I believe in one of his works, Ludwig von Mises called for a fixed money supply. Assuming this is the case, where would the extra money come from to repay interest?
Obviously if you put money in the bank it would automatically start increasing in value as production increased. However, for there to be an incentive to invest the money (as opposed to just storing it) one would have to be rewarded with a positive interest rate. Otherwise one would just keep the money in storage while it increased in value and firms wouldn’t have access to invested funds.
But if the money supply is fixed and prices are constantly falling, how do firms make enough money to pay back both the initial loan and the interest? For example, in 2008, firm X is loaned 100 pounds with an interest rate of 5%. It therefore has to pay back 105 pounds. But as production is increasing, although the real value of money is increasing, the actual amount of money remains the same, which means each firm is going to be earning an increasingly smaller proportion of the total money as more firms spring up. Therefore although they may be able to earn the real value of the loan, they will find it extremely difficult to recover the same quantity of money i.e. 100 pounds plus an extra 5. So in 2012 firm X might be able to earn 80 pounds in profits which would be worth, for example, 120 pounds in 2008 prices but still doesn’t equal the sumk to be paid back - 105 pounds.
The solution of course is negative interest rates - but this would be no better than just storing the money and paying a fee. In fact it would be worse because the stored money could at least be accessed on demand.
For governments in general and the US government in particular, Ludwig von Mises had a policy recommendation: do not increase the stock of money any further. He made this point in “Monetary Reconstruction” (written in 1952 and published in 1953): “The first step must be a radical and unconditional abandonment of any further inflation. The total amount of dollar bills, whatever their name or legal characteristic may be, must not be increased by further issuance.”
The interest to pay you for time deposits will just come from the money earned on interest payments to the bank paid by borrowers, and the storage fees you pay for demand deposits.
For instance, if an individual borrows money from the the bank at 8% interest, that means it will pay you <8% for your time deposits, say, 6%. That extra 2% will be pocketed by the bank to pay for it’s operations and whatever is left over will be profit. Also, like I said, it will make money from holding your demand deposits.
Oh, I should note that most banks don’t charge anymore for demand deposits, but I was assuming a free market banking system in which you probably would.
Yes, in the sense that your use of “would” should be defined properly. As we know depositors cannot claim a certain interest rate apart from the rate competetion in the market can allow for. Thus they cannot claim a positive rate either. What depositors can claim, however, is the best offer available. In your scenario it would seem prudent to assume that no rate could ever be positive when production increases; how could it? So the best offer available would in any case be a negative rate.
It would be incorrect to state that a positive rate is good and a negative rate bad if one does not consider the real economy and the purchasing power of money in this economy. If purchasing power of money increases at a rate relatively greater than the rate of interest a negative rate of interest is not bad, it is good. Indeed it is positive if you consider it in comparison.
Let us then avoid confusing nominal value of money and purchasing power of money. The negative rate in your scenario only tell us that the nominal value of money in the bank decreases, i.e. the amount of money in each deposit decreases.
You then said:
This is not correct. If you demand deposit you would obviously be able to demand your money on mere whim. Let us say this would cost you -2% p.a. If you time deposited let us say you could get between -1% and -1.75% p.a. (depending on which ever time window you choose). If you invested your money everything would be possible of course. Let us assume the market rate would be -1.65% p.a. Also, let us assume a +/- 7% possible return on investment. Thus by investing you would get between -8.65% and +5.35%
By investing you could get a nominel increase or decrease in the value money even though the market rate would be negative. In all cases, except investment, the purchasing power of each deposit would increase. Investment could go either way depending on the system of profit and loss.
In regards to your second point, assume a bank sets up up offering only demand deposit services at cheap fees that would cost, for example, -1.75% p.a. Consumers would simply put their money in this bank rather than in an investing bank with time deposits.
Although I suppose this would therefore be an incentive for banks with time deposits to offer even lower negative interest rates.
I think that interest rates under a tighter monetary policy would be much higher than those we see today.
Interest rates have nothing to do with the supply of money. Interest rates is not new money created, is just value created so that payments can be made (interest expense) and yet yield an interest income. In other words, interest rates is the price of money, in a tight monetary policy like the one Mises argues you can expect interest rate to be higher than in loose monetary policy.
I beleive that Mises argued for a fixed money supply, and it would be the best money if such thing would be possible.
The incentive to invest: Some people argue that if money gain purchasing power year after year, people would not invest. This is false, since investing can yield a positive return, while hoarding money has a cost (storage, insurance, risk of theft).
People today still invest in bonds, stocks, business ventures, etc… even though they can just buy C.O.D and have their purchasing power increased (in normal time) at no risk. Why do they invest? Simple: to increase their return.
The same would be true with a fixed money supply: people would invest for a higher return, and firms would have access to funds. Real saving would actually be higher since the interest rate would not be artificially lowered by credit expansion and act as a disensentive to save.
How to make money with decreasing prices: Firms made money through all the 19th century even though prices were falling. This doesn’t cause any problem whatsoever, entrepreneurs forcast consumer prices and bid up factors of production to generate a positive spead.
How to pay back a loan + interest with fixed money supply: Obviously, not all firms have to pay back their loan in full + interest the same day at the same time, otherwise this would not be possible. The total amount of money payable in point any time is always significantly smaller than the total money supply. Taking a example with a single firm borrowing the total money supply in existence is totally uneralistic, and it such case, the firm would simply default on its obligation.
The fact that the purchasing power of money increases in the future (still an uncertain fact, economic stagnation or regression can occur that would do the opposite) doesn’t affect the interest rate. It affect the present price of money, its current purchasing power. For example, if a good (lets say a stock) is expected to appreciate in value over time, it changes its current price, but not the ratio of borrowing its current price against the price paid to borrow and pay it back it in the future.
The interest rate will always be positive, fixed money supply or not.
Where did Mises argue for a fixed supply of money? Mises has only argued for an end to government inflation, this isn’t the same as saying there should be a fixed supply of money. Obviously, a fixed supply of money would be disasterous to the economy, as real interest rates would have to be really high because of high price deflation due to population and economic growth.
In a free market, however, the monetary supply fluctuates with demand. If demand rises, the “price of money” rises, and therefore, mines, mints, etc. have an incentive to make more money. If the “price of money” falls, then less money will be made since the profit of making money wouldn’t be as high.
What you assume, is that with a fixed money supply the interest rate would be higher, and you maintain that increasing the money supply (through mining) would lower the interest rate, and in this regard I can directly quote Mises:
But there’s other quotes that positively states that the size of the supply doesn’t matter:
Mises, Human Action, p421:
Each individual and all individuals together always enjoy fully the advantages which they can derive from indirect exchange and the use of money,no matter whether the total quantity of money is great or small. … theservices which money renders can be neither improved nor repaired by changing the supply of money. … The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do.
But reading those chapters (17-19, on money and interest) in Human Action really convers this idea much more than isolated quotes.
Anyhow, it’s pretty clear Mises advocated a non-changing money supply, ie. fixed from those quotes.
High price decrease doesn’t cause high interest rates. Does falling prices of computers and electronics causes higher interest rate? Where’s the link there?
On the contrary, price decrease caused by economic growth increases the marginal exchange value of money and causes consumer to reduce their cash holding all things considered equal. When they pay less for their expenditures, they have more money left for other means, such as saving and investing. Price decrease cause by economic growth is neutral on the interest rate, it can go either way, it’s an empirical issue.
Plus, if anyone thinks that lower prices prevent companies from making money, they should explain how the computer industry survived -and greatly expanded- through the last 30 years.
Economic growth is never industry wide either, some sectors have productivity gain while others don’t. Neither it is easily predictable.
The main point with economic growth, is while good prices decrease, wages tend to stay stable, which causes no problem for the loanable funds market even for consumer debt.
As for population growth, it does increase the demand for money, and causes prices to decrease in general and wages to decrease, but it does so at a slow rate that can be factored on. For instance, world population increase is estimated at 1.14% per year, and will continue to decrease.
Note further that in developed countries, population growth is essentially stalled or declining without immigration and recent immigration birth rate, with population of europe and america having less than 2.1 children by couple in average.
Anyhow, changes in the money supply do not cause changes in the originary interest rate per se if there’s no fractional reserve banking, where every increase in the money supply participate in credit expansion which directly lower the loanable fund interest rate.
If changes in the value of money would change too much, either up or down, the market would use another commodity as money to lend which people are willing to contract debt with.
For example, if the gold supply would shrink by 50% per year, because of some mysterious phenomenon, probably it wouldn’t be used as money since it wouldn’t be practical enough to make loands.
I agree that in a free market, the supply would not be constant, and would rise according to the profitability of mining activities, but if gold didn’t have non-monetary use, it would not a good thing per se.
But since gold has non-monetary usage as well, the mining of money would provide for usage of the metal for the other goods (non-monetary jewelry, dentistry, electronics, etc…) as well. Which would probably have the effect of having close to a fixed -monetary-supply of gold.
Irrational fear of decrease in prices (“deflation”) among the mainstream economists always confused money supply contraction induced decrease in prices (which causes bankruptcies and recessions) and economic growth induced decrease in prices (which has beneficial effects for the economy at large).
Students are so bombarded with horror stories about decreasing prices that it is very hard for someone to change their mind in this subject, no matter what explanation is used.
You’re confusing one tiny sector of the economy with the entire economy. It doesn’t matter if electronic prices fall by 15% every year when everything else rises by 20%.
The key is that if everything falls in price by 15% yearly, even if you take a loan that charges only 1% yearly, the real interest rate is significantly higher.
No. Most people won’t charge negative or no interest rates. Thus, if I loan my money out to you, even if the nominal interest rate is low, but deflation is high, then the real interest rate will be high.
Where did I say a company that lowers costs can’t make money?
Again ignoring the considerable increase of real interest rates if we had deflation…
You’re not refuting the argument. You’re essentially using some kind of ad hoc fallacy by saying that the population grows “but not by that much.” If the population grows and we have a fixed money supply, we will have secular price deflation. If we have price deflation, real interest rates will rise. If real interest rates will rise, it will be harder for businesses to obtain large amounts of credit necessary to start or open new operations.
They change the real interest rate.
Which kind of was my point in the post. The market would choose a superior currency able to adapt to the demand for money and therefore avoid any unnecessary inflation or deflation.
It would still work to alleviate deflationary pressures.
If we had a fixed amount of money, large scale price deflation would lead to a higher real price of credit. That means less business activity, as savings are unlikely to make up for the sometimes huge amounts of capital that have to be laid down to produce something.
First, let me say that it is not clear to me whether when you mean “deflation” you mean only decrease in prices or decrease in the money supply.
The last part is non sequitur : “If real interest rates will rise, it will be harder for businesses to obtain […] credit”. When interest rate rises, demand for credit contracts, not necessarily when real interest rises.
When prices decreases, who cares about the “real” interest rate? That’s a measure that makes sense only with inflation of the money supply because it distord monetary calculation.
If one lends at 2%, but general prices decrease at 3% per year, the business paying the loan back isn’t paying 5% interest, it’s still paying 2%, and has no problem whatsoever paying it back whether that price decrease is caused by economic growth or population increase (the latter which causes wages to fall).
In your example where prices fall by 15% per year, is that caused by economic growth or population increase? In both case, it’s widely unrealistic.
Real interest rate (factored for price increase statistic) is something that prevent saving when there’s price inflation increase by money supply increase. In that case people tend to stop investing since the prevailing (manipulated by the central bank) interest rate falls below the CPI figure.
If there’s actual price decrease caused by economic growth or population increase, then no one cares about the “real interest” rate, since it has no impact on the ability of business or individuals to pay the nominal interest back, as opposed to price decrease caused by money supply contraction.
That being said, even if what you say were true, which I don’t believe, and under a condition of sustained economic growth causing 15% per year price decrease, and businesses wouldn’t be able to get credit somehow and instead only invest profits: Who cares! The economy would be massively more productive than it ever was in history, credit is not a goal by itself, but a mean to economic growth. If you get 15% economic growth without it, it apparently isn’t helping much after all.
Anyhow, I still believe that 1) Credit (generated by real saving) helps economic growth, and 2) Price decrease caused by economic growth or population increase has no negative effect on the supply of loanable funds, but even if it was, I hope I made the case that it wouldn’t matter anyway.
But I think that the concern about lending in an environment of falling prices due to progress and a quasi-stable money supply (to not argue 0%/year or say 2-3%/year under gold) is overblown. If I as a businessman know that prices are steadily falling, why wouldn’t I just figure out how to scrape by until I can accumulate the capital via profits to then invest? If I postpone the investment, then the goods I will buy will be cheaper. Also, any of the profits I have made in the interim will have more purchasing power. As long as the money supply is quasi-stable, then people can calculate and plan.
As opposed to times like now, for instance.
The savvy businessman might also gain access to capital in other ways. Perhaps he can provide non-monetary compensation to enable himself access to capital, such as the goods from the factory. Perhaps instead of borrowing money, he issues shares of ownership in the venture.
(And BTW, I am not replying to Jon in particular. I just wanted to be honest and admit I haven’t read the article yet.)
Yes, I have read it now. I find it startling that so many of my free-market, non-intervention buddies (idols? - no, that is too strong) are advocating all kinds of intervention. GUYS, I THOUGHT I KNEW YOU!!
How else do you deflate the bubble than by deflation? How can banks make themselves more sound, either to return to the regulated reserve ratio in the face of credit losses or to merely increase their reserve ratio, without reducing the amount of credit in the marketplace? What if I pull my money out of the bank, and force them to unwind the credit pyramid sitting on top of my real money? Am I the evil deflator, that must be coerced by government power to stop the madness of claiming my own money? Maybe what we should do is force everyone to deposit all their money in the banks, then force the banks to lend up to the reserve ratio? Then we can get rid of that pesky deflation.
I am actually saddened to see the references from these great authors either calling for, or resigning themselves to, intervention, even as a necessary evil.
On another branch of this topic, how can the FRB pyramid be deconstructed to get back to sound banking? How do you sort out who has first title to the “real” money? On second thought, I will start a new thread with this question.