Does Deflation Lead To Hoarding Of Money?

[mansoor_h_khan]

Recently I participated in an internet online forum with a person who subscribes to the Austrian school of economics. He claimed that there is no additional incentive to hoard money in a deflationary environment as compared to a environment of stable prices. So I came up with this investment decision example to show him that there is in fact a strong additional incentive to hoard money.

Here is the scenario:

I am an owner of a bread making factory. The factory makes loaves of bread at the rate of 1000 loaves per month. But I can improve the business process by hiring a consultant to improve the business process such that in one year the production rate will be 1100 loaves per month. The consultant will need to be paid 1200 pieces of gold for his services. Each loaf of bread is currently selling for 1 piece of gold . The prevailing deflation rate is 5%.

All revenue and cost numbers are in terms of pieces of gold.

With no improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 12000 12000 12000

Revenue 12000 11400 10830 10288

With improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 13200 13200 13200

Revenue 12000 12540 11913 11317

Net gain in gross margin (in terms of pieces of gold) due to improvement:

Year 1 = 0, Year 2 = 1140, Year 3 = 1083, Year 4 = 1028

Now let us consider the same project in an environment of stable prices (no inflation or deflation):

With no improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 12000 12000 12000

Revenue 12000 12000 12000 12000

With improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 13200 13200 13200

Revenue 12000 13200 13200 13200

Net gain in gross margin (in terms of pieces of gold) due to improvement:

Year 1 = 0, Year 2 = 1200, Year 3 = 1200, Year 4 = 1200

Notice that my payback time for the deflationary environment will be a longer. This raises the hurdle to invest. All investments are risky. And the longer I have to wait to get paid back the more risky it is.

Conclusion: Deflationary expectations raise the incentive to hoard money.

[scepticus]

you are 100% correct. a capitalist economy (even a 100% reserve one with no aggregate debt) is not workable in the event of long term secular nominal price declines.

I suggest you avoid debating these matters with idiots who won't listen for their own ideological reasons. It is a waste of your time!

Edited March 17, 2010 by scepticus

[fallingbuzzard]

...in a logical population

Conclusion: Deflationary expectations raise the incentive to hoard money.

[sharpe]

you are 100% correct. a capitalist economy (even a 100% reserve one with no aggregate debt) is not workable in the event of long term secular nominal price declines.

I suggest you avoid debating these matters with idiots who won't listen for their own ideological reasons. It is a waste of your time!

At times the Romans had stable prices for up to a hundred of years.

Wouldn't banks be just dieing to lend in a deflationary environment?

Price falls are a natural consequence of improving efficiency. For example grain prices have been falling for a long time, yet there is no supply or demand problem in the grain market.

Is there any evidence that long term price declines stops the functioning of a capitalist economy?

[sharpe]

Recently I participated in an internet online forum with a person who subscribes to the Austrian school of economics. He claimed that there is no additional incentive to hoard money in a deflationary environment as compared to a environment of stable prices. So I came up with this investment decision example to show him that there is in fact a strong additional incentive to hoard money.

Here is the scenario:

I am an owner of a bread making factory. The factory makes loaves of bread at the rate of 1000 loaves per month. But I can improve the business process by hiring a consultant to improve the business process such that in one year the production rate will be 1100 loaves per month. The consultant will need to be paid 1200 pieces of gold for his services. Each loaf of bread is currently selling for 1 piece of gold . The prevailing deflation rate is 5%.

All revenue and cost numbers are in terms of pieces of gold.

With no improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 12000 12000 12000

Revenue 12000 11400 10830 10288

With improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 13200 13200 13200

Revenue 12000 12540 11913 11317

Net gain in gross margin (in terms of pieces of gold) due to improvement:

Year 1 = 0, Year 2 = 1140, Year 3 = 1083, Year 4 = 1028

Now let us consider the same project in an environment of stable prices (no inflation or deflation):

With no improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 12000 12000 12000

Revenue 12000 12000 12000 12000

With improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 13200 13200 13200

Revenue 12000 13200 13200 13200

Net gain in gross margin (in terms of pieces of gold) due to improvement:

Year 1 = 0, Year 2 = 1200, Year 3 = 1200, Year 4 = 1200

Notice that my payback time for the deflationary environment will be a longer. This raises the hurdle to invest. All investments are risky. And the longer I have to wait to get paid back the more risky it is.

Conclusion: Deflationary expectations raise the incentive to hoard money.

Does the cost of capital change this example significantly?

Interest rates are lower in a deflationary environment so discount rate is also likely lower. Depending on the rates this could give equivalent payback periods

[Georgia O'Keeffe]

Recently I participated in an internet online forum with a person who subscribes to the Austrian school of economics. He claimed that there is no additional incentive to hoard money in a deflationary environment as compared to a environment of stable prices. So I came up with this investment decision example to show him that there is in fact a strong additional incentive to hoard money.

Here is the scenario:

I am an owner of a bread making factory. The factory makes loaves of bread at the rate of 1000 loaves per month. But I can improve the business process by hiring a consultant to improve the business process such that in one year the production rate will be 1100 loaves per month. The consultant will need to be paid 1200 pieces of gold for his services. Each loaf of bread is currently selling for 1 piece of gold . The prevailing deflation rate is 5%.

All revenue and cost numbers are in terms of pieces of gold.

With no improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 12000 12000 12000

Revenue 12000 11400 10830 10288

With improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 13200 13200 13200

Revenue 12000 12540 11913 11317

Net gain in gross margin (in terms of pieces of gold) due to improvement:

Year 1 = 0, Year 2 = 1140, Year 3 = 1083, Year 4 = 1028

Now let us consider the same project in an environment of stable prices (no inflation or deflation):

With no improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 12000 12000 12000

Revenue 12000 12000 12000 12000

With improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 13200 13200 13200

Revenue 12000 13200 13200 13200

Net gain in gross margin (in terms of pieces of gold) due to improvement:

Year 1 = 0, Year 2 = 1200, Year 3 = 1200, Year 4 = 1200

Notice that my payback time for the deflationary environment will be a longer. This raises the hurdle to invest. All investments are risky. And the longer I have to wait to get paid back the more risky it is.

Conclusion: Deflationary expectations raise the incentive to hoard money.

yep, although clearly its circular as hoarding money results in the deflation

The current inflation model has the benefit of quicker technilogical progress with the downside of massive malinvestment

The non inflation model would slow down progress but has the upside of minimal malinvestment

Personally i prefer the current model as its an easy way to do well & make a living, from a social perspective i have the gut feel that 2 would also result in more poverty.

I dont think it matters though because im 99% certain that major deflation is where the west is at for at least the next couple of decades (although it will have years of inflationary spikes in between)

Edited March 18, 2010 by Tamara De Lempicka

[mansoor_h_khan]

Does the cost of capital change this example significantly?

Interest rates are lower in a deflationary environment so discount rate is also likely lower. Depending on the rates this could give equivalent payback periods

Great Point. I did not think of this. The difference in discount rate might give the same NPV. Very good thought.

But how about economy that is drenched in debt. Seems to me that real debt burdens will rise greatly. But for an economy with little or no debt. Deflation may not matter?

Mansoor

[sharpe]

Great Point. I did not think of this. The difference in discount rate might give the same NPV. Very good thought.

But how about economy that is drenched in debt. Seems to me that real debt burdens will rise greatly. But for an economy with little or no debt. Deflation may not matter?

Mansoor

Yes - I think you are at the crux of the question. Is the "paradox of thrift" real? Is there any evidence to support the idea or otherwise?

As you say deflation hurts those with debt and benefits those with savings. Presumably if interest rates were allowed to operate in a free market as debt levels rise, so would interest rates so it would be self correcting. Is our current position a logical conclusion from artifically low interest rates?

Could call it the "Paradox of profligacy". The more the central bank tries to stimilate the economy, the greater the debt levels and mal investments and greater the eventual crash.

[scepticus]

the paradox of thrift is real.

it arises because of wage and price rigidities in the economy. An economy has two sources of spending, consumption and investment.

When an economy having no rigidities suffers a shock which causes a fall in investment, there is little change in overall output because consumption increases to compensate. This occurs because prices of money/debt and goods and wages automatically adjust to the lowered level of investment. In this kind of economy interest rates would be negative.

However in the rigid economy, workers fight pay cuts, producers avoid dropping prices and debt holders won't accept haircuts. This leads firms to lay off workers and reduce output to maintain profits, and it leads to deflation in which the real rate of interest is very strongly positive even when the nominal rates is at or near 0. This strong real rate coupled with falling investment is a positive feedback loop from which it is very difficult to escape.

[sharpe]

the paradox of thrift is real.

it arises because of wage and price rigidities in the economy. An economy has two sources of spending, consumption and investment.

When an economy having no rigidities suffers a shock which causes a fall in investment, there is little change in overall output because consumption increases to compensate. This occurs because prices of money/debt and goods and wages automatically adjust to the lowered level of investment. In this kind of economy interest rates would be negative.

However in the rigid economy, workers fight pay cuts, producers avoid dropping prices and debt holders won't accept haircuts. This leads firms to lay off workers and reduce output to maintain profits, and it leads to deflation in which the real rate of interest is very strongly positive even when the nominal rates is at or near 0. This strong real rate coupled with falling investment is a positive feedback loop from which it is very difficult to escape.

Thanks for this helpful summary

Is there any evidence for this? Say an actual example where something like this has happened

[mansoor_h_khan]

the paradox of thrift is real.

it arises because of wage and price rigidities in the economy. An economy has two sources of spending, consumption and investment.

When an economy having no rigidities suffers a shock which causes a fall in investment, there is little change in overall output because consumption increases to compensate. This occurs because prices of money/debt and goods and wages automatically adjust to the lowered level of investment. In this kind of economy interest rates would be negative.

However in the rigid economy, workers fight pay cuts, producers avoid dropping prices and debt holders won't accept haircuts. This leads firms to lay off workers and reduce output to maintain profits, and it leads to deflation in which the real rate of interest is very strongly positive even when the nominal rates is at or near 0. This strong real rate coupled with falling investment is a positive feedback loop from which it is very difficult to escape.

Can you please give an example of how negative interest rates happen? How they manifest themselves in a non-rigid economy?

Mansoor

[scepticus]

Can you please give an example of how negative interest rates happen? How they manifest themselves in a non-rigid economy?

sure. lets assume the rigidity of paper cash, a 0% risk free asset is not available.

Now, all money is bank deposits. banks will clear inter bank liabilities between themselves by exchanging their own collateral (e.g. mortgage loans) with the government in exchange for government debt securities of various maturity. The government will charge banks interest according to the demand for such borrowing and the competing uses the government has for its own funds.

bank deposits can't leave the system. say you buy gold. whoever sells you the gold deposits your payment back in the banking system.

now lets say an economic shock comes along and people don't want to invest. banks don't want to lend. they stop lending that which has been deposited with them. except, where can they deposit it? all deposits at a bank, the bank must put them somewhere. Other bansk don't want to borrow their deposits. so they go to the government - hey mr president, borrow my deposits - no interest!

by the government says, all the other banks are offering me funds at 0%. we don't need all that cash. give me your best offer. The banks compete to deposit funds with the government which leads to negative deposit rates at the central bank. the negative rates offered by trhe government are passed on to savers so banks can make money on the spread. say governemnt offers -1.5%. The banks offer savers -3%.

Now, when these rates get sufficiently negative it makes sense to offer the funds to other borrowers in the real economy. even if many default, the return will be better than what the government is offering. So this results in a transfer of wealth from savers to borrowers but borrowers use the transfer to pay down debt which results in deflation. so although negative rates cause people not to want to hold money, because the money supply is shrinking it is not as bad for savers as it seems. In fact real rates could even be positive.

eventually via this transfer debt is destroyed, and asset prices decline. in this case asset price declines are OK because teh debt owing on them has declined too. This is the way to safely de-leverage an economy.

removing the 0% bound on interest lets the price of debt adjust to asset prices. ultimately no-one is particularly better or worse off after a period of negative nominal rates, unlike in deflation or hyperinflation.

the dis-incentive to save makes up for a lack of investment by boosting consumption, because remember it is investment which increases debt, not consumption, as long as the consumption is not based on consumer credit.

[scepticus]

Thanks for this helpful summary

Is there any evidence for this? Say an actual example where something like this has happened

the great depression

[jonb]

sure. lets assume the rigidity of paper cash, a 0% risk free asset is not available.

Now, all money is bank deposits. banks will clear inter bank liabilities between themselves by exchanging their own collateral (e.g. mortgage loans) with the government in exchange for government debt securities of various maturity. The government will charge banks interest according to the demand for such borrowing and the competing uses the government has for its own funds.

bank deposits can't leave the system. say you buy gold. whoever sells you the gold deposits your payment back in the banking system.

now lets say an economic shock comes along and people don't want to invest. banks don't want to lend. they stop lending that which has been deposited with them. except, where can they deposit it? all deposits at a bank, the bank must put them somewhere. Other bansk don't want to borrow their deposits. so they go to the government - hey mr president, borrow my deposits - no interest!

by the government says, all the other banks are offering me funds at 0%. we don't need all that cash. give me your best offer. The banks compete to deposit funds with the government which leads to negative deposit rates at the central bank. the negative rates offered by trhe government are passed on to savers so banks can make money on the spread. say governemnt offers -1.5%. The banks offer savers -3%.

Now, when these rates get sufficiently negative it makes sense to offer the funds to other borrowers in the real economy. even if many default, the return will be better than what the government is offering. So this results in a transfer of wealth from savers to borrowers but borrowers use the transfer to pay down debt which results in deflation. so although negative rates cause people not to want to hold money, because the money supply is shrinking it is not as bad for savers as it seems. In fact real rates could even be positive.

eventually via this transfer debt is destroyed, and asset prices decline. in this case asset price declines are OK because teh debt owing on them has declined too. This is the way to safely de-leverage an economy.

removing the 0% bound on interest lets the price of debt adjust to asset prices. ultimately no-one is particularly better or worse off after a period of negative nominal rates, unlike in deflation or hyperinflation.

the dis-incentive to save makes up for a lack of investment by boosting consumption, because remember it is investment which increases debt, not consumption, as long as the consumption is not based on consumer credit.

If rates become negative, it also makes sense for savers to turn up at the counter and ask for their money back to put under the mattress. The banks only have, depending on their fractional reserve ratio, somewhere in the region of 6%-8% of their deposits available as cash, so they would need to either call in loans, which can be difficult or impossible depending on the terms of the loan, or attract more deposits from elsewhere. Either, method, reducing lending or increasing deposits would mean raising interest rates.

[scepticus]

If rates become negative, it also makes sense for savers to turn up at the counter and ask for their money back to put under the mattress.

if you had been reading more carefully, you would have noted that I began by assuming paper cash did not exist.

various economists and other commentators have suggested doing away with paper cash, for various reasons, one of which is to enable negative nominal rates

[Fraggle]

all deposits at a bank, the bank must put them somewhere.

Why? Why can't the bank just have a large amount of non-invested deposits especially as if they put them anywhere, they'll lose money?

[Fraggle]

However in the rigid economy, workers fight pay cuts, producers avoid dropping prices and debt holders won't accept haircuts.

The third of those leads to the other two. Whoever devises a way for all debt to be automagically adjusted will one day have an economics prize named after them.

[mansoor_h_khan]

various economists and other commentators have suggested doing away with paper cash, for various reasons, one of which is to enable negative nominal rates

Scepticus,

It has been a while since we discussed this (negative interest rates). This still bothers me. You have suggested this as a way to balance supply and demand (i.e., deal with deflation). So, this is a way to put pressure on money holders to "spend" their money sooner rather than later. correct?

However, in the modern world due to longer life spans (and with it much longer portion of life where the individual is not expecting and/or able to work) and given the very high level of specialization (which makes replacing ones job much harder after a job loss) and inability to rely on other family members for financial support (due to change of traditions) the propensity to save (in general globally--maybe not in UK) is very high. In other words money holders are trying to "save" for bad times and retirement much more than they ever did in the history of the world.

Why not do the following (the focus of the following recommendations is to build increased production capacity for the future and have an implicit social contract which promises that "future production capacity" will be "shared" to insure social stability). The central government can print money and:

1. Build infrastructure to reduce business costs and commute times so future workers and businesses will be more productive.

2. Invest in education and training and increase the "creativeness" of current and the next generation of workers.

I realize the extra newly printed money can come back as inflation in the far future. But this can happen anyway. It all depends on future productive capacity of society. If there is too much inflation the government can tax and destroy money to bring inflation in check.

Mansoor H. Khan

[scepticus]

Using negative nominal rates does not alter the fact that the natural equilibrium for the rate of interest on money is zero. It just means that when the debt load exceeds peak sustainable debt that the debt is reduced via a general , partial auto-jubilee that is targeted at all creditors in the monetary economy. The alternatives are deflationary default which targets effectively a random set of creditors for a full 100% haircut and leaves others alone, or an inflationary default which has the same effect as the negative nominal rates case but also having an upward effect on overall prices.

The fact people NEED to save does not alter the ability of civilization to absorb savings in the real world. if there is more saving required than the world can absorb then that implies the structure of civilization would have to change to reduce the level of required saving to something that can be absorbed.

If the world cannot absorb the level of required saving to create viable pensions then that says that a civilization relying on lifetime individual saving for old age care is not viable.

[mansoor_h_khan]

If the world cannot absorb the level of required saving to create viable pensions then that says that a civilization relying on lifetime individual saving for old age care is not viable.

Ok, now we are getting somewhere. The world can always absorb savings. It can always keep on making bad investments on NPV basis (like dot com madness or the housing bubble or the CRE bubble). The "good" part of bad investments is that they do "give" income to many those who might not otherwise get it or get much of it. A big part of the problem now is that we don't have as much investment activity resulting in too many unemployed.

I am NOT saying that bad NPV should be targeted. Just that they (bad investments) ultimately seem to have great social value (in deflationary or danger of deflationary times).

Obama's desire to have the federal gov spend more is constantly being attacked. Without social stability the "system" will be totally screwed anyway.

Also, we seriously need to rethink the idea that relying on lifetime individual saving for old age care is viable for most people.

For thousands of years people got old and they weren't tossed on the streets. Family and secondarily the community did take care of them.

Mansoor

[Andy_K]

With no improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 12000 12000 12000

Revenue 12000 11400 10830 10288

With improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 13200 13200 13200

Revenue 12000 12540 11913 11317

Net gain in gross margin (in terms of pieces of gold) due to improvement:

Year 1 = 0, Year 2 = 1140, Year 3 = 1083, Year 4 = 1028

Now let us consider the same project in an environment of stable prices (no inflation or deflation):

With no improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 12000 12000 12000

Revenue 12000 12000 12000 12000

With improvement:

Year 1 Year 2 Year 3 Year 4

Loaves 12000 13200 13200 13200

Revenue 12000 13200 13200 13200

Net gain in gross margin (in terms of pieces of gold) due to improvement:

Year 1 = 0, Year 2 = 1200, Year 3 = 1200, Year 4 = 1200

Notice that my payback time for the deflationary environment will be a longer. This raises the hurdle to invest. All investments are risky. And the longer I have to wait to get paid back the more risky it is.

Conclusion: Deflationary expectations raise the incentive to hoard money.

You have compared apples with oranges. You have not taken into account that the real value of the gold changes in the deflationary environment.

In real terms, your net gain margin should be:

Year 1 = 0, Year 2 = 1140/0.95, Year 3 = 1083/0.95^2, Year 4 = 1028/0.95^3

Which is:

Year 1 = 0, Year 2 = 1200, Year 3 = 1200, Year 4 = 1200

Exactly the same as the stable environment.

[EUBanana]

you are 100% correct. a capitalist economy (even a 100% reserve one with no aggregate debt) is not workable in the event of long term secular nominal price declines.

Was the 19th century not

1) a long time

or

2) not capitalist?

Edited July 31, 2011 by EUBanana