In his podcast last week Russ Robert’s asked why fairly sensible people are concerned about deflation. I want to answer that.
I will try to explain my point of view in an Austrian-esque way because I think that will help facilitate the discussion. Forgive me if I botch the nomenclature.
Simply put deflation or even very low rates of inflation matter because when nominal interest rates hit zero they fail to communicate the proper signals to savers and borrowers.
When interest rates are above zero, higher interest rates tell potential savers that if they refrain from consuming today that more real resources can be produced tomorrow. Higher interest rates tell potential borrowers that there is a high demand for using real resources today. Lower interest rates do the exact opposite.
There is a problem, however, when the nominal interest rate hits zero. The fact that nominal interest rates can’t get any lower destroys the power of the market to convey the right signals.
To see this its important to see why interest rates might need to go below zero to send the correct signals.
Suppose that suddenly many people became fearful about the near future. They might want to protect themselves by transferring resources from today into the near future. However, there is a limit on our physical ability to do that. For one there are a limited number of investment projects which could begin today and produce a positive return in a short amount of time.
We could try to store physical goods and services for use tomorrow, but there would be storage costs. More importantly, if we were uncertain about what the future would bring ,we might not exactly know which real resources we wanted to store and so there are costs to picking the right ones.
All of those factors mean that in order to achieve what people want – more security about the near future – there is an economic price to be paid.
If prices were working perfectly then this economic price would be reflected in a negative real interest rate.
If there is inflation in the economy then negative real interest rates can be achieved when the nominal interest rate is below the rate of inflation. The correct signals are sent between borrowers and savers and everything can work out.
If there is deflation, however, then the real interest can’t get negative because nominal interest rates can’t go below zero.
[ For my long time readers I know I made a big deal about explaining that nominal rates can and would go below zero during a severe crisis, but this piercing of the lower bound is a small phenomenon in comparison to the effects I am talking about here ]
Said again, the core problem is that transferring real economic resources into the near future is costly but the interest rate can’t reflect that.
The reason the interest rate can’t reflect that is because at zero people can begin to hold cash as a form of savings. This doesn’t reflect any actual transfer of real resources into the future but each individual believes that it does. Everyone thinks that because they will have more money in the near future that they can buy more in the near future. However, it can only be possible for everyone to buy more in the near future if production is higher in the near future.
Everyone is mistakenly thinking that holding cash represents “true savings” when it doesn’t.
As this everyone tries to hold more cash, consumption in virtually every cash based sector declines. Importantly, consumption in medical services shouldn’t decline because medical services are not paid for out of pocket.
This decline in most forms of consumption causes many business inventories to rise. In some sense this is what people wanted. They wanted there to be more near term investment and higher inventories are a form of investment.
The problem comes because building inventories is costly for businesses. They have to pay suppliers but they are not getting revenue. This would be fine if the savers were providing the businesses with funds to hold them over. However, the savers are not providing the businesses with funds. The savers are holding their funds as cash.
The businesses respond to increasing inventories by reducing orders to suppliers. The suppliers would then have an inventory build on their hands and so they reduce production, layoff workers and stop capital investments.
This is what we see as rising unemployment and falling capital expenditures.
This decreased production – which is the exact opposite of what people wanted – is surprising and induces even more fear about the near future and even more build up of cash.
What’s needed to stop this is for somehow the interest rate to get low enough to both convince people to save less and to induce businesses to enter into costly inventory builds. That means the real interest rate needs to be negative, which requires inflation.
Now you might ask. Why wouldn’t this always happen when there was deflation. This gets at the struggle Russ and Don had over deflation generated by rising productivity vs deflation generated by a falling money supply.
High productivity growth rates produced by advancing technology or capital deepening mean that there are plenty of ways to invest resources today that will produce more resources tomorrow. So you don’t have to worry about interest rates going negative.
However, it should be the case that a sudden drop off in productivity growth will lead to the same type of trap. The prediction of this type of story is that with a fixed money supply changes in productivity growth will produce booms and busts out of proportion with the productivity changes themselves.
Rising productivity raises the equilibrium short term real interest until the point that the loanable funds market can clear and the economy roars to life. Drops in productivity growth drop the equilibrium short term real interest rate until the point the market can no longer clear and the economy crashes.
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Sunday ~ January 23rd, 2011 at 9:14 pm
Daniel Hewitt
Hello Karl,
Are you defining deflation as a decrease in the supply of money/credit, an increase in the value of money relative to goods/services, or interest rates below zero?
Sunday ~ January 23rd, 2011 at 9:21 pm
Johnnie Linn
Exactly what in the near future would everyone be fearful about? If it was about the probability that someone to whom one has lent funds will default on repayment, then, truly, we can do nothing without incurring costs of acquiring the durable assets. But if borrowers to whom you lend can be trusted not to default, you would be willing to lend to them at a negative interest rate if that was less costly than using other means to protect your wealth. So there is really no “absolute zero” in real interest rates. There may be an “absolute zero” in the number of borrowers who will not default if they are under the same threat of having their (your borrowed) assets lost during the time they are in their possession.
Monday ~ January 24th, 2011 at 12:36 am
jazzbumpa
Importantly, consumption in medical services shouldn’t decline because medical services are not paid for out of pocket.
Guess again, my friend. While this is true of say – Norway – it is most assuredly not true in the U.S. Though I had medical insurance while I was employed, and paid a fair chunk of change in out-of-pocket monthly premiums, an infection in my finger (believed to be from a spider bite) wound up costing me almost $2000 – of money out of my pocket.
The reason I paid it had nothing to do with any financial consideration. This condition could have led to a bone – or worse yet – blood infection. Sometimes money isn’t what drives a decision.
Other than that, a rather nice description of the paradox of thrift.
Of course, that is a Keynesian idea that the Austrians will reject out-of-hand.
http://krugman.blogs.nytimes.com/2009/07/07/the-paradox-of-thrift-for-real/
Cheers!
JzB
Monday ~ January 24th, 2011 at 11:26 am
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Monday ~ January 24th, 2011 at 1:08 pm
Doug Bonar
Does it matter if people hold their cash as cash or as demand deposits?
It seems to me that most people don’t stuff greenbacks under the mattress, but leave them in bank accounts. So it seems like it is the banks’ decision(s) about whether to hold the money (themselves losing the rate they pay) or to seek investments.
Monday ~ January 24th, 2011 at 2:19 pm
sardonic_sob
It matters enormously. Cash in the mattress is actively detrimental to economic activity, be you Keynesian sinner or Austrian saint. I’ve never heard ANYBODY argue that the greater good is served by sleeping on greenbacks. (Though this doesn’t apply to holding PM as money quite so much for Austrians.) Money in the bank is available for SOME kind of economic activity, however limited by the nature of its deposit terms.
However, cash in demand deposits, while it’s clearly invested and has impact on economic activity, is something banks are forced by law and custom to be fairly conservative with. If we all put our money in zero yield checking accounts and statement savings that pays 0.5% APR, it’s still not good.
Here is an interesting question I’ve just thought of: a Keynesian would clearly have no problem with the idea that under some circumstances it’s okay for people to lose purchasing power due to inflation. (Though of course any Keynesian of good will would hope that the inflation would be more or less exactly canceled out by improved productivity/monetary flow, and in good circumstances would be more than canceled out to the benefit of all.)
I’m trying to think of a circumstance where an Austrian would agree that yes, it is economically beneficial (not morally right, we’re not talking about fairness here) for people holding cash or extremely low-risk investments to actively lose purchasing power. In other words, how can we all come out ahead by inflating/hidden taxing/indirectly stealing from cash-holders?
Can’t do it, but then I’m not trying that hard. Anybody have a good example handy?
Monday ~ January 24th, 2011 at 5:10 pm
Doug Bonar
So, in the original analysis, does “holding cash” mean “stuffing cash under the mattress” or “demand deposits at the bank(s)”?
I don’t think the greater good could ever be served by CutM, but then again, I don’t really expect individual choices to always serve the greater good.
It seems to me that the main difference between the two is that CutM leads to inflation in the next time period, but DD doesn’t (or leads to less) if we assume that the bank lends most of it out which leads to more goods available in the next period. I think CutM => inflation was the point of one of the paragraphs above in describing why the zero bound was a problem So, what I’m interested in is whether two things that seem close to equivalent (now that we have FDIC) for the individual have meaningful differences more globally.
In a way, it seems that direct deposit, ATMs and FDIC are more important than I thought. Not just convenience or consumer protection, but in helping the economy by making DD as safe and easy as CutM.
Monday ~ January 24th, 2011 at 5:48 pm
sardonic_sob
Mr. Smith will have to address his meaning himself, but I hasten to agree that the impact of FDIC on how Americans deal with “cash” is severely understated by most people, and that while the average American of today probably doesn’t even realize it themselves, it really does make us different from people of the past or in other countries where there’s no You Absolutely Will Not Lose Your Money place to stick ready cash. (Note that YAWNLYM != YAWNLYPurchasingPower, obviously.)
Tuesday ~ January 25th, 2011 at 11:45 am
engineer27
Re: deflation due to rising productivity vs. falling money supply — In 2008-2009, we had both a collapse in the money supply and a surge in productivity.
But in that case, deflation of any type was bad for borrowers.