Monetary Deflation: Really That Bad?

[krazy_kaju]

Though many economists seem to agree that secular price deflation (that is falling prices without monetary deflation) isn’t a bad thing, most also agree that monetary deflation is awful, since not only do prices fall, but wages and profits fall as well. This is conceived as negative since the real value of debt increases, making it harder for debtors to pay back their creditors. Thus, monetary deflation is perceived to harm both debtors and creditors.

I increasingly disagree with the above. If individuals come to expect deflation, I believe that this deflation could play a positive role. In a world where deflation is expected, firms could still be profitable, since they would modify their behavior in order to continue being profitable in a deflationary environment. Being profit-seeking institutions, they would continue to accumulate capital and invest in R&D, thereby increasing labor productivity. This increase in labor productivity would mean one crucial thing - the fall in prices would exceed the fall in wages and profitability. Thus, though wages and profits would fall while the real value of debt would rise, the greater fall in prices could offset the increasing real value of debt.

So assuming a rather drastic deflation rate of 10% per year, the real value of debt would increase by 10% while nominal wages and profits would fall by 10%. At the same time, prices would fall by more than 10% (assuming normal GDP growth rates, prices would fall by approx. 12-13%). So any deflation would ultimately make the increasing real value of debt moot.

I think there could be very positive side effects that expected monetary deflation could have: households and firms would run very sound balance sheets and real saving/investment would increase. Monetary deflation would obviously create an incentive to save money and a disincentive to borrow (“dissave”) money. This would push households and firms to become more dependent on their own resources (saved income) over the resources of others (borrowed income). This increase in net saving would directly or indirectly increase real investment, by pushing interest rates lower and freeing up resources for investment use.

Now, I’m not saying that monetary deflation is a policy arraignment that the government or its central banks should seek. Instead, I believe that a free market currency system ought to determine the supply of money. But at the same time I believe that the dangers of monetary deflation are widely exaggerated.

What are the thoughts of others on this topic?

[Esuric]

@krazy kaju

I increasingly disagree with the above. If individuals come to expect deflation, I believe that this deflation could play a positive role. In a world where deflation is expected, firms could still be profitable, since they would modify their behavior in order to continue being profitable in a deflationary environment.

This is essentially the same argument the monetarists make when they defend inflation. You can’t anticipate the actual rate of inflation or deflation, since human beings don’t respond to such circumstances in identical, or even similar ways.

@krazy kaju

Being profit-seeking institutions, they would continue to accumulate capital and invest in R&D, thereby increasing labor productivity.

When you talk about perpetual monetary deflation, you’re presupposing disparity between the market and natural rates of interest. The former is elevated above the latter. Such a condition constricts capital accumulation, and forces sales in order to achieve the level of funds necessary in order to maintain business activity. New investments are suffocated.

@krazy kaju

This increase in labor productivity would mean one crucial thing - the fall in prices would exceed the fall in wages and profitability. Thus, though wages and profits would fall while the real value of debt would rise, the greater fall in prices could offset the increasing real value of debt.

Prices would fall faster than costs. Labor productivity would rise at a slower rate relative to the decline in overall prices. You would get a Wicksellian rot.

@krazy kaju

Monetary deflation would obviously create an incentive to save money and a disincentive to borrow (“dissave”) money.

Yeah, that’s the problem. It would force an unnatural savings rate. The structure of production would lengthen, but at a slower rate than the forced savings rate. Thus, costs wouldn’t fall as fast as prices.

@krazy kaju

Now, I’m not saying that monetary deflation is a policy arraignment that the government or its central banks should seek. Instead, I believe that a free market currency system ought to determine the supply of money. But at the same time I believe that the dangers of monetary deflation are widely exaggerated.

Mises and Hayek have both explicitly stated that deflationism has negative economic ramifications. It’s just as bad as inflationism from an economic point of view, and almost as bad from a political point of view (deflationism is what legitimized the inflationist’s position, at least in the public’s eyes).

[filc]

@Esuric

Yeah, that’s the problem. It would force an unnatural savings rate. The structure of production would lengthen, but at a slower rate than the forced savings rate. Thus, costs wouldn’t fall as fast as prices.

Not necessarily, if the savings is done by way of investment. There would be less credit, but more capitalists willing to invest their savings.

I agree that any drastic or immediate fluctuation in a monetary base is harmful, but I believe strongly that, assuming the money supply is stable, long term deflation is just a sign of economic prosperity.

[Catalan]

@filc

I agree that any drastic or immediate fluctuation in a monetary base is harmful, but I believe strongly that, assuming the money supply is stable, long term deflation is just a sign of economic prosperity.

I think Krazy Kaju is talking about “purposeful” deflation, as opposed to secular price deflation. In other words, a decrease in the supply of money versus an increase in production.

[Esuric]

@filc

Not necessarily, if the savings is done by way of investment. There would be less credit, but more capitalists willing to invest their savings.

The interest rate on deposits would exceed yields on securities (in the aggregate). Extremely profitable firms wouldn’t suffer, but the vast majority would.

[filc]

Going to duck myself out and just follow along. Can’t content with intellectual heavy weights, but it’s this kind of stuff I enjoy. You guys remind me that I can learn something new every day. [:)]

[krazy_kaju]

@Esuric

@krazy kaju

I increasingly disagree with the above. If individuals come to expect deflation, I believe that this deflation could play a positive role. In a world where deflation is expected, firms could still be profitable, since they would modify their behavior in order to continue being profitable in a deflationary environment.

This is essentially the same argument the monetarists make when they defend inflation. You can’t anticipate the actual rate of inflation or deflation, since human beings don’t respond to such circumstances in identical, or even similar ways.

It’s called simplification. Economics would never exist as a serious discipline if in order to be an economist one had to view all of the minute details of the economy at once.

Just as there are inflation expectations, there would be deflation expectations. Firms that correctly predict deflation would become more profitable than otherwise, forcing firms to try to form accurate expectations.

@Esuric

When you talk about perpetual monetary deflation, you’re presupposing disparity between the market and natural rates of interest.

I’m not sure if you’re just confusing terms here or are trying to make a separate point, but here is my response:

Not necessarily. Currency naturally goes out of circulation overtime due to wear and tear from use. This doesn’t require any interest rate manipulation. In such a case of deflation occurring due to a naturally shrinking money supply, the market rate of interest would be no different from the natural rate. Both would fall as saving would release resources for investment.

@Esuric

@krazy kaju

This increase in labor productivity would mean one crucial thing - the fall in prices would exceed the fall in wages and profitability. Thus, though wages and profits would fall while the real value of debt would rise, the greater fall in prices could offset the increasing real value of debt.

Prices would fall faster than costs. Labor productivity would rise at a slower rate relative to the decline in overall prices. You would get a Wicksellian rot.

@krazy kaju

Monetary deflation would obviously create an incentive to save money and a disincentive to borrow (“dissave”) money.

Yeah, that’s the problem. It would force an unnatural savings rate. The structure of production would lengthen, but at a slower rate than the forced savings rate. Thus, costs wouldn’t fall as fast as prices.

What is an “unnatural” savings rate anyway? If market participants choose a shrinking money supply, who are you to say that they’re wrong?

In any case, monetary deflation would not cause prices to fall faster than costs. Most costs associated with production are overhead costs that, given proper expectations, could be modified to move in tandem with prices. Remember, essentially, costs are nothing more than prices themselves, so saying that one would fall before the other is somewhat silly.

And why would investment slow? With a rise in saving, even with a rise in hoarding, the deferred consumption spending would spur investment spending. This is because less resources would be used by lower order industries, thereby making higher order industries more profitable. In addition, households would provide more loanable funds to the market while demanding less back in return, thereby further increasing the profitability of higher order industries.

Many econ enthusiasts and economists place too much power in money. It’s nothing more than a medium of exchange. Making it out to be much more is a mistake.

[DD5]

@krazy kaju

Now, I’m not saying that monetary deflation is a policy arraignment that the government or its central banks should seek. Instead, I believe that a free market currency system ought to determine the supply of money. But at the same time I believe that the dangers of monetary deflation are widely exaggerated.

If the monetary deflation is the natural free market result after a bust, that is, the unwinding of the previous credit expansion, then I think that given the choices - let the natural process, as painful as it is, take place or intervene with more coordinated credit expansion by a central bank - the former must be the preferred alternative, or the only alternative as Mises would point out.

I don’t think a monetary deflation of any serious magnitude can ever occur with sound money, such as a 100% gold standard. In fact, it’s practically impossible.

[krazy_kaju]

@DD5

I don’t think a monetary deflation of any serious magnitude can ever occur with sound money, such as a 100% gold standard. In fact, it’s practically impossible.

I agree. It would just be too profitable (and commonsensical) for free market money producers to continue to slowly expand the money supply. In all honesty, I am mostly playing mind games with myself in this thread.

[krazy_kaju]

@Esuric

@filc

Not necessarily, if the savings is done by way of investment. There would be less credit, but more capitalists willing to invest their savings.

The interest rate on deposits would exceed yields on securities (in the aggregate). Extremely profitable firms wouldn’t suffer, but the vast majority would.

I think you’re missing the bigger picture here. If consumers consume less, then resources are released back into the economy, making inputs for higher order goods less costly.

[Esuric]

@krazy kaju

It’s called simplification. Economics would never exist as a serious discipline if in order to be an economist one had to view all of the minute details of the economy at once.

Just as there are inflation expectations, there would be deflation expectations. Firms that correctly predict deflation would become more profitable than otherwise, forcing firms to try to form accurate expectations.

Yes but this simplification, when laxed, invalidates your argument, the same way that it invalidates the monetarist argument. furthermore, deflation, like inflation, would not affect all incomes and prices in the same degree or even same direction. You would still have misdirections of resources.

@krazy kaju

Not necessarily. Currency naturally goes out of circulation overtime due to wear and tear from use. This doesn’t require any interest rate manipulation. In such a case of deflation occurring due to a naturally shrinking money supply, the market rate of interest would be no different from the natural rate. Both would fall as saving would release resources for investment.

Gold does not deteriorate; money substitutes which deteriorate would be replaced. Also, Inflation (Austrian notion of inflation) presupposes an arbitrary reduction in the market rate relative to the natural rate; thus, (unnatural) deflation, ipso facto presupposes an arbitrary elevation of the market rate above the natural rate.

@krazy kaju

What is an “unnatural” savings rate anyway? If market participants choose a shrinking money supply, who are you to say that they’re wrong?

One which is forced by certain market conditions (disparity between actual preferences and consuming/saving behaviors). The savings rate in 2008 was at -3%; this is unnatural, and it is the result of an arbitrarily reduced market rate of interest.

@krazy kaju

In any case, monetary deflation would not cause prices to fall faster than costs. Most costs associated with production are overhead costs that, given proper expectations, could be modified to move in tandem with prices. Remember, essentially, costs are nothing more than prices themselves, so saying that one would fall before the other is somewhat silly.

This is only true in a world with complete price elasticity (no rigidities) and perfect foresight. Your argument is basically the EMH (efficient market hypothesis); namely that prices at all times reflect underlying fundamentals and actual preferences.

@krazy kaju

And why would investment slow? With a rise in saving, even with a rise in hoarding, the deferred consumption spending would spur investment spending. This is because less resources would be used by lower order industries, thereby making higher order industries more profitable. In addition, households would provide more loanable funds to the market while demanding less back in return, thereby further increasing the profitability of higher order industries.

The reduction in consumption would over-take the reduction in costs. Again, the structure wouldn’t expand as fast as it should in order to make production profitable. The reason why savings are good is because it allows for more capital intensive production, which lowers cost per unit instep with falling prices. But forced monetary deflation would have costs falling, but, again, at a slower rate than price deflation.

@krazy kaju

Many econ enthusiasts and economists place too much power in money. It’s nothing more than a medium of exchange. Making it out to be much more is a mistake.

Money is half of all economic exchanges; it is one of three types of goods; in capitalist economies, it is intrinsically linked to capital; it allows for the further division of labor and eliminates the double coincidence of wants. It is the most important economic variable, and it is never neutral.

[Esuric]

@krazy kaju

I think you’re missing the bigger picture here. If consumers consume less, then resources are released back into the economy, making inputs for higher order goods less costly.

This is not an instantaneous process. It has to go through the financial system, and permeate amongst the real economy. It faces all sorts of rigidities.

[krazy_kaju]

@Esuric

Yes but this simplification, when laxed, invalidates your argument, the same way that it invalidates the monetarist argument.

Not at all. Instead of stating “some individuals will expect too much deflation, others will expect too little, and a minority will get it just right, but, over time, in the aggregate, the expectations will be accurate” I decided to shorten it to everyone expects the right amount of deflation.

As a side note, it doesn’t matter what monetary regime a country adopts, there will always be price changes on the macro and micro levels that will dictate that individuals form expectations. I’m not sure of what monetary persuasion you are, zero price level or productivity norm, but both would require market participants to form expectations.

furthermore, deflation, like inflation, would not affect all incomes and prices in the same degree or even same direction. You would still have misdirections of resources.

Misdirection of resources in what way?

@Esuric

@krazy kaju

Not necessarily. Currency naturally goes out of circulation overtime due to wear and tear from use. This doesn’t require any interest rate manipulation. In such a case of deflation occurring due to a naturally shrinking money supply, the market rate of interest would be no different from the natural rate. Both would fall as saving would release resources for investment.

Gold does not deteriorate; money substitutes which deteriorate would be replaced.

What if secular price deflation occurs, which prompts individuals to hold more of their savings “under the bed” or in full reserve banks? This could foreseeably shrink the pool of circulating currency at a greater rate than is replaceable.

@Esuric

Also, Inflation (Austrian notion of inflation) presupposes an arbitrary reduction in the market rate relative to the natural rate; thus, (unnatural) deflation, ipso facto presupposes an arbitrary elevation of the market rate above the natural rate.

Nope. You’re assuming credit expansion or contraction. I fail to see how a general change in the monetary supply would effect the market rate relative to the natural rate, so please explain.

@Esuric

@krazy kaju

What is an “unnatural” savings rate anyway? If market participants choose a shrinking money supply, who are you to say that they’re wrong?

One which is forced by certain market conditions (disparity between actual preferences and consuming/saving behaviors).

You again seem to be falling into thinking that monetary contraction must come through credit contraction, which simply isn’t true. If individuals decide to hoard a portion of their income, the monetary contraction would not necessitate credit contraction, as the amount of loanable funds would not necessarily have to shrink.

The savings rate in 2008 was at -3%; this is unnatural, and it is the result of an arbitrarily reduced market rate of interest.

The residents of New Orleans suffered a horrible disaster due to Hurricane Katrina. In order to rebuild their city, they borrowed more than they saved. The macroeconomy of New Orleans became net borrowers/debtors. Was this “unnatural?”

@Esuric

@krazy kaju

In any case, monetary deflation would not cause prices to fall faster than costs. Most costs associated with production are overhead costs that, given proper expectations, could be modified to move in tandem with prices. Remember, essentially, costs are nothing more than prices themselves, so saying that one would fall before the other is somewhat silly.

This is only true in a world with complete price elasticity (no rigidities) and perfect foresight.

You are an entrepreneur. You pay for workers, rent, electricity, raw materials, etc. Your job as an entrepreneur is to be profitable. In order to be profitable, you need to be able to accurately predict the prices for your product as well as for your inputs. Landlords, raw materials producers, and power plants must do the same. My point here? Think supply and demand. The landlord, power plant CEO, raw material producer, etc. all know that the price will most likely head downwards. They also are all entrepreneurs and if they set their prices too high, then they won’t sell all of their product. Thus, their prices must move in tandem with consumer prices ultimately.

This kind of expectation-formation already occurs and will occur no matter what on the micro level. The fact of the matter is that even under a “zero price level” regime, prices will continue to change on the micro level. Some prices will go up, others will go down. Entrepreneurs continually engage in price expectation-formation and the successful ones are also the profitable ones.

In any case, I’m not assuming complete price elasticity and perfect foresight. I am assuming accurate foresight, which is practically a given.

@Esuric

The reduction in consumption would over-take the reduction in costs.

You’re a landlord. You expect prices to fall. Will you continue to charge the rent you did last year and see all of your tenant businesses go bankrupt or will you lower the rent you take from your tenants over time in accord with the general price level?

It’s a simple question about the profit motive. If you agree that firms seek to be profitable, then you will agree that they will lower their prices along with the price level, since otherwise they’ll find themselves without customers.

@Esuric

Money is half of all economic exchanges; it is one of three types of goods; in capitalist economies, it is intrinsically linked to capital; it allows for the further division of labor and eliminates the double coincidence of wants. It is the most important economic variable, and it is never neutral.

It’s a medium of exchange. How could it possibly be “intrinsically linked to capital?!?” Even in the absence of money, capital can exist. What do you call the spears, knives, baskets, and other accessories tribal societies use, if not a very primitive form of capital?

[krazy_kaju]

@Esuric

@krazy kaju

I think you’re missing the bigger picture here. If consumers consume less, then resources are released back into the economy, making inputs for higher order goods less costly.

This is not an instantaneous process. It has to go through the financial system, and permeate amongst the real economy. It faces all sorts of rigidities.

It’s not an instantaneous process, but it is a quick one. In order to remain profitable, entrepreneurs have to venture to predict the changes in prices of both their inputs and outputs. This means that the firms whose output is the input of other firms, have to change their prices in accordance with their client’s needs. In the real world, prices are quite flexible as it turns out.

[Esuric]

@krazy kaju

Not at all. Instead of stating “some individuals will expect too much deflation, others will expect too little, and a minority will get it just right, but, over time, in the aggregate, the expectations will be accurate” I decided to shorten it to everyone expects the right amount of deflation.

This is an unsubstantiated assertion which flies in the face of Austrian economics. It is the rational expectations approach which has been entirely invalidated by the crisis. Expectations don’t matter–actors cannot rationally calculate when price levels are changing because of purely monetary fluctuations (as opposed to changes in preferences).

@krazy kaju

Misdirection of resources in what way?

Prices, again, wouldn’t fall in the same degree or same direction. Some prices may rise during the deflation, some will fall, and some will fall faster than others. Since prices guide production, this must necessarily lead to arbitrary misdirections. The general effects of deflation resemble that of inflation, except the former does lead to a bust. Arbitrary deflation is perma-quasi-bust.

@krazy kaju

What if secular price deflation occurs, which prompts individuals to hold more of their savings “under the bed” or in full reserve banks? This could foreseeably shrink the pool of circulating currency at a greater rate than is replaceable.

1, I don’t understand this “replaceable” argument; it reminds me of Gesell. The deterioration of money is not an economic problem; arbitrary alterations in objective prices, and their effects on production, are economic problems. 2. I don’t want to talk about theoretical economic conditions lacking functional financial systems. Placing money under the bed only occurs when there isn’t a functional loanable funds market.

@krazy kaju

Nope. You’re assuming credit expansion or contraction. I fail to see how a general change in the monetary supply would effect the market rate relative to the natural rate, so please explain.

I’m assuming the validity of basic logic. If you willfully diminish the money stock you will arbitrarily elevate the rate of interest.

@krazy kaju

The residents of New Orleans suffered a horrible disaster due to Hurricane Katrina. In order to rebuild their city, they borrowed more than they saved. The macroeconomy of New Orleans became net borrowers/debtors. Was this “unnatural?”

This is a non-sequitur. If you wish to refute my position, then you’re going to have to show how a -3% savings rate (2008 savings rate) can possibly reflect actual preferences with rational economic agents. If your argument is that market prices always represent underlying preferences, you’re going to have to explain this crises, and then refute Bohm-Bawerkian capital theory.

@krazy kaju

You are an entrepreneur. You pay for workers, rent, electricity, raw materials, etc. Your job as an entrepreneur is to be profitable. In order to be profitable, you need to be able to accurately predict the prices for your product as well as for your inputs. Landlords, raw materials producers, and power plants must do the same. My point here? Think supply and demand.

Your accurate predictions are based on the price mechanism. Production isn’t guided by extremely intuitive entrepreneurs; it’s guided by market forces which manifest themselves as prices. When you arbitrarily tamper with the money stock, you arbitrarily tamper with prices–which can only readjust itself through natural market forces, in the face of asymmetric information and price rigidities. Do you wish to refute the existence of asymmetric information and price rigidity?

@krazy kaju

The landlord, power plant CEO, raw material producer, etc. all know that the price will most likely head downwards. They also are all entrepreneurs and if they set their prices too high, then they won’t sell all of their product. Thus, their prices must move in tandem with consumer prices ultimately.

They don’t know which prices will head downwards, and they don’t know the extent of deflation. Even with perfect prices, there are still entrepreneurial failures.

@krazy kaju

In any case, I’m not assuming complete price elasticity and perfect foresight. I am assuming accurate foresight, which is practically a given.

In Lucas’ and Fama’s world.

@krazy kaju

It’s a medium of exchange. How could it possibly be “intrinsically linked to capital?!?” Even in the absence of money, capital can exist. What do you call the spears, knives, baskets, and other accessories tribal societies use, if not a very primitive form of capital?

Because capital markets don’t actually exchange real capital goods; they exchange money, which is then used to purchase capital goods and engage in investment. Your confusion is due to the fact that you seemingly accept the classical view of money (neutral). Money is not capital, but it is demanded as capital. When people say that money is scarce, they’re really just saying that capital is scarce. I suggest you read The Theory of Money and Credit (Mises).

@krazy kaju

It’s not an instantaneous process, but it is a quick one

Another unsubstantiated assertion. In such a world, there could be no recessions. Your super-rational and omniscient actors would quickly undo government policy and restore equilibrium. Actors would see an artificially low interest rate, and react accordingly; they would see inflation, and act accordingly. My professor perfectly sums up this position: “Rational expectations claims that everyone but the economists has the perfect model.”

[filc]

Question: Why is it assumed that investment will always be done through the model of the loans market? Couldn’t more savings also end up in the stock market? Offering capital to corps?

[Catalan]

@filc

Question: Why is it assumed that investment will always be done through the model of the loans market? Couldn’t more savings also end up in the stock market? Offering capital to corps?

In an environment free of rampant credit expansion all stock market investments must come by means of savings—whether you are using your own savings, or you are borrowing from the savings of another individual. When a company issues stock it is basically an easier way to accumulate the necessary capital to make an investment; it is similar to a direct loan from stock holder to company management.

[DD5]

@filc

Question: Why is it assumed that investment will always be done through the model of the loans market? Couldn’t more savings also end up in the stock market? Offering capital to corps?

Most savings are, in fact, done through other means. The loans market is overly emphasized in mainstream economics. Keynesians greatly err in treating the loans market as the sole market for investments when it is actually relatively small compared to the entire savings market.

Austrians talk a lot about the loans market only because of the boom/bust cycle that is set in motion by the loans market. I do also wonder sometimes if people here realize this when they are debating. I think people tend to forget that most savings are in fact not channeled to investments through the banking system.

[Giant_Joe]

@krazy kaju

In a world where deflation is expected, firms could still be profitable, since they would modify their behavior in order to continue being profitable in a deflationary environment. Being profit-seeking institutions, they would continue to accumulate capital and invest in R&D, thereby increasing labor productivity. This increase in labor productivity would mean one crucial thing - the fall in prices would exceed the fall in wages and profitability. Thus, though wages and profits would fall while the real value of debt would rise, the greater fall in prices could offset the increasing real value of debt.

This is part of the model of the semiconductor industry. The capital costs continue to increase, the labor tends to get paid just fine, and companies aren’t always going out of business. (though some are, because the capital costs are becoming astronomical for the smaller companies)

Another important matter to remember about this market is that it is still growing strong and hasn’t reached maturity. I’m interested in finding out… If the market stops growing as fast as it does, does the level of capital investment by these firms change, and by how much?

[frank_Hollenbeck]

I was a monetarist for 15 years, until I picked up a Rothbard book which changed my perspective of economics. My problem with macroeconomics is that it is not base on microeconomc principles. let me say something about the inflation deflation debate, and tell me if you think I am right: take two goods, apples and oranges, and you have 10 of each and price of each is 1$ based on suppply and demand conditions. Money supply is 20$. Now suppose that society prefers oranges to apples. In this economy, the price of oranges go up and the price of apples must go down: however, how much oranges go up and apples go down will depend on price elasticities of supply and demand. In such a situation we could have average prices (infaltion) go up down (deflation) or stay the same. Using this example it seems to me totally absurd to say that the average price increase of oranges and apples should be 2%. But isn’t that what the monetarist are telling us what should be optimal monetary policy?