Deflation causes a turnover in the social order?

[ianlippert]

So it looks like we are going to have another discussion on the great depression and I decided to look up a few of the old threads. I found this quote by Borodog:

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Keynes has been discredited for decades. Although it is interesting to note that his earlier, less well known works, particular on money and deflation were essentially correct. He realized that deflation did not lead to depression, but what it did lead to was a turnover in the social order, as debtors could no longer service their debt at the lower price level, they would go bankrupt. This of course doen't cause society a problem at all; the businesses keep operating, the consumers still buy, the workers still work, there are just new owners. Lord Keynes realized that the landed aristocracy, who were heavily debt leveraged, could lose everything in a deflationary period, and the old social order would be destroyed, along with the inflationary banking institutions that caused it (a deflation would raise the demand for money and cause a run on the banks; since there were more notes in circulation than reserves in the vaults, the banks would fail). Hence the rich and powerful, particularly those whose lifestyles and businesses are heavily debt leveraged, have an extremely powerful interest in seeing that an inflationary banking policy is kept in place. But not too inflationary, as in the 20s. This is when Keynes formulated his proposterous print-money-backed-by-nothing-and-spend-your-way-to-prosperity economics, because he believed it ensured that massive deflationary events could be avoided or controlled (of course the opposite is the case; it is inflation that causes malinvestments and the eventual recession and deflation). Because this ridiculous theory can be used to justify kooky government public policy it quickly gained supporters.


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I thought this was interesting, but I'm not entirely sure what it means. What exactly happens during deflation? Its seems that a lot of people think that deflation is part of what caused the great depression, and it is often cited as the reason to get off the gold standard so that you can avoid deflation. But I dont really see how its any bad or worse than inflation. Just better for some and worse for others. What exactly is involved in a turnover in the social order?

[iron81]

My understanding of the problems involved with deflation is that it discourages spending. When a currency deflates, its value increases over time. This means that you can buy more with your dollar tomorrow than today.

The problem is that the guy who you buy your car from needs that dollar today to feed his family The health of an economy is measured by the amount of economic activity and economic activity is discouraged when someone believes that their dollar will go further if they wait to buy stuff.

[diddle]

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My understanding of the problems involved with deflation is that it discourages spending. When a currency deflates, its value increases over time. This means that you can buy more with your dollar tomorrow than today.

The problem is that the guy who you buy your car from needs that dollar today to feed his family The health of an economy is measured by the amount of economic activity and economic activity is discouraged when someone believes that their dollar will go further if they wait to buy stuff.

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Deflation happens all the time. Similar computers today are 1/2 the price of ones from last year.

[Borodog]

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My understanding of the problems involved with deflation is that it discourages spending. When a currency deflates, its value increases over time. This means that you can buy more with your dollar tomorrow than today.

The problem is that the guy who you buy your car from needs that dollar today to feed his family The health of an economy is measured by the amount of economic activity and economic activity is discouraged when someone believes that their dollar will go further if they wait to buy stuff.

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This is essentially the standard argument, and it is clearly patently fallacious. Essentially the claim is that people withhold spending with the belief that they can buy more tomorrow, which acts to lower prices, which means they should wait, because they can buy more tomorrow, and so ad infinitum. It's ridiculous, because people have to consume. One cannot simply stop consuming and wait for prices to drop to zero say that you will be infinitely wealthy at some distant point in the future.

The trick is that consumers preferentially withhold their spending. Which is of course what they always do. So profits will fall in some lines of production, perhaps below the level at which some producers can service their debts. They can either renegotiate their debts (which actually happens quite often), or they can go bankrupt. If the business can be profitably run at the new, lower price level once the debt service no longer has to come off the top, then the business unit will continue to run, just in new hands. Employees will still be employed, widgets will still be made, bought, and consumed.

If the business cannot run profitably at the new lower price level, then it should not be in business anyway. The factors of production wasted in the unprofitable line of production are freed up to be acquired and put to use in profitable lines, i.e. those lines consumers actually want.

Deflation can only be bad across the economy after economy wide inflation has tricked entrepreneurs all across the economy into making unwise investments that must then be liquidated. This sets up a lot of producers to have their investments suddenly revealed to be unprofitable. If those producers are debt leveraged, it can be very bad for them.

It is well-known that inflation favors debtors. It is also no accident that Americans are deeply in debt; they are reacting in the rational way to the system as it is set up. Banks are incentivized to issue credit because it is essentially a license to print money. Have you ever wondered why literally everybody want to give you a credit card? It's because it is incredibly lucrative. The banking industry is the most profitable in America, pulling an levels of profit of about 20%, which is almost 3 times the average level of profit for most industries. Americans are incentivized to take on debt because inflation favors debtors.

Note that I'm not saying that "everybody wins" with inflation. I realized it looked like I said that because I said being a creditor is lucrative and inflation favors debtors! What I meant is that inflation favors debtors relative to non-debtors. Everyone is still harmed by inflation; it's just that non-debtors, people with dollars (which become progressively more worthless) who buy things outright are harmed more.

To see why, imagine you and I buy a car, each for $20,000. I buy outright, you finance. Now, through a little deus ex machina, there is twice as much money as there was before, proportionally allocated as it was. Having twice as much money, but the same amount of goods and services, the general price level will double. But the note on your car is still only $20,000. It "should" now be $40,000. You get to pay of the debt (formed in "today's dollars") in "tomorrow's dollars", and the car cost you only half as much.

This is an extreme example, of course; that's not the way it works usually. The money supply doesn't double every year, and a few select people get their hands on the new funny money first, which enriches them relative to the rest of us. But the effect is still there.

[hmkpoker]

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My understanding of the problems involved with deflation is that it discourages spending. When a currency deflates, its value increases over time. This means that you can buy more with your dollar tomorrow than today.

The problem is that the guy who you buy your car from needs that dollar today to feed his family The health of an economy is measured by the amount of economic activity and economic activity is discouraged when someone believes that their dollar will go further if they wait to buy stuff.

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As a counter-example, I turn your attention to the computers/electronics market. This is/was probably the fastest growing market in the history of mankind; the technology of PC's and TV's expanded so fast that the prices of these goods has been regularly plummetting over the past few decades, while the quality has been improving, in spite of inflation. It is now common sense that any cool new PC or Best Buy gadget will be obsolete in under two years (or less, depending on how you define "obsolete"). Buying anything tomorrow will definately be cheaper than buying that same thing today in this market, and these are all luxury items that no one really needs.

If what economists claim of deflation is true, no one would ever buy electronics. Or the industry would die out from a lack of sales. It's always going to be cheaper in the future, so why buy today?

The reason is time preference. In spite of the knowledge that these goods will be cheaper in a few months, people want to buy these goods now. And accordingly, American households are quick to fill with new toys that are all rapidly depreciating in value, will undoubtedly be cheaper had they held out, and will need to be replaced in a very short period of time.

[Borodog]

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My understanding of the problems involved with deflation is that it discourages spending. When a currency deflates, its value increases over time. This means that you can buy more with your dollar tomorrow than today.

The problem is that the guy who you buy your car from needs that dollar today to feed his family The health of an economy is measured by the amount of economic activity and economic activity is discouraged when someone believes that their dollar will go further if they wait to buy stuff.

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As a counter-example, I turn your attention to the computers/electronics market. This is/was probably the fastest growing market in the history of mankind; the technology of PC's and TV's expanded so fast that the prices of these goods has been regularly plummetting over the past few decades, while the quality has been improving, in spite of inflation. It is now common sense that any cool new PC or Best Buy gadget will be obsolete in under two years (or less, depending on how you define "obsolete"). Buying anything tomorrow will definately be cheaper than buying that same thing today in this market, and these are all luxury items that no one really needs.

If what economists claim of deflation is true, no one would ever buy electronics. Or the industry would die out from a lack of sales. It's always going to be cheaper in the future, so why buy today?

The reason is time preference. In spite of the knowledge that these goods will be cheaper in a few months, people want to buy these goods now. And accordingly, American households are quick to fill with new toys that are all rapidly depreciating in value, will undoubtedly be cheaper had they held out, and will need to be replaced in a very short period of time.

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Beautiful.

[Dan.]

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The reason is time preference. In spite of the knowledge that these goods will be cheaper in a few months, people want to buy these goods now. And accordingly, American households are quick to fill with new toys that are all rapidly depreciating in value, will undoubtedly be cheaper had they held out, and will need to be replaced in a very short period of time.

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Would you then agree that these people are acting irrationally by buying these goods now (assuming they are not a necessity)?

[Poofler]

If the increased utility from having the toy now is worth the amount of price depreciation, why is it irrational?

[hmkpoker]

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Would you then agree that these people are acting irrationally by buying these goods now (assuming they are not a necessity)?

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Absolutely not.

If this is true, then the "rational" action would be to never buy such a good; forever deferring the purchase in favor of delayed, more profitable investment. Can you imagine a fellow who enjoys video games and has lots of disposable income never buying video games? That would be incredibly irrational, yet if the price of video games is always going to be cheaper tomorrow than it is today, then as long as time is irrelevent we must conclude that any act toward personal utility must be irrational, which is utterly ridiculous.

Time preference is not necessarily irrational.

[Borodog]

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The reason is time preference. In spite of the knowledge that these goods will be cheaper in a few months, people want to buy these goods now. And accordingly, American households are quick to fill with new toys that are all rapidly depreciating in value, will undoubtedly be cheaper had they held out, and will need to be replaced in a very short period of time.

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Would you then agree that these people are acting irrationally by buying these goods now (assuming they are not a necessity)?

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No. Do you see why?