January 22, 2003
From the desk of Jane Galt:Scott Rosenberg wonders if the deflation we may be facing is due to cheap Chinese production.
Umm. No.
That's good deflation -- deflation produced by the higher productivity of comparitive advantage. In other words, it actually costs less, in total resources, to make something in China than in the US; therefore, prices fall. We've had that sort of deflation in all sorts of industries forever, and it doesn't cause the kind of deflation that economists worry about. The computer industry is the best example of this, but there are many, many others. Moreover, we've been importing from China, and before that Japan, for decades -- no deflation. Finally, trade is a relatively small part of the US economy.
The kind of deflation that economists worry about is the kind that is caused by a mismatch between the supply of money and the demand for it. Specifically, people want to hold more money and spend less, so you need more money in circulation. The problem is that, like hyperinflation, deflationary expectations can actually create more deflation -- people expect prices to fall, and therefore they want to hold onto their money longer. Manufacturers have to cut prices to sell their goods, which confirms the expectations and makes people hold their money longer. . .
Just create more money, you say? Would that it were so easy. The primary vehicle for money creation in the US is not the printing press, but the banks, which create money by extending credit. (I'm simplifying like hell here; if someone thinks I've simplified too far, feel free to email and let me know.) Part of severe deflation is usually that the banks don't want to create credit, because continued deflation makes it less like that people will be able to repay. At the same time, even if they wanted to create credit, people don't want to borrow, because deflation means they will have to repay their loans in dollars that would buy more tomorrow than they will today -- you'd need a hell of a lucrative opportunity to borrow in cheap dollars in order to repay with more expensive ones.
If the deflation is severe, banks will stop lending entirely, because the real interest rate gets unhinged from lending risk. The real interest rate is the rate of interest adjusted for inflation: if inflation is 2%, and you're paying 5% on your house, the real interest rate is 3%, while the nominal rate is 5%. Now, if the inflation rate is -3%, a real interest rate of 3% means that the bank would just give you the money, and you'd pay them back when you get around to it. But why would they do that? You might default -- whereas if they stick the money in their vaults, perfectly safe, they'll get the same return without the risk. So as nominal interest rates approach zero, banks have no incentive to lend at all. (This is very rare.) That's the supply side problem. The demand side problem is that if the banks charge a rate above what would otherwise be the market-clearing real interest rate in order to adjust for risk, people will find the loans too expensive and decline to borrow. The mechanism for generating money starts to break down. So just when you want the banks to be lending like crazy to stimulate demand, they lose their incentive to do so.
No one's really figured out how to end deflation, except have World War II, which doesn't seem very practical. Japan's tried Keynsian stimulus -- it failed. It's tried any manner of schemes to stimulate demand -- no go. Possibly some of the solutions that haven't been tried would work, but since the reason they haven't been tried is that they're politically untenable, that's not very helpful.
So no, we don't want deflation. Unless you're the sort of person who was so moved by your grandparents' tales of how desperately poor -- but cheerful and plucky! -- they were in the Great Depression that you'd like to give it a try yourself. But if we do get it, you can't blame it on trade.
Posted by Jane Galt at January 22, 2003 12:19 PM | TrackBack | Technorati inbound linksInteresting -- I hadn't read that piece before. Comes perilously close to sounding like those "work the rot out" folks in the Hoover Administration towards the end.
Good points Jane, but I believe the real problem is that real interest rates become bigger, instead of becoming negative. If nominal rates are 0, and inflation is -3% (deflation of 3%), the real interest actually starts to increase, not become more negative. Higher real interest rates and deflation encourage people to save instead of spend, causing firms to cut prices leading to more deflation.....
No. If deflation goes too low the risk-free real interest rate, which is what I'm referring to, drops below zero, at which point no one lends. Perhaps I was unclear.
Achilles is right; the para on real interest rates is confused and needs a rewrite. The problem is not that real interest rates go negative but that *nominal* interest rates *can't* go negative (by much; US Treasury rates went negative in the 1930s if I remember right and Japanese interbank rates have done by a few basis points). Thus, under deflation, the zero nominal interest rate might still imply a real interest rate high enough that nobody wants to borrow. It's a demand side problem.
I'd also note that the assertion that Keynesian policies "haven't worked" in Japan is highly controversial and many economists disagree. Japan has had positive economic growth for most quarters in the 1990s; the problem has been that the growth hasn't been enough to close a large output gap and affect employment. If it wasn't for the stimulative fiscal policy, Japan could have looked very like the USA in the 1930s, and it doesn't.
Finally, there's nothing stopping the government from using the printing press (or its virtual equivalent, which would be the purchase of private sector bonds by the monetary authority) to create inflation if deflation is the issue; this is arguably a solution much more in the spirit of Keynes than the "Vulgar Keynesian" fiscal policy response.
>>If deflation goes too low the risk-free real interest rate, which is what I'm referring to, drops below zero, at which point no one lends. Perhaps I was unclear.
You're misremembering. If we have deflation of 5%, then the lowest that the real rate can be is 5% (zero nominal minus -5% inflation). A zero or negative real interest rate is associated with high inflation, not low, and it isn't the case that "nobody lends" (after all, if nominal rates are 5% and inflation is 10% then a 5% real loss from lending is better than a 10% real loss from keeping cash idle). Nobody lends during deflation because you can see the purchasing power of your money grow over time without lending, but that's a *positive* real return for you as (non)lender.
I don't understand your interpretation of the Krugman piece, by the way; he has consistently been of the opinion that unorthodox monetary policy is the solution to deflation and liquidationism isn't. Unless I have missed something?
Just create more money, you say? Would that it were so easy. The primary vehicle for money creation in the US is not the printing press, but the banks, which create money by extending credit.
I'm surprised - this sounds perilously close to endogeneous money theory, a big no-no in conventional circles...
The claim that the problem with deflation is that they force real interest rates to be negative just isn't right Jane. Since
real rate = nominal rate - rate of inflation
it is a fact that a negative rate of inflation implies a real rate that is larger than the nominal rate. So unless there is any reason to believe that nominal rates don't have a zero nominal bound, that part of your posting needs a change. D-squared explained it better than I can so you should take his suggestion to heart.
But I agree with the general idea of distinguishing between favorable supply shocks and falling prices because of lack of demand.
I was also confused by your statement about the Krugman piece. Krugman and Svensson and others writing about liquidity traps have argued that unconventional monetary policy is the key. I am not knowledgeable enough about what the Hoover Administration said about "working the rot out" but if what you are saying is that Krugman is advocating is a "wait and the economy will come back to equilibrium" story you are dead wrong. Krugman has forcefully advocated that the last thing you want to do in a liquidity trap is to take a wait and see approach. But like I said I am not sure what you meant with your remark about the Hoover administration and Krugman.
It wasn't a slam -- the phrasing just reminded me of the Hoover-era arguments that the economy was trying to get back to a very low level so it could grow again. . . I'd never made the connection that way before. There's no economics here, just literary criticism.
I will try to edit to make it clearer: I'm thinking of something in my head that's clearly not being correctly verbalized: to wit, that if you could induce banks to pay people to take their money, the risk free rate the economy should be setting could be a negative number, even as it won't be, because nominal rates won't drop below zero.
Okay, that was really stupid. I don't know what I was thinking. I think I fixed it.
I'm glad you brought this topic up because I do view it as an important issue.
As for Krugman's piece I think you may have misunderstood, as d^2 says. After all Krugman is hardly of the "let it solve itself" approach. He has been, for years now, advocating that the Japanese govt should seek to rekindle inflation to solve this. Back when he first started talking about it (1998) most disagreed with him, as I recall. And now it's fast becoming the new conventional wisdom (notice Moody's new report on Japan).
One thing I was confused about in the Krugman article was HOW he would re-inflate the economy.
Now I've seen *everything*: Rosenberg's channeling Laffer & Bartley's kooky old "relative inflation should show up 1 for 1 in the exchange rate" theory.
What deflation?
The banks are printing money like it is going out of style!
Read and learn my friends!
http://www.dailyreckoning.com/body_headline.cfm?id=2828
if the inflation rate is -3%, a real interest rate of 3% means that the bank would just give you the money, and you'd pay them back when you get around to it. But why would they do that? You might default -- whereas if they stick the money in their vaults, perfectly safe, they'll get the same return without the risk.This is not precise. The problem is fractional reserve. Banks create money - credit - out of thin air. In that circumstance, then, yes - banks won't lend given your assumptions. But they won't lend because they control the money supply. So your statement should run more like, "if they don't create money, they get the same return with no risk."
If we consider a (non-real-world) scenario of hard money in honest, non-fractional-reserve banks, then the incentive to lend is unrelated to the deflation rate. It is correlated with the real interest rate. Bank vault holdings deflate just like anyone else's money.
Right now we are on the downside of a business cycle. So we can expect deflationary pressures. The explanation starts with the following simple fact: the interest rate is a market price, similar in many ways to any other price in a market. When the government mucks with it, economic distortions happen.
Consider something simple, say, the price of bread. Assume that there is a government agency charged with "stabilizing" bread prices, by somehow setting prices higher or lower than they would be on a free market. What happens? Econ 101 tells us: if the price is raised above the free market price, a surplus results. In the longer run, the bread producers drop production. If the price is dropped below the market price, a shortage results. In the longer run, the bread producers crank up production.
The point is, that the government cannot simply change a market price and expect everything else to stay the same. The market price is a signal, by which the actions of producers and consumers are coordinated "as if by an invisible hand". When you muck with it, producers and consumers respond as if the change reflected the real capital structure of the economy. They act, and their actions are based on untruth; to the extent that their actions are rational and well calculated, they will be wrong. That's a bad thing.
Now consider the interest rate. In a free market, this a market-clearing price of future goods versus present goods. When lots of people are saving money, they are signaling a demand to consume in the future. In this case interest rates drop (lots of money coming into banks), and entrepreneurs are signalled that people want stuff in the future. So the entrepreneurs borrow money and create new businesses or expand existing ones. Conversely, when few people save, the reason is because they consuming in the present. In this case the interest rate increases - little money to lend. And producers are signalled not to borrow and expand; people want stuff now, not in the future.
So what happens when the government can intervene and artificially lower rates? Well, to entrepreneurs and producers, the signal is: Expand production! People want stuff in the future! So they borrow and expand production. Meanwhile, actual savings don't merit that expansion; there is not actually going to be that future demand that the interest rate signals. People just keep spending for present consumption. Result: a boom. Everyone is spending; things look good. Prices tend to rise because all goods (consumer and capital) are in demand.
However, in the longer run, all the new production facilities start to come on line. But consumers don't want all the new goods - the producers were responding to a false signal. So what happens? Prices drop; non viable businesses (*cough* dot com) go bankrupt. This is the bust part of the cycle, and it is an inevitable result of the boom. Deflation results because there's an oversupply of consumer goods.
That's where we are now.
The only way out of the bust is to let the market work. The structure of capital needs to be realigned with the reality of consumer demand. Bankruptcies have to happen; unprofitable lines of production must be sold off; the misallocation of resources which happened in the boom must be corrected. It's not a monetary problem per se - it's a problem of a oversupply brought on by monetary mismanagement. In fact there is no monetary solution to the problem; you simply cannot change the real structure of capital by moving money around.
That is the Austrian view of the business cycle, in a nutshell. For a much better explanation of the problem (and lots of other stuff about how banking works), check out Rothbard's The Mystery of Banking (pdf).
So Jason, care to put your money where your mouth is?
As I stated above, Austrian economic theory predicts that, being in a bust after a boom, the stock market will go down. How much further is a matter of debate, but many of us expect dow 5000 before the end of the bear market. Therefore, the proper investment move right now is to buy cash, commodities, or maybe bonds. Being in the stock market broadly is not a good idea; of course some individual stocks will be good as always. But broader indexes will decline.
Since you think Austrian theory is "nuttery" then you think that you should be investing in something else. Stocks? Where do you expect the dow to go?
I propose the following bet: we both buy $1000 of our favored investment. I buy what Austrian theory predicts to be good; you buy whatever your ideas tell you. Then we meet again in a year. Care to put up?
I have no idea if "Austrian theory predicts" that the stock market is going to go down more, but I agree. This doesn't change that the Austrian theory of the business cycle is a) wildly inconsistent with the data and b) makes no logical sense anyway.
Leonard, as both JM Keynes and Jane have pointed out, this piece of Austrian analysis is wrong. Because its nominal value is fixed, and because it is a store of value and unsubstitutable in that role, money isn't like other goods. Because the nominal rate of interest has a floor at zero, it is entirely possible for the time price of money to get divorced from the market clearing rate of exchange between present and future goods.
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