Tuesday, May 19, 2009

The Deflation "Problem"

Ben Bernanke is concerned about deflation. That's why he is printing so much money:

“We are currently being very aggressive because we are trying to avoid” deflation, Fed Chairman Ben S. Bernanke told an Atlanta Fed conference on May 11.
Greg Mankiw is so concerned about deflation and a lack of consumer spending that he is calling for negative interest rates:
Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.
That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn’t a flaw — it’s a benefit.The idea of making money earn a negative return is not entirely new. In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it. John Maynard Keynes approvingly cited the idea of a carrying tax on money. With banks now holding substantial excess reserves, Gesell’s concern about cash hoarding suddenly seems very modern.
Economist Hans Hermann Hoppe has responded in brilliant fashion to those who charge that money hoarded is unproductive and must be counter-acted. Writes Hoppe:

The first natural response to the thesis that money held in or added to cash balances is unproductive is to counter, why, then, if money held in or added to cash balances is unproductive of human welfare, do people hold them or add to them? If cash holdings are indeed "good for nothing," no one would hold or add to them — and yet almost everyone does so all the time! And since all money is always held or hoarded by someone — when it "circulates," it only leaves one holding hand to be passed into another — money must be continuously "good for something" all the while it is being held (which is always)...

To the extent that a man feels certain regarding his future needs, he will invest in consumer or producer goods. To invest in money balances is to invest neither in consumer goods nor producer goods. Unlike consumer and producer goods, which are used up in consumption or production, money is neither used up through its use as a medium of exchange nor transformed into another commodity. To invest in cash balances means, I am uncertain about my present and future needs and believe that a balance of the most easily and widely saleable good on hand will best prepare me to meet my as-of-yet unknown needs at as-of-yet unknown times.

If a person then adds to his cash balance, he does so because he is confronted with a situation of (subjectively perceived) increased uncertainty regarding his future. The addition to his cash balance represents an investment in presently felt certainty vis-à-vis a future perceived as less certain. In order to add to his cash balance, a person must restrict his purchases or increase his sales of nonmoney goods (producer or consumer goods). In either case, the outcome is an immediate fall in certain nonmoney goods' prices. As the result of restricting his purchases of x, y, or z, the money price of x, y, or z will be lowered (as compared to what it would have been otherwise), and likewise, by increasing his sales of a, b, or c, their prices will fall. The actor thus accomplishes exactly and immediately what he wants. He commands a larger (nominal and real) cash balance and is better prepared for an increasingly uncertain future. The marginal utility of the added cash is higher than (ranks above) the marginal utility of the nonmoney goods sold or unbought. He is better off with more cash on hand and less nonmoney goods, otherwise he would not have reallocated his assets in this way. There is more investment in the removal of perceived uncertainty, and there is less investment in needs, present or future, considered as certain.

The situation does not change if there is a general increase in the demand for money, i.e., if all or most people try to increase their cash holdings, in response to heightened uncertainty. With the total quantity of money given, the average size of cash holdings cannot increase, of course. Nor is the total quantity of producer and consumer goods that make up the physical production structure affected by a general increase in the demand for money. It remains unchanged. In generally striving to increase the size of their cash holdings, however, the money prices of nonmoney goods will be bid down, and the purchasing power per unit money will correspondingly rise. Thus, the (increased) demand for and the (given) supply of money are equilibrated again, but at a higher purchasing power per unit money and lower prices of nonmoney goods. That is, even if nominal cash balances cannot rise as a result of a general increase in the demand for money, the real value of cash balances can; and it is this increase in the value of real cash balances that brings about precisely and immediately the effect desired: being better prepared for a future deemed as less certain.

No one cares about the nominal number of money units in his possession. Rather, people want to keep cash with a definite amount of purchasing power on hand. If the purchasing power per unit money increases as the result of an increased demand for cash holdings, each unit of money confronted with an array of generally lower nonmoney goods prices can do a better job in affording its owner protection against uncertainty.


  1. "The Fed has deflation dread disorder"...

    Another Austrian economist on the warpath? No.

    "Federal Reserve complicit in supporting the low teaser rates"... "(the) teaser rates came from Washington".Those comments are from a recent interview podcast (for the specific quotes see minute 30:18) featuring Ed Leamer, Professor in Economics & Statistics and director of UCLA Anderson Forecast.

    An interview worth checking out.

    Deflation Dread Disorder. I think we have a diagnosis.

  2. In the tradition of Bastiat, the following question occurred to me: If deflation is bad because people are holding off from buying, wouldn't inflation be bad because people hold off from selling?