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Paul Krugman: Inflation, Deflation, Debt
September 2, 2010, 2:53 pm

Some readers ask what’s actually a very good question: even granted that inflation reduces the real liabilities of debtors, it also reduces the real assets of creditors. So why is there any benefit to the economy?

The answer is, I think, easier to understand by considering the reverse case: the problem of debt-deflation. Here a falling price level increases the real value of all debts — and Irving Fisher famously argued that this has a contractionary effect on the economy, possibly turning into a vicious circle. Why?

The answer is that on average, debtors are more likely to be constrained by their balance sheets than creditors. The 1929-33 plunge in prices made heavily mortgaged farmers poorer, while making wealthy people sitting on cash richer; but while the farmers were forced to slash spending to make their payments, the people sitting on cash merely had the option of spending more — an option many didn’t take. Or, to lapse into economese, the marginal propensity to spend out of wealth is surely higher for debtors than for creditors, so the redistribution of real wealth caused by deflation is contractionary. And conversely, redistribution through inflation raises overall demand.

And all of this in turn explains why debt, even if it’s debt we collectively owe to ourselves, can be a major economic problem.