

In 1933, Irving Fisher was the first to identify the dangers of over-indebtedness and deflation, demonstrating their contribution to the Great Depression in the United States. Forty years later, Charles Kindleberger applied the theory in a global context, emphasizing the problems that arise in a world lacking coordinated and consistent monetary, fiscal, and regulatory policies, as well as an international lender of last resort. In 2011, Richard Koo used Japan’s experience to highlight the risks of a prolonged balance-sheet recession, when over-stretched debtors deleverage in order to rebuild their balance sheets.

The debt-deflation cycle begins with an imbalance or displacement, which fuels excessive exuberance, over-borrowing, and speculative trading, and ends in bust, with procyclical liquidation of excess capacity and debt causing price deflation, unemployment, and economic stagnation. The result can be a deep depression.

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