China in the Debt-Deflation Trap

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.

In 2000, the imbalance was America’s large current-account deficit: the world’s largest economy was borrowing heavily on international capital markets, rather than lending, as one might expect. According to then-Fed Chairman Ben Bernanke, the problem was that countries running large surpluses were buying so many US Treasuries that they were negating the Fed’s monetary-policy efforts. But, as Claudio Borio, Hyun Shin, and others have pointed out, excessive off-balance-sheet and offshore lending by US and European banks also added procyclical pressure.