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Cutting spending worsens the debt burden
Spending cuts hurt incomes
In a deleveraging, people, businesses, banks, and even governments tighten their belts and cut spending so they can pay down debt. That should shrink the debt burden, but the opposite happens. One person's spending is another person's income, so cutting spending cuts incomes, and incomes fall faster than debts are repaid. Businesses cut costs, which means fewer jobs and higher unemployment.
Defaults and restructuring
Many borrowers then find they can't repay, and a borrower's debts are a lender's assets. When borrowers don't repay the bank, people get nervous and rush to withdraw their money, banks get squeezed, and defaults spread. Lenders would rather have a little of something than all of nothing, so they accept debt restructuring: getting paid back less, over a longer time, or at a lower interest rate than first agreed.
The depression
Debt disappears this way, but income and asset values disappear faster, so the burden keeps getting worse. The severe contraction that follows is a depression, and a big part of it is people discovering that much of what they thought was their wealth isn't really there. A defaulted bar tab is the small version: the bartender's asset has basically vanished.
How can paying down debt increase debt?
Economist Irving Fisher described this loop in his 1933 paper The Debt-Deflation Theory of Great Depressions. Forced selling of assets pushes prices down, and falling prices raise the real value of what is still owed. Fisher wrote that the more debtors pay, the more they owe.
Between 1929 and 1933 US consumer prices fell about a quarter, according to the Bureau of Labor Statistics price index, while many debts were fixed in dollar terms.
How does a bank run spread so fast?
Banks hold deposits that can be withdrawn at any time but lend the money out for years, so they cannot pay everyone at once. Douglas Diamond and Philip Dybvig modeled this in 1983, showing that when depositors fear others will withdraw, withdrawing first becomes the sensible choice.
Federal Reserve history counts more than 9,000 US bank failures between 1930 and 1933. The Federal Deposit Insurance Corporation was created in 1933 to insure deposits.
Why would lenders accept getting paid less?
A lender compares a restructuring with what a failed loan would recover. Forced sales of collateral in a downturn tend to fetch low prices, so a reduced but real payment can be worth more than a fight over the whole sum.
Under US bankruptcy law, a reorganization plan generally must give each objecting creditor at least what it would receive in a liquidation.
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