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Deflation Part II

November 17, 2012 Leave a comment

[Note: For some reason, the columns don’t line up in the finished product the same way that they do when I’m typing them.  I tried to fix it but it’s not perfect.  Should be decipherable though.]

In the last post (quite a while ago, I know) I said this:

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.

This is that post.

Consider two different banking systems.  In the first system, base money is some commodity (like gold) and people lend this to banks in return for bank credit.  In addition to this, banks also issue credit to other borrowers in excess of the amount of base money they have in reserves.  This is, in fact, the way most people think of the banking system.  Let us begin by imagining that depositors deposit 1000 oz. of gold in the bank and the bank issues them notes redeemable for the same.  Assume that the interest rate on deposits is zero for now (interest plays a key role but not in the point I am trying to make here).   The balance sheets of depositors and banks will then look like this.

Depositors                                                     Banks

Assets                             Liabilities                  Assets                                      Liabilities

Notes     1000                                                     Gold               1000               Notes    1000

Banks then make an additional loan in the form of bank notes redeemable for gold in the amount of 2000 oz. to entrepreneurs, again at a zero interest rate.  The entrepreneurs then spend these notes on productive assets.  The balance sheets of the banks and the entrepreneurs will then look like this.

Banks                                                                   Entrepreneurs

Assets                              Liabilities                      Assets                           Liabilities

Gold        1000              Notes        3000             Notes       2000           Loans         2000

Loans      2000

Now imagine that entrepreneurs produce “goods” and the value of a “good” in terms of gold is initially 1 oz./good.  Also, assume that entrepreneurs believe the price level will remain at this level in the near future.  Furthermore, their productive investments of 2000 goods (the amount they can purchase with their loans at the above price) will yield 3000 goods in the future.  At the expected future price of 1 oz. of gold per good, this will easily allow them to repay their loans and leave them with a profit of 1000 goods (or oz. of gold depending on how you wish to account for it).

But now, instead of the price remaining at 1 oz. per good suppose that the price level falls to 1/2 oz. per good.  If this happens, entrepreneurs will be unable to repay their loans as their goods will only be worth 1500 oz. of gold.  They will go bankrupt and the bank will repossess their goods.  The bank’s balance sheet will now look like this.

Bank

Assets                                    Liabilities

Gold             1000                 Notes              3000

Goods          1500

Notice that the notes, which the entrepreneurs took out on loan and then spent, are still out there but the loan which offset them has been wiped off the books and replaced with a real asset which at the current price level is worth less than the face value of the notes.  In other words, the bank is now insolvent.  At this point, let us assume that the contract governing this bank’s agreement with its depositors was along the lines of that which I have previously suggested would prevail in a free market for banking and this caused the bank to suspend convertibility, liquidate all assets and distribute the remaining gold to the holders of notes at whatever rate were then possible.

This would mean the bank would sell the goods for gold which would give them 2500 oz. of gold to offset 3000 oz. worth of notes.  The conversion rate would then be 5/6 of face value.  So depositors would receive 833.33 oz. instead of the 1000 that they deposited.  So are they worse off or better off than they would have been if the price level stayed the same?

With the 833.33 oz. of gold that depositors receive, they can now buy 1666.67 goods at the new price level of 1/2 whereas they could only buy 1000 at the old price level with their full 1000 oz. of gold.  So in real terms, (in terms of goods), depositors became richer from the deflation even though they lost some gold.  In addition, the people who sold the original goods to the entrepreneurs for bank notes, will be in the same position being able to redeem those notes at only 83.33% of par but being able to buy twice as much with the gold they receive.  They will be able to buy 3,333 goods instead of 2000.

So even though the entrepreneurs lost all of their profit (1000 goods), this loss was more than offset by the gains to the holders of notes (2000).  It is worth noting here that the failure the losses to exactly offset the gains is due to the fact that our actors are holding an initial endowment of gold which becomes capable of purchasing an additional 1000 goods from somewhere outside our model.   A model in which prices were neutral in the sense that the gains were exactly equal to the losses would have to be bigger and more complicated.  Specifically, it would have to say something about why the price level changed.  For instance increasing the amount of goods or decreasing the amount of gold would add a source of real gain or monetary loss which would allow one to account for all of the net gains and losses as being from some non-monetary cause.  The goal here, is simply to show that deflation itself would not cause a dramatic fall in real wealth in that type of system even if it were unexpected, it would only shift real wealth from debtors (entrepreneurs) to creditors (depositors).

Banks, in this model are essentially just a vehicle for facilitating the use of credit for exchange and function as an intermediary between borrowers and lenders.  Since their assets and liabilities are both nominally delineated, a fall in the price level would not harm the bank if their debtors still paid their loans.  It is the defaults caused by the deflation which hit the banks’ balance sheets and then ultimately hit the depositors in a nominal sense.  But the nominal hit is more than offset in a real sense by the increased purchasing power of their money.

Now consider a different case.  Instead of base money being a commodity like gold whose quantity is fixed by circumstances of nature, base money is dollars which are printed by the central bank and loaned to the banks.  Again, assume that all interest rates are zero for the sake of simplicity and assume that banks borrow $1000 from the central bank which it prints up and delivers to them to be held as reserves.  Then firms borrow $2000 to invest in capital and the households who would have been depositors before, having no ability to print their own base money, now become borrowers and borrow $1000 from the bank to purchase durable consumer goods like houses, cars, boats, etc.

Then the balance sheets will look like this.

Banks     

Assets                                       Liabilities 

Reserves            $1000           Loans (from C.B.)       $1000

Loans                 $3000           Notes                             $3000

Firms

Assets                                        Liabilities

Capital                   $2000      Loans              $2000

Households

Assets                                        Liabilities

Con. Goods            $1000       Loans             $1000

Again, assume that firms can turn their capital into what would be $3000 worth of goods at the initial prices and assume that everyone expects the price level to remain constant.  Also, assume that households own the firms and expect to receive the profits from them ($1000) as income to pay off their loans.

Then, unexpectedly the price level falls by 1/2.  The output of firms is now only worth $1500 which is less than they owe so the bank repossesses their assets.  Households then receive no income and can’t pay their loans so the bank repossesses their assets.  The bank’s balance sheet then looks like this.

Bank

Assets                                                  Liabilities

Reserves                     $1000             Loans (from C.B.)               $1000

Goods                         $2000             Notes                                     $3000

The goods represent the output of the firms and the consumer goods revalued at the new price level of 1/2.  The bank is now insolvent.  The Central bank, which insured the bank’s notes, seizes the assets of the bank, and prints dollars to pay off the bank’s liabilities.  In this way the central bank sucks up all of the real assets.

The key difference here is that in the first system, every dollar borrowed was offset by a dollar loaned from someone in the private sector.  In the second system, the private sector is a net borrower with the surplus borrowing being loaned by the central bank.  So whereas a fall in the price level in the first system just shifts real wealth from private borrowers to private lenders, in the second it shifts real wealth from the private sector to the central bank.

There are two important issues not addressed here.  One is what the central bank does with those assets.  A favorable view of central banking might suppose that, having created money to redeem the debts of the bank, they then sell the goods back onto the market which would simply transfer the real wealth to the holders of that debt.  A less favorable view would be to imagine that the central bank distributes these assets to the member banks who control it in a way that is very favorable to them.  Regardless of what you think actually happens, as a libertarian, I’d prefer not to put a centralized authority in a position to wield this kind of power, but that’s just me.

The second question is “why would a sudden unexpected fall in prices occur in the first place?”  This is really the million dollar question.  And I will take this opportunity to remind the reader that you should never reason from a price change (shout out to Scott Sumner) since in a market economy, prices are inherently endogenous.  That this phenomenon is actually caused by central banking is what I intend to show eventually.

For now, let me point out that it is pretty difficult to imagine why this would happen in a system of free banking with a commodity monetary base.  This would require a sudden unexpected decrease in the quantity of money, increase in the quantity of all other goods, or decrease in velocity.  The production of individual goods are certainly subject to significant random shocks but it is hard to think of a shock which would unexpectedly increase the output of all goods significantly.  And the quantity of precious metals is determined by the amount in nature, which is fairly constant, relative to the expected total demand over all of time.  Neither of these things is prone to sharp fluctuations which would result in an unexpected fall in the price of precious metals, especially when the demand comes largely from use as money.  And this is no coincidence, it is precisely why these goods are selected by the market for use as money in the first place.

It is asserted by many that a fall in prices can have a significant negative effect on real wealth.   But this claim seems dubious to many because it is not clear how changes in prices actually destroy real goods.  Nonetheless, we seem to observe that the economy is subject to catastrophic downturns as a result of monetary causes.  The anti-central banking crowd has done little to square this reality with the notion that deflation should be harmless in a free market.  This is because they fail to fully appeciate  the difference between such an economy and the one we are observing.  Hopefully this will help to illuminate this difference.

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