Sunday, August 2, 2009

The Deflation Scare

I have several times in this blog questioned why it is that deflation might be a bad thing, including in my discussion of a new form of money. Having presented my arguments, I thought it might be useful to find out exactly why economists insist that deflation is something to be feared. Having read through some academic literature, I found an excellent paper which clearly shows that the deflation scare is exactly that - a scare.

There is absolutely no evidence that deflation will cause depression. I have therefore written a summary of the paper in question below, which is by Gregor Smith (reference at end). It might be noted that his paper is written in the polite tones of academic discussion, but the message is clear. He divides up his paper into some basic arguments and I will follow the format.

1. Deflation is associated with depression

Smith reviews the study of Atkeson and Kehoe (2004) who considered the empirical evidence for a link between the deflation and depression. He summarises their work by concluding that only ‘for 1929-34 is there a positive relationship between the inflation rate and the output growth rate’ and that ‘excluding 1929-34, there is virtually no link [between deflation and depression], even though there were other periods of deflation, especially under the gold standard’ (p1046).

My comment: The important point here is that there have been many, many deflations in which there has been a growth in output.

2. Unexpected deflations are associated with depression

In a contrast to the work of Atkeson and Kehoe, Smith reviews the work of other researchers have utilised different analytical models which have found a relationship between depression and deflation, for example in Canada 1870-96. However, when models take into account other shocks in the economy, the correlations found appear to be coincidental rather than causal, and such shocks also serve to explain the only correlation found by Atkeson and Kehoe.

My Comment: Again, it appears that that there is no evidence that deflation and depression are connected and as Atkeson and Kehoe identify, there are many examples that directly contradict the idea that deflation and depression are linked.

3. Sticky nominal wages

In his review of the literature, Smith finds some problematic findings on the relationship between wages and deflation, such that each of the studies fails to fully explain the relationship between wages and deflation. For example, he reviews the work of Bordo, Erceg and Evans (2000) which explains wage stickiness for the period of the early 1930s, but fails to explain wages in the slow recovery for the period of monetary growth after 1933. His conclusion is that there is a need for further research if there is to be a meaningful debate on how wages might be determined in deflations. In summary, there is a general lack of research that might present any firm conclusions on the relationship between deflation and wages.

My Comment: It is worth noting that, if wages were to remain static in monetary unit terms during a period of steady deflation, the recipient of the wages would find the purchasing power of their wage increasing. As such, the person would, in real terms, see an increase in their wealth. Even if the person’s wage were to decrease in a period of deflation provided that the decrease is less than the rate of deflation, they would still be seeing an increase in their wealth. Why such outcome might be viewed as problematic is entirely unclear. Actual wages in monetary unit terms are irrelevant without relating them to what they might purchase in terms of goods and services.

4. Debt deflation

Smith identifies Fisher (1933) work as being the key work on debt deflation, whose theory Smith summarises as ‘depressions begin with debt liquidation, leading to deflation and then to bankruptcies, and to a fall in output and employment’ and that there is an association between these events and ‘a nominal fall in interest rates and a rise in real interest rates’ (p1050). Smith then identifies that Fisher is rarely cited in empirical studies, that the majority of studies cover the period of the Great Depression, and that the studies that cite Fisher provide ‘little empirical evidence on the mechanisms Fisher outlined’ (p1051). From this starting point, Smith reviews many studies, and concludes that ‘the historical research does not seem to me to provide much evidence on the debt deflation mechanism in the 1930s’, and that no recent studies are identifying debt deflation in a deflationary environment that might support a ‘spectre’ of deflation hypothesis.

5. Deferred Spending

The idea that deferred spending is a result of deflation is described by Smith as the worst argument made against deflation, noting that the saving from deferred spending will lower the rate of interest and increase investment. Smith is quite right to question the principles of deferred spending, but his questioning might be taken further.

Smith later looks at some modern deflations, such as Hong Kong coming out of the Asian crisis, and finds that there is a correlation in these cases with unemployment. However, in some of the cases that he examines, the deflation appears to be resultant from shocks (i.e. the shock of the Asian crisis itself for Hong Kong and the collapse of property prices, the property and equity melt down in Japan). In two cases, Britain and Canada in the 1920s and 30s, the explanations are less clear, though some of the deflationary episodes followed episodes of high inflation, and other parts of his analysis again cover the Great Depression. Without more detail on the episodes in these countries, with which I am not familiar, I am unable to comment on these.

It should be noted here that he is presenting a very limited number of examples in which there is a correlation between unemployment and deflation, and his conclusion is that, whilst he has found a link between deflation and depression (in the form of unemployment), he can not square this with the other studies. Most importantly, he points out that there are 'different kinds of deflations', meaning that there is no reason to link deflation to depression. His own examples, are therefore not indicative of the idea that deflation will cause a depression, or that deflation must be accompanied by depression. Even Smith, despite a genuine intention to examine deflation from a firmly empirical point of view, appears to have a basic confusion in the cases that he studies. The confusion arises from trying to impose economic theory on to the evidence.

The source of the unemployment in Japan and Kong Kong was, in both cases, the result of unwinding bubbles in which resources were allocated in unsustainable ways. The bubbles in the economies led to the destruction and misallocation of capital, and labour being directed into unsustainable businesses. Unemployment is inevitable. It will take a considerable amount of time for the bubble based businessed to unwind, and further time for retraining and redeployment/retraining of workers who are laid off as a result. It is a simple and logical explanation. Why on earth would deflation result in unemployment? As Smith himself identifies, there is a lack of evidence for this mechanism.

The interesting thing about Smith's work is that it is a review from academia (interestingly including work of Ben Bernanke). As was mentioned at the start, he uses polite academic language, which is the language of polite questioning and requests for further study. Nevertheless, he presents a compelling demolition of the idea that there is any evidence that deflation will lead to depression, or that depression accompanies deflation.

The most important point in the paper by Smith is that it shows that deflation can take place during periods of growth in output, that the deflations associated with depressions are mostly the result of shocks and were not causal. At the moment the world economy is undergoing a shock. That this shock might cause deflation does not make deflation a 'bad thing'. It would simply means that it is associated with a 'bad thing'. However, the scare of deflation has been used to justify the printing of money, low interest rates and the fiscal stimuli.

As I argued in an earlier post, it is not deflation that is a problem, but the move from inflation to deflation, or even high inflation to low inflation. What we are seeing in the stimuli and money printing is an attempt to prevent such an occurance. For any borrowing undertaken at a fixed interest rate before the change, these result in real increases in the burden of debt for the period of the fix. Preventing this problem might be seen as a justification for the policy, but the broader cost of these policies is a risk of hyper-inflation. The scale of the potential problem of the increase in the debt burden has never been spelt out, but it is the only legitimate reason that might be used to justify the deflation scare. More to the point, the transition from high inflation to low inflation has an identical effect upon debt burdens (see notes for further explanation), but we have never heard arguments against moving from high to low inflation. Why is that?

At the moment, the depression is already taking place. That depression might create deflation is not to say that the deflation is itself problematic. When looking at the deflation scare, it is a genuine puzzle that the scare has been allowed to gain so much traction. There is simply no evidence that a deflation would take the economy deeper into depression. Despite this, all over the OECD there is a huge experiment in monetary exansion, and an explosion of debt, with the fight against deflation as one of the explanations for this policy.

It just does not add up.

References:

Atkeson, A. and P. J. Kehoe (2004), "Deflation and depression: is there an empirical link?," American Economic Review, 99-103.

Bordo, M. D., C. J. Erceg, and C. L. Evans (2000), "Money, sticky wages, and the Great Depression," American Economic Review, 1447-63.

Fisher, I. (1933), "The debt-deflation theory of great depressions," Econometrica: Journal of the Econometric Society, 337-57.

Notes

Note1: I have included a previous discussion of deflation from a previous post in the notes below, and have added an additional example that shows that consumers do not defer spending:

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In the following examples, it will be shown that the reality is that people do not delay purchases in the expectation of lower prices.

Example 1 – Fast Moving Consumer Goods

If a shampoo manufacturers were to improve their output by 5% through a manufacturing innovation each year, their output of shampoo would increase, and this would reflect in a decrease in the price of shampoo. In other words, there will be a steady and continued deflation in the price of shampoo. According to the idea that consumers will delay purchases in an environment of deflation, in such a situation, consumers would choose to walk around with greasy hair, never buying shampoo in the expectation of further price decreases. Such a proposition is fatuous.

Example 2 – Hedonic Goods

Over the last few years countries such as the UK have seen the emergence of many discount airlines, such as Easyjet. The emergence of these kinds of airlines, and the increase in competition within the sector, has seen the price of air travel deflating. Much of the utilisation of these airlines has been by consumers using the discount airlines to have cheap foreign holidays, and this can be described as a hedonic good. It is an entirely discretionary expenditure as there is no necessity to go on holiday to another country. Despite the continual deflation, there have been many years of continual expansion in the discount air travel market. The deflation has not prevented consumers from taking flights to go on holiday, but rather has had the opposite effect.

Example 3 – Computers

Personal computers (PCs) are an interesting case, as they have year on year improved performance and year on year seen deflation of actual prices. It is also an example that includes both business purchases and consumer purchases. Despite the ongoing deflation in the prices, the market for PCs has had a long period of explosive growth throughout this deflationary period. It seems that the steady deflation in prices has had no impact through the postponement of purchases.

Example 4 – Special Cases

Remaining with the example of PCs, it is possible to construct a hypothetical example of how consumers might indeed delay their purchase in expectation of deflation. If one of the large computer manufacturers were to announce that they would be introducing a new type of computer in the coming year, and that the computer was to offer twice the performance at half the cost, it is quite likely, assuming their claim were credible, that consumers might delay their purchase of computers in expectation of this future deflation.

Example 5 – Purchasing on Credit

The example of purchases on credit with interest of goods and services suggests that there is a fundamental flaw in the deferred purchase argument; that theorists have misunderstood the psychology of consumers. Purchasing a product on credit at interest is a real increase in the cost that will be paid for the good, whilst saving the money with interest paid is a real decrease in the cost paid for the good. Despite this, many consumers do not defer the purchase, but instead choose to purchase the good at greater cost now, than the cost in the future. Furthermore, in sectors such as computers, the deflation of the good does not prevent purchases utilising credit.

If the thinking of those who argue against deflation is considered, such a deflation is a ‘bad thing’ as consumers withhold their money in expectation of lower prices. If this logic is followed, then the new and more effective design of computer is not a good thing for the economy, as it has created a deflation in the price of computers, and has caused a delay in the purchasing of computers. However, once the computer is introduced, it will make more computing power available to more people. How this might be a ‘bad thing’ is not entirely clear. Everyone who purchases a computer sees their wealth increase, as they are able to enjoy relatively more computing power in relation to their income. They are quite literally wealthier.

Debt and Deflation

There is an argument that suggests that deflation causes problems with the servicing of debt, as the value of the debt sees relative increases through the deflation. This is a scenario that appears to be very plausible, and can be backed by some solid calculations and formulae. However, what is missed in such arguments is that it is not deflation that is problematic, but the move from inflation to deflation. It is not the change in the value of money that is problematic, but the change in inflation/deflation from the original inflation/deflation position from the time of the issuance of the loan.

A good example of this can be seen in private mortgages on housing. If a loan is taken out in a high inflation environment, the interest rate will be relatively high. The targeted central bank interest rate will be high, and the lenders will seek to account for the high inflation by charging a rate of interest that will overcome the devaluation of the money that they are lending, such that they can achieve a positive return. If the interest rate is fixed over a period of, for example, five years and at year four the rate of inflation has fallen by a half, the holder of the debt is effectively seeing the value of their debt inflating. The earlier rate of inflation was eroding the value of their overall debt, and this was accounted for in the interest rate. However, with inflation falling, their debt value is no longer declining at the same high rate, but they are still servicing the debt as if this were the case. Their payments in relation to the actual value of the debt have increased.

If we think of this example and think of a change in the rate of inflation from 5% to 2%, and compare this with a change from 2% inflation to deflation of 1%, we can see that there is the same process taking place. In both cases we are seeing the relative burden of debt in relation to income moving in exactly the same way. In the inflation and deflation environment, interest rates will move to reflect the underlying changes in the value of money, and debt burdens will be locked into repayments that are based upon an out of date criterion.

In other words, it is not inflation or deflation that is problematic, but rather it is the change in inflation/deflation that alters the burden of the debt. As such, any monetary system should aim to achieve either stable inflation or stable deflation.


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Note 2: I am currently trying to convert my concept of a fixed fiat currency system into an academic paper. In doing so, I have given it much more thought, and have challenged many of my own ideas. The result is considerable refinement of the idea, and it appears to be an even stronger system than I first thought. I also worked out that the idea was probably inspired by my study of PWR nuclear reactors many years ago. For those that are interested, the money is represented by the neutrons, and the primary and secondary loops are the economy. The moderating effect is similar, and the control rod position might be the point at which the money supply is fixed. There are, of course, points which do not translate from one system to another, but I hope you can see the similarities.

29 comments:

  1. Interesting commentary. Could you please put up the Gregor Smith reference citation. Thanks.

    Brian P

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  2. Good idea on the academic paper, but please do not use Gold's value as being the labour to mine it. Gold's value is its rarity and inability to create it or mine it in high quantity unlike fiat debt based paper money. A fixed quantity of currency means that its purchasing power will increase (steady deflation) as an economy grows due to productivity growth.

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  3. Yes very good - obviously it is to do with protecting vested interests, but interesting to see how crudely / falsely this is done.

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  4. Brian:

    Apologies for missing the key reference. I do not have it to hand here, but will try to do so later.

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  5. I think the Gregor Smith reference is:

    Smith, G. W. 2006. “The Spectre of Deflation: a Review of the Empirical Evidence,” Canadian Journal of Economics 39.4: 1041–1072.

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  6. You argue:

    if wages were to remain static in monetary unit terms during a period of steady deflation, … the person would, in real terms, see an increase in their wealth. Even if the person’s wage were to decrease in a period of deflation provided that the decrease is less than the rate of deflation, they would still be seeing an increase in their wealth. Why such outcome might be viewed as problematic is entirely unclear.

    The fatal flaw in this argument is that it fails to take account of the effects of debt and leases during unexpected deflationary periods. If nominal wages remain constant but prices of goods fall (and hence sales earnings), eventually this will cause profits to fall if companies have debt to service or rent to pay.

    Consider a factory that makes clocks. It manufactures 100 clocks a month, and the clocks sell for $1 each. Earnings are $100 dollars for the month. Wages are $80. Profit is $10, but payments for debt and rent are $10.

    This can be summarized here:

    Output 100
    Sales $100
    Wages $80
    Profit $10
    Debt payments and rent $10

    However, the economy is hit by a recession and deflation occurs. Now the clocks only sell for $.90. Sales are only worth $90. But nominal wages are still costing $80.

    What has happened? It can be shown here:

    Output 100
    Sales $90
    Wages $80
    Profit $0
    Debt payments and rent $10

    Profits are now zero, because debt and rent still have to be paid. Debt deflation has occurred.

    The company is going bankrupt, unless it slashes wages.

    Wages are not going to remain static in monetary unit terms during a period of steady deflation: they must go down at some point.

    Moreover, even if wages fall at a rate less than the deflation rate, rent and debt payments are unchanged, because they are set by contract.

    Debt deflation is real – and devastating.

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  7. Cynicus,

    Thanks for the reply. Will keep in touch. I went digging through JStor for any related papers. They might be useful for a term assignment.

    Brian P.

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  8. Lord Keynes: Thanks for adding the reference.

    Regarding the devastation of the debt deflation, I am not sure that your example caputures what is going on.

    Your scenario assumes that the cost of debt and rent will remain static. If the interest rate is not fixed, this will not be the case. If there is a general deflation the cost of rent will also go down. Finally, the cost of the inputs for the manufacture of the clock will also go down.

    In addition, wages can fall in absolute terms but still retain their purchsing power. If everything is falling in price, then the purchasing power of lower absolute wages remains the same as the higher wage.

    In the event the interest rate is fixed, this will have a negative impact upon the company. However, it is the only impact, and will only last as long as the fix. Furthermore, the lender will have greater profits from the higher real rate. This profit will then be used for new investment at lower interest rates.

    The current crisis is one in which there is potential for deflation due to overcapacity in many industries, for example retail. This is resultant from the credit boom. Unless another new bubble can be formed, the overcapacity will still need to be removed, and this will cause unemployment. In these cases the deflation is simply a symptom, not the cause of an underlying problem.

    In the case of retail, for example, there are currently endless rounds of sales. There are just too many shops in relation to the spending power of consumers. This is pushing down prices, and still many shops can not achieve sufficient sales to survive. Only when the overcapacity is removed, will they be able to return to profit.

    Deflation is the symptom, not the cause. Changing the units of money in the economy can not remove the underlying problem of over capacity.

    Furthermore, as I pointed out in the article, would you argue against moving from high inflation to low inflation. The effect on debt is the same as a move from low inflation to deflation? It seems the argument against the alteration of debt burdens is only made when the word 'deflation' appears, and that is simply inconsistent and illogical. If the effect on the debt burden is the same in each case......???

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  9. Your scenario assumes that the cost of debt and rent will remain static.

    But these are precisely the things that will be fixed in nominal terms by contracts, if deflation is unexpected. If the lease of a building is fixed for a year, the business is locked into a year contract of rent at a fixed rate.

    In addition, wages can fall in absolute terms but still retain their purchsing power. If everything is falling in price, then the purchasing power of lower absolute wages remains the same as the higher wage.

    Yes, that was my point. Nominal wages will have to fall at some point.
    But, when they do, there is no reason why real wages will not fall. If employment is cut and purchasing power is diminished, this will reduce demand even more, making a depression worse. We are back to the problem of a deflationary spiral.

    Furthermore, the lender will have greater profits from the higher real rate. This profit will then be used for new investment at lower interest rates.

    Precisely, it disadvantages productive members of the community, to the advantage of rentiers.
    Furthermore, in unregulated financial markets, the extra money of banks could just as easily be spent on creating asset bubbles, not productive investment.

    Furthermore, as I pointed out in the article, would you argue against moving from high inflation to low inflation. The effect on debt is the same as a move from low inflation to deflation? It seems the argument against the alteration of debt burdens is only made when the word 'deflation' appears, and that is simply inconsistent and illogical. If the effect on the debt burden is the same in each case......???

    Moving from high to low inflation is not the same thing as deflation. The point is that sustained and severe deflation can lead to a deflationary spiral, if there is a very high level of debt. This is far less likely if there is just a shift from high to low inflation.

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  10. The example of purchases on credit with interest of goods and services suggests that there is a fundamental flaw in the deferred purchase argument; that theorists have misunderstood the psychology of consumers. Purchasing a product on credit at interest is a real increase in the cost that will be paid for the good, whilst saving the money with interest paid is a real decrease in the cost paid for the good. Despite this, many consumers do not defer the purchase, but instead choose to purchase the good at greater cost now, than the cost in the future. Furthermore, in sectors such as computers, the deflation of the good does not prevent purchases utilising credit.

    But again you ignore how consumers would behave in an environment of general, strong and sustained deflation in the CPI, not just of one product in a booming economy.

    If the consumers have lost their jobs or have seen wage cuts in a recession during general price deflation, then would they be so ready to purchase goods?

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  11. Lord Keynes:

    You say that:

    'This is far less likely if there is just a shift from high to low inflation.'

    But why.....? The impact upon the debt burden is identical. Asserting this does not make it true. Moving on....to another point...

    From the point of view of the renter, the fixed term of the lease will create a greater burden relative to turnover. However, in a move from high inflation to low inflation, the situation is identical. Over the term of the lease, the income over the term will decline relative to the rent. With less inflation their revenue will not be the same as high inflation. Moving from an expectation of revenue of 110 to 100 is the same as a move from 100 to 90. In both cases, the change is 10. One is expectations from high inflation to no inflation, and the other is from no inflation to deflation.

    If there is very high inflation expectations, the expectations will also be of ongoing high growth in revenues and this will feed into business planning. Likewise rents be set to account for high inflation over the term. If a renter expects inflation to be 20%, they will set their rent higher than if they expect 10%. In an inflationary environment rents will rise every year, and the higher the inflation, the higher the rise will be.

    The unexpected shift from high to low inflation will mean that expected growth in revenue will not take place. The failure to meet growth expectations might leave many businesses exposed, including on the ability to service the rent that they agreed at the start of the term.

    In both cases, rent will be set in considerations of an inflationary/deflationary environment, and any significant change will have negative consequences.

    You say:

    "But, when they do, there is no reason why real wages will not fall. If employment is cut and purchasing power is diminished, this will reduce demand even more, making a depression worse. We are back to the problem of a deflationary spiral."

    But why is employment cut? You are linking deflation to unemployment. Why?

    Deflation **might** lead to wage cuts, but that does not mean higher unemployment. You simply assume that deflation means high unemployment, and assume that deflation causes the unemployment. This is why I went to the trouble of detailing Smith's paper. To prevent people making these assumptions.

    You say:

    "Precisely, it disadvantages productive members of the community, to the advantage of rentiers."

    I do not like the term rentiers, as it has emotive connotations. I do not like the current situation of the banks, but do not think that the underlying function of banks is a bad thing. Allocating capital is not an act of evil or a 'bad thing' (provided that risk is not insured by the state so that there is no downside). Using the term rentiers is an emotive term. Why use it in this context, if it is not to sway through rhetoric rather than argument?

    Also, you would equally need to protest when the banks profit from a move from very high inflation to low inflation. In both cases the banks profit.

    Also, in both cases, the person taking the loan has an opportunity (in most circumstances) of fixed interest over varied periods of time, or floating interest rates. They make that choice, and assume the risk.

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  12. Continued from last comment....

    You also forget that, in the reverse scenario, the bank loses out. From low inflation to high inflation they will lose in a fixed interest rate deal. The "rentiers" do not always get it right and sometimes make smaller profits, or lose money, as a result. Do you protest the unearned windfall falling upon the borrower at the expense of the bank? I think not....

    Overall, your argument is emotive and populist, only painting one side of risk. Both parties in any interest rate agreement take risks. If a business fixes interest and high inflation takes place it wins. If inflation falls, it loses. Likewise for the bank, but in reverse.

    You say:

    "Furthermore, in unregulated financial markets, the extra money of banks could just as easily be spent on creating asset bubbles, not productive investment."

    This is of no relevance to the issue of inflation and deflation. This is more rhetoric.

    The final point I would make is that whether moving from high inflation to low inflation, or low inflation to deflation, any business that puts itself in a position to be unable to manage the process is being poorly managed. Most businesses will see many changes to their revenue and costs over a period of time. Good businesses adapt to these changes, marginal businesses die.

    For example, a sudden inflation in oil prices hit the airlines recently. Their management of the process was different from airline to airline - as one would expect, and some airlines were in deep trouble, and others managed the effects without too much trouble.

    Whilst nobody wants instability (one of my core arguments is for stability), businesses do adapt....

    More to the point, you have still not demonstrated why high to low inflation is different from low inflation to deflation. The idea of the deflationary spiral is unsupported in any way. All businesses include expectations built on any number of scenarios, and change to scenarios might have a negative impact. That only deflation might have an impact just does not add up.

    I am sure you will respond again, as you always do, but I will leave the debate here.

    As a final note, nothing here is in any way a defence of the banks in the current system, in which state support is providing them with a win only option. However, in principle, there is nothing wrong with banks making money from taking the risk of lending money. The necessity is that the risk must be there.

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  13. Deflation Debate

    For anyone who wants to read my longer response on the deflation debate, see my blog:

    http://socialdemocracy21stcentury.blogspot.com/

    A sample:

    When there is a depression or recession, and deflation occurs, there are reasons why deflation can cause deeper economic contractions. The crucial point is that, if there is a very high level of debt before a recession begins, then deflation can have devastating effects.

    Quite simply, Cynicus Economicus does not address the issue of profit and wage deflation, loss of consumer income, and the effects of continuing deflation.

    It is the interaction of factors caused by deflation in a recession that can lead to a self-reinforcing downward spiral of prices, profits and wages.

    The crucial factor is that the deflation continues.

    If prices fall, eventually profits fall as well, and employers must cut wages or reduce employment.

    Because of wage “stickiness,” businesses will often be forced to reduce employment, rather than reduce wages.

    Debtors will suffer when they become unemployed and have no income.

    Recessions can cause deflationary pressures. When demand falls and consumption falls sharply, first inflation falls through distress selling. If demand and consumption do not recover (or indeed become worse), this cost cutting caused by businesses reducing excess inventory will result in actual deflation. During this process unemployment rises and there will be downward pressure on wages. If there are steep cuts in wages, then incomes are reduced: this is the real cause of debt deflation: unemployment and cuts to wages.

    There is both empirical and theoretical evidence that large amounts of debt in an environment of unanticipated wage and price deflation has disastrous effects on economic activity (Zarnowitz 1992: 156; Caskey and Fazzari 1987).

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  14. Things in the economy are quite obviously getting better. This is demonstrated by every major indicator.

    What most of the economic data is several weeks old, with more positive data most likely in the pipeline.................................. The

    The recession is coming to a close - Government policy worked - What are you going to blog about now?

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  15. i think there is a difference between the price deflation caused by productivity improvements -ie PCs and those caused by deflationary 'expectations'. productivity expectations cant be taken for granted but if a central bank is credible and announces a 5% deflation ,say, then there is every reason to believe that people will put off making purchases. my point is that the productivity improvements are much more volatile than monetary base decreases-which can be controlled by the central bank

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  16. ...in both cases, the person taking the loan has an opportunity (in most circumstances) of fixed interest over varied periods of time, or floating interest rates. They make that choice, and assume the risk.
    ...You also forget that, in the reverse scenario, the bank loses out. From low inflation to high inflation they will lose in a fixed interest rate deal. The "rentiers" do not always get it right and sometimes make smaller profits, or lose money, as a result. Do you protest the unearned windfall falling upon the borrower at the expense of the bank? I think not....


    I had to smile at the idea that banks and borrowers take equal risks! All the banks have to do is to insert some small print that allows them to set interest rate "collars" at their discretion, or similar devices. Recently various banks were found to have substituted their own "Bank X Base Rate" in place of "Bank of England Base Rate" in their tracker mortgage small print, which technically allowed them to ignore any falls in BoE interest rates as it suited them.

    We are simply not talking about equally armed opponents here. I do not think many bankers would lose sleep over being called "rentiers" by us peasants.

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  17. Cynicus

    You admonish a reader above, for using the term rentiers - an emotive and populist term, in your eyes.

    Where he using the term in an emotive and populist way to sway opinion - by no means certain - the views of many impartial and informed commentators, such as ex-IMF economists Simon Johnson and Joseph Stiglitz, imply that the practises of the financial industries in the USA and UK - primarily the banks - justify such criticism and even more besides; the picture is that of financial oligarchs with a death-grip on our economies through the capture of our corrupt (surely proven beyond doubt by the expenses scandal in the UK and various lobbying scandals in the US) political systems. For years, the argument goes, we have had privatized banking profits, yet as soon as the bad times come we socialize the losses. Taxpayers paid once for interest on mortgages and loans - and over-priced mortgages at that, as the banks expansion of credit chased up asset prices - then are paying all over again through raised taxes and reduced services, in order to bail out the very lenders who overcooked the credit expansion that got us in trouble!

    The one constant? The structure of the city, with minor alterations (no glass-steagall 2 for instance)and financial sector bonuses.

    Or is there anything in the above that you disagree with Cynicus - for if not, you must admit you were incorrect to admonish your reader, unless you had done so for not fastening on the term "parasitic" in front of the offending word.

    By the governments own figures, Inequality had risen at a fast rate throughout Blair and Browns debt-"boom"; the recession/depression/stagnation is finishing the job, turning us more than ever into a land of haves and have nots.

    Or do you disagree with that Cynicus? Or see something inherently good in it?

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  18. Does the untidy ending of a 'bubble' - like the one we have recently experienced in housing - merely disguise the fact that a commodity essential to life *could*, in the right circumstances, end up being controlled by a 'rentier class' which basically holds the population to ransom?

    Do the usual rules of the free market apply when people have no choice but to pay whatever is demanded for, say, rent for a house, without which they would not be able to work at all?

    Doesn't banking already have that feel about it..? And hasn't it always been so?

    (Sorry to be falling for the "emotive" and "populist" line of reasoning!)

    ReplyDelete
  19. Lemming and Anonymous:

    I was aware that my defence of banking would raise some hackles. However, I make no defence of the current system, in which government is in bed with the banking system. I made very clear that I do not accept the current cosy system, and in my money reform I propose a system which entirely dismantles such cosiness/corruption, and subjects the banks to scrutiny that removes the information asymmetry. Furthermore, I propose the dismantling of a system in which any bank becomes 'too big to fail' such that no bank can dominate any market.

    Yes, the current position of the banks is abysmal and is distorting the economy in favour of the banks. This does not detract from the principle that, in a system in which banks take **real** risk, there is a balance of risk on fixed interest rate contracts. Both sides must make their own assesment of the risk of inflation/deflation/interest rates, and the state of the broader economy.

    Lemming:

    You said the following:

    "I had to smile at the idea that banks and borrowers take equal risks! All the banks have to do is to insert some small print that allows them to set interest rate "collars" at their discretion, or similar devices. Recently various banks were found to have substituted their own "Bank X Base Rate" in place of "Bank of England Base Rate" in their tracker mortgage small print, which technically allowed them to ignore any falls in BoE interest rates as it suited them."

    With regards to consumers and commercial entities, a system of well funded independent oversight would rectify such problems. When there is no information asymmetry, then such practices will see the light of day. This kind of practice survives because the so called 'financial advisors' are paid commission by the financial services companies. I have proposed dismantling such systems.

    I have outlined how the banking system should work. I make absolutely no defence of the current corrupted system. However, banks in an environment of independent scrutiny, where they face the risks of their own losses, have an important function within an economy. The use of the term rentier suggests that banks do not earn their profits. At the moment, this may be true, which is why I make no defence of the current system.

    If working correctly, banks are a useful part of the economy that make a positive contribution. If you read Lord Keynes' statement and my response, I am simply pointing out that his use of the term is suggesting that banks are inherently a 'bad thing', which is simply banal.

    Having been one of the few people who has consistently argued against the bailouts of the banking system, from the moment the first bailout was proposed to now, having specifically said I am against the current system in my reply to Lord Keynes, I find it somewhat puzzling to see these comments.

    I am simply pointing out that banks are not inherently bad.

    ReplyDelete
  20. Anonymous:

    Regarding what I am going to blog about now. It is nice to see your optimism. I beg to differ on the idea that the crisis is over. It is still in the early stages. If you have followed the blog, you will understand why.

    Dyslexic:

    I am not sure I follow your point. Would you like to clarify?

    ReplyDelete
  21. The Economist's economic dictionary sums up the danger of a deflationary spiral very nicely:

    Deflation is dangerous, however, more so even than inflation, when it reflects a sharp slump in DEMAND, excess CAPACITY and a shrinking MONEY SUPPLY, as in the Great DEPRESSION of the early 1930s. In the four years to 1933, American consumer prices fell by 25% and real GDP by 30%. Runaway deflation of this sort can be much more damaging than runaway inflation, because it creates a vicious spiral that is hard to escape. The expectation that prices will be lower tomorrow may encourage consumers to delay purchases, depressing demand and forcing FIRMS to cut prices by even more. Falling prices also inflate the real burden of DEBT (that is, increase real INTEREST rates) causing BANKRUPTCY and BANK failure. This makes deflation particularly dangerous for economies that have large amounts of corporate debt. Most serious of all, deflation can make MONETARY POLICY ineffective: nominal interest rates cannot be negative, so real rates can get stuck too high.

    You say:

    More to the point, you have still not demonstrated why high to low inflation is different from low inflation to deflation. The idea of the deflationary spiral is unsupported in any way.

    The answer is this: of course the change from high to low inflation can have the same effects!

    But the crucial point is that in the absence of

    (1) High debt levels before deflation
    (2) An actual recession
    (3) A contraction in the money supply
    (4) Continued and severe unexpected deflation
    (5) high unemployment

    continued lower inflation or actual deflation will not have the same effects.


    You seem to forget that it is the interaction of these factors that creates the deflationary spiral. As I have already conceded, deflation by itself may not necessarily be problematic.

    Nor is a limited period of disinflation, provided it stabilizes.

    In a booming economy disinflation (a fall in the rate of inflation or a slower increase in prices but not an actual fall) will not have the same effects as long-term, severe deflation in a recession where there is a large amount of debt.

    A change in the inflation rate from 3.5% to 2% over one year and then stable inflation at 2% in a booming economy with low debt and high employment will not be a serious problem.

    Many businesses would probably not even experience a fall in the prices of their products.

    The inflation fall might even be due to external factors like falls in the prices of imports of raw materials.

    ReplyDelete
  22. Correction: Money does not rise in value when you move from High Inflation to Low Inflation 1

    The specific effect of debt-deflation you are talking about here is when money rises in value through deflation. That is, if you pay back loans in money of higher value later (when it can purchase more) you are experiencing the specific aspect of debt deflation I was talking about.

    You say:

    A good example of this can be seen in private mortgages on housing. If a loan is taken out in a high inflation environment, the interest rate will be relatively high. The targeted central bank interest rate will be high, and the lenders will seek to account for the high inflation by charging a rate of interest that will overcome the devaluation of the money that they are lending, such that they can achieve a positive return. If the interest rate is fixed over a period of, for example, five years and at year four the rate of inflation has fallen by a half, the holder of the debt is effectively seeing the value of their debt inflating. The earlier rate of inflation was eroding the value of their overall debt, and this was accounted for in the interest rate. However, with inflation falling, their debt value is no longer declining at the same high rate, but they are still servicing the debt as if this were the case. Their payments in relation to the actual value of the debt have increased.

    No, they are only paying a higher real interest rate, assuming that actual deflation does not occur.

    You can calculate the effect of higher real interest rates in this example here:

    In 2000, a business takes out a loan for five years at a 15% interest rate when inflation is 10% and the bank thinks it will stay at around 10% for some years. The real interest rate in 2000 is 5%. But the inflation falls to 5% by 2003. The real interest rate has risen to 10%.


    NIR = nominal interest rate
    I = inflation rate
    RIR = real interest rate.

    year NIR I RIR
    2000 15% 10% 5%
    2001 15% 10% 5%
    2002 15% 9% 6%
    2003 15% 5% 10%
    2004 15% 5% 10%

    But this effect is different from paying the money back when it is of greater value through deflation.

    ReplyDelete
  23. Correction: Money does not rise in value when you move from High Inflation to Low Inflation 2

    From Wikipedia:

    Deflation is a sustained decrease in the general price level resulting in a sustained increase in the real value of money and other monetary items. Money and other monetary items are worth more all the time during deflation as opposed to being worth less all the time during inflation. Deflation is negative inflation.
    Disinflation is lower inflation. Prices are still rising during disinflation, but at a lower rate. The general price level still rises, but at a slower rate resulting in a continued, but lower rate of real value destruction in money and other monetary items. A lowering of inflation is not deflation but disinflation.
    Deflation means the general price level is not increasing at all, but, actually decreasing continuously and the internal functional currency – money - and other monetary items are worth more all the time. Deflation causes an increase in the real value of money and other monetary items.
    Inflation destroys real value in money. Disinflation destroys real value in money more slowly. Deflation creates real value in money.


    http://en.wikipedia.org/wiki/Disinflation

    The debt deflation effect we are talking about is when you pay back your loan in money of greater value due to deflation. (But of course paying higher real interest rates is also a part of the problem under deflation as well and to this extent the too situations are similar.)

    But even under disinflation (the move from higher inflation to lower inflation) the value of money is still falling, because it is only the rate of inflation that has changed.

    You are paying back your loan at a higher real interest rate, but the specific debt deflationary effect we are talking about here is different from paying a higher real rate of interest: it requires that the value of money has fallen through actual deflation.

    ReplyDelete
  24. "With regards to consumers and commercial entities, a system of well funded independent oversight would rectify such problems. When there is no information asymmetry, then such practices will see the light of day. This kind of practice survives because the so called 'financial advisors' are paid commission by the financial services companies. I have proposed dismantling such systems."

    Over the last few months I have learned well - perhaps too well - from this blog that most economic problems can be explained by distortions of free market mechanisms. So why should the relationship between businesses and consumers require "independent oversight"? Why doesn't the Invisible Hand punish bad business practice?

    Perhaps if we substitute "expertise asymmetry" for "information asymmetry" we can see why: the ordinary punter doesn't stand a chance against the financial institutions. He will be suckered in regardless of how free and open the exchange of information is.

    ReplyDelete
  25. Lemming:

    Thanks for the comment. If you take a look on the fixed fiat post, on the reform of finance part, you will find that the independent oversight is free market, but that I accept a little regulation of how information is distributed to ensure sufficient resource in the hands of independent rating type agencies. The system assures that they only act on behalf of investors only, and have the resource to be effective in their scrutiny.

    The interference is minimal and simply extends some protection to the information from ratings and monitoring agencies, and is just a method of ensure independent scrutiny and sufficient resource is brought to bear on the banks/financial organisations such that their activities might be understood by investors.

    It is the absolute minimum of interference. In this scenario, the asymmetry will disappear, and the 'ordinary punter' will be protected. It is just getting the resource into independent agencies, and resourcing them so that they can match the banks.

    Sorry, a rushed reply.

    ReplyDelete
  26. Cynicus

    thank you for your response and for clarifying the point that you do not defend the current banking and political structure. Perhaps you are right to seek to remove emotive terms from technical discussions, but in my eyes you just cant leave out the problems we have with the banking and political status quo as that is the crux of why we are where we are. Many people have benefitted to a large extent from the way this country is structured, and continue to do so whilst as a result, many more people slip into poverty through no fault of their own. For me, this issue is too large to be avoided.

    Also, I agree with your analysis when you say, in response to another anonymous reader, that this crisis is just getting started - governments may, to give them some scant credit, be doing an OK job of managing our decline, but the decline has barely started and will be felt for many years. In earlier essays of your own you do a very good job of explaining in laymans terms why this is the case, and readers would be well advised to revisit these tracts in your archive. I think the problem is partly due to the fact the massive west-east wealth transfer has been obscured by our governments and will continue to be obscured - i dont see any signs of mainstream media attempting to disseminate the actual facts on the ground into the mass conciousness - far easier to spin economic data into a green shoots story

    ReplyDelete
  27. http://www.rand.org/pubs/conf_proceedings/CF264/#behaviorally_informed_financial_services_regulation

    Maybe sort of relevant to Lemmings points. RAND has these videos of talks relating behavioural economics to Financial Services Regulation (by Sendhil Mullainathan of Harvard). Mainly at the level of communications from corporations to individuals, but I think wider understandings can be extrapolated. The main point i got is that information does not equal understanding. Fully rational models of efficient markets are being exposed as wishful lunacy.

    ReplyDelete
  28. Lord Sidcup

    Many thanks for the link. I watched the video with interest.

    Yes, "information does not equal understanding" was exactly the point I was struggling towards, and your final sentence sums up my thoughts very neatly!

    ReplyDelete
  29. @cynicus,

    my point about price deflation was that the 'good' deflation caused by improvements in productivity (PCs etc) doesnt cause people to put off their purchases.so there is no downward spiral in demand. on the other hand if it is deflation caused by an erosion in the monetary base (say-the central bank sucks out money at a constant 0.5% a year) then people may find it very rational to put off purchases since prices will fall at a predictable rate. this clearly will cause demand to reduce. productivy led price decreases are much more unpredictable than that caused by a transparent central bank.( a mythical creature)

    so your example of falling PC prices not causing people to put off purchases is not a good one for the true effects of deflation(monetary)

    ReplyDelete

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