Question on deflation and debt

[uberliber]

Okay, so I have a question about massive debt.

Let's pretend that we have this current crisis, where everyone is in a massive amount of debt. But instead of injecting hundreds of billions of newly created money into the economy, our government does it the Austrian way. The government does nothing. They let the economy deflate back to normal levels. Prices fall, wages fall, and all the necessary adjustments start taking place and the economy starts to recover.

Now here's my question: What about all the incurred and inflated debt in a period of deflation? Incomes would decrease, but loans taken out in the inflationary period would still exist. So if drastic deflation happens, wouldn't this cause a problem? People could never afford to pay their loans in a deflationary period.

I'm a strict Austrian adherent, but I'm not sure what the right response is.

I thought that possibly the problem could be solved by the strengthening of the monetary unit due to the deflation. But with static prices as far as previous loans, I don't that would matter. The strengthening of the currency is because of the fall of prices right? So it wouldn't help with static loans.

However, if you were to lay out a syllogism for the other solution, it doesn't fit:

1) Inflated loans need to be paid off
2) In a deflationary period, one cannot afford these loans.
3) These loans need to be taken care of.

4) Inflation should commence to pay off previously inflated loans.

I think I agree with the first 2 for sure. I think #3 is a fault on my part because it seems like a moral premise and not an economic one.

But #4 is what I can't cope with. That action is also the same as "Debase the monetary unit and purchasing power to help pay off previously inflated loans". That doesn't seem like a good solution at all.

Any comments?

[joel]

It is a good question. Here are some thoughts.

- Those loans were made during the boom, when interest rates were artificially low. Perhaps this compensates somewhat for deflation. (In a theoretical economy with a constant low rate of price deflation, that would be factored in, resulting in lower nominal interest rates. Also note that this means the problem you describe could occur only in the case of sudden/unexpected price deflation, not prolonged deflation, in which people would act on their expectation of lower future prices. Also, people will have anticipated the deflation to varying degrees.)

- Any unsound investments (including loans) ought to be liquidated.

-Let's take a generic case where Alice borrows 100 units (of currency) at the height of the bubble, and purchased a asset costing 100 units. Then suppose that after the bubble bursts, prices fall 25%, so the asset would sell for only 75 units. Whether this causes Alice to go bankrupt depends on various factors. Perhaps Alice has the means to pay back the 100 units with units that are worth more than when she borrowed. On the other hand, maybe it was a very short-term loan and her ability to pay back was dependent upon the revenues from the use of the asset (and those revenues will now be less). In the first case Alice continues to repay the loan, taking the loss. In the latter case maybe she goes bankrupt.

One thing that Rothbard mentions is that in today's bankruptcy law, the unpayable debt is forgiven, effectively a coerced transfer from the creditor to the debtor. He says that in ideal bankruptcy law the debt would not be forgiven but repayment would be facilitated. Let's take this policy, and assume that Alice is always the one who takes the loss. Thus in an unexpected price deflation, there is a transfer of wealth from debtors to creditors, in the case of loans taken out (but not repaid) before the price drop. Note that there is not wealth loss, just a wealth transfer. In the case of a company, it is a transfer from the shareholders to the bondholders.

But there are also redistributions of wealth in the case of (unexpected) inflation. In the same way there is a transfer of wealth from creditors to debtors. There is also transfer of wealth due to the fact that all prices don't change at the same time or to the same degree. Because the effects 'propogate' across the economy, you can't 'balance' deflation with printing more money. The likely effect would be that then you would have the deflationary causes propagating changes on some prices while the newly created money would propagate its changes on other prices first. Rather than cancelling out the effects of each other, they would likely each have their own wealth-redistributing effects going on in parallel.

Hulsmann points out, "Both deflation and inflation are, from the point of view we have so far espoused, zero-sum games. But inflation is a secret rip-off and thus the perfect vehicle for the exploitation of a population through its (false) elites, whereas deflation means open redistribution through bankruptcy according to the law."
http://mises.org/story/3231

In addition to that, if the new money hits the loan market first, then it will artificially lower interest rates and make things worse.

So one response to your question might be that although price deflation has wealth-redistributing effects, it is an unfortunate but inevitable effect of the recovery process, and at least such transfers are more visible than the hidden/invisible (but just as real) transfers that occur in inflation. Rothbard points out various benefits to deflation in the recovery phase. One is that the credit contraction results in lower bank reserve ratios. Thus the banks more quickly become sound, restoring confidence in them.

[uberliber]

If the money supply was inflated in order to allow payment of these loans, then maybe more wealth redistribution would have to take place. To combat this, I'm assuming OMO would be the tool of the Federal Reserve since lowering reserve requirements takes too long. If that was the case, it would result in a further decrease of interest rates. If that's the case, more people would take loans and the deflationary period would be held off.

But once again, I think this would just cause another bubble and the same thing would happen again. The economy would deflate and people couldn't pay off their loans in that inflated period. (And I'm referring to unexpected inflation by the way.)

So basically, there is no way around it? The Austrians would just say that the recovery needs to happen. People would either have to file bankruptcy or liquidate assets. The only people that would be hurt are the people who took undertook massive debt during the boom. With long term deflation, it wouldn't be much of a problem.

Now you were talking about wealth redistribution. Are you referring to the people who get the newly created wealth from the expansion in the money supply? The people who get that money are the debtors right?

Can you explain this a little more?: "Because the effects 'propogate' across the economy, you can't 'balance' deflation with printing more money" Is that once again, dealing with who gets the money first?

I'm still trying to understand all this :( The business cycle is hard to conquer.

[joel]

Now you were talking about wealth redistribution. Are you referring to the people who get the newly created wealth from the expansion in the money supply? The people who get that money are the debtors right?

Can you explain this a little more?: "Because the effects 'propogate' across the economy, you can't 'balance' deflation with printing more money" Is that once again, dealing with who gets the money first?

Yes, that's it. Well, there are two sources of wealth redistribution.

The first is the transfer of wealth from creditors to debtors (for unexpected inflation) and transfer from debtors to creditors (for unexpected deflation). This does not happen at the same time or to the same degree for every loan. Because the effects 'propagate' over time. Which leads to the other source of wealth redistribution.

In the case of inflation, those who get the newly created money first gain. Those who get it last (or not at all) are the losers. There is a transfer of wealth from the latter to the former. Those who create the new money buy stuff with it, increasing the income (and prices) for whatever they purchase. The sellers of that stuff then are next benefitted, and go out and spend their increased income, pushing up prices and increasing the income for the sellers of that stuff, and so on. The price inflation thus propagates across the economy. Those who get the money first benefit from a larger income. For others, the first effect they feel is the prices of the goods they want to buy increasing, before their incomes increase. They are the losers whose wealth is transferred to those who get the new money earlier.

A similar effect occurs in the case of deflation, though it is a bit harder to see because there isn't "new money" flowing around. Let's suppose a central bank contracts the money supply by selling a previously acquired asset, let's say an oil reserve, and then the money from the sale is destroyed. This depresses the price of oil, thus starting off the price deflation. The purchasers of the oil also now have less wealth (they have less money because of the purchase, and they can't turn around and sell the oil for the purchase price, because the price has fallen). Thus they will purchase from others in the market less than they would have otherwise. Also, assuming their demand for cash holding hasn't changed, they will try to replenish their cash balance back up to the normal/previous level. Again, this will restrict their purchases of other goods, and increase their sales. The price of the goods that they fail to purchase will drop, and the price of the goods for which they increase sales will drop. This continues to propagate across the economy, some prices falling earlier, some later, and various prices falling to different degrees. For some people, the first effect they see will be prices falling for the things they want to purchase, before their income falls. Those people will benefit. They gain whatever wealth was lost by those whose incomes fell before the prices of the things they want to purchase.


By the way, I started reading Man, Economy, and State, and I think it is a great book. Rothbard explains a lot of things really well. I too am understanding business cycles better the more I read. One thing that turned on a light for me was in chapter 7, General Pricing of the Factors of production, where he explains that the discounted marginal value product of a factor equalizes across the stages. Because of the (interest) time discount, this means that the (non-discounted) marginal value product of the factors must increase in the earlier stages, by the amount of the discount. Thinking in these terms, you can then see more clearly see what would be the effect of sudden changes in the interest rate, which would change the amount of discount. It becomes more clear why a drop in the interest rate will allow earlier stages to bid factors away from the later stages.

[uberliber]

By the way, I started reading Man, Economy, and State, and I think it is a great book. Rothbard explains a lot of things really well. I too am understanding business cycles better the more I read. One thing that turned on a light for me was in chapter 7, General Pricing of the Factors of production, where he explains that the discounted marginal value product of a factor equalizes across the stages. Because of the (interest) time discount, this means that the (non-discounted) marginal value product of the factors must increase in the earlier stages, by the amount of the discount. Thinking in these terms, you can then see more clearly see what would be the effect of sudden changes in the interest rate, which would change the amount of discount. It becomes more clear why a drop in the interest rate will allow earlier stages to bid factors away from the later stages.

Excellent, thanks for your thoughts.

Yea, Man, Economy, and State is the most complete book ever written on economics in my opinion. The first 200 pages were absolutely torture though. He is so obsessed with making sure that his audience understands the material that he tends to dedicate 5 pages to an extremely simple topic. But it's a good thing he keeps this over-detailed format when it comes to the hard topics as well.

But wow, chapter 7, that's an accomplishment. I just got to chapter 3 and I've been working on it for awhile. With classes, I never got a chance to really hit it hard, but now I finally can.

Also, I just got America's Great Depression which looks pretty interesting. I'll start that tomorrow. Have you ever read it?

[joel]

Also, I just got America's Great Depression which looks pretty interesting. I'll start that tomorrow. Have you ever read it?

Yes, AGD is good. It refutes the notion that there was an unhampered market before the Depression or during Hoover's term. I only wished the book continued into FDR's administration. I think Robert Murphy's book on the Depression and New Deal covers additional things beyond Rothbard's book.

A while back I started reading Rothbard's History of Money and Banking. I haven't read it all yet, but what I read was really interesting. I would include it in recommended reading if you are interested in history.

I think the next book I want to read when I eventually finish Man Economy and State is de Soto's book on the business cycle (Money, Bank Credit, and Economic Cycles).

[uberliber]

That's what I'm looking for. I read Jim Powell's book FDR's Folly which covered FDR's administration, so I'm looking for some information prior to the crash. The thing I don't like about Powell's book, is that he starts off by saying it was the FED's fault for the Depression because it contracted the money supply when it should have kept inflating. So I don't pay any attention to Powell when it comes to monetary policy. That's his weakness. But if you want a good book on the failed fiscal policy of FDR, I definitely recommend FDR's Folly.

But I'll check out Robert Murphy's book as well. And yea, I have the History of Money and Banking on my wishlist. Is it just American history, or is it banking in general?

That book by de Soto is one I've been looking at for awhile. It's just too expensive for me right now. For my birthday, my soon to be wife is giving me the choice between de Soto's book and Conceived in Liberty by Rothbard. I'll probably go with the latter because I'd like to learn some more monetary theory before checking out de Soto's work.

In a year or two I'm going to transfer to Grove City for their Masters program in economics. I'll get to study under Jeff Herbener. I picked up some of his lectures on Mises.org, and they were awesome. The reading list for the Masters program there is Man, Economy, and State, and Human Action. I can't wait.

[joel]

But I'll check out Robert Murphy's book as well. And yea, I have the History of Money and Banking on my wishlist. Is it just American history, or is it banking in general?

It is just American history, from the colonies up to FDR, if I remember correctly.

For my birthday, my soon to be wife is giving me the choice between de Soto's book and Conceived in Liberty by Rothbard.

Congratulations on the engagement and birthday. I too am getting married (in October), and just had a birthday a few days ago.

In a year or two I'm going to transfer to Grove City for their Masters program in economics. I'll get to study under Jeff Herbener. I picked up some of his lectures on Mises.org, and they were awesome. The reading list for the Masters program there is Man, Economy, and State, and Human Action. I can't wait.

That sounds fun.


I had one other thought about the deflation thing. If it occurs it is due largely to the contracting money supply due to the unwinding of the prior credit expansion. If Austrian advice was followed (i.e., commodity money and no fractional-reserve banking) there wouldn't be the potential for that contraction in the first place. The difficulty lies in the best way to transition from the current state of affairs.

Another example of the difficulty of transition is given by von Mises regarding protectionism. If the government imposes tariffs to "protect" domestic sugar producers then those producers gain--but only temporarily. Over time the structure of production adjusts to the tariff and the (pure/entrepreneurial) profit from the tariff disappears. Once that happens, it would still be better to not have a tariff (because the tariff reduces total output), but to remove it might mean sudden (short-term) losses for all domestic sugar producers. (http://mises.org/humanaction/chap29sec3.asp)