In this paper we provide a theoretical and an empirical analysis of Fisherian debt deflation theory. According to this theory, a drop in the overall price level causes an increase in the real interest rate through the Fisher equation. The higher real interest rate increases the real debt burden, and agents attempt to reduce their burden of debt by repaying it. This distress reduction of debt originates a subsequent reduction in the lending activity of the financial intermediaries, starting a deleveraging process. This deleveraging process reduces economic activity, causing additional deflationary pressure in a feedback loop [Fisher (1933), Tobin (1975, 1980), Minsky (1982), Bernanke (1983) and Kindleberger (1996)]. So the key role played by financial leverage is clear, since it measures the reduction in loans issued by the financial sector, and therefore the credit contraction and the descent in aggregate investment and demand. Indeed, one of the main empirical findings is the crucial role played by financial leverage in explaining the links between real and monetary variables in business and financial cycles [Schularick and Taylor (2012), Claessens et al (2012), Gambetti and Musso (2017), Adrian and Shin (2008), Bonci and Columba (2008), Keister and McAndrews (2009)]. However, there remains some work to be done to consistently incorporate financial leverage into debt-deflation models. In this respect, the limited participation models [Fuerst (1992), Christiano and Eichenbaum (1992)] constitute a good option to make this role explicit. In this paper we build a limited participation model that allows the real and nominal effects of changes in the financial leverage to be explained, opening a new theoretical approach to elucidate relevant aspects of the debt-deflation theory. In addition, this stylized debt-deflation model justifies an empirical analysis developed by applying a vector-error-correction model (VECM), which confirms and quantifies the role played by the observed deleveraging process in the Euro Economy and explains the recent economic crisis of the Eurozone.
Data/Methods
Data (January 2008 - February 2019) were obtained from Eurostat and the European Central Bank (ECB) for the following variables: Harmonized Index of Consumer Press (HICP) core index; real interest rate (inflation adjusted bank lending rate); and financial leverage (loans to deposits ratio for the private sector). To apply the VECM, we run Augmented Dickey-Fuller and Phillips-Perron unit root tests to assess stationarity, and the Johansen multivariate cointegration test to investigate potential long-run relationships between the series.