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Deflation

One of the great timeless questions in macroeconomics is: what are the real effects of changes in the value of money?  The current conventional wisdom (if I may simplify) is that in the long run, it doesn’t matter (money is neutral) but in the short run monetary issues are important.  More specifically, in the short run, inflation is good in some situations and mostly innocuous in others so long as it doesn’t get out of control, but deflation is bad and should be avoided.  The fear of deflation seems to be mostly empirically motivated (we have observed deflation and recessions happen together) and explained mainly by assuming prices (especially wages) are sticky in the downward direction so markets can’t adjust efficiently.  Interestingly, the same progressives who buy into this logic have spent the last century doing their best to create institutions which prevent prices from falling (minimum wage, labor unions, subsidies, bailouts, etc.) but that is a topic for another post.  What I want to do here is establish a distinction between one situation where deflation is not scary and another situation in which it is. 

First let us imagine (sigh…) a free market with real money.  I have already argued that this situation would most likely be characterized by moderate deflation due to the relatively fixed quantity of precious metals compared to output.  In this case the rate of inflation/deflation would be determined in the marketplace.  It would include all expectations of future events and it would be efficient.  What I mean by this is that people would utilize the ability of money to act as a store of value to the extent that this is preferred to their next best option and only to that extent.  In this case the price of holding money would be the difference between the rate of return that one could receive from some other investment and the rate of return on holding money (the rate of deflation).  People would only pay this price because there is a benefit to them of holding money (liquidity preference).  If there were no liquidity preference, then this price would be zero, the rate of deflation would be equal to the real interest rate and the nominal rate would be zero. 

Note that this price is separate from the real interest rate which is the price of consumption now in terms of consumption in the future.  If people did not prefer consumption now to consumption in the future, the real interest rate would be zero.  If this were the case, and there were liquidity preference then there would be some inflation and this would represent the price of holding money.  The important thing to understand is that these rates are manifestations of the real situation in the market including peoples preferences and expectations for the future, they are not random.  In this situation, there is nothing harmful about deflation.  The rate would be determined as exactly that rate which leads to an efficient level of investment, savings and consumption based on people’s preferences and expectations, and it would be relatively predictable so people could plan accordingly.  This wouldn’t mean that people’s predictions would always be right, there is still a random element to the nature of the world, but this system would not add unnecessary distortions or uncertainty.  If a ship full of gold sunk, or a new productive mine were discovered, these rates would change, some people would be worse off and others would be better off but the rates would be changing to the new efficient levels.  They would reflect the new perception of reality faced by the market and the economy would continue on from there in an efficient manner.  I will speak more to the specific ways that these rates would change in a later post.

Now I will transition to the current system.  Let me point out that the explanatory power of the model I am developing here is independent of the motivation for these systems.  However, since this is a blog about freedom and not a scholarly journal, I will take the opportunity to point out some connections which I find interesting.  Keep these things in mind.

1. Progressives and Marxists, rather than observing how the world actually works and trying to design institutions that are desireable in light of that information, begin by imagining how they wish the world worked and try to use government to make nature conform to their whims. 

2. Progressives and Marxists wish they lived in a world with no “rentier class.”  That is, they wish capital was free (not scarce) and you could not make money by lending or investing. 

3. Keynes was a progressive/marxist.  Recall this quote from the General Theory: “Now, though this state of affairs would be quite compatible with some measure of individualism, yet it would mean the euthanasia of the rentier, and consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital.”  So was Woodrow Wilson (and like the entire government in 1913…).

4. The government cannot alienate your God-given liberty, but it can manipulate the options which you are at liberty to choose.

Ok, with these things in mind let’s look at what the Fed does.  Actually, I will talk more specifically about what it does later, for now let’s say that they set the interest rate.  But notice that what they set is the nominal rate.  If the real interest rate is determined by real factors (time preference and investment opportunities), then it would be independent of this rate and the difference would manifest itself in the form of inflation/deflation.  If they set the nominal rate lower than what it would be in a free market this means that holding money becomes more expensive.  If they set it lower than the real rate you will have inflation, meaning people, instead of realizing a return on holding money are actually being taxed for doing so.  The lower the nominal rate in relation to the real rate, the less appealing it is to hold money.  This will tend to increase velocity and may drive down real rates.

The effect of this decrease of interest rates on real investment is not as clear as is commonly imagined.  To see this, notice that there are three things you can do with wealth.  Save it (by holding money), invest it, or consume it.  What they are doing is essentially taking one option away (holding money).  But lower interest rates are likely to encourage consumption as it is investment.  This means these two alternate uses will both pull harder on the existing wealth than with a higher interest rate (this is just another way of saying the market is out of equilibrium).  Whether this leads to more or less real investment depends on which one pulls more harder.   This is an issue I do not have a completely satisfactory answer to yet but I will deal with it in more detail later. 

Keynesians handle it by assuming that when more consumption and more investment are demanded, more wealth is magically created at no cost to anyone.  If you assume this then it’s a win-win.  Unfortunately that’s ridiculous.  Even if you believe that this results in greater investment than when interest rates are higher, it is not necessarily more efficient.  In fact, basic economic reasoning indicates that it would be less efficient.  Keynes contrived a complicated and in my opinion flawed theory to try to argue that sometimes it might be more efficient.  Regardless of the effect on investment, what it does do is make it harder to make money by lending money.

There are many interesting things going on here but I want to turn the focus back to deflation.  What happens here is that the government, by setting the nominal interest rate, controls the money supply (this is often stated the other way around but the distinction is unimportant) and this affects inflation.  This has led to a dual mandate.  The Fed often claims that its goal is to use monetary policy (setting of interest rates) to promote whatever they somehow decide is an appropriate amount of economic growth and to keep inflation at low positive levels.  I intend to show eventually that this system necessarily leads to periods of unexpected deflation but for now I just want to consider what the effects of this would be if it happened for some reason. 

With fiat money and the fed doing what it does, deflation would still not be inherently devastating to the economy at large.  If the fed decided to choose the nominal rate that would have been determined in a free market, we would most likely have moderate deflation, it would be predictable and the economy would function fine.  There are two situations which combine to make deflation problematic.  One is when it is unexpected.  This means people find themselves in a situation that would not have been optimal had they known that deflation was going to happen.  This could result in inefficient intertemporal decision-making.  In other words, we may get the wrong amount of investment (too high or too low) and that investment may be in the wrong things.  This is essentially the classic Austrian business cycle story where we get a depression because we have to liquidate and reallocate the malinvestment that we accumulated due to the inappropriate interest rates and unexpectedly low inflation rates.  This story is probably correct but the main criticism of it is that it doesn’t seem like enough to explain long deep depressions and I agree.  Of course Austrians will argue that this is true but when we have had long depressions they have been perpetuated by misguided government intervention which is true but I think there is also something else going on here. 

If you just had households lending to firms and you got unexpected deflation, then firms would be made worse off and some would go out of business but this would not be devastating to the macro economy.  Households would actually be better off.  Even if entrepreneurs defaulted on their loans (provided it was only due to the deflation), they would get back assets worth more than what they would have otherwise (but of a lower nominal value).  The assets would get reallocated and production would go on only mildly interrupted.

The second ingredient in this cocktail is debt.  If the interest rate were at its natural level and the fed came along and offered to loan as much money as people wanted at some rate lower than this, consumers would want to consume more and investors would want to invest more.  Both would want to borrow more money.  If they knew this rate would persist forever and inflation was free to adjust, then the inflation rate would adjust to put this market in equilibrium.  However, if people mistakenly believe that the Fed will maintain a certain rate of inflation which is not compatible with equilibrium given their low nominal rate, then consumers will borrow money in order to consume thinking the price of consumption today is very low in terms of consumption tomorrow because they expect to pay back the loans with cheaper dollars.  Investors will also borrow more for the same reason.  Then, if deflation happens, they will both lose because they are both borrowers. 

So who becomes the owner of all the real wealth in the economy?  The banks of course.  But wait–I hear you cry–aren’t the banks the hardest hit by these downturns?  Why yes, in fact, I should have been more specific.  You see, most banks are actually debtors as well.  They lend money in nominal terms so they stand to gain on the one side by deflation.  The problem is that they also borrow in nominal terms.  Some of this borrowing comes from households but remember that by keeping nominal interest rates low (and inflation expectations high), this type of saving is drastically reduced.  But the demand for lending is increased, so banks make up the difference by borrowing from the Fed.  This seems like a great deal.  The fed loans you money at 2 percent and you lend it out at 4.  How can you lose? 

Well if there is a sudden outbreak of unexpected deflation you lose.  That’s because when prices fall, firms can’t pay back the nominal value of their debts.  This wouldn’t necessarily be a problem.  If they had collateral, the banks would just take the collateral and they would be even better off because even though it wasn’t worth as much as they were owed in nominal terms, it would still be worth more in real terms than the nominal value of the debt would have been worth without the deflation (there are some assumptions involved here but I’m trying not to be too technical). 

So if you’re a bank and this happens, you don’t get the money you thought you would get but you got a farm or a factory instead.  This is ok because while dollars are less valuable after the deflation, these real assets are no less valuable than when you accepted them as collateral.  Except there’s one little problem.  You still owe your creditors a fixed amount of dollars.  So even though the assets of the bank may be worth even more in real terms than before the deflation, the obligations of the bank are worth even more than that.  In this way a bank may become insolvent.  If the Fed decides that a bank is insolvent, it seizes the assets of said bank. 

So the real wealth gets sucked up by the Fed.  Where does it go from there?  Well it would be nice if we could, oh I don’t know…..audit the Fed!  But apparently we can’t, even when a majority of our representatives sponsor a bill to do so.  The paper profits that they accumulate (I should say that they choose to accumulate on a set of books that nobody can look at) go right into the treasury.  The assets that they seize from insolvent banks get sold off.  Usually this is to other banks.  Usually those banks come from a small group of Wall Street banks who always seem to be profitable even during these downturns and whose heads happen to be running the Fed. 

Regardless of the degree of insidiousness involved, a lot of wealth is likely to be destroyed in this process (foreclosed houses don’t tend to be in very great condition).  I don’t know how large it is reasonable to imagine the magnitude of this effect is, but what is probably more problematic is that the wealth becomes concentrated in the hands of a few institutions who don’t really know how to make use of it.  This wouldn’t be much of a problem except that there is very little other wealth left in the hands of the people who do know what to do with it which they could trade to acquire it.  This may result in much of it being underutilized for some time.  Throw in some government sponsored price rigidities and uncertain property rights, and you have a pretty good recipe for depression.  But you can’t claim that the problem is deflation and that’s why we need the Fed to protect us from it.

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  1. June 1, 2010 at 7:47 am

    great…

    • Free Radical
      June 2, 2010 at 2:57 am

      haha sorry…

  2. Monkeyfodder
    June 15, 2010 at 12:01 am

    Put some math together and present this in a Macro brown bag. That would be entertaining to attend.

    • Free Radical
      June 15, 2010 at 7:36 pm

      I’m working on that but the math is actually no that straightforward because you run into expectations issues

  3. Monkeyfodder
    June 17, 2010 at 12:11 am

    Well let me know the expectations issues. I was a stats undergrad major

  1. June 24, 2010 at 6:09 am

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