Australian economist Steve Keen, who beat off the famous Nouriel Roubini to win the Revere Award by his peers for predicting and warning about the global financial crisis as far back as December 2005, has published what I consider to be the definitive plain-English essay on understanding what debt deflation is, and why this recession is different from all other post-WW II recessions.

In simple terms, the crucial point that Steve teaches in this essay is that consumption plus investment (i.e. “economic activity”) is directly driven by the sum of GDP (a.k.a. income) PLUS the change in debt level. I remember a senior bank executive in late 2007 telling me that consumer loans had been increasing at the rate of 20% per year! That net increase in debt, added on top of Cypriots’ income, was surely behind the crazily exuberant conditions we had experienced here in the last few years leading up to the crisis.

And it wasn’t just here, of course. Households, businesses and governments in the West have been loading up on debt for the better part of the three decades that ended in 2008. The positive number for net change in debt each year added to the EARNED ability of households and businesses to consume and invest from the 1980’s to date. The music has stopped, the growth in private debt ended, and private sector actors are in fact deleveraging (reducing debt). Aggregate demand for products, services, shares or property must take a hit once the growth rate of debt slows down, let alone when net debt falls during deleveraging – it is mathematically required, as Steve Keen has shown in his essay.

So, we see now why debt deflation is a trap that economies cannot easily get out of. The falling “net new private sector debt” (per period of time) reduces aggregate demand relative to prior periods, putting downward pressure on asset prices. The expectation of further falls in asset prices hit the demand and supply of net new debt, fulfilling the prophecy of falling asset prices. As a result, the pool of economic actors who believe asset prices have further to fall continues to expand, and the net new debt generated by the economy continues to fall. This vicious circle is very hard to stop, especially if the starting point is a monster debt-fuelled bubble, like Japan in 1990 or the West in 2007/2008. Chances to reverse this dynamic improve once private debt has fallen to very low levels and once the pool of actors who think asset prices will fall further has stopped expanding. Even then the reversal is not automatic: for various reasons, and not just because of demographics, Japan is still stuck in deflation, 20 years on. And it also unlikely that a reversal can come soon to bring relief. Good old fashioned empirical research such as this work by Stuart Staniford shows that the deflationary aftermath of past deleveraging episodes had taken of the order of a decade to work through.

Some uninformed observers of the situation recognise part of what is going on, but then pin their hopes on Central Banks and on Quantitative Easing. However, Japan’s experience showed that QE simply keeps zombie banks alive: it does not plug the aggregate demand gap caused by the deleveraging outcomes in the private sector.

Cyprus, as a small paper boat floating on a lively ocean, experienced the upside of this cycle, in the form of tourism and foreign demand for immovable property. Since the downside started, guess what – Cyprus is loading up on government debt to try to keep the party going. Even if this maintains an illusion of economic activity for a while, we should know by now where and how this will end. Once the foreign debt burden passes a critical level, as it did in Greece, the Ponzi scheme that we mistook for real growth all these years will collapse here too, just as it did in Greece.