Debt deflation is a economic theory that states that recessions and depressions are due to debt rising, in real value terms, due to deflation. This causes people to default on their loans and mortgages.
It was made popular by the renowned economist, Irving Fisher, who put this forth during the Great Depression. This was a follow up to the works of John Maynard Keynes who for proposed the idea yet found it lacking.
If there is a period of indebtedness, when the debt bubble pops, this will lead to liquidation.
This from the archives of St. Louis Fed:
Debt liquidation leads to distress selling and to contraction of the money supply, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of the money supply and its 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.
Several studies prove that the empirical support for the validity of the debt deflation hypothesis as laid down by Fisher and Ben Bernanke is substantial, especially against the background of the Great Depression. Empirical support for the Bernanke transmission mechanism in the post–World War II economic activity is weaker.
There was a renewal of interest in debt deflation in academia in the 1980s and 1990s, and a further renewal of interest in debt deflation due to the Great Financial Crisis of 2007–2010 and the ensuing Great Recession.
