The structural aspect of deflation and depression is also crucial. The ability of the financial system to sustain increasing levels of credit rests upon a vibrant economy. At some point, a rising debt level requires so much energy to sustain - in terms of meeting interest payments, monitoring credit ratings, chasing delinquent borrowers and writing off bad loans - that it slows overall economic performance. A high-debt situation becomes unsustainable when the rate of economic growth falls beneath the prevailing rate of interest on money owed and creditors refuse to underwrite the interest payments with more credit.
When the burden becomes too great for the economy to support and the trend reverses, reductions in lending, spending and production cause debtors to earn less money with which to pay off their debts, so defaults rise. Default and fear of default exacerbate the new trend in psychology, which in turn causes creditors to reduce lending further. A downward spiral begins, feeding on pessimism just as the previous boom fed on optimism.
The resulting cascade of debt liquidation is a deflationary crash. Debts are retired by paying them off or restructuring, or default. In the first case, no value is lost; in the 2nd, some value; in the 3rd, all value.
In desperately trying to raise cash to pay off loans, borrowers bring all kinds of assets to market, including stocks, bonds, commodities and real estaste, causing their prices to plummet. The process ends only after the supply of credit falls to a level at which it is collateralized acceptably to the surviving creditors.
