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Debt and Deflation

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.


  1. Steve618
    September 24, 2012 at 4:45 am

    I think the temptation to default on debt (both secured and unsecured) will increase as the value of the debt increases in real terms. I think people will care less and less about credit scores as credit tightens or disappears altogether. Creditors make out only if debtors continue to pay on loans. Foreclosing on depreciating assets won’t benfit creditors much.

  2. Free Radical
    September 25, 2012 at 5:59 pm

    Yes exactly. Of course, in a world with natural money and a natural banking sector, foreclosure in the case of a significant unexpected deflation would benefit creditors (though there would be no reason to expect such a thing to happen) but in this world, most creditors (banks) are also in debt to the FED in nominal terms. So even if they inherit a large amount of real assets from their debtors, they will still become insolvent since the nominal value of those assets will be lower than the nominal value of their accounts at the FED, putting them at the mercy of the FED who can decide to bail them out, if they like them, or break them up and distribute their assets to banks that they do like (Goldman Sachs and J.P. Morgan) if they don’t like them. And we call this a free market…

  3. Steve618
    September 26, 2012 at 6:53 pm

    Seems like a recipe whereby the Fed ends up owning a huge chunk of the real property and assets in the U.S. (the “value” in dollar terms becomes irrelevant). The Fed’s plan to purchase mortgage backed securities need not have anything to do with “stimulus”. The Fed “wins” either way. They either get a return on their investment or end up with the collateral. Thus the american serf is born

  4. Free Radical
    September 26, 2012 at 11:13 pm

    Yes! That’s basically what I’m getting at. On a side note, it’v very reassuring to see that someone is picking up what I’m laying down here. Now tell ten people and tell them to tell ten people (=.

    I would add one thing though. What the FED calls “quantitative easing” is not really any different from what they normally do (buying debt) except that it doesn’t really affect short term interest rates (since they are already practically zero) and they potentially can buy up different kinds of debt under this heading (not just T-bills). What I am asserting is that they are essentially turning to other securities because they run out of conventional ones. In this case, one way to keep putting money out is to just start buying other stuff. Of course, as I am arguing, this will not be a transitory need, it will just keep getting bigger and bigger until they run out of things to buy (in other words until they own everything). This possibility you have rightly identified.

    Another way of accomplishing essentially the same thing is to have the Federal Government borrow more which increases the amount of government debt in the market thus creating more conventional securities for the FED to buy in order to create more dollars, and the the government buys stuff. In this way instead of the FED ending up owning everything, the Federal government just keeps getting bigger and bigger until it essentially owns everything (or at least dominates the market for every good and service, which is not that hard to imagine if you look around right now). Of course, then we would all be collectively indebted to the FED but whether they could/would do anything about it remains unknown. In theory the government could just dissolve the FED if they decided it was a problem (which is what they should just do right now) but any way you slice it things become more centrally owned/controlled which is undesirable if you like things such as individual liberty.

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