Google “Irving Fisher” and “debt deflation.” There is a paper of hos from 1935 I think you should read to understand the larger picture. One of the first hits Google will give you for Fisher’s paper will be out of the St. Louis Fed.
Then there is a short paper by Hyman Minsky I will try to find a URL to for you. If I cannot find a location for it, I can forward it to you directly.
Gotta be careful with Fisher, as he was the celebrity economist who claimed that “stocks have reached a permanently high plateau” days before the Crash of October, 1929.
Anyway, here’s his debt deflation theory:
According to the debt deflation theory, a sequence of effects of the debt bubble bursting occurs:
1.Debt liquidation and distress selling.
2.Contraction of the money supply as bank loans are paid off.
3.A fall in the level of asset prices.
4.A still greater fall in the net worth of businesses, precipitating bankruptcies.
5.A fall in profits.
6.A reduction in output, in trade and in employment.
7.Pessimism and loss of confidence.
8.Hoarding of money.
9.A fall in nominal interest rates and a rise in deflation adjusted interest rates.
What Fisher didn’t note was at what point overall debt accumulation would become so much of a burden that deflation and bubble-bursting becomes inevitable. In other words, how to predict a crisis before it happens.
Fisher did hint, however, that **credit** was as much a part of the money supply as cash.
Fisher seemed at a loss for government debt, though.
Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links:
Debt liquidation leads to distress selling and to Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation.
This contraction of deposits and of their velocity, precipitated by distress selling, causes
A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
A still greater fall in the net worths of business, precipitating bankruptcies and
A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make
A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to pessimism and loss of confidence, which in turn lead to Hoarding and slowing down still more the velocity of circulation.
The above eight changes cause
Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest. —(Fisher 1933)
What I'm talking about is what bursts the "bubble" in the first place. - The Fed - and then it goes down the line. It's disinflation and deflation or tightenging of money. See Milton Friedman's Quantity of Money.
I'm not saying that there weren't problems that need correction. If I recall correctly the inflation rate of 4% for 2007 was too high.
What I want is justification for why it was allowed to go negative and NGDP to fall by 3.8% in the second half of 2008. That is when the Fed should have started stabilizing to the trend rate to keep this spiral from getting out of control, but it did not.