Does deflation lead to hoarding of money?

Miscellaneous Newbies
1

Recently I participated in an internet online forum with a person who subscribes to the Austrian school of economics. He claimed that there is no additional incentive to hoard money in a deflationary environment as compared to a environment of stable prices. So I came up with this investment decision example to show him that there is in fact a strong additional incentive to hoard money.

Here is the scenario:

I am an owner of a bread making factory. The factory makes loaves of bread at the rate of 1000 loaves per month. But I can improve the business process by hiring a consultant to improve the business process such that in one year the production rate will be 1100 loaves per month. The consultant will need to be paid 1200 pieces of gold for his services. Each loaf of bread is currently selling for 1 piece of gold . The prevailing deflation rate is 5%.

All revenue and cost numbers are in terms of pieces of gold.

With no improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 12000 12000 12000

Revenue 12000 11400 10830 10288

With improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 13200 13200 13200

Revenue 12000 12540 11913 11317

Net gain in gross margin (in terms of pieces of gold) due to improvement:

Year 1 = 0, Year 2 = 1140, Year 3 = 1083, Year 4 = 1028

Now let us consider the same project in an environment of stable prices (no inflation or deflation):

With no improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 12000 12000 12000

Revenue 12000 12000 12000 12000

With improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 13200 13200 13200

Revenue 12000 13200 13200 13200

Net gain in gross margin (in terms of pieces of gold) due to improvement:

Year 1 = 0, Year 2 = 1200, Year 3 = 1200, Year 4 = 1200

Notice that my payback time for the deflationary environment will be a longer. This raises the hurdle to invest. All investments are risky. And the longer I have to wait to get paid back the more risky it is.

Conclusion: Deflationary expectations raise the incentive to hoard money.

2

I would say that depends on the level of deflation. A real normal deflation would have no impact in the incentive to hoard money. But…

We can see that as the housing bubble burst investors are waiting and waiting (hoarding) until deflation in housing prices reaches a bottom …so they can invest.

3

The revenue in the first two charts goes down. It doesn’t necessarily mean deflation. It is possible that consumers don’t want bread. Investors therefore can put their money in butter. Why mess with it?

4

In a deflationary environment wouldnt either the consultant have to charge less for his services or either would his services would have to yeild a greater gain in order for the investment to happen. After all the starting points could not be the same if there are different expectations for the future.

In other words would deflation affect the costs of the investments (your starting point) as well.

5

Assume $1= 1 piece of gold for your example.

I hope I understand the problem you are presenting correctly, but the error in your reasoning is that you just assume the cost of initial investment of 1200 breads (for the consultant) to be $1200 in both cases. This isn’t a valid assumption. Deflationary expectations would be factored in just like inflationary expectations are factored in today. The capital value of your initial investment is more likely to be worth $1028 according to your example and not $1200.

It is true however that people are likely to save more in the form of hoarding but for different reasons. One reason is that the money unit is to be expected to gain in value as oppose to lose in value as in today’s inflationary environment. People won’t have to constantly try to flee into investments they understand nothing about. You leave the riskier investments to those who have the most knowledge and not to sweet old granny.

6

What I was trying to say but more clearly stated.

7

Right. The question seems to be akin to Keynes’ alleged “paradox of thrift.” The market correctionary measure of deflation is seen as a bad thing where individuals are trying to respond appropriately to problems that the government created. Keynes loathed the virtue of savings and “thrift,” believing that if people sacrifice by spending now and always instead of saving, the growth in the economy would reward them for their “contribution.”

8

One problem I see with the chart is what are the other prices in the market doing? Going up or down? What about your costs too?

9

“..as compared to a environment of stable prices”

Although in Austrian theory all prices have a tendency to move towards the state of equilibrium [i.e stasis, or stability], I was under the impression that standard boiler-plate Austrian theory also points out that such an environment [i.e stasis, or overall price stability], does not/cannot exist in reality, and is only an artificial construct to be used when appropriate, if at all .

Your Austrian economist online friend would appear to be unwittingly comparing apples and oranges, and to have perhaps led you down the same road . Oh well. [:(]

Regards, onebornfree

10

As I mentioned in your other thread, your analysis ignores the rising purchasing power of the money (in this case, gold). If I pay 1200 gold in year 1, this is not valued the same as 1200 gold in year 4. My accountant might assume that I need to earn back exactly 1200 gold in order to “break even,” but this is not so. In your example, I’d only need to earn back 1028.85 gold in order to “break even”, as the purchasing power of money has risen. Ceteris paribus (in other words, all places deflating equally—far departed from reality, but it simplifies the analysis), 1200 gold in year 1 buys the exact same amount of any good as 1028.85 gold in year 4.

Since I believe he was referring to me in the OP, I’ll address this. I completely understand that the ERE is a fictitious construction, and this is exactly one of those scenarios where using it allows us a more cogent analysis of the effects of deflation/inflation. I mean, honestly, this whole example is horribly contrived and ignores millions of variables, but the basic principles we’re analyzing still work when reality is resumed.

11

like the mythical unicorn, we will never see deflation.

12

“like the mythical unicorn, we will never see deflation.”

when does myth become lies? is deflation a drop in money supply …would you consider it also a drop in currency supply if you dont consider the current-dollar money??

anyway… www.economagic.com shows m1 at 1.18 trillion in 1995. in mid 1997 m1 was at 1.06 trillion.

what is that called when m1 decreases about 100 billion dollars over a year and a half or so???

if you dont consider the dollar-currency as money what do you call the drop in m1…something other than deflation???

13

No, people attempt to keep the current amount of wealth on hand. So they have increase cash holdings to offset the decrease in the value of the currency. Keep in mind that it is not the value that matters but peoples perception of value or more importantly where the value is heading. So as inflation accelerates, people who prefer to hold cash naturally increase their holdings to keep up with inflation.

14

If a person can most effectively “invest” money by hoarding it, why is that a bad thing? The notion that deflationary trends are destructive to free enterprise is something that has been thoroughly discredited by the simple progress of technology. That I can buy the same computer for $50 today that I would have to spend $1000 on five years ago has not resulted in catastrophe for the consumer electronics industry. Rather, it has permitted people who could not afford certain products five years ago to buy them.

Moreover, people hoarding money results in less consumption/investment, which spurs producers to produce less, thus increasing the price level. In other words, in a free system, general deflation results in market forces which curb it. Thus, in an uncontrolled system (one in which there is no central actor attempting to force the price level), general deflationary trends will be short-lived and mild, as will inflationary trends.

As a sidenote, technological improvements will in general result in deflation. As production prices go down and quality rises, competitors will be driven to reduce prices, and as the level of technology rises, new frontiers of goods will be envisioned and implemented in order to take advantage of the relative increase of wealth of the average consumer and satisfy wants that the earlier consumer wouldn’t be able to fill (and probably wouldn’t even realize he had them). The breadmaker today benefits from cleaner water, indoor plumbing, electricity, and various other advantages that make his job much easier than it would be otherwise. An average consumer 100 years ago probably had no idea how useful, and how much of a game-changer the modern computer would be. The notion of a device capable of performing billions of mathematical operations per second would have been seen as visionary. Once the consumer gets a new good, he realizes a whole new bevy of wants that can be fulfilled. This process is endless.

15

Go back to your spreadsheet and calculate the bread maker’s cumulative gain in loaves of bread (instead of gold), and how many loaves can the consultant buy with his 1200oz of gold after year 4. I see:

Cummulative 4yr Gain in Loaves (deflation): 3,793

Cummulative 4yr Gain in Loaves (no deflation): 3,600

Loaves to Consultant After Year 4 (deflation): 1,400

Loaves to Consultant after Year 4 (no deflation): 1,200

With deflation both the bread maker and the consultant end up with more loaves of bread after year 4 compared to a “no deflation” scenario. Gold deflation simply means bread inflation. And vice versa, gold inflation simply means bread deflation. Neither case says anything about people’s incentive to invest, and in both cases both the bread maker and the consultant GAIN by their exchange of gold (loaves) for consulting services. Hope this proves that your conclusion is wrong.

16

Mansoor,

Those who are participating in this thread might benefit from full disclosure of your economic perspective. They can then decide how to proceed.

You went on to agree with “Economics in a Nutshell”. That is your persective, right? It is simply not possible to untangle your beliefs about deflation until you address the shortcomings in your overall economic understanding. Numbers 1 through 7, above, are economic fallacies, and #8 is a fiction you created on your own. This website has the resources to guide you out of this muddle, if you wish. Many here are ready and willing to guide you. The choice is yours.

17

The best rebuttal to the above was given by Krazy Kaju in my previous past about Too Much Thrift. He said that producers of money (coinage) in this case would rush to find and produce more gold and this would keep going until their was no more profit in doing so.

I wanted one of you guys to say that so I could give the following reply.

Yes. Krazy Kaju is right and if there was not enough gold available and populace would probably switch to other metals or maybe paper with multiple currencies operating in the land. My question to the Austrian community is this: If this occurred would we not repeat all the history of money and be eventually be back to today’ s money (i..e., bits in a computer) because it is the most convenient form of money and because I don’t have to carry it around and count it and protect it from physical theft?

Mansoor

18

“Keep in mind that it is not the value that matters but peoples perception of value…”

whats the difference?

19

Perceptions on average over time need to match reality. All else we will get screwed.

Mansoor

20

“Keep in mind that it is not the value that matters but peoples perception of value…”

what else places value in a thing…only people that i know of. they have to perceieve the thing to value it.

so whats the difference if saying a perceived thing has value and a person perceiving value in a thing??

whether its one minute or one year.