I have an economics professor who basically worships at Ben Bernanke’s feet. He seems to side with the deflationist in their thinking that the Fed needs to inject more paper into the economy. In fact he even states the Fed should have done more of it as if a couple trillion of new money wasn’t enough. His reasoning is that in 2008-early 2009 money velocity and the money multiplier crashed so the Feds had to make up for this or the sky was goig to come crashing down.
Now he had previously said that the US government and its citizens have overspent and borrowed far too much than was sustainable. So I attempted to use this against him by saying that the decrease in velocity and the money multiplier was the beginning of people and businesses attempting to deleverage. I knew I was setting myself up, but I just had to say it. He told me that if money demand increases too much and spending falls then prices would fall leading to deflation obviously. This in turn makes outstanding debts that much more of a burden to pay off.
Maybe I’m being naive, but how would deflation make outstanding debts more difficult to pay off? A fall in prices means the dollar has more purchasing power so we would be able to spend less money to get the same amount of goods and services. If we are spending less, we can save more and use the extra savings to pay off debt quicker.
how would deflation make outstanding debts more difficult to pay off?
In a deflationary environment, the purchasing power of each dollar will increase, but that increase will be accompanied by pay cuts for individuals and lower earnings for businesses. So if we assume 20% deflation (adjust all numbers except loan payments) and the quantity and quality of services purchased with the new more valuable money is the same (buying the same things for less)… you can see that Before you had a balanced budget but after you are $240 in the hole. Because those debt payments are fixed you will have to decrease the amount of money you spend on everything else making debt payments a larger part of your spending.
Why are debtors favored over creditors? And it’s not true that creditors and debtors are two separate classes as the Marxists would have it. yes, tell him that: “As the Marxists would have it”
And if he still insists on this two distinct class nonsense, then how are all creditors favored since it is certain that the number of debtors walking out on their loans will surely rise.
Besides, they should have thought of that problem before when they inflated the money supply. Now it’s time to make the necessary corrections.
If your professor had some better sense of the capital structure of the economy, and how artificial tampering of the money supply distorts that structure, he wouldn’t be saying this nonsense.
Inflation/deflation should have no impact whatsoever on debts. Anyone with a brain simply writes inflation into contracts that ocurr over a long amount of time.
Once again, economists have made a straw man of the market instead of looking at what actually happens…
Inflation/deflation should have no impact whatsoever on debts. Anyone with a brain simply writes inflation into contracts that ocurr over a long amount of time.
Should or shouldnt is not really important. I does have an impact.
Also it is not as simple as you make it out to be. How can a lender simply write into the contract allowances for inflation or deflation for a 30 year mortgage. No one can know what the economic environment will be in 30 years. From a lenders point of veiw the only answer to this is to not make long term loans.
But then that simply shifts the burden to borrowers who are buying a house or are planning long term projects. How do they budget a project when there could be dramatic shifts in thier debt payments.
I dont see deflation as any more or less damaging than inflation, but saying it is a non-issue is a bit much.
I don’t see how it can be denied that deflation benefits CURRENT creditors over CURRENT debtors… unless maybe you could say that the increased value of the debt would be offset by an increased rate of defaults.
The burden is on both; borrowers and creditors. It is a mutual exchange after all. Not one guy doing the other guy a favor.
It is mutual exchange but that doesent mean both sides will consider the same factors. Thats my only point. The only reason a bank would adjust price for deflation is if the borrower takes it into account when bargaining for price.
For example when a bank lends, the interest rates they off on the loan should be tied to several factors like risk of inflation, default, other investments, etc. These are the risks the bank assumes when making a loan. The borrower should consider different risks and factors when deciding to agree to the loan. Inflation and default risk are not among those considerations.
"How can a lender simply write into the contract allowances for inflation or deflation for a 30 year mortgage. No one can know what the economic environment will be in 30 years. "
You write into the contract “He has to pay the principal plus 4% interest [say] plus whatever inflation is.”
This is standard practice in countries with high inflation.
You write into the contract “He has to pay the principal plus 4% interest [say] plus whatever inflation is.”
Having no idea what inflation will be in 5 years much less year 30 it would be like signing a blank check. I certainly would not sign a contract with such a large uncertain factor. Then on top of that if you remove the central bank and with it the certainty of inflation, things become even more dicey for long term lending.
The above would certainly be feaseable with short term lending, much in the same way people sign loans with variable interest rates tied to prime. But anything longer than a 5 year maturity would be like a shot in the dark.
Anyway my only point is that inflation and deflation are problematic for an economy.
But wages are much slower to change than other prices, especially when politicians get involved.
That may be in some cases, but it remains that in a deflationary environment prices fall and wages would typically fall with them and debt will be harder to repay after prices and wages fall.
There may be a little window where certain peoples wages have not fallen making the repayment of thier debt easier, but economy wide debt will become a bigger burden.
Seems the topic has sort of taken off since I posted. So to get back to what my professor said would you say that he is correct in his assertion that in a debt based fiat currency and fractional reserve banking system that allowing the money multiplier and velocity to fall dramatically would be devastating to the econonomy and that the Federal Reserve acted as it should have by increasing the money supply? In other words it was a massive last ditch effort to cover up the fatal flaw of fractional reserve banking? Most of our money due to money multiplier is nothing but book entries and not actually created by the Federal Reserve. Widespread deleveraging would retire debts to zero essentially decreasing the money supply. But not all debts would be retired equally or at the same rate so as the money supply decreased leading to falling prices, revenues, and wages, those who still held larger debts would feel the pinch.
What I ultimately would like to ask is this: Is the problem ultimately fractional reserve banking? I know Rothbard called FRB nothing more than fraud so I assume many or most Austrians are in favor of full reserve banking?
Deflation, when driven by an excess demand for money, increases the real burden of debt. It is not a solution to anything. In my opinion, your professor is quite correct.
Yeah, it’s a real burden to make the necessary corrections for the errors of the previous inflation. Let’s just continue to inflate.
Of course, since an excess demand for money is the evil of all evils according to you, then you must also provide the necessary liquidity to banks in order to avoid the dreadful monetary deflation that a fractional reserve banking crisis would result in, since that in turn would lead to further excess demand for money by individuals.
Edit: In other words, socialism should bailout the system during a crisis.
I would say yes. Modern economists fears of deflation are based on how FRB works. In the current crisis allowing the default of all these loans would immediately shrink the money supply dramaticly. Then you would have dramatic falls in prices and earnings. Making the burden of that debt which did not default harder to carry. Those who previously would have no problem carrying their debt would now find themselves unable to. This would lead to more defaults and a further restriction of the money supply. Their fears are justified. This sort of sequence would be devestating.
However, the defaults have to occur, but our policy makers have chosen to have it done over the next decade or so, as opposed to the next few years.
They fear liquidation over inflation because they don’t understand ABCT. So “justified” is a bit inaccurate given the alternative.
Sure, if I just know half the story and engage in false choice fallacies and other false dilemmas, I too oppose any attempt for the economy to correct itself.
They fear liquidation over inflation because they don’t understand ABCT. So “justified” is a bit inaccurate given the alternative.
Sure, if I just know half the story and engage in false choice fallacies and other false dilemmas, I too oppose any attempt for the economy to correct itself.
I think they are more fearful of deflation than inflation because of how each relates to debt and then how that debt relates to money supply. They see deflation as self reinforcing.
Default on debt contracts the money supply… when the money supply contracts and prices and wages fall debt becomes more burdensome… leading to more defaults… which lead to futher contraction of the money supply… which leads to more deflation etc. etc.
In the process of this accelerating deflation many other people and companies will be taken down, not because they have malinvested but because of a devestating monetary shock to the economy. That is why I say their fears are justified.
i dont think Austrians and mainstream economists disagree on this. This is simply the mechanics of what happens given our current monetary system. What is disagreed apon is what initiates the cycle. Thats where the ABCT comes in. The understanding of why these things happen.
On a side note I think that inflation may have the same reinforcing mechanism, but I havent heard it discussed much.
How does one define “excess” demand for money? How do we know then one’s demand for money is excessive?
Are you ignoring the cause of the deflation? Are you ignoring the prior monetary inflation / credit expansion?
Would we be discussing what to do about “deflation” if the prior monetary inflation / credit expansion had not occurred?
See also DD5’s and Southern’s replies, above.
This is a near century old debate between the ideas of interventionists and the economists*. The interventionist* justifies the initial monetary expansion by the central bank (2001 - 2004), then justifies the even greater expansion needed to counter the inevitable bust (2007 to ???).** The debate will not be settled here.
*I use the term “interventionist” to describe the orthodox schools of economic thought, like the professor described in the OP.
**The tightening of 2004-2006 exposed the malinvestment.