A Template for Understanding Big Debt Crises

1. Debt cycles drive economic booms and busts

Classically, a lot of short-term debt cycles (i.e., business cycles) add up to a long-term debt cycle, because each short-term cyclical high and each short-term cyclical low is higher in its debt-to-income ratio than the one before it, until the interest rate reductions that helped fuel the expansion in debt can no longer continue.

Debt fuels growth. When credit is easily available, there's an economic expansion. When credit isn't easily available, there's a recession. Over time, debts rise faster than incomes, creating long-term debt cycles. This process is self-reinforcing:

• Rising spending generates rising incomes and net worths
• This raises borrowers' capacities to borrow
• Which allows more buying and spending, etc.

Cycles inevitably reverse. Eventually, debt service requirements become too big relative to incomes. Asset prices fall, debtors struggle with payments, and investors become cautious. This leads to:

• Decreased spending
• Falling incomes
• Credit contraction
• Falling asset prices
• Further spending cuts

2. Central banks play a crucial role in managing debt crises

The key to handling debt crises well lies in policy makers' knowing how to use their levers well and having the authority that they need to do so, knowing at what rate per year the burdens will have to be spread out, and who will benefit and who will suffer and in what degree, so that the political and other consequences are acceptable.

Central banks have powerful tools. To manage debt crises, central banks can:

• Lower interest rates
• Print money
• Provide liquidity to markets
• Guarantee assets/institutions

Timing and balance are critical. Central banks must:

• Act quickly to prevent spiraling deflation
• But avoid fueling runaway inflation
• Spread out debt burdens over time
• Balance interests of debtors and creditors

Political constraints often hamper response. Effective crisis management requires:

• Public support for potentially unpopular measures
• Legal authority to take bold actions
• Coordination between monetary and fiscal policy

3. Deleveraging can be deflationary or inflationary

The two biggest impediments to managing a debt crisis are: a) the failure to know how to handle it well and b) politics or statutory limitations on the powers of policy makers to take the necessary actions.

Deflationary deleveraging occurs when:

• Debts are in domestic currency
• Central bank can print money freely
• Focus is on debt reduction/defaults

Key features:

• Asset prices fall
• Spending and credit contract
• Unemployment rises

Inflationary deleveraging occurs when:

• Significant debts in foreign currency
• Limited ability to print money
• Currency devalues sharply

Key features:

• Rapid currency depreciation
• High inflation/hyperinflation
• Debt burdens grow in real terms

Policy response determines outcome. The balance between austerity, defaults, money printing, and wealth transfers shapes whether deleveraging is deflationary or inflationary.

4. Policy makers face difficult trade-offs during crises

It is from a desire to help reduce these risks that I have written this study.

Key policy dilemmas:

• Austerity vs. stimulus
• Bailing out banks vs. moral hazard
• Supporting currency vs. boosting exports
• Helping debtors vs. protecting creditors

Short-term vs. long-term trade-offs. Actions that provide immediate relief (like printing money) can create long-term problems if taken to extremes.

Political pressures complicate decisions. Public anger at banks/elites can make it difficult to take necessary actions to stabilize the financial system.

Unintended consequences. Policy moves often have ripple effects that are hard to anticipate, requiring frequent adjustments.

5. The Great Depression exemplified a deflationary deleveraging

To reiterate, the two biggest impediments to managing a debt crisis are: a) the failure to know how to handle it well and b) politics or statutory limitations on the powers of policy makers to take the necessary actions. In other words, ignorance and a lack of authority are bigger problems than debts themselves.

Key features of the Great Depression:

• Stock market crash of 1929
• Widespread bank failures
• Sharp contraction in money supply
• Collapse in spending and production
• Deflation and high unemployment

Policy mistakes worsened the crisis:

• Adherence to gold standard limited monetary policy
• Insufficient fiscal stimulus
• Trade protectionism (e.g. Smoot-Hawley tariffs)
• Allowing widespread bank failures

Recovery came through bold policy action:

• Abandoning the gold standard in 1933
• Large-scale money printing
• Deposit insurance and banking reforms
• Major public works programs

6. Germany's 1923 hyperinflation illustrates inflationary deleveraging

The most iconic case is the German Weimar Republic in the early 1920s, which is examined at length in Part 2.

Causes of German hyperinflation:

• Massive war debts and reparations
• Loss of productive capacity after WWI
• Political instability and lack of tax revenue

Key features:

• Rapid currency depreciation
• Exponential price increases
• Collapse of normal economic activity
• Social and political upheaval

Lessons learned:

• Dangers of monetizing large external debts
• Importance of maintaining central bank independence
• Need for coordinated international crisis response
• Political consequences of economic chaos

7. The 1930s recovery shows the power of monetary stimulus

Though most people mistakenly think that the depression lasted through the 1930s until World War II so I want to be clear on what actually happened. It is correct that it took until 1936 for GDP to match its 1929 peak. But when you look at the numbers in the charts below, you can see that leaving the gold peg was the turning point; it was exactly then that all markets and economic statistics bottomed.

Key policy moves by FDR administration:

• Abandoning the gold standard
• Devaluing the dollar
• Large-scale government spending programs
• Banking reforms and deposit insurance

Economic impacts:

• Sharp rebound in industrial production
• Rising asset prices (stocks, housing)
• Falling unemployment
• Return of modest inflation

Limitations of the recovery:

• Uneven distribution of gains
• Lingering high unemployment
• Incomplete resolution of debt overhangs

8. Economic conditions can fuel political extremism

Driven by weak economic conditions, an uneven recovery (in which the elite was perceived to be prospering while the common man was still struggling), and ineffectual policy makers, populism was a global phenomenon in the interwar period (the 1920s to the 1930s), leading to regime changes not only in the United States, but also in Germany, Italy, and Spain.

Economic factors contributing to extremism:

• High unemployment
• Sharp inequality
• Loss of savings/wealth
• Perceived unfairness in crisis response

Political manifestations:

• Rise of fascism in Germany and Italy
• Communist movements gaining strength
• Isolationism and nationalism in many countries
• Erosion of democratic norms

Policy implications:

• Importance of addressing inequality during recoveries
• Need to maintain public faith in institutions
• Dangers of scapegoating and divisive rhetoric

9. War economies operate under different economic principles

War economies are totally different from regular economies in terms of what happens with the production, consumption, and accounting for goods, services, and financial assets.

Key features of war economies:

• Massive government spending and deficits
• Strict controls on production and consumption
• Labor shortages and wage controls
• High inflation often followed by post-war deflation

Economic impacts:

• Full employment but restricted consumption
• Rapid technological advancement
• Massive expansion of productive capacity
• Accumulation of war debts

Post-war challenges:

• Converting war production to civilian use
• Managing demobilization of soldiers
• Dealing with accumulated debts
• Rebuilding destroyed infrastructure

Last updated: January 24, 2025