Is there really such a thing as a deflationary spiral?

[joel]

This is something I've been thinking about, and I thought I would start a thread since there are reports coming out about consumer prices dropping in the past month or two (e.g., http://news.yahoo.com/s/ap/20081119/ap_on_bi_go_ec_fi/economy), and I thought it would be worthwhile to discuss the fear associated with dropping prices (such as that expressed in the above article).

Most of my life I'd heard people say things like, "Sure, inflation is bad but deflation is disaster." And it is said that it is disastrous because it is a vicious cycle, that is difficult or impossible to stop or get out of. But a while back I realized that I did not know why people thought dropping prices caused a vicious cycle of further dropping prices and disaster for the economy. So I looked around and could not find any argument that held water. Below, I'll explain my thinking, and I'd be interested in hearing if anyone has any different ideas.

First of all, we need to keep in mind the distinction between inflation/deflation of the money supply vs inflation/deflation of prices. They are related, but not identical. Also, when thinking about this topic, I find that it is easy to mix up prices in general with the purchasing power (or price) of money. All else being equal, prices and purchasing power of money are inversely related. Finally, note that prices in general (and the purchasing power) are determined by supply and demand: the money supply and the demand for money (i.e., the demand for cash holdings).

Looking around for arguments for why deflation of prices causes a self-perpetuating cycle, I find that these arguments fall into two, contradictory categories:
that the deflationary spiral is perpetuated by a lack in consumer purchasing power, and
that the spiral is perpetuated by an excess of consumer purchasing power.Even supposing both theories are valid, the two effects cannot combine, because they are mutually exclusive. The first says that consumers have too little money. The Second says that consumers have too much money (i.e., people are "hoarding" money). My first general observation is that everyone is a consumer, and thus the consumers always hold all the money. They don't hold more or less money than there is. And if the total money supply is "too large" or "too small", then prices in general will adjust toward balancing the supply and demand for money. That is, if deflation of prices is occurring because there is a shortage of money, then the deflation of prices is eliminating the shortage--bringing supply and demand toward balance--thus opposing further price deflation. So, in that general picture, it seems that such situations should tend toward an equilibrium level, not a self-perpetuating spiral. Now, let's consider each of the two theories individually.

The first theory says that the spiral is due to a lack of consumer purchasing power. A lack of purchasing power (lack of money) can occur if the money supply suddenly contracts. But then, as I pointed out above, this just creates a new equilibrium point toward which prices will settle. But there is no reason the money supply would continue contracting in a spiral (especially when the central bank is rapidly creating more money). Instead, this theory says that the spiral can occur even without a simultaneous contraction in the money supply. It holds that a drop in productivity/profits results in a drop in wages, which reduces consumer spending, which results in further drop in productivity, etc. First of all, we still don't have an explanation for why this would be a vicious cycle. Perhaps the productivity drops, and then the drop in wages and purchasing power simply drops to re-balance everything out in a new equilibrium. There are various possibilities: (a) wages could be dropping at the same rate as (or slower than) prices in general thus not hurting consumers, (b) a drop in wage rates can even cause an increase in total wages paid out (e.g., dollars per hour can drop while total number of hours of labor that firms purchase increase). Moreover, if general purchasing power were dropping (faster than prices, in order to cause a feedback loop), then it will prevent people from holding large cash holdings. People will be forced to spend what money they have (on food, shelter etc.). As people spend their cash holdings, that will put an upward pressure on prices. Finally, this theory includes a simultaneous drop in production as one side of the spiral. A drop in production and the availability of goods also puts upward pressure on prices. Thus there are various factors at play that push prices upward, stopping the deflation of prices. And all this is in addition to the fact that even if wages drop, the consumers always still have all the money. There is no reason to think that things would not settle down toward a new equilibrium.

The second theory is a bit more reasonable, but still fails. It says that when prices fall, people will expect prices to fall even further in the future. Because of this expectation, people will put off purchases, so that they can purchase in the future, when prices are lower. Thus people attempt to increase their cash holdings (i.e., the demand for money increases), which causes further price deflation. Now this is true. But does it cause a vicious cycle? First note that it could be self-perpetuating only if people over-estimate deflation. If people anticipate deflation exactly, then their behavior serves only to bring us to the new equilibrium level more quickly (i.e., it would cause a faster rate of deflation in the short term, but not more total deflation). Only if people over-estimate deflation will it cause more total deflation than there would have been otherwise. For example, suppose the general price level drops from A to a new equilibrium at B, and would remain there, except that people incorrectly think that it is going to drop to an even lower level C, so they try to increase their cash holdings 'too much', by delaying purchases. This indeed causes prices to drop below B, the level they would have been at otherwise. But note that the underlying demand for money has not increased, it increased only because people mispredicted the future. Perhaps this can continue for a while, but the further prices are pushed below the equilibrium (B), the less that actual deflation will match expectations. That is, people delayed their purchases, believing that prices would drop to C. This causes prices to drop, but not all the way to C. People will realize they overestimated deflation, and will stop trying to increase their cash holdings as much (i.e., they will go ahead and make their delayed purchases), which will cause prices to rise back toward B. Remember, that the actual demand for money has not increased. People have not decided to spend less money, they simply have decided to delay their purchases. They will not delay forever. If nothing else, eventually the corresponding drop in production output will put upward pressure on prices, eventually causing deflation to be less than expected. Thus any mis-prediction of deflation (whether it comes from simple mis-prediction or psychological effects, such as panic) is self-correcting, not self-perpetuating. So there is no reason to believe deflation would be self-perpetuating.

Another way to look at it is that this spiral theory could equally as well be reversed to 'prove' that price inflation necessarily causes an inflationary spiral. If people expect inflation--anticipate higher prices in the future--then they will want to make their purchases sooner rather than later. They will seek to decrease their cash holdings because cash is losing value, and they will borrow and finance purchases in order to purchase sooner. These activities tend to push prices higher, causing a greater rate of inflation than there would have been otherwise. But we've all experienced price inflation without an inflationary spiral.

Also note that if the deflation is part of a recession/depression due to overconsumption, overindebtedness, and malinvestment, then people delaying their purchases, and saving/lending/investing more is just what the economy needs to help speed up the market correction process.

Finally note that if both theories have some effect, and price deflation causes both market activity tending to decrease consumers' purchasing power, and market activity tending to increase consumers' purchasing power, then the two tend to cancel each other out.

So, neither theory holds water. Neither gives us any cause for fear of price deflation.

One other alternative approach taken is to refer to historical events, such as the Great Depression or Japan in the 1990's, as examples of disastrous deflation. The main problem with this approach is that it is impossible to look at the complexity of raw historical data and conclude "X caused Y". There are consistent, alternative explanations for the same historical data that conclude either that the deflation in those historical events was innocuous, or that it was beneficial, and that other factors at play were to blame for the depressions. Therefore, the historical data is not sufficient to prove deflation is disastrous or self-perpetuating. We need a positive theory explaining why it would be so.

[edited to add]
Also other historical events can be pointed out on the other side. The last few decades of the 1800's experienced continual price deflation, but a booming economy. Thus deflation was not self-perpetuating or disastrous.
[/edited to add]

So I suggest that you do not fear as you read news articles reporting drops in consumer prices.

If someone has some other reason to believe that price deflation is self-perpetuating, please let me know.

[uberliber]

I don't have the time to write a full reply right now, but I will eventually.

Inflation is bad. That is a fact. Deflation on the other hand, is not.

Inflation has nothing to do with more wealth, but rather just decreases the purchasing power of each unit of money. The only way to truly increase wealth in a nation, is more production. More demanded goods being produced.

Say we have 10 pieces of candy. In one society, each piece of candy retails for $1. The GDP of this country is now $10. In another society, each piece of candy retails for $5. The GDP of this country is $50.

The first country has a GDP of $10, and the second country has a GDP of $50. Is the second more wealthy? Of course not. Prices have nothing to do with wealth.

As for deflation...without a central bank, deflation would be the norm. The CPI would be in a constant state of decline. The money supply would not increase, but instead every unit of money would gain value.

The price of good would fall because of technology advances. Input goods would become cheaper, and everything would be cheaper. This means the nominal GDP would me much less. But the production is the only thing that should be measured.

So a constant state of deflation would be the situation if we had no central bank, and it would not be a bad thing.

[PolarBeer]

If someone has some other reason to believe that price deflation is self-perpetuating, please let me know.

If you're simply asserting that deflation would definitely halt before goods had zero value and purchasing power hit infinity, then yes, you have my ageement. :smile:

Perhaps if you could discuss your alternative theory to deflation being self-perpetuating in the context of the great depression, that might clarify what you're actually putting forward?

[joel]

If you're simply asserting that deflation would definitely halt before goods had zero value and purchasing power hit infinity, then yes, you have my ageement. :smile:

I'm also saying that there would not be a self-perpetuating deflation rate, whether constant or increasing. (Mathematically speaking, a constant (or even monotonically increasing) rate of deflation would not necessarily take purchasing power to infinity at any time. I.e.., a value can increase linearly or even exponentially without there every being an asymptote to infinity.)



Perhaps if you could discuss your alternative theory to deflation being self-perpetuating in the context of the great depression, that might clarify what you're actually putting forward?I think maybe you are asking why, then, is deflation associated with depressions? This is a good question, especially because you'd expect the opposite to be more likely. As economic activity drops, goods and services become harder to come by, so we might very well expect goods and services to become more and more expensive, that is, we'd expect inflation.

As my opening post argued, the answer is not the one usually given--that deflation and depression are mutually self-perpetuating. Rather, the answer has to do with fractional reserve banking.

As you suggest, let's take the Great Depression as an example. Massive deflation occurred in the Great Depression primarily because the money supply contracted, not simply because of some self-perpetuating spiral of lack of purchasing power (or hoarding of money).

The money supply contracted (and prices deflated) in the first few years of the 1930's because of fractional reserve banking. Banks make promises to pay money (e.g., in the form of checking account and savings account deposits) that are treated as if they were money. This effectively increases the money supply. Banks multiply the effective money supply by some ratio over their reserves (held in their vault or at a central bank), e.g., 10:1. When the bubble burst, loans were considered riskier, and banks needed more solid ground in order to increase their trustworthiness, so they sought to hold a larger ratio of reserves. Also, because of the unstable/insolvent nature of this fractional reserve banking, people trusted banks less, and wanted to hold more cash, and less bank 'deposits'. This reduced the amount of money banks had in reserves. These combined actions very quickly reduced the effective money supply. If it were carried all the way to its ultimate conclusion, all the effective expansion of money created by fractional reserve banking would be evaporated, and we'd be back to just the monetary base. Before a depression the effective money supply is much more than (e.g., 10 times) the monetary base, thus this can be like a 90% contraction of the effective money supply. But this does not spark of a self-perpetuating spiral. At most it must end when we hit the monetary base.

Thus, massive deflation in a depression is due to this unsound nature of the effective money supply. Today the Federal Reserve today is attempting to counterbalance this by rapidly creating new dollars out of thin air (see http://www.theologyweb.com/campus/showpost.php?p=2505119&postcount=21). I fear that, rather than helping, this patching over of a symptom will delay the market corrections needed to fix the underlying problems causing the depression, and may very well make the problems worse.

One other way that price deflation and depression are associated is that typically many prices were bid up too high in the preceding boom, and simply need to come back down toward their equilibrium value. Again, no reason this effect would be self-perpetuating. Rather, this is an instance of self-correction, not self-perpetuation.

Thoughts?

[uberliber]

Money supply after $100 is deposited (Required Reserve Ratio = 10%):

[(1/.1) x 100] -100 = 900

$900 is now in the money supply even when the real value is only at $100.

This effect of fractional reserve banking mixed with the FED distorting interest rates is what causes fake booms and real busts. Deflation has nothing to do with it. Deflation is a result, not a cause of depressions and recessions.

The marginal propensity to spend (MPC) decreases massively in recessionary periods. GDP (a.k.a. Aggregate Demand):

The MPC is the slope of the aggregate expenditure line: Rise/ Run or Change in AE/Change in GDP

And to figure out C, you do: [Consumption +{ MPC (Y-T)} ] Our current situation is that the MPC massively decreased

Y= C+I+G+NX or Real GDP= C+I+G+NX

When the MPC decreases, C will decrease as well. This causes a leftwards shift in Aggregate Demand. This causes a recessionary gap which is absolutely necessary.

Prior to the recessionary gap, we were at an inflationary gap because the aggregate expenditure was far above the potential GDP at the time. This inflationary gap is is what we call a boom, and it is caused by an increase in the money supply due to fractional reserve banking, and the lowering of interest rates. With the low interest rates, we borrowed way more than we should have, increasing the inflationary gap. So the success we had was beyond the potential GDP.

When the recession hits, and we fall into the recessionary gap, it shows us where we are really at. The bad investments which were made because of low interest rates, will have to clear out.

The only solution of course is to have the aggregate expenditure meet at the potential GDP and stay at the equilibrium. Of course, this will not happen because of our monetary policy and obsession with borrowing more than we can afford.

So to sum it up, the deflation is not a bad thing by any means. It is just the market correcting itself and means we are slightly short of potential GDP but moving towards it. It is actually a good thing for us, but not government. So don't expect the market to correct itself for two reasons: 1) They want inflated tax revenue. 2) Inaction is political suicide at a time like this, even when it is necessary.

This bust will be much worse than people are thinking...

[nomad]

What about the foreign policy implications? With dollars in popular use all over the world, a drop in the value of the dollar could put america for sale - not just its goods, but its real estate, equities (and therefore corporations), and government debt as well. What will it mean when foreign countries hold a significant portion of our debt - a debt that might look increasingly unrealistic to expect full repayment on?

I'm not sure it impacts this really, but it seems like just looking from a strict pricing 'local-economic' perspective may miss something. I'm only an amateur, and haven't had a lot of time to ponder these posts completely.

[Philosophickle]

What about the foreign policy implications? With dollars in popular use all over the world, a drop in the value of the dollar could put america for sale - not just its goods, but its real estate, equities (and therefore corporations), and government debt as well. What will it mean when foreign countries hold a significant portion of our debt - a debt that might look increasingly unrealistic to expect full repayment on?

I'm not sure it impacts this really, but it seems like just looking from a strict pricing 'local-economic' perspective may miss something. I'm only an amateur, and haven't had a lot of time to ponder these posts completely.

It would mean that we are in a worse position to import and other countries are less likely to borrow money to us. The US govt. rarely defaults on any loans; and why would they when they have money printers that they can operate for free that concurrently lowers the value of foreign debt? Taking out loans is a great idea when you own the printers, because you effectively create wealth for yourself as long as you spend the printed money first).

[joel]

What about the foreign policy implications? With dollars in popular use all over the world, a drop in the value of the dollar could put america for sale

Note that this thread is debating the supposed badness of price deflation. That is a rise in the value of the dollar (or whatever money). A drop in the value of the dollar is price inflation.



- not just its goods, but its real estate, equities (and therefore corporations), and government debt as well.
I assume you are talking about a case in which we increase our sales to foreigners (exports) and decrease our imports. This can indeed happen temporarily when the money supply is inflated. When the money supply increases, not all prices rise at the same time or to the same extent. The exchange ratio between the domestic money and foreign money tends to adjust more quickly than other prices. This discrepancy makes domestic goods cheaper for foreigners to purchase, and foreign goods more expensive for us to purchase. This is temporary and lasts only until prices in general have readjusted to the new supply of money. But this does enrich foreigners (to some degree) at the expense of residents. This is one of the negative effects of inflation.

A contraction of the money supply would have a temporary effect in the opposite direction.



What will it mean when foreign countries hold a significant portion of our debt - a debt that might look increasingly unrealistic to expect full repayment on?
As of September, 28.5% of the debt is owned by foreigners (see http://www.fms.treas.gov/bulletin/ and click on "Ownership of Federal Securities"). Inflation actually makes debt smaller (the dollars that are promised to be paid in the future are worth less than the dollars originally borrowed). Thus, as Sasha pointed out, the government can print money to repay the debt. At this point, this would multiply the monetary base by 5. This poses the risk of hyperinflation.

Note that some of the debt matures and is repaid each year (the longest term debt is the 30 year bonds). If the government has a deficit, then the amount that the treasury needs to borrow is the amount of the deficit PLUS the amount of the debt that matures that year. As the debt grows larger, the government has to borrow more and more money just to pay off its previous loans. As you point out, this can become increasingly unrealistic. If distrust began to set in, then the longer term loans would also start to be called in, and people would be less willing to lend additional funds to the government, further reducing confidence in the national debt. Eventually the government would not be able to borrow enough to pay off its previous loans, let alone support a deficit. If this happens, the government has 3 choices:

1) reduce spending and increase tax revenue to generate a surplus large enough to cover the difference. (If this is possible. If confidence collapses as I described, then most of the debt could be called in at once.)

2) hyperinflate the currency

3) default on its loans.

[nomad]

Note that this thread is debating the supposed badness of price deflation. That is a rise in the value of the dollar (or whatever money). A drop in the value of the dollar is price inflation.


You are correct, I spoke backwards. I really mean deflation of prices.



I assume you are talking about a case in which we increase our sales to foreigners (exports) and decrease our imports. This can indeed happen temporarily when the money supply is inflated. When the money supply increases, not all prices rise at the same time or to the same extent. The exchange ratio between the domestic money and foreign money tends to adjust more quickly than other prices. This discrepancy makes domestic goods cheaper for foreigners to purchase, and foreign goods more expensive for us to purchase. This is temporary and lasts only until prices in general have readjusted to the new supply of money. But this does enrich foreigners (to some degree) at the expense of residents. This is one of the negative effects of inflation.

Did you mean deflation here? Just making sure I am following you. If you meant inflation... that usually is because of exchange rates IIRC, which don't necessarily apply here. We aren't talking about (say) Chinese buying dollars with yuan at favorable exchange rates, they already have the dollars. Contraction of the money supply would tend to make dollars more expensive worldwide, but the dollars are already abroad. Otherwise, yes, this is pretty much what I am talking about. Except I am not necessarily talking exports. In this open economic world, it is just as easy for a foreign investor to buy, say, a copper mine as a bronze statue. It is just as easy to acquire the means of production themselves as the products.

Maybe I just don't understand how it works, or am overestimating the percent of the money supply that is physically outside the country.

Which is something else that I was thinking about, though I don't know how it really works. Price deflation may bring prices to their 'real' values, but I disagree it is necessarily painless. Built into those higher prices may be higher prices paid for the means of production themselves. If I pay $1 million for a factory, and (simplifying, horrible examples, fill in your own numbers if you have more realistic ones) expect to sell $100k in goods each year, paying $40k for salaries, $20k for raw materials, and $40k in debt service. Now, all prices drop in half (let's assume for everything). Now, I can only sell $50k in goods. I only pay $20k in salaries and $10k in raw materials - but I still owe $40k in debt service a year. I go bankrupt. A new competitor can compete though, because a new factory is only $500k, and economics work out roughly like before, but half values.

Does this 'skidding' effect have a drag on the economy? Deflation also has an inherent contraction effect as the value of much capital also deflates. Or am I reading too much into it? I can't even sell my factory without losing money and going bankrupt. And you could say I already put all the money into the economy spending the $1 million to buy the factory, so it's already there. But now the bank can't depend on my debt payments to leverage for making more loans (because I defaulted), so it has to contract as well. What happens to that money that was theoretically in the money supply? Does it just disappear as easily as it was created? It also may increase the risk of new loans - because we don't know if the deflation will continue or not - and so the capital actually in circulation may drop further.

I think you are right though, this may be just returning to a nominal level.



As of September, 28.5% of the debt is owned by foreigners (see http://www.fms.treas.gov/bulletin/ and click on "Ownership of Federal Securities"). Inflation actually makes debt smaller (the dollars that are promised to be paid in the future are worth less than the dollars originally borrowed). Thus, as Sasha pointed out, the government can print money to repay the debt. At this point, this would multiply the monetary base by 5. This poses the risk of hyperinflation.


Theoretically, I understand that, though I just realized I don't understand the mechanics of that (we don't just hand out the new bills, they have to be distributed into the money supply somehow). But I can read up about that separately.

I guess what you are saying is that, since printing money causes inflation, even if deflation did occur which got out of control, you can always print money and cause inflation to counteract the effect?

[uberliber]

Theoretically, I understand that, though I just realized I don't understand the mechanics of that (we don't just hand out the new bills, they have to be distributed into the money supply somehow). But I can read up about that separately.

I guess what you are saying is that, since printing money causes inflation, even if deflation did occur which got out of control, you can always print money and cause inflation to counteract the effect?

The FED usually uses Open Market Operations. They FED buys bonds from commercial banks which increases their reserves and results in an increase in the overall money supply. This is what decreases the interest rates. With lower interest rates, people take out more loans, usually resulting in the maximum increase in the money supply which is [(1/.1)*deposits]-deposits

Another tool they can use is changing the discount rate. They FED has the power to make it cheaper for banks to borrow from each other. This of course encourages more reckless lending and further increase in money supply and poor investments.

[joel]

Y
Did you mean deflation here? Just making sure I am following you.

I meant inflation.



If you meant inflation... that usually is because of exchange rates IIRC, which don't necessarily apply here. We aren't talking about (say) Chinese buying dollars with yuan at favorable exchange rates, they already have the dollars. ...Except I am not necessarily talking exports.
In the example of inflation that I gave, when I talked about foreigners and imports/exports, what I said does not apply only to national borders. Consider what I said in such a way that "foreigners" simply means "anyone who does not commonly use the U.S. dollar (or whatever currency) as their normal medium of exchange". And exports/imports are relative to people who do use dollars as their normal medium of exchange vs those who don't.
If the supply of dollars increases, then the exchange rate with foreign currency changes before dollar prices generally rise. This makes foreigners who happen to own dollars want to buy stuff (spending away their holdings of dollars), and those who don't own dollars will want to obtain dollars at this cheap rate and buy stuff with them. Thus exports increase, and imports decrease. Perhaps even more so because foreigners already have dollars. Even if they aren't actually exchanging currency, they will use the going market exchange rate and do their economic calculation in their own currency.

If the money supply contracted, it would have the opposite effect. Temporarily the exchange rate would change before prices drop in general. Thus in the foreigners' eyes the dollar (including the ones they already hold) is more valuable than before, but prices haven't yet dropped to reflect this fact, so they will reduce their spending of dollars, and will refrain from acquiring new dollars to spend. This temporarily reduces exports and increases imports.



In this open economic world, it is just as easy for a foreign investor to buy, say, a copper mine as a bronze statue. It is just as easy to acquire the means of production themselves as the products.
Note that the products are always more valuable than the means of production, if for no other reason than that it takes time to yield the product.



Which is something else that I was thinking about, though I don't know how it really works. Price deflation may bring prices to their 'real' values, but I disagree it is necessarily painless.
I never said it was necessarily painless. My main point is that it is not a self-perpetuating problem, and is not necessarily painful.

If the problem that prices were bid up too high through a period of "boom" and market bubbles (as is caused by the Fed manipulating interest rates), then the recovery from this will be painful. And it is inevitable. There is nothing we can do to prevent it. The prices coming back down is one of the symptoms. It is not the cause of the painful effects. Trying to stop or slow the prices from correcting will only create additional unnecessary pain. The bankruptcies result from the previous malinvestments, not from the price deflation per se.

As far as capital prices going down: Suppose you purchase a building for $1million at one point of equilibrium, and at a later point of equilibrium the building goes for $500k. Further suppose that this difference were due solely to the change in the purchasing power of money. Sure, you can sell the building for only $500k, but each of those dollars is worth twice each of the dollars you used in the original purchase. Thus you are getting the same value.

A new competitor coming may only have to pay a lower price, but with dollars that are more costly.

As far as debts in general, even if there is constant deflation, this would be taken into account in the form of a discount on interest rates, just as a price premium is added to interest rates in times of inflation.



What happens to that money that was theoretically in the money supply? Does it just disappear as easily as it was created?
Part of the difficulty in the discussion on this topic is that we end up using the word money for different things, and so language makes it harder to distinguish. And the distinctions were more obvious when gold was money. Then it was more obvious that Federal Reserve Notes were not money, but money substitutes and fiduciary media (instruments of debt), as are demand deposit balances (e.g., checking/saving account balances). When private banks 'increase the money supply' they are not really increasing the money supply in the narrower sense. Rather they are increasing the quantity of 'fiduciary media', and increasing the apparent or effective money supply, and thus we speak of money supply in the broader sense. Yes when this credit expansion reverses the fiduciary media (and thus the effective money supply) disappears just as easily as it was created.

You can even do this on your own without being a bank. Suppose you write some checks written out to "Cash". Suppose you use them to purchase things, and suppose that people trust you enough that they don't cash them right away, but circulate them around as if they were worth the money equivalent of their face value, knowing that they can cash them at any time. As long as you keep your checking account balanced with the outstanding checks, there is no increase in the money supply. But suppose you find that a certain amount of your checks tend to stay in circulation (i.e., the rate at which you write new ones is equal to the rate at which they are getting cashed). So you realize that you could write additional checks not covered by the balance in your checking account, knowing that they tend not to all be cashed at the same time. Or, better yet, you take that 'excess' balance in your account that never gets withdrawn and you loan it to someone at interest, or invest it somewhere. Now you have increased the effective money supply because the face value of all your outstanding checks at any given time is greater than the balance in your account, and the checks are traded as if they were equivalent to their face value. You have created 'money' out of thin air. When this expansion of the money supply reverses, then the checks simply get cashed and the additional money supply disappears as easily as it was created. If, in this process, you manage to replace the funds before the checks get cashed (perhaps at a profit because you invested the 'excess' balance), then no one is the wiser, and you've gotten away with it.

If you do this intentionally, or if people do this with something other than money (e.g., the operator of a grain elevator doing the same thing with grain) then this is correctly called fraud (embezzlement), and is prosecuted. But this is exactly what banks do with money.

If a bank is unable to replace the funds in time, then they call it a "bank run", and instead of the bank being prosecuted for embezzlement, the blame gets shifted to the customers who are simply asking for what is rightfully theirs. Just as the holders of your checks are perfectly in their rights to cash them at any moment. And yet the government helps and encourages banks to increase the effective money supply in this fraudulent manner even more than banks would be able to on their own.



Theoretically, I understand that, though I just realized I don't understand the mechanics of that (we don't just hand out the new bills, they have to be distributed into the money supply somehow). But I can read up about that separately.
What I just explained is how private banks expand the effective money supply on top of Federal Reserve Notes (and liabilities of the Fed). The mechanics of the Fed creating new notes is slightly different. (Really it is any different only because we are no longer on the gold standard.)

When I said that one option for repaying the debt is hyperinflation, here is how it would work. The Fed would agree to purchase enough bonds from the Treasury to give the Treasury enough dollars to pay off the national debt (or at least to purchase whatever is needed beyond what the public is willing to purchase). The Treasury has a checking account at the Federal Reserve. The Treasury prints up all the bonds and tries to sell them on the open market. Those that the public is not willing to purchase are purchased by the Fed. The Fed writes a check for the bonds, and the Treasury deposits the check in its checking account at the Fed. Actually I don't know if there literally is a physical check involved. The point is that what happens in this scenario is that the Fed increments the balance of the Treasury's checking account, without decrementing any other account. Presto, more dollars exist. (The pinting press never even needed to be turned on, because it's all electronic.) The Fed now owns some new bonds, and the Treasury owns some newly created dollars. The Treasury can now write checks to people and businesses to pay off the national debt.

Suppose you are one of those owners of a Treasury bond. The Treasury writes you a check and you take it to your bank and deposit it into your account. In the process of clearing the check, your account is incremented, and the Treasury's account at the Fed is decremented, just like a normal checking account.

If, instead of depositing the check, you took it to your bank and asked for the cash, then your bank would forward you the cash out of their reserves, and then the bank would demand reimbursement from the Treasury's account at the Fed. If the bank wants the cash, then the Treasury's account is decremented, and the printing press is turned on and the Fed ships newly printed money to the bank. If the bank doesn't need the cash then the Fed will simply decrement the Treasury's account and increment the account that the bank has at the Fed (just like the Treasury has an account at the Fed).

In this way the government could pay off the national debt at once by hyperinflating the currency.



I guess what you are saying is that, since printing money causes inflation, even if deflation did occur which got out of control, you can always print money and cause inflation to counteract the effect?First of all, the point of this thread is that I am questioning whether it is even possible for deflation to "get out of control" (other than in the case of the (fraudulent) bank expansion of the effective money supply re-contracting).

In the case of deflation, yes, it may be possible for the Fed to create enough money to keep prices from dropping much in general. But it's not clear that this is a good thing. It is likely that the two processes will not simply cancel each other out, other than with respect to the general 'price level.'. Rather we'd have both a deflationary process and an inflationary process running simultaneously and we would accrue the negative side affects from both. This is what happened in the 1920's, where these two processes went on simultaneously, keeping prices relatively level. But a side effect of the inflationary process was an unsustainable boom (market bubbles), which lead to the crash of 1929 and the Great Depression.

[uberliber]

In the case of deflation, yes, it may be possible for the Fed to create enough money to keep prices from dropping much in general. But it's not clear that this is a good thing. It is likely that the two processes will not simply cancel each other out, other than with respect to the general 'price level.'. Rather we'd have both a deflationary process and an inflationary process running simultaneously and we would accrue the negative side affects from both. This is what happened in the 1920's, where these two processes went on simultaneously, keeping prices relatively level. But a side effect of the inflationary process was an unsustainable boom (market bubbles), which lead to the crash of 1929 and the Great Depression.

Besides inflation, deflation, and stagflation, there is disinflation. This is basically a more gentle and slower process of deflation which attempts to avoid a massive contraction. The inflation rate does not drop from 5.5% to 0%. Instead, the inflation rate goes usually quarterly from say 5.5% to 5%, then 4.5%, then 4%.

[joel]

Besides inflation, deflation, and stagflation, there is disinflation. This is basically a more gentle and slower process of deflation which attempts to avoid a massive contraction. The inflation rate does not drop from 5.5% to 0%. Instead, the inflation rate goes usually quarterly from say 5.5% to 5%, then 4.5%, then 4%.
Also note that if a contraction of the money supply hits the loan market before prices in general have fallen (e.g., in the case of credit contraction as I described earlier) this causes a temporary increase in interest rates.

(This is the mirror of the effect we normally see where the Fed inflates the money supply in a credit expansion for the purpose of temporarily pushing interest rates down.)

[nomad]

http://www.ft.com/cms/s/0/582d470c-c307-11dd-a5ae-000077b07658.html

This is what I was talking about, though it's small-scale and tends like you said to raise the prices back up, so it has nothing to do with deflationary spirals, and (if anything) only to do with national security.

More replies later, I didn't want to mix this with the other one quoted. Might be tonight or tomorrow before I can get back to this.

[joel]

Even if it were true that 'hoarding' money causes a self-sustaining fall in prices, there is no reason this would cause a decrease in production or overall market activity--i.e., no reason this would cause a depression.

Suppose that the money supply M consists both of cash 'hoarded' (e.g., stuffed under the mattress) H and cash in circulation C. This is the terminology used by those who argue that a deflationary spiral leads to doom, though it is not technically accurate. All money is always held in cash holdings; there is no such thing as money 'in circulation' but not being held by someone. But for simplicity let's take the distinction to mean that H represents the cash holdings that are held longer than normal because people are delaying purchases because they anticipate lower prices in the future, while C represents cash holdings that are spent more like they would be in the absence of the expectation of falling prices. C won't ever fall to zero because people still need to pay their bills, and eat food, etc.

But suppose people decide to stuff more money under their mattresses because they expect prices to be lower in the future, so they reduce C in half, adding that half to H. This reduces the effective money supply to C, causing prices to fall more quickly than they would have otherwise. That is, it causes more price-deflation which supposedly causes the deflationary spiral. This is true that the increased 'hoarding' will cause a price drop. If C drops in half, then prices may drop in half. But there is no reason for this to cause a depression. It does not mean that economic activity is cut in half. It does not mean that real income or consumption drops in half. On the contrary, the remaining half-C doubles in its purchasing power, and thus real incomes, consumption and economic activity remains the same. Sure less money is chasing goods, but that means the money that is still chasing goods can chase more goods than it could before. In such a case the falling of prices prevents a depression. Only if prices did not fall would the reduction in C represent a drop in consumer demand, causing a depression.

That was the long-run analysis. Following is more detail about the short-run effects, for those of you who are interested. The effects of 'hoarding' money does not proportionally or instantly change prices in the markets. The effects propagate. Also not everyone anticipates falling prices at the same time or to the same extent. So some people will choose to 'hoard' more or less than others. For simplicity, let's classify everyone into two categories, (A) those who anticipate a greater fall of prices or anticipate them sooner, and (B) those who anticipate a smaller (or no) fall in prices or don't anticipate it as soon. Those in A will 'hoard' more and sooner. Their means of increasing their cash holdings will be to increase their sales of things (lets say jewelry for example) and/or refrain or delay purchases (let's say cars for example). These activities will push down the prices of jewelry and cars. This may be of some short-term detriment to jewelry and car producers because the prices of other things in the market have not yet fallen to the new equilibrium. But it benefits those in group B who want to buy jewelry and cars, because it increases the purchasing power of their cash and incomes because the prices of those things have fallen, thus their demand for those things rises to counteract the fall of the demand due to A. The falling of prices will propagate across the market. The prices of the various goods in the market will not fall at the same time or to the same extent. Some people will see short-term benefits due to some prices falling before others and others will see a corresponding short-term harm from those same events. Depending on the individual preferences of those who are harmed and benefitted, the end result may result in a rise or a fall in overall consumer demand. But which will result cannot be predicted or planned. But the point is that it is not necessary that consumer demand will fall as a result of increased cash 'hoarding.'

[joel]

Some empirical evidence: the consumer price index from 1800 to 2005 (http://www.economics-charts.com/cpi/cpi-1800-2005.html).

Note that from 1800 to 1915, prices were quite stable in the long run. Inflation is not the normal condition of a market economy. In fact, the normal trend is downward--price deflation--and the economy was growing over this time. This is sufficient to refute the idea that price deflation means disaster or depression. On the contrary, a downward curve reflects the fact that goods and services are becoming more affordable and standards of living are rising over time as the economy grows.

The three notable upward spikes during this time were not due to the market, but due to government printing presses in war: the war of 1812, the Civil War, and World War I. During war, the government would print massive amounts of government banknotes (promises to pay gold) and declare them legal tender, meaning that by law people were forced to accept them as if they were as good as gold, thus causing inflation. The inflation in the Civil War was due to "greenbacks". The inflation in WW1 consisted of the newly-devised Federal Reserve Notes, via the recently-created Federal Reserve System.

Note that the 1920's flattens out for most of the decade instead of the normal 'deflationary' curve. The downward curve is the normal progress. Thus we can see that the 1920's, though level in prices was actually, in a sense, inflationary because goods and services were becoming more available over time and thus dropping in real cost, while prices were held roughly constant. Thus the purchasing power of the dollar was falling, even though prices remained level. This occurred because the Federal Reserve was rapidly expanding the money supply over that period. There is good reason to believe that this was likely the main cause of the market bubble resulting in the Great Depression.

The 1929-1933 drop was due to a contraction of the money supply (largely due to people wanting to hold more cash in an economy with fractional-reserve banking). Note that this drop was comparable to the drop after 1920, but the 1921 drop did not cause a Great Depression. Deflation does not cause depression. With fractional-reserve banking, large deflation can be an effect alongside a depression, but deflation is not its cause. In fact, falling prices is a mechanism by which the market recovers. A depression will be prolonged by preventing prices from adjusting downward.

In 1933 FDR seized the people's gold by executive order and ceased redemption of Federal Reserve Notes (i.e., declared that it would no longer honor its contractual obligations to Note holders--at least for U.S. citizens.). This started an inflationary trend but was limited by the fact that the Federal Reserve still had to redeem its notes in gold for foreign governments, and by the Bretton Woods Agreements.

As the inflation rate started to pick up (due, again to government printing presses in time of war), Nixon came along and blamed the inflation on "international money speculators" and officially ended all ties to the gold standard for the supposed purpose of ending inflation. Instead this removed the last restraints of the gold standard upon the government's printing presses. Over the next 3 decades the dollar lost about 80% of its remaining value (not counting the hidden loss (hidden due to a growing economy), as seen in the 1920's).