I’ve been wondering something. I think most of you will agree that if we were to set up a gold standard and stop printing money, we would get deflation since the rate at which gold is extracted (about 1% per annum) is far smaller than most rates of economic growth. Yes I do realise today’s economic growth rates are overvalued since they are driven by debt and inflation, but even so.
Now in the absence of price fixing (including minimum wages) there’s essentially no big problem for businesses, as nominal prices and costs would adjust and profit margins wouldn’t change. Consumers of course would only benefit from a short term higher purchasing power on their savings. This however, is where the problem I’ve been thinking about lies.
If the purchasing power of money perpetually increases, we have a serious problem with the credit market. In theory, contracts could eventually adjust to have Principal + Interest after a set period of time to be less than the original Principal, since purchasing power would increase. However, this then begs the question, if after loaning out your money you’re going to get less back (nominal), why don’t you just keep it for a while and end up having more value. Basically I’m saying that with deflation there would be a serious disincentive to save, unless interest rates rise to very high levels, levels necessarily exceeding the rate of deflation.
Initially I was thinking that with perpetual deflation, the problem of returning P + I where Interest does not yet exist in the monetary stock necessarily makes some people insolvent, simply because they can’t return more money (nominally) than exists. So I thought excellent, with deflation you would have to return less than you originally borrowed nominally, so there’s no shortage of cash. But then why would people lend out money? The only solution is that interest rates are even higher, to ensure that more money is returned than borrowed, despite deflation rates, but in this case we still have the problem of P + I exceeding P.
Any thoughts? Am I right that with perpetual deflation, interest rates must exceed the rate of deflation for people to have an incentive to save, but then we’re still stuck with the P + I problem. Then again, maybe P + I exceeding P is not such a terrible thing? Maybe it’s the free markets way of ensuring a certain amount of investments (the less successful ones) go bankrupt. I’m not sure…
I’m not sure that follows. If you’re better off keeping your money then that’s exactly what you’ll do. Holding on to your money you essentially gain purchasing power proportionate to the rate of deflation. Any interest you earn on top of this will be an added benefit, and will likely compensate you for the risk component of the loan. However, even if you live in an inflationary environment it doesn’t make sense to make loans that don’t compensate you for the risk you’re taking - the difference is that in an inflationary environment the lender also wants to recover the money he’s lost to inflation (since he’s interested in the real rate of return)… so it would seem to me that it’s most likely interest rates would be much higher (nominally) in an inflationary environment. Real interest rates, however, will be exactly the same (and determined, as always, by time preferences + some compensation for risk, which will probably vary depending on how risk averse the lenders are and how much capital/savings are available to loan in the market etc.).
What also differs in the two scenarios is that in a fiat money system (and inflationary environment), as opposed to a gold money system (which might have monetary inflation that runs at rates slightly below that of the growth rate of the economy), the lender is also faced with uncertainty about future inflation since they cannot know what monetary policy will be in the medium to long term… so they will likely want to be compensated for the relatively greater risk that they must take in a fiat money system, as compared to the hard money system - this is yet another expense which must be born, ultimately, by the borrower and will push nominal interest rates up even further again.
All in all, I’m not seeing many benefits for either the lender or the borrower in a fiat money system… nor do I see how a fiat money system (inflationary money) in any way encourages savings. If anything, and if the united states is any example, it rather punishes savers and encourages borrowing and over consumption - since the Fed is always helping out people in debt by inflating monetary supply and decreasing the total real amounts that must be repaid on these debts (in conjunction with putting a price floor on interest rates by guaranteeing certain minimums via government bonds, who’s price is set by the Fed’s primary dealers).
I really don’t think P + I is a very big problem becuase you’re trying to express the returns in this equation in nominal terms… whereas lenders will be thinking in real terms. They want to know the benefits of deferred consumption (lending) will exceed immediate consumption by a sufficient amount to justify that deferred consumption (as determined by their time preferences and risk apetite/aversion).
During deflation, banks operate under normal circumstances as today (but during a goldstandard without the possibility to create money from nothing). This puts into effect the actual business idea where the bank borrow money from depositors and lend it out for a higher interest and the difference becomes the profit. There is no need to adjust the contracts because of a higher purchasing power of the money. With a more scarce supply of money, money will simply cost more. Banks must offer an interest to get the depositors to get hold of money to lend out. The acquired money will then orientate to the most lucrative investments because they can handle the costs of paying the interest and the constant nominal principal even though their income perhaps could decrease in nominal terms because of the higher purchasing power of money. Simply, the offered interest from the bank is added to the increasing value of the money, it doesn’t substitute it.
The possibility of not being able to pay back the debt depends not on the deflated monetary stock but on your ability to earn the money for it. The problem with the non-existent money to pay the interest occurs during inflation when money IS debt and therefore the money to pay the interest can’t exist without causing further debt and further claims for interest.
The only problem with deflation is all the debt all of society is burdened with, all this debt would have to be liquidated and the result would be a serious blow to the economy. But the problem isn’t deflation itself but the earlier inflation which downsides is revealed.
Let’s suppose that the economy experiences a 3% price deflation per year with constant output (this may be due to an increase in the demand for money, that is, a reduction in its velocity of circulation).
People thinking in real terms need a nominal rate which is equal to the real rate plus price inflation (minus 3% in this case), in order for the price level change to be neutral.
However, if the real rate is less than 3% the nominal rate cannot be neutral because it would hit the lower 0% bound. Being money a durable good, in fact, holding money is always better than lending it at a negative nominal rate.
This problem is negligible because deflation rate will not be very high in a gold standard monetary system. Considering that dP (variations in the price movement) are equal to dM + dV - dQ, and dM in the gold standard will be positive, dV will be positive most of the time, and the only problem is dQ. However, a positive dQ implies real growth, and, thus, higher real rates of return, so that it is unlikely that an economy experiencing deflation due to dQ will have real rates so low to have negative neutral nominal rates.
Only negative changes in V may be a problem (increase in money demand), but except for the cyclical variations in dV, I don’t know if they would play a major role. On average, dV tends to be positive, not negative. Cyclical fluctuations in the Austrian framework will not play a role in a gold standard banking system, so that there is no reason to believe that strong negative dV will ever occur.
PS The reasoning uses a fisherian setting for simplicity. The same result holds if I wrote in a wicksellian/misesian capital theory fashion.