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Debt and Deflation

September 19, 2012 4 comments

I think I have found a way to make my point about monetary policy and debt fairly simply.  But before I get into that I want to point out why deflation is bad.  First, consider the case in which deflation is not bad.

Bob owns a widget factory.  To make widgets, he hires labor and buys steel.  It takes 1 hr of labor and 1 lb. of steel to make one widget.  labor costs $10/hr. and steel costs $5/lb.  The price of widgets in period 1 is $20.  The factory can produce 1000 widgets per period.  Bob holds real wealth in the form  of a factory.  The factory has real value because of its ability to convert labor and inputs into widgets which have a higher (real) value than the labor and inputs required to produce them.  For simplicity’s sake let’s value the factory at the level of profit for one period (it should be the present value of all future profits but for our purposes, that’s just extra math).  This value will be 1000(20-10-5)=$5000.  And let’s say that Bob uses his income to buy cheeseburgers which cost $10 each.  With this income he can buy 500 cheeseburgers per period.  Bob holds wealth in the form of a factory which has a nominal value equal to $5000 and a real value equal to 500 cheeseburgers or 250 widgets, whichever you prefer.

Now imagine that in period 2, due to monetary causes, the price level falls by a factor of 1/2.  What is the effect on Bob’s wealth?  Well he can still produce 1000 widgets.  The price of the widgets fell to $10 but now the cost of the inputs is only $7.50.  So he only makes $2.50/widget or $2500 total.  But cheeseburgers now cost only $5 so he can still buy 500 cheeseburgers, the same amount as before.  In other words, he is no better or worse off.

This is the kind of scenario that classical economists had in mind when they declared that “money is neutral.”  And this is the kind of scenario that Austrians and other conservatives still have in mind when they proclaim that deflation is nothing to worry about.  Now consider a slightly different situation.

Bob is considering buying a factory (the same factory as above).  In order to do so, he must take out a loan.  The price of the factory is $5000.  The nominal interest rate is 5% and Bob expects prices to rise at a rate of 10%.  To get a loan, Bob must make a down payment of $1000 and put the factory up as collateral.  But this seems like a good deal because in the next period, Bob will owe 4000×1.05=4200, but the (nominal) value of the factory will increase by 10% to 5500.  This means that Bob’s wealth (the difference between the value of the factory and what he owes to the bank) will go from $1000 to $1300, a 30% increase.  Since the price of cheeseburgers only goes up 10%, Bob gets richer in real terms so he will be eager to take out this loan and buy the factory.

Now, again, imagine that prices, instead of rising by 10% fall by 1/2.  This will make the factory only worth $2500.  But Bob still owes $4200.  Cheeseburgers get cheaper but it doesn’t matter because Bob’s wealth didn’t fall by 1/2, it actually became negative.  The Bank will repossess the factory and Bob will be 100 cheeseburgers poorer than he was in the first period due to the down payment which he loses in the process.

Notice that this is essentially what happened in 1929 with investors buying stocks on margin and in 2008 with the housing market.

What I have not done here is show that this is bad on a macro level.  Some may argue that, this is bad for Bob, but his loss is offset by a real gain to his creditor, so this is still nothing to fear on an economy-wide scale.  Again, this would be the case with free money, but it is not the case with our system.  However, I will leave that discussion for another post.  The main point to take away from this is that there are two factors which combine to make deflation problematic.  One is that it must be unexpected.  If Bob expected prices to fall by 1/2, then he would have factored this into his decision and it would have been reflected in the market interest rate.  The other is debt.  When people actually own assets outright, the price level can go up and down without having a major impact on their real wealth.  But when their assets are highly leveraged, they are very susceptible to a fall in the price level because the nominal value of their debts does not fall with the nominal value of their assets.  An understanding of this concept will be important prior to what I want to talk about next.

 

The Height of “Democrisy”

September 6, 2012 Leave a comment

I’m the first person to admit that there are some serious shortcomings with the Republican Party but  when things like this happen, it leaves me absolutely flabbergasted that anyone continues to support the Democratic Party.

This is the party named for democracy.  By the way, here is the definition of democracy.

de·moc·ra·cy /dɪˈmɒkrəsi/ [dih-mok-ruh-see] noun, plural de·moc·ra·cies.

1. government by the people; a form of government in which the supreme power is vested in the people and exercised directly by them or by their elected agents under a free electoral system.
Now, with this definition in mind, let’s look at what the Democrats did here.  The leaders of the party decided they needed to change the platform to get themselves out of a developing political jam.  So they take it to the people and put it up for a vote.  But the people don’t vote for what they want.  Taken aback by this, they try to subtly indicate to the people which thing they are supposed to vote for and try the vote again.  When the people still don’t choose the right thing, they seek advice on the process looking for a way to get them to choose the right thing.  When no way can be found, they try the vote again and when the people, once again, choose the wrong thing, they simply declare that they had actually chosen the right thing and proclaim the matter closed.
Even in their own party the notion of democracy is nothing but a convenient cover for a group of elites to impose their will on the masses.  And the astonishing thing is that when it fails in this capacity, they don’t give up imposing that one little piece of their will on the masses.  Instead, they completely drop the disguise and just hope nobody will notice.  If they act like this when amending their own party platform, imagine how they will handle the important stuff like healthcare reform……. Wait, didn’t we already do healthcare reform? How did that go again, I can’t remember?
This party is now based on two types of people.  People of no particular principles, who are dependent on them for some particular government giveaway and people who are not paying any attention whatsoever.  Unfortunately, there are a lot of both.  So in an attempt to wake some of them up I am creating a new term.  Feel free to spread it around.
de·moc·ri·sy [dih-mok-rih-see] noun, plural de·moc·ri·sies.
1.   A governing body made up of people who claim to represent the will of the people while instead using the people as a pretense for pursuing their own personal political designs.
Feel free to spread it around.

Misconception #3: We are Experiencing Hidden Inflation

September 5, 2012 2 comments

The last one is the big one that should have blown your mind but nobody is commenting on it so if you missed it make sure you see Misconception #2.  This one is less profound but it is still important.  The hyper-inflation crowd is always pointing to food prices to argue that there is high inflation.  But this is dreadfully poor economics.  It’s true food prices are high but this is because there is a drought.  Similarly, gas prices are high because of turmoil in the middle east, government regulations which make it difficult/impossible to drill for oil or build a refinery (my oil-refining-friend insists that there will never be another refinery built in this country), and indirectly because of the same drought thanks to asinine ethanol standards.  But these are both increases in relative prices.  This is a distinctly different phenomenon from an increase in the price level (commonly referred to as “inflation”).

Furthermore, the use of core inflation (excluding food and energy prices) is not a plot to disguise high inflation.  And let me point out that I’m totally a believer in plots by “the establishment” to subtly misguide us, but this is not the case here.  How do I know this?  Because it doesn’t actually hide anything.  It turns out that if you want, you can just look up the headline inflation numbers.  Here is a post with some helpful graphs.  Notice how the only real difference between core and headline inflation is that headline is more volatile.  And most recently, it has been below core inflation.

There is a legitimate intellectual debate over whether core or headline inflation should be used by policy-makers but as far as I’m aware, “just going to the grocery store” has not received any serious consideration among stuffy academics like myself.  This is not a conspiracy.  There just isn’t high inflation.  If you understand Misconception #2, (or Thomas Jefferson) this shouldn’t surprise you because central banks cause first controlled inflation and then uncontrollable deflation.