A deflationary spiral is a very serious problem in a modern economic system.
Historically this may be caused when an asset bubble is burst. In this case the real estate market.
Decrease in prices leads to lower demand as people delay purchases ,with the expectation of lower prices tomorrow.The beginning stages of the real estate crash began this way, as demand for new houses was delayed, with the anticipation that prices would stabilize and begin to fall.
While prices of new and existing homes fell in 06 and 07, construction of new homes, and real estate speculation continued. This resulted in an ever increasing glut of house inventory, at the same time as the credit markets began to freeze up.
The lower the prices fell, the more homes became valued beneath the mortgage that was owed.
Many home owners had become owners with little or no down payment.
Many of these purchasers were granted loans beyond their ability to pay the mortgages, counting on the continued appreciation of real estate to produce equity that would secure mortgage payments.
This risky “bad” paper (loans) had been combined in various investment packages, and leveraged in the secondary market as ”sub prime” assets. These risky mortgages were labeled secure, due to booming real estate collateral.
Banks and Wall Street titans carried these intrinsically risky loans at irresponsible multiples( up to 30x and more) to value their own stability and balance sheets.
As the falling housing market picked up speed, the vulnerability of these sub prime assets became more and more obvious.
The lower prices fell, the more demand dried up, and the more critical and obviousthe banking vulnerability became.
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Chapter II
A Deflationary Spiral
Let The Bailouts Begin