Deflationary spiral

A deflationary spiral of declining (asset) prices and downward pressure on economic growth can start when investors are no longer confident that a country can fulfill its interest cost and repayment obligations. As a result, investors will demand higher risk premiums on government sovereign bonds, so long-term interest rates are again under upward pressure. This is occurring in Spain, for example. If the government finds it more difficult and costly to borrow, so will the private sector. They are thus under pressure to reduce their borrowing, but this is negative for the economy as less credit results in less economic activity, lower employment, and thus less consumption.

What adds to the deflationary spiral is that worsening economic prospects lead to asset price declines (mostly real estate and stock prices), while many consumers have borrowed with these assets as collateral. Consequentially, the value of these loans drops, and resulting bank losses mean that banks must reduce lending further to solidify their balance sheets. However, if each bank does this, the result is a worsening economic contraction.

Moreover, higher interest rates (caused by higher risk premia) increase the debt burden for both the government and private individuals, and further inhibit economic growth.

This is generating a self-sustaining negative spiral for the economy. Investors then demand even higher risk premiums, lower asset prices imply there will be even less borrowing and more deleveraging, slowing growth, and so forth.