The Riksbank causes “debt deflation”

New Ekonomistas post (in Swedish). Here is an English translation.

A dangerous thing concerning debt is what Irving Fisher (1933) called ”debt deflation.” It is usually described as deflation causing the real value of nominal debt to increase. Loan-to-value and loan-to-income ratios also increase, since the debt is fixed in nominal terms but the nominal value of assets and income fall. This may hurt the economy through bankruptcies, deleveraging, and fire sales.

But the important thing with the concept of “debt deflation” is not deflation, that is, negative deflation. The important thing is that the price level becomes lower than previously anticipated. This implies that real debt and loan-to-value and loan-to-income ratios become higher than anticipated and planned for. Everyone has probably not realized that this is something that the Riksbank has caused by neglecting the objective of price stability and conducting a monetary policy that has resulted in inflation below target.

The majority of the Riksbank Executive Board maintains in their latest policy decision and in the minutes that “although a lower repo-rate path could lead to inflation attaining the target slightly sooner, it could also increase indebtedness and thus the risks to economic development in the longer run” (the minutes from the meeting on September 4, 2013, summary).

As I have shown in a previous Ekonomistas post (English translation) and a (Vox column), the majority is wrong when it says that a lower policy rate would increase household indebtedness. It has misunderstood how the policy rate affects real debt and the debt ratio (the debt-to-income ratio). A lower policy rate would reduce (not increase) household real debt and the debt ratio. This is because it would increase the price level and nominal disposable income faster than total nominal debt. The effect is small, however. A 1 percentage point lower policy rate during 1 year leads over the next 4-5 years to about 1 percent lower real debt and debt ratio than without the rate increase. Thereafter real debt and the debt ratio slowly rise back to the level they would have hade without the rate increase.

But a larger effect on household debt and the debt ratio arises because the Riksbank has over a long period neglected the objective of price stability. The Riksbank has conducted a policy that has led to average inflation substantially below the inflation target of 2 percent. This has led in the medium and long run to a substantially lower price level and nominal disposable income than if inflation on average had been kept on target. Then real debt and the debt ratio have become higher.

As we can see in figure 1, the price level in Sweden has now fallen significantly under the level it would have had if inflation had on average been 2 percent since 1997. In this context, the Riksbank stands out among the other central banks that have had inflation targets as long the Riksbank. The other central banks have kept average inflation on or very close to their targets, as I have shown in a previous Ekonomistas post (English translation) and in a Vox column. For instance, in the figure we see that Bank of Canada, which also has an inflation target of 2 percent, has kept average inflation almost exactly on 2 percent since 1997.


That the price level in the medium and long run becomes substantially lower than if it had increases by 2 percent per year has substantial consequences for real debt and the debt ratio. Since 1997 long-run inflation expectations have been anchored at 2 percent. That actual average inflation has become much lower means that the price level and nominal disposable income now have become substantially lower than what the borrowers anticipated when they took out their loans. It means that the real value of the loans and the debt ratio has become substantially higher than the borrowers anticipated and planned for.

How much the real value of the loans has increased is shown in figure 2. The increase in the real value in July 2013 of a particular loan, compared to if average inflation had been equal to 2 percent, is measured along the vertical axis. The horizontal axis shows the date the loan was taken out. The earlier the loan was taken out, the higher the real value of it tends to be in July 2013. We see in the figure that a loan that was taken out in the beginning of 2003 now has a real value that is about 9 percent higher than what the borrower anticipated the loan was taken out. This is also a substantial redistribution of wealth from borrowers to lenders, that is, from mortgage holders to banks.


That the price level has become lower than if inflation had been 2 percent also implies that the borrower’s nominal disposable income has become correspondingly lower. This means that the debt ratio in July 2013 for a loan taken out in the beginning of 2003 also has become 9 percent higher than if the Riksbank had kept average inflation on target. 9 percent is a big increase. The debt ratio for this loan has probably become even more than 9 percent higher, since the Riksbank’s tight policy, especially the last few years, has led to lower real disposable income than if average inflation had been 2 percent.

Thus, the Riksbank has by during a long period neglecting the objective of price stability caused real debt and the debt ratio to be substantially higher than if average inflation hade been kept on target.

Fisher, Irving (1933), “The Debt-Deflation Theory of Great Depressions,” Econometrica 1, 337-357.