Let’s Talk about Debt and Deflation

The issue of debt continues to rise in the headlines especially considering the US debt levels continue to rise and has reached over 101% of GDP as of 2013. The issue of debt does have its negative impact on the economy including loan payment and raise the uncertainty level of an economy. But in times of economic slowdown when households and companies tend to reduce their level of debt, it’s up to the US government to spend more even if it means increasing its debt burden.

And the US government has done more than its peers in Europe, which could partly explain why the US economy is in much better shape than the EU – yes this is only one out of many factors but still an important one.

Just take a look at the following chart:

Source of chart taken from FRED 

It shows the M1 Multiplier and Loans and Leases in Bank Credit, All Commercial Banks over the last five years.

The money Multiplier indicates just how much money the banks spread around compared to the amount they save as reserves. This ratio, as expected, gone down between 2008 and 2010 as the Fed “printed money” but the banks “sat on the cash” either because they didn’t want to give it our and/or households and companies didn’t want to take on more. They were in the process of de-leveraging.

The loans and banks credit also fell, which is another way to look at the same thing – fewer loans and less debt added to the private sector, which only brought down the multiplier.

In the past year of so banks started to see a rise in their loans and credit given to the private sector, albeit the money multiplier still remains low.

So where does it leave us? Well, this could suggest the situation is very slowly staring to change. But it could also suggest that once the FOMC start to raise its cash rate, the ratio, which is already low, could fall even further down. And a low money multiplier additional deflationary pressures.

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