[derosa8]

Whenever the subject of the gold standard or commodity monies are discussed, the deflation objection usually follows.

Here is Keynes in “A Tract on Monetary Reform” (1923) explaining the danger of deflation:

“In the first place, Deflation is not desirable, because it effects, what is always harmful, a change in the existing Standard of Value, and redistributes wealth in a manner injurious, at the same time, to business and to social stability. Deflation, as we have already seen, involves a transference of wealth from the rest of the community to the rentier class and to all holders of titles to money; just as inflation involves the opposite. In particular it involves a transference from all borrowers, that is to say from traders, manufacturers, and farmers, to lenders, from the active to the inactive.

But whilst the oppression of the taxpayer for the enrichment of the rentier is the chief lasting result, there is another, more violent, disturbance during the period of transition. The policy of gradually raising the value of a country’s money to (say) 100 per cent above its present value in terms of goods … amounts to giving notice to every merchant and every manufacturer, that for some time to come his stock and his raw materials will steadily depreciate on his hands, and to every one who finances his business with borrowed money that he will, sooner or later, lose 100 per cent on his liabilities (since he will have to pay back in terms of commodities twice as much as he has borrowed).

Modern business, being carried on largely with borrowed money, must necessarily be brought to a standstill by such a process. It will be to the interest of everyone in business to go out of business for the time being; and of everyone who is contemplating expenditure to postpone his orders so long as he can. The wise man will be he who turns his assets into cash, withdraws from the risks and the exertions of activity, and awaits in country retirement the steady appreciation promised him in the value of his cash. A probable expectation of Deflation is bad enough; a certain expectation is disastrous” (143–144).

My question is:
(1) What would be an economically sound response to this objection?

(2) Is this cat too far out of the bag to reverse the trend? In other words, are the critics right that because “virtually all” businesses borrow reams of money continually, anything that caused deflation would be catastrophic?

[jmherbener]

First, the claim about wealth transfers isn’t true unless capitalists and entrepreneurs fail to anticipate the changes in money’s PP, If they correctly anticipate higher prices in the future, they bid more heavily for factors of production today and factor prices rise today keeping rates of return the same, i.e., interest rates are unaffected. If they correctly anticipate lower prices in the future, they bid less heavily for factors of production today and factor prices fall today keeping rates of return the same, i.e., interest rates are unaffected.

Second, price deflation in today’s world would cause widespread default on debt obligations. However, this has little effect on production. After the defaults, capitalists would still find it better to fund superior entrepreneurs and not inferior ones. If superior entrepreneurs are currently in charge, then they would likely remain. For example, if Apple defaulted on its debt because of its increasing burden during price deflation and capitalists thought Tim Cook was still the best person to run Apple, why wouldn’t they just renegotiate a partial default and continue with production they anticipate will be profitable in the future? Why wouldn’t banks simply renegotiate mortgages to relieve part of the debt homeowners who are likely to continue paying back on new terms? The point is that asset values need a one time reduction to come in line with the new anticipated deflationary future. The best way to deal with this is to take the loss and move on.

[derosa8]

Thanks for the explanation Professor Herbener. So, would steady deflation be the natural state of an unhampered market economy?

And if so, it seems that this is not always the case if one looks at Price Inflation numbers from the 19th century [which I realize is not an unhampered market, but thought because it is a gold standard it should have that effect]. Here are the inflation numbers:

http://socialdemocracy21stcentury.blogspot.com/2012/10/the-gold-standard-did-not-prevent-price.html

[derosa8]

Also, as far as your remark, “Why wouldn’t banks simply renegotiate mortgages to relieve part of the debt homeowners who are likely to continue paying back on new terms?” — is it in the banks’ best interest to do that?

[jmherbener]

In the unhampered market, the production of money and money substitutes would be regulated by profit. If the PPM was anticipated by entrepreneurs to rise during economic progress, then they would produce more money to earn the profit. The increased production of money would moderate the rise in the PPM.

The classical gold standard of the nineteenth century permitted the issue of fiduciary media. Also, there were issues of silver money as well until the Gold Standard Act of 1900. Of course, price inflation and booms and busts occurred as a result.

Once the prices of the houses, for which mortgages are claims, collapses, then banks must judge whether it is wise to quickly renegotiate the terms of the mortgage to make it feasible to get the most payments possible. Whether they renegotiate or not depends in part on their anticipation of the restoration of housing prices. If they think the prices will rise again soon, they will be reluctant to renegotiate. This is another source of inefficiency introduced by government attempts to prop these prices up again through monetary inflation. Another factor is the likelihood of the homeowner to pay back the mortgage on the old or new terms.

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