Debtors of any class, government, business, or individual, have limited liquidity. That is why the debt (borrowed liquidity) was needed in the first place. Debtor liqudity may come from tax revenues, business earnings, or monthly earned income--but it is limited. First off, every thing in the universe is limited, however unimaginable those limits might be. Second, government revenues, business earnings, et. al. are indeed limited when speaking in context of the here and now. We borrow-- for a car, a house, whatever-- and the banks lend us money on the carefully considered assumption that we will be worth more tomorrow,or next year, than we are today. Businesses and governments borrow and are loaned money, via stocks and bonds, on basically the same assumption.
There is no reliable data on what the real limits are--how much of current income can be paid on residential mortgage debt, or credit cards or whatever without creating a deflationary economic environment. Speaking in the vast macro-economic sense, yes that is true; but, in reference to individual, business and, yes, even government "debtor liquidity" there are, of course, available,.e.g. Moody's, Morningstar, etc.
Point is that in the macro economy, you reach a point where aggregate debt service by government, business and individuals consumes so much of periodic liquidity that the entity involved can no longer afford to make additional purchase commitments... Again, this is based on the assumption of a static condition: That he who has $5 today, will have $5 tomorrow and $5 next week, maybe less but never than a penny or two more.
In the business environment, pricing power disappears and prices begin to drop; so do profits. True enough, to a point. Prices drop simply because they must in order to the company to maintain it's place in the market- but prices can only drop to a point. When profit derived from these lower, unsubstantiated price cuts (Spacely's Sprockets cut prices not because they found a better,cheaper way to make sprockets but simply because they had to) reach a certain point the company simply stops making the products. Only the federal government can continue to make something, be it goods or services, at a loss.
Deflation becomes imbedded--because new debt is incurred, not to buy additional assets but instead to make payments on existing debt. Which can not be lowered-either by fiat or allowed to drift downward. The cause of this is, in a word: contracts. No matter if it is in re: a union pay agreement, a purchasing order for a business, or a 30 year mortgage.
So we have skipped payments; interest only months; rising default rates and mortgage foreclosures. Monthly payments are made with additional credit card debt. A general decline in market prices is probably not too far ahead. This is because, as the old saying goes, "water seeks its own level". If, for whatever reason, real estate/housing prices are out of wack with reality the Free Market, if allowed to work, will bring them down (or raise them up) to their true level.
This is a fair summary of the current economic environment. As Shostak points out, the historical experience is that additional lending has been counterproductive No doubt, no doubt, but then you come to the sticky question of "additional lending", according to whom? by whose standards? By whose defination?" etc., etc., but that, as they say, is for another day.
How do we get out of this mess? Well you have to see how people get additional liquidity other than through the debt process. You have to expect new jobs to be created and employment to go up; compensation has to go up; business income has to go; tax receipts must go up. If anybody sees any positive signs on any of these items, or if anybody can see any reason why any of these things might happen, they should post immediately. I don't. IMHO, it's call "politics". Elections are not too far off and it is to the benefit of not a few to make sure the kettle stays hot and well stirred
Bump
"How does debt result in deflation? Having read these words several times I find myself still puzzled by the wording/meaning of this question. Is the question: 'How does deflation effect debt?'"
No. My analaysis is that excess levels of debt are the primary cause of deflations like the one which occurred in 1929 as a result of the margin debt creation of which was facilitated by the fed in the mid 20's; and like the current situation which is the result of excess debt at every level, credit card consumer; mortgage; government and business, facilitated by fed policy in the early and mid 90's.
The excess debt requires commitment of current liquidity wherever it comes from, to payment for past spending and acquisitions rather than current utility. Entities (individual and otherwise) are using current cash flow to pay for spending that occured some time ago. Thus current spending is curtailed.
Deflation results because entities can no longer cause increases in money supply because they don't have excess liquidity to make monthly payments on new debt because all excess liquidity is commited to old spending. Deflation further results from retirement of existing debt--the amount of debt retirement comes out of the money supply. So money supply sinks and you get deflation which ultimately progresses into depression in the extreme version.
The 1990's experience is more serious than the 1920's version because the amount of debt is much greater and the excess exists in more segments of the economy.
Your description of the assumptions that lead entities to incur debt and lenders to make the loan is correct. And the default in that assumption is what has caused the problem. If incomes, profits, tax revenues and values continued up, there would be increasing liquidity to make payments on existing debt plus pay for additional purchases. Problem is that incomes, profits, tax revenues and values are now going down--the Fed made a serious policy error and facilitated the creation of so much excess debt in the 90's that current liquidity is curtailed to a degree that has resulted in layoffs, lower compensation, loss of pricing power and the like resulting in a major deflationary period which is now becomeing a depression.
I am not sure what you mean by your concluding point. In order to get out of this without a major adjustment shock--2 out of every 3 houses in foreclosure; Dow at 1200; municipal bond defaults; you need to be able to see how incomes and revenues go up and available liquidity is generated other than through borrowings. Since I don't see that happening, I think the political answer ought to be to look for a way to resolve the illiquidity problem.
We could amend the Bankruptcy Act to permit debtors to elect to hand over all their net collateral assets in a speeded liquidity proceeding to the creditors. We need a legal mechanism to get through the procees that took us from 1930 to 1949 the last time. We need a sound money system so that creditors and debtors alike can be sure that when their liquidity problems are resolved, they can go back to work free from concern that government policy will rob them of the proceeds of their endeavors.