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Peter Schiff on Deflation

April 9, 2014 3 comments

A while back I sort of blasted Selgin for his position that deflation is not necessarily bad.  That was a bit unfair of me since he actually has a fairly nuanced and not totally unreasonable point.  If we had a monetary policy regime which caused deflation to not be bad (in other words, if we had one entirely different than the one we have) then it wouldn’t be bad.  But my reaction was sort of a knee-jerk response to a point of view that I run across often in libertarian circles that drives me nuts.

Here is the guy I was really arguing with.  So let me take out my frustration on him.  There is a lot that is wrong with this so I will try to knock off the really obvious but less important points first and work my way up to the big important stuff.  First of all, Schiff discusses an article on Bloomberg which he provides no link to.  IMO this represents a breach of blogging etiquette (there’s not a single link in the piece, it’s almost like he doesn’t expect the reader to question any of the bold empirical claims he is making).  Here is the link.

Postponing Consumption

Here is the argument.

 . . . there is now a nearly universal belief that deflation is an economic poison that works its mischief by convincing consumers to delay purchases. For example, in a scenario of 1% deflation, a consumer who wants a $1,000 refrigerator will postpone her purchase if she expects it will cost only $990 in a year. Presumably she will just make do with her old fridge, or simply refrain from buying perishable items for a year to lock in that $10 savings. If she expects the cost of the refrigerator to decline another 1% in the following year, the purchase will be again put off. If deflation persists indefinitely they argue that she will put off the purchase indefinitely, perhaps living exclusively on dried foods while waiting for refrigerator prices to hit zero.

That is a perfectly good debunking of a position that I don’t think anybody actually holds.  I dug out my intermediate macro text and I think I have identified what he is arguing with.  Here is Blanchard on the subject.

When inflation decreases in response to low output, there are two effects: (1) The real money stock increases, leading the LM curve to shift down, and (2) expected inflation decreases, leading the IS curve to shift to the left.  The result may be a further decrease in output.

We have just looked at what happens at the start of the adjustment process.  It is easy to describe a scenario in which things go from bad to worse over time.  The decrease in output from Y to Y” leads to a further decrease in inflation and, so, to a further decrease in expected inflation.  This leads to a further increase in the real interest rate, which further decreases output, and so on.  In other words, the initial recession can turn into a full-fledged depression, with output continuing to decline rather than returning to the natural level of output.  The stabilizing mechanism we described in earlier chapters simply breaks down.

Now I actually have a lot of issues with this theory.  For instance, it assumes irrational inflation expectations.  Also it assumes an exogenous change in output which causes inflation to fall.  I am actually inspired to explore these issues in a later post (this is not to say that economists are unaware of them).  But nowhere is it assumed that people, expecting prices to fall slightly, will decide to not consume at all.  There is a much more complex argument underlying this.  It involves a feedback loop between prices, inflation expectations and consumer demand which is certainly questionable.  But Schiff is not even scratching the surface of the actually questionable parts.  He is just seeing a result that he thinks is questionable (and is) and he is imagining that it is the result of a ridiculous formulation of the underlying consumer demand function (which it is not) and he is pointing out how ridiculous that demand function would be.  If this were what any economist had in mind, then he would have an excellent point.  However, I don’t think that is the case.

Sticky Wages (and “a change in demand is different from a change in quantity demanded”)

This is an area where I sort of agree with him.  The role of sticky wages tends to be exaggerated with a conspicuous lack of attention put on artificial (government) sources of stickiness like unions and minimum wage and price controls.  But he is going too far by claiming that these are the only source of price stickiness.  Certainly, at the very least, we can acknowledge that long-term contracts exist.  Plus there’s the whole debt thing that I’m always talking about (more on that later).  But what really betrays a failure to comprehend the sticky-wage argument is this.

However, inflation allows employers to do an end run around these obstacles. In an inflationary environment, rising prices compensate for falling sales. The added revenue allows employers to hold nominal wage costs steady, even when the raw amount of goods or services they sell declines.

This misses the point entirely.  He seems to be taking a decrease in the quantity sold for granted (reasoning from a quantity change?) and then treats the inflation as a completely independent phenomenon that just puts extra money in sellers’ pockets in spite of this decrease in order to allow them to keep wages high.

The actual argument behind sticky wages is not that the monetary authority has to cause inflation when the quantity of goods produced falls in order to keep wages from falling.  It is that they have to prevent prices from falling because wages can’t fall and that would cause the quantity of goods produced to fall.  This being due to the fact that employers could not continue to employ the efficient number of workers at the new, higher real wage.

So if we don’t start our reckoning by assuming that the thing we are trying to avoid happens exogenously (for no apparent reason), and instead we imagine that aggregate demand drops, perhaps due to unexpectedly tight monetary policy, we can make better sense of things.  In this case, demand for all goods would decrease.  This means that sellers would have to either reduce their prices or sell less or do both.  If all prices (including wages) were not sticky at all, they would simply lower their prices and wages until they were at the same quantity of sales and employment but at lower prices and wages.  But if they can’t lower wages, it will not be optimal for them to keep producing the same quantity at a lower price and the same wage.  This will cause them to cut back production (by laying off some workers) and lower prices until they are maximizing profits given the new lower demand and inefficiently high, sticky wages.

This, of course, can be avoided if the monetary authority avoids tightening, or in the case of aggregate demand (which is not the same as quantity) dropping for some other reason, by adopting a more accommodative policy to push it back up.  Is this a compelling argument for having a monetary authority manipulate the price level in the first place?  Maybe not, you decide.  But it is not a nonsensical argument and arguing with a distorted, straw-man version of it doesn’t get us anywhere.

And while we’re on the topic of Peter Schiff not really understanding what “demand” means, let’s deal with this:

Economists extrapolate this to conclude that deflation will destroy aggregate demand and force the economy into recession. Despite the absurdity of this argument (people actually tend to buy more when prices fall), . . .

There are two problems here.  One is that deflation doesn’t destroy aggregate demand, falling aggregate demand causes deflation.  I can forgive him for this because the textbook argument I cited above does actually give the impression that the causation goes both ways.  I think this is a problem with that exposition.  So I would be inclined to agree with his criticism if he didn’t blow it with the parenthetical statement.

This is econ 101 stuff.  The quantity demanded by a given consumer (or all consumers) is larger when price is lower and other things are constant.  This is different from a fall in demand!  Market prices are determined by supply and demand.  When demand falls, both price and quantity fall.  Aggregate supply and demand mean something a little different but the basic intuition is the same.  If your argument against the deflationary spiral is that “people buy more when prices fall” you are several layers of reasoning short of understanding the thing you are arguing with.

Debtors and Creditors

This is where it starts to get near and dear to my heart.  Schiff points out that inflation helps debtors but hurts creditors, giving the impression that it is simply a sterile transfer from one group to another with the implication that it goes on because the beneficiaries are more politically connected than those on the other side.

While it is true that inflation (by which I mean more than expected inflation) helps debtors and hurts creditors, this does not make the net effect neutral.  This is because people in aggregate are net debtors vis-à-vis the banking system.  So it is possible for us to all go broke together.  This is where my crackpot theories diverge from both the Schiff/Rothbard crackpot theories and from the “mainstream” (crackpot) theories.  So going into that in detail here would take us far afield but if you’re interested click here, here and here.

The Zero Inflation Boundary

Schiff gives the impression that, until this Bloomberg article, economists were only worried about negative inflation and that they only advocated low, positive levels of inflation because this provides a buffer against accidentally falling into deflation but that so long as this is avoided, there is no problem.  I don’t think this is an accurate characterization of the stance of most mainstream economists.

There are two separate issues here.  One is the question of the appropriate long-run policy regime.  This is where Schiff probably got this idea.  Most macro models have some version of money neutrality in the long run.  Often, this takes the form of superneutrality which means that the monetary authority can grow the money supply (and therefore the price level) at any rate they want without affecting the real economy in the long run. 

This leaves policy-makers (assuming they control the money supply) with the issue of selecting a long-run growth path for money and prices.  A natural argument, if you believe in sticky prices/wages, is then to say that a positive but moderate inflation target might be best because it allows for some cyclical fluctuation around the target without triggering the sticky-wage problem.  This, admittedly, is a lot like Schiff’s characterization of the mainstream position.  But this is not really the issue that most economists are concerned about when they warn about inflation being too low.

It is one thing to argue that the monetary authority could follow a zero-inflation long-run policy path and it would be no better or worse than a 2% inflation or 10% or -2% inflation path.  It is something else entirely when the monetary authority sets a 2% inflation target and then produces 1/2%.  It’s not that there is something magic about crossing the zero-lower-bound on inflation.  The problem is when inflation runs below expectations.

When people make long-term financial decisions, they do so with some expectation about future prices.  For instance, if you invest in producing a good, you have to predict the price of that good in the future.  If the price turns out to be lower than you thought, your calculations will be wrong.  There is not some eternal magic number that the price must be and the central bank has to make it hit that price or else cause a lot of problems.  It’s just that they have to not screw up peoples’ calculations by causing them to expect a certain price level and then causing a different level to occur.

This is particularly problematic when it goes on for an extended period of time without any attempt at filling in the gap.  The bigger that gap gets the bigger the difference between the actual price level and the level people were expecting when they initiated long-term financial positions in the past.  Plus if they go on like this for a while without changing their target, it starts to become unclear what to expect from them in the future.

This is mostly important for decisions involving nominal debt because, as I like to go on and on about, debt contracts are long-lived and nominally denominated so your obligation in nominal terms does not fluctuate with the nominal value of other things like your labor or your house or the output of your business.  And remember, aggregately, we are net debtors so when the price level grows more slowly than we were expecting, this causes a systematic weakening of the financial position of the economy as a whole.

This is my special way of characterizing the issue at the heart of the inflation question.  There are different ways of characterizing these issues and different models for trying to understand them but almost all of them rely in an essential way on the role of inflation expectations.  Peter Schiff is not even scratching the surface of these issues.

 

P.S. This is the most unimportant point and I originally put it at the beginning but it is probably also the most inflammatory and I figured some people might not make it past it to the more important stuff so I cut it out and stuck it here at the end.

 

Definition of “Inflation.”

This is a common sticking point for Rothbardians (which is what I am now using to refer to a particular popular sect often known as “Austrians” on the advice of commenter John S).  Economists almost universally use this word to refer to the change in the aggregate price level.  Rothbardians commonly assert that this is the “wrong” definition in the sense that it was not the original definition.  This is a completely pointless debate.

Usually this argument is brought up for one of two reasons.  One is to generally discredit mainstream economists and imply that they don’t know what they are talking about because they don’t even use the “right” definitions of words.  The other is to weasel out of hyperinflation predictions by saying “well, okay, prices haven’t really risen that much but that’s not the actual definition of inflation…”

I am no expert on the evolution of this term and I don’t care about it enough to research it but just for fun here is my educated guess of how things went down.  Originally inflation meant what the Rothbardians say it means because at that time, that was the most useful definition for thinking about the economy.  Eventually the state of economics evolved in such a way that someone had to give a name to the rate of change in the aggregate price level and they called it the “inflation rate” because they figured prices tended to be positively correlated (perhaps proportional) to the size of the money supply, other things being equal.  As the science continued to evolve, economists found themselves being very interested in the rate of change of prices and not so much in the money supply, except to the extent that it affected prices.

To see why this is reasonable consider the following thought experiment.  You need to make some investment/consumption decisions.  Maybe this is buying a house, or investing in the stock market or taking a new job or whatever, it doesn’t matter what it is.  An angel comes down from heaven and offers to do you one of two favors.  He will either tell you what the size of the money base will be in ten years (and not the price level) or he will tell you what the price level (somehow defined) will be and not the size of the money base.  Which would you prefer?

Before 2008, you probably could have at least argued that the choice was trivial because you could extrapolate pretty easily from one to the other but that notion should be dead now.  Of course, Rothbardians realize that what really matters is prices, their arguments are always actually about the price level.  They never say “we’re going to have hyperinflation of the money supply and you should be really worried about that even though prices will never rise more than 2% per year.”  When they make their inflation arguments, they are always talking about the price level.  It is only when those predictions don’t come true that they step into their time machine and act like the original argument that took place two years ago was really a hundred years ago and “inflation” didn’t really mean what you thought it meant.  And by the way, they weren’t really making a prediction because Austrians don’t make predictions so if you thought they were, you must have been confused.

When economists say “inflation” they are talking about changes in the price level.  All economists realize that this is what other economists mean.  If you want to use it in a different way, and be clear that this is what you are doing, because it allows you to say something interesting, I have no problem with that but if you are just ridiculing someone for using a word to mean what most people commonly accept it to mean, you are wasting everyone’s time.

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Why Hyperinflation is Not a Threat II: Debt and Anti-Debt

January 16, 2013 5 comments

Last time I told you that money does not represent a debt from the Federal Reserve and that even if it did, it would not serve as an anchor for the real value of a dollar because the assets of the Fed are also denominated in dollars.  So what does money really represent and what does anchor the real value of a dollar?

In the past, paper money was created by banks.  You could take gold or silver or something of the sort to a bank and they would give you a bank-note which could be redeemed at any time for some quantity of gold or silver or the like in the future.   As long as people generally trusted the health of the bank, they could trade the notes instead of the gold or silver which was somewhat more convenient and also allowed for an “elastic” money supply (I’ll postpone a discussion of that topic).  Originally, the government got involved in money essentially by assuming the same job as a bank.  They would trade dollars for gold and gold for dollars at a given rate.  In this scenario, money represents a debt from the bank or the government to the holder of the note.  The gold or silver or other real good which backed the money is a sort of “anti-debt.”  It is the means by which these debts can be extinguished.

Today, money is not backed by gold or silver or anything in this manner.  The process of money creation is of an altogether different nature. There are a few different ways it is done but they amount to essentially the same thing.

If you buy a government bond, that represents a debt from the government to you.  It is redeemable at a fixed time for a fixed amount of dollars.  The dollars you use to buy the bond do not represent a debt from you to the government.  They represent the means by which the government can extinguish its debt to you.  At the appointed time, the government must produce the requisite amount of dollars to retire your bond or else default on its debt.  The number of dollars required to do this at that time does not depend on variables such as the price level, rate of inflation, real interest rates, GDP, etc..

If you sell a government bond to the Federal reserve, the debt which the government owed you is transferred to the Federal Reserve.  The dollars which the Fed prints and gives to you represent the means by which that debt can be extinguished.  The Fed doesn’t owe you anything, the government owes the dollars to the Fed.  When the bond comes due, the government must either get dollars from taxes or issuing more bonds in order to retire that bond, or, as they normally do, just issue another bond and give it to the Fed, which cuts out the middleman (you).

Alternatively, the Fed can loan to a bank.  When a bank borrows dollars from the Fed, it’s not the Fed that owes the bank, it is the bank that owes the Fed.  The dollars, again, represent the means with which the bank is able to extinguish this debt.  The principle is the same, in either case, the dollar is created and traded for debt.  In both cases, the debt is from someone else to the Fed and the dollar is not the debt but the “anti-debt.”  This is an important distinction between modern fiat money and traditional bank-notes which, at one time were backed by gold or silver.

To see how this provides an anchor for the value of a dollar, we must go a step farther.  If the Fed loans to a bank, that money becomes part of the bank’s reserves.  If you sell a government bond to the Fed, you most likely deposit the money which you get in return in the bank and it becomes part of bank reserves.  Alternatively, you may spend it on something else, but in this case the person to whom you pay the money most likely deposits it and it becomes part of bank reserves.  I can drag this out through as many steps as you please, but the point is that most of this base money will end up as bank reserves.

The money which the Fed creates and which is able to extinguish Federal Reserve debt is the money base.  Some of this ends up in people’s wallets but most of it ends up in bank vaults (or accounts with the Fed which amount to the same thing).  The base money that ends up in bank vaults acts exactly like gold did in the old system.  It is anti-debt.  The banks then issue bank credit on top of this which is debt.  This bank credit takes the form of checking accounts, saving accounts, certificates of deposits and so forth.  If you deposit a $20 bill in the bank and they add $20 to your checking account balance, this is a modern form of bank credit.  It is redeemable at any time at the bank for $20 in cash.  Again, the cash is the anti-debt into which this bank credit is convertible.

And just like people could use bank-notes to transact, we now can use this modern bank credit.  You can go to the store, buy a gallon of milk and pay with a check or a debit card.  At the end of the day, the store will deposit the check with their bank and their bank will settle any balance that arises with your bank by transferring cash, just like in previous times banks would have settled by transferring gold.  So what we typically call “money” and what we use to buy things is made up of both base money (currency) and bank credit.  The bank credit represents a debt of base money from the bank.  The base money is anti-debt opposing some debt with the Federal Reserve.

But not all bank credit is created from depositing currency.  The majority of it is created in opposition to a new debt to the bank.  This process is just like the one described above when the Fed creates base money.  Someone goes to the bank and wants a loan.  The bank may give them a loan in the form of bank credit. Alternatively, the story often goes that the bank lends cash and the borrower spends it and the then whoever they gave it to puts it in their bank and their bank lends some of it as cash and this process continues.  It makes no difference which story you tell.  The result is that bank credit increases the quantity of what we call money beyond the quantity of base money created by the Fed.

This increase in money comes with an increase in debt.  This is the key.  The debt is nominally denominated. In order to pay it off, someone must produce a fixed quantity of dollars.  If they don’t pay their debts, there are usually undesirable consequences.  Usually those consequences involve the loss of some real property.  If you don’t pay your mortgage, the bank takes your house.  If you don’t pay your car loan, they take your car.  If a business doesn’t pay their debts, they go bankrupt and the creditors take their assets.  It is all of these assets securitizing all of the debt which is created in the process of creating our money that provides a real anchor for the value of a dollar.

Maintaining a stable value for the dollar depends on maintaining a balance between the quantity of money and the quantity of debt.  The reason that the hyperinflation scenario described by many Austrians and conservatives, in which people lose confidence in the dollar and stop accepting it and the value plummets, never happens is because people with debt need those dollars to pay off their debt.  They won’t just decide not to take them.  If some people suddenly lost confidence in the dollar and decided not to hold any, those people with debt would be happy to take them off of their hands.  In fact they would compete over those unwanted dollars.  If someone owed $10,000 on their car, and not paying would result in the loss of the car, then they would be willing to trade any possession they own which they value less than the car for $10,000, including some quantity of their labor (or the car for any amount of dollars greater than $10,000).  In this way, all of those assets–the houses, cars, boats, businesses, etc.–which secure all of our debt are “backing” the dollar.  Dollars are convertible into these assets at a fixed rate.  It’s just that this rate varies from person to person, there’s no “car standard” or “house standard” so it’s not obvious to people.

What’s more, the process by which money is created, destroys money when reversed.  In other words, when people pay off their debt, the money supply decreases.  Now here’s the kicker.  Here is M2 (base money plus most forms of bank credit).  Here is total credit market debt owed.  Notice that total debt is about five times the size of M2.  Now consider what would happen if people did the opposite–that is, if people decided that they didn’t want to hold debt any more.  They start deleveraging and the money supply starts to contract.  As this happens the price level starts to fall.  There are different ways to explain it but they amount to the same thing, people compete for the dollars that they need to pay down their debt by offering other goods and services at a more favorable rate.  As the money supply contracts, it gets harder and harder to get the dollars required to pay off debt.  The prices of goods fall but the value of debt remains the same since it is nominally denominated.  Since there is more debt than money, it is impossible for everyone to get out of debt, some people will have to default.  This can result in a mad scramble to get the limited quantity of dollars so as not to be left bankrupt and with no real assets.

This is a deflationary scenario and this is the true danger which constantly hangs over our economy.  This is exactly what started to happen in 2008.  Notice in the graph of total debt, that it begins falling short of the trend right before the recession.  This is why the government stepped in and started throwing borrowed money at the economy to stop the bleeding.  When the private sector isn’t willing to borrow enough to keep the money supply growing fast enough to keep up with (artificial) inflation expectations and hold off this contraction, the government has to do it.  I’m not saying this is desirable or natural or unavoidable.  It’s an artificial problem we have brought on ourselves but if we really want to have any chance of fixing it, we have to understand what’s really going on.  We can’t just complain about the debt and ignore the system that makes it necessary.  If conservatives every got into power and actually tried to balance the budget without completely reforming the monetary and financial system, it would cause a recession that would discredit conservatives and free-market economics for a generation (at least) and probably destroy the Republican party.

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.

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.

 

Misconception #2: Money isn’t Backed by Anything

August 25, 2012 3 comments

If I had it to do over again, this would be number 1.  Even most economics textbooks don’t get this right.  They usually say something like “The only reason a dollar, or a franc, or a Euro has any value is because we have a stable system in which people are known to accept these pieces of paper in return for something valuable.”  This creates an impression of money as this worthless paper that is out there circulating around which, although it has no particular value to anyone, is somehow magically able to be exchanged for things which do have value.  There are two main intellectual consequences of this.

The first one is that many people come to the conclusion that this doesn’t really make sense which is true.  The second one, is upon coming to this conclusion, most people further conclude that because it doesn’t make sense, it won’t be able to go on forever and that when it fails, it will be because people, for some reason, become no longer willing to accept the money, having no particular value, in exchange for goods and services.  Or in other words: the money will become worthless.  Or in still other words: we will run into hyper-inflation.

This reasoning I find to be a fascinating study in what people are willing to question.  The thinking seems to be something like this:

1. Textbooks are correct.

2. A textbook says that this is why money works.  Therefore, this must be why it works.

3. But it doesn’t really make sense that money could work this way.

4.  Therefore, at some point, it must stop working.

As usual, the flaw turns out to be a false premise more so than false reasoning (though there is a bit of both).  If it doesn’t make sense for money to work like that, it wouldn’t be working now.  The real problem is that that explanation of why money works is completely bogus.  Once you relax the premise that the textbook must be right, things change dramatically.

The reality is that money is backed by debt (see misconception number 1).  Nobody owes you anything in return for your dollar (like they would if there were a gold standard for instance), but instead you most likely owe somebody dollars.  This serves a similar purpose.  For instance, if you have a $100,000 mortgage, then you can “convert” your dollars into your house at the rate of $100,000/house.  You don’t take the dollars down to the bank and turn them in for a house but if you fail to turn in your dollars for a few months, the bank will come to you and take your house.  This is not the same as a gold standard of course, but it is far from a situation where “money isn’t backed by anything.”

Now ask yourself: “if everyone else suddenly stopped being willing to accept money and the value of it plummeted, what would I do?”  Would you shrug and say “well I guess the dollar is worthless now” and start using your cash to blow your nose, wipe your butt and start fires to keep warm until the bank comes and takes your house?  Or would you go out and trade a loaf of bread for $100,000 and pay off your loan?  If you answered the latter, then consider that everyone else with a mortgage/car loan/boat loan/student loan/credit card debt would probably reason along similar lines and that the number of people finding themselves in that category comprise nearly the entire population of these United States and then realize that this is precisely why the dollar never suddenly becomes worthless.

Once you notice this fact, this should start falling into place.  Number 3 should go a long way toward explaining why recessions happen.

The Argument Gary North Has Been Waiting For Since 1933

August 8, 2012 2 comments

The nice thing about patronizing a not-so-popular blog: you get a lot of individual attention.  “Anonymous” (a very popular name here in the blogosphere…) directed me to this post by Gary North so I thought I would address it.  Here is the heart of his argument:

. . . (I)t is not possible for depositors to take sufficient money in paper currency notes out of banks and keep these notes out, thereby reversing the fractional reserve process, thereby deflating the money supply. That was what happened in the USA from 1930 to 1933. If hoarders spend the notes, businesses will re-deposit them in their banks. Only if they deal exclusively with other hoarders can they keep money out of banks. But the vast majority of all money transactions are based on digital money, not paper currency.

Today, large depositors can pull digital money out of bank A, but only by transferring it to bank B. Digits must be in a bank account at all times. There can be no decrease in the money supply for as long as money is digital. Hence, there can be no decrease in prices unless it is FED policy to decrease prices. Read more…

“Overleveraged Society”

September 22, 2011 2 comments

Of course I don’t want to make too much out of one data point but it’s interesting that the day after my hyperinflation post the dow is down____ gold is down 2.5% and silver is down 9.5%, oil is down 6.4%.  Not exactly inflation expectations running away with themselves.  And I heard a reporter on the news say (paraphrasing) “Everything is down.  The only thing that is up–this might surprise you–is the U.S. dollar.” People just don’t get inflation/deflation…..

Well some people do.  Here is what  Bob Worthington, president of Hatteras Funds, had to say in a WSJ article today (emphasis added).

The problems that exist here in the U.S. and Europe, in terms of an
overleveraged society, have not been resolved in the past two to three years.
Credit bubbles, when they burst, take a long time, for any economy to really fix
those problems,

Maybe Wall Street is finally reading my blog.

This move by the Fed is actually an interesting test of my theory.  Supposedly (there is some doubt about whether it will really go down like this) they will keep the size of their portfolio the same but change the structure of it to lower longer-term rates.  If my theory is correct and it is really about the quantity of money, this should have a limited effect.  If it is really about interest rates then this will help.  It’s worth mentioning beforehand that there may be some effect on velocity (or to look at it another way an increase in higher order measures of the money supply with no change in base money) brought about by increased borrowing due to this change in term structure.  In this case it could have some effect even when my theory is right.  I’m guessing this is more or less what the Feds have in mind–to get the money out of the bank vaults so to speak.  However, I will go on record as saying I don’t expect a significant positive effect.  Of course, I wish I had made this prediction yesterday….