Expert Commentary

Debt Deflation: Where It Should Be Most Severe

As debt deflation begins, here are the nations where it is likely to be most severe.

First and foremost, let me state this. Debt deflation is a strong force no matter how we slice and dice statistics. That's because it's really all about psychology and the negative trend in social mood that drives the deflation. In a debt deflationary period, the economy will face dire times no matter what. That said, it is possible to identify which countries are most at risk of a severe debt deflation and those where the debt deflation might be relatively milder.

A recent report from OMFIF (the Official Monetary & Financial Institutions Forum) looked at the debt implications of the recent Covid-19 responses from governments around the world. The report looked at various ways of measuring debt levels as well as its affordability and sustainability. Just looking at the level of government debt as a percentage of Gross Domestic Product does not give any sense of the full picture at all. On that measurement, the five nations with the highest debt are, in decreasing order, Japan, Greece, Italy, Portugal, U.S.A and France. The report makes the point that Japan's government debt-to-GDP ratio has, of course, been sky high for decades and there has been no debt crisis. What it fails to mention is that private sector debt in Japan has been deflating for decades too, and that is why the country remains in a funk.

It;s really private- sector debt that we need to focus on most in a debt deflation for the very simple reason that the private sector cannot print money to service the debt. Sure, there are many nuances to that with regard to Quantitative Easing, but that essential fact means that the private sector feels the urge to deflate its debt more acutely than the public sector, not to mention that lower credit quality in the private sector deflates debt via defaults.

If we strip out government debt and just look at the private sector, the chart below shows some interesting aspects. Japan, Greece, Italy, Portugal and the U.S.A all now show relatively mild levels of debt compared with the rest of the world. France, though, is still on the extreme side of the list. Using this calculation, Hong Kong, the Netherlands, Switzerland, Sweden and Ireland are the five countries most at risk of a severe debt deflation.

Note that this calculation does not include the financial sector. If it did, the U.S.A would be further up the "at risk" scale. However, it gives us an understanding of which countries might feel the most pain in a debt deflationary period.

Severe Debt Deflation Risk Chart