What's wrong of deflation?

Economics Economics Questions
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“A single market will adjust pretty fast, but in reality the goods used for investment are not interchangeable with the goods used for consumption, so an even more convoluted process of price-adjustment must take place (e.g., a fall in the price of corn causes wheat prices to fall, which causes the price of farmland to fall, which lowers the price of building a factory on that land, which lowers the price of tools…).”

Isn’t this just the market process at work? If money were just another commodity, prices would still fluctuate accordingly. Isn’t this process “optimal” in itself?

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22

Doesn’t the logic of a deflationary spiral lead to the conclusion that an economy can implode into complete non-existence if the money supply doesn’t increase?

23

Joe,

But what I was saying was that is it possible purely through monetary policy. It would seem like in that sort of arena, rogue ‘Austrian’ banks could thrive because they would be offering both sound money and lower interest rates to borrowers, and that the only way to stop something like that from happening would be to use the other powers of government.

I’m not sure what you mean. How would a bank offer both sound money and lower interest rates?

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Doesn’t the logic of a deflationary spiral lead to the conclusion that an economy can implode into complete non-existence if the money supply doesn’t increase?

Reisman argues that a deflationary spiral can exist up to the point where all fiduciary media has been liquidated. I don’t think Reisman is necessarily correct regarding the redemption of all fiduciary media, but I think that his greater point is absolutely correct. I don’t think Keynesians believe that a deflationary spiral will occur indefinitely (although, Keynesian theory is pretty difficult to decipher - it took me a while to fully understand Keynesian theory behind the liquidity trap, for example), though.

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they would be offering the real market rate while the central bank and its crony banks had its interest rate set artificially high.

remember we are talking about the “reverse” business cycle theory, or at least I was, and how that wouldn’t really be possible in the same way, or at least using the same tools but in the opposite manner as the normal business cycle works today with central banks causing artificial credit expansion, and thus lower interest rates. The only way for a government to set off a “reverse” business cycle would be to use some of its other tools, as you mentioned earlier.

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The deflation we have now is caused by defaults on loans by individuals, corporations and banks, so what’s wrong with it is partly obvious; it’s a symptom of wider economic pain, such as people not being able to pay their mortgages.

More fundamentally, our money is created as debt issued at interest. The amount of money in the economy is equal to the outstanding debt. So if there are ten trillion dollars in the economy that have been issued at an average annual interest rate of 10%, then eleven trillion is owed back by the end of the year. So either the money supply grows by more people going into debt, or the money won’t exist to pay back many of the loans and there will be large scale defaults. Some defaults are ok, but too many and deflation can become a cycle - people default, there’s less money, forcing more defaults.

The fractional-reserve economy is basically a giant ponzi scheme - unless new people are taking out loans or going deeper into debt, the amount of money in circulation won’t increase, and the extent the amount of money in circulation doesn’t increase, loans will be defaulted on.

27

Ravochol,

The deflation we have now is caused by defaults on loans by individuals, corporations and banks, so what’s wrong with it is partly obvious; it’s a symptom of wider economic pain, such as people not being able to pay their mortgages.

The point is that to a large degree this is due to malinvestment, which must be liquidated. As such, in this case, monetary deflation may be considered necessary. Even if you are a free banker, or an individual who believes that banks should increase liabilities to meet an increase in the demand for money, there would still be a necessary fall in the supply of money due to liquidation of loans caused by malinvestment.

More fundamentally, our money is created as debt issued at interest. The amount of money in the economy is equal to the outstanding debt.

This isn’t always true. For example, the Federal Reserve’s inflation of bank reserves is not debt, as banks are not liable to pay them back.

So if there are ten trillion dollars in the economy that have been issued at an average annual interest rate of 10%, then eleven trillion is owed back by the end of the year.

Well, all money isn’t created at once, so there’s no reason why all debt would have to be paid back “by the end of the year”.

Some defaults are ok, but too many and deflation can become a cycle - people default, there’s less money, forcing more defaults.

The causality is that malinvestment causes defaults. This “cycle” of monetary deflation ends when prices adapt to the new supply of money, returning profitability and readjusting the structure of production according to society’s time preference - as such, there is really no deflationary spiral.

28

Joe,

they would be offering the real market rate while the central bank and its crony banks had its interest rate set artificially high.

remember we are talking about the “reverse” business cycle theory, or at least I was, and how that wouldn’t really be possible in the same way, or at least using the same tools but in the opposite manner as the normal business cycle works today with central banks causing artificial credit expansion, and thus lower interest rates. The only way for a government to set off a “reverse” business cycle would be to use some of its other tools, as you mentioned earlier.

Generally speaking, if a central bank were to set the interest rate artificially high it would do so by reducing the volume of money in circulation, and so would necessarily affect the rate at which member banks can loan.

29

exactly, so if there was some sort of rogue bank outside of the central bank system, it wouldn’t have its money being sucked out by the central bank, therefore it would have more loanable funds.

During inflation, a rogue bank wouldn’t be able to compete since its not part of the getting free pieces of paper club. Everyone looking to take a out a loan would just go to the banks that were part of the central banking system, because they had the lower rates.

But if the central bank switches from leaf blower to vacuum cleaner past the point of the market rate of interest, then people are going to look for other credit intermediaries, no?

30

exactly, so if there was some sort of rogue bank outside of the central bank system, it wouldn’t have its money being sucked out by the central bank, therefore it would have more loanable funds.

Well, I don’t know. That depends entirely on the amount of deposits the bank has, whether time or checkings, and what reserve ratio the bank is operating on (I assuming a bank not legally bound to a 100-percent standard). But, yes, it might be possible that a bank independent of a central bank would not feel the effects of tightening credit, as a central bank reduced the supply of money.

So, I guess I see what you’re saying (I misunderstood your opening post). An “Austrian” bank could succeed if it were allowed to operate, and it survived a fall in business during the boom years, although it would still have to operate with the same currency and as such would feel the effects of deflation, even if it wasn’t hit first.

31

But I think it would only ‘feel the effects of deflation’ to the extent that everything else in the economy does.

The main problem with credit expansion, in terms of creating the business cycle, is not the inflation itself (although of course that is bad for its own reasons), but rather the distortion on interest rates.

I think a bank outside the system would be able to operate at the market rate, the problem during the boom as to why this wouldn’t work is that nobody would borrow at the market rate when there is a below market rate option. I guess the opposite would be that it might be hard for the ‘Austrian’ bank to find lenders because it might not be able to offer as good of terms to savers, especially in a deflationary period where people are saving by just holding onto their cash.

32

The main problem with credit expansion, in terms of creating the business cycle, is not the inflation itself (although of course that is bad for its own reasons), but rather the distortion on interest rates.

The problem is actually the inflation, and the distortion this causes on the structure of production. The interest rates act only as a price mechanism, signalling information.

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no because you could have inflation without distorting the structure of production. Take the case of the money fairy that Rothbard talks about in What Has Government Done to our Money? Would that cause a business cycle? I don’t see why it would. There wouldn’t be an expansion of credit, in any sense more than there would be an expansion in the amount of money spent on gas and groceries. All the prices would have doubled.

What sets off the trade cycle according to the Circulation-Credit theory, has to involve more than ‘just’ inflation. You need something like fractional reserve banking.

35

I’m not sure I get the debt delation argument. Sure debt is more expensive when we experience deflation, but assets are worth more by the exact same about. A firms asset-to-liability ratio does not change due to deflation.

What does change are time preferences, during inflation, people will prefer to invest less thus hurting the economy, while during deflation people will prefer to invest more.

36

Joe,

It is inflation which is responsible for distorting the structure of production, in the first place. Yes, inflation can have no effect on the structure of production if it occured simultaneously throughout all sectors of the market, but more often than not this is not the same (especially if the money money is introduced through the loanable funds market). One of the cornerstones to Austrian theory is that inflation does not occur instanteneously nor simultaneously, and this is a major reason why Austrians reject the use of the mechanistic quantity theory of money. The entire Austrian business cycle theory supposes that it is this inflation which distors the price of higher-order capital-goods relative to consumer-goods and lower-order capital-goods.

What makes the interest rate important is that it transmits information, which is what the price mechanism in general does.

What sets off the trade cycle according to the Circulation-Credit theory, has to involve more than ‘just’ inflation. You need something like fractional reserve banking.

Fractional-reserve banking is blamed for causing the business cycle, because it causes inflation (through the extension of fiduciary media).

37

Chris Pacia,

What does change are time preferences, during inflation, people will prefer to invest less thus hurting the economy, while during deflation people will prefer to invest more.

Should be the opposite. Usually, when there is high uncertainty people prefer to hold money.

38

“Should be the opposite. Usually, when there is high uncertainty people prefer to hold money.”

I agree, initially as inflation kicks in there is uncertaincy which causes an increase in the demand for money. However, as people start to expect inflation they decrease their demand for money, trying to get rid of it before it becomes worthless.

39

That is what I am saying. Its the “inflation of the loanable funds market” aka artificial expansion of available credit. And I know that in the real world, that is pretty much the only avenue in which inflation occurs. But I would still say that it is the artificial expansion of credit that is the cause of business cycle and not simply an increase in the amount of things that are considered to be money. Would you say that in a free society, where gold was money, that a large discovery of gold would cause inflation? sure. Would it cause a business cycle? I don’t think so.

40

What’s the different cebetween “expansion of credit” and “an increase in the amount of things that are considered to be money”. As per your last question, see Murray Rothbard’s take on the great price revolution in Europe, and the business cycle which occured in Spain around that time (especially Sevilla). Also, see Doug French’s take on tulipmania. If new gold is introduced into the market due to a rise in demand, I don’t see why this would cause a business cycle, but if new gold is introduced by account of artificial stimulation then I don’t see why it wouldn’t.