The truth about money, inflation and deflation, part I

Everywhere you look, you see arguments about whether the bigger risk is inflation or deflation.  Amrose Evans-Pritchard never goes more than a story or two without warning of the perils of a deflationary spiral.  We hear constant stories about deflation hitting the markets, with even Roubini Global Economics joining the fray.  But by far the most predictable reaction you will get will be from bankers, who fear deflation more than anyone, which at first seems implausible since loans owed to them become more valuable if deflation hits.  But is there really any deflation?  And if there is, should we be worried?  The true answer to both questions is NO. 

Inflation or deflation as their true definitions go, refer to an increase or decrease in the money supply.  For the first 4,000 years or so of civilization, money was simply the most marketable commodity; something that just about anybody would take in return for his goods or services, because he knew it would be useful in getting what he needed later.  The money supply was easy to measure:  It was the sum of all the circulating gold or silver coins that were used in exchange.  If nobody kept track of that number, it did not matter, since they were always scarce and valuable.  There were times when rulers debased their coins, or clipped portions of each coin to make more, and that usually led to a financial crisis that brought down the ruler.  Of course, the fact that he had to resort to debasement in the first place probably meant that he was in trouble to begin with.  The one big disruption in money supply came in the 16th Century when Spain stole all the gold from Central and South American Indians, brought it back to Spain, and spent it into the economy.  What happened was obvious from the vantage point of history, yet the same principles apply today.  The “wealth” of Spain, measured as all the goods and services that were available for purchase, did not change much when all that extra gold came to the country.  Yet the medium of exchange, gold, was inflated substantially.  Where before there was 1 dubloon bidding for that keg of wine, now 2 dubloons could bid for the keg, since there was more gold.  Naturally, the one bidding 2 won over the one bidding 1.  Thus the price for wine doubled, and the same happened for every other good and service that was in demand.  In not too much time, the wealth had trickled down to the citizens from the royals, and they all had more money, but were no richer because there was no more stuff available than before.  But the rest of Europe did not have access to all this gold, yet they understandably wanted a chance to get their hands on some.  So they sold stuff to Spain at pre-inflationary prices, which still prevailed throughout Europe.  It did not take long before most goods were imported, since Spain could not produce at the low prices the rest of Europe could produce at.  Productivity in Spain fell dramatically, and increasingly more brazen imperial adventures were required, bringing back more Central American gold, to continue to fund a country that now operated on a strong trade deficit with the rest of Europe.  And so it went, that Spain stopped producing, instead importing their goods, paid for by the flood of extra gold that was coming in.  Sounds like a good deal, if you can sustain it, which of course was the problem – they could not sustain it.  The gold ran out, the bills could not be paid, and Europe kept the gold and its goods, while Spain went into a deep depression for an extended time.  What happened to Spain is that in the beginning, the money supply was inflated, creating imbalances between those who had the new money and those who did not, leading to increases in prices locally where the money was, then the loss of competitiveness to those who had no money.  This could be sustained so long as ever-increasing amounts of gold made their way into Spain to fuel ever-increasing monetary inflation, to keep the rest of Europe producing so Spain could consume.  Being that Spain was using gold, which is scarce and readily depleted, they ran out of gold.  At that point, the unsustainable nature of Spain’s economy became obvious, and the depression hit.  One could say the “bubble popped”, because the dynamic was very much that of an economic bubble, though the focus of the bubble was Spain’s empire.  From this we learn that the bubble that starts when currency is inflated always ends badly, because of the imbalances it creates, and the unsustainable nature of the flow of money from the source.  Had Spain been using paper currency, they could have kept it going a lot longer, to the point where the currency itself would become without any value.  Gold however, was favored as money because it is limited, and even with this once-in-history surge in supply, it still could not be sustained indefinitely.  Spain’s bubble burst when they ran out of currency, but in other circumstances, the bubble bursts when the currency itself loses all value.  This is in essence the insight that Ludwig von Mises brought to economics some 300 years later, and which mainstream economics has somehow lost.

Over time, with the development of banking, receipts for gold issued by banks or governments became the most marketable commodity, with advantages over using gold coins.  They were called Francs and Dollars, or other names, but they represented gold (or silver) coins that could be redeemed at will, at a fixed exchange rate.  You could not have significant inflation or deflation so long as gold coins were the basis for exchange.  If I deposit 100 gold coins in my bank, which lends those coins to a creditor, who defaults on the loan, then the bank, or I, have lost 100 gold coins, but those coins still exist, and someone else has them, so the supply of money has not changed.  But banking like this is not conducive to making a lot of loans, which is not good for bank profits.  So the bankers made use of the fact that most people trusted them to have on hand the gold coins they deposited with them, and rarely withdrew them.  The bankers loaned out receipts for a  portion of those coins, which meant that they no longer had title to all the coins they promised their depositors they had.  The one who borrowed the receipts for gold coins may have transferred them to another bank, and that bank may or may not have called in the actual coins from the first bank.  The coins only existed once, but receipts existed twice.  This increased the effective money supply.  If the bank of the borrower also made loans with the coins they had called in, then a third set of receipts were created for the same coins.  When everyone is dealing only with receipts for the coins, nobody can know from personal experience the degree by which the money supply has been expanded, but entrepreneurs who had developed a business plan and acquired money to make it come to fruition would find that it was insufficient, as capital goods and labor that they had planned for would be costlier than expected, the result of more money in the economy competing for a relatively stable supply of goods and services.  They had now experienced price inflation.  The bankruptcies that result from business plans becoming unrealistic would mean loan defaults.  When a bank has issued receipts for gold as a loan, and that loan defaults, the bank has to write off the value of the loan from its list of assets.  But it still retains the liabilities represented by the receipts for gold they had issued.  So long as everyone pretends this is not a problem and everyone accepts receipts for gold at face value, the system can work a little longer.  But with the defaults brought about by the inflation, one bank or another is going to call in the receipts of other banks, to bolster their reserves, or to redeem receipts for gold to their depositors.  The situation becomes very unstable, and one trigger event will cause a wave of redemption.  At that point, it becomes clear that the vast majority of gold receipts are not backed by coins, and the wave turns into a panic.  The first to come to the bank to redeem their receipts get their gold coins, but after about 10% of depositors, there are no more gold coins.  The receipts are now worthless, and only the coins themselves are of value.  This has resulted in a rapid reversal of the initial inflation, and deflation of the money supply.  The economy will likely seize up for a period of time, until new banks are opened, or surviving ones with credibility draw the holders of gold coins to deposit them and again making loans with a portion of the deposit.  But note that the actual monetary base, being the number of gold coins in existence, has not changed.  Only the receipts for gold, which were never fully backed by gold, became worthless to the extent that they could not be redeemed.  So while there was deflation, and we can assume a total withdrawal of all gold and redemption or default of all gold receipts, there was a floor to this deflation, and it could never become a spiral, dropping below the level of existing gold coins, or of the pre-inflation money level.  Any milder panic would have less deflation.  This is the business cycle as it came into being with fractional-reserve banking, where money creation unbacked by precious metal would alternatively inflate and deflate the money supply.  Prices generally followed, offset by other factors in the economy such as productivity increases. 

In part II, I’ll discuss the role of fiat money, and how the situation works in today’s financial structure.


About krakondack

An arrogant know-it-all who presumes to lecture qualified public officials, and other authority figures, on their errors and shortcomings.
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2 Responses to The truth about money, inflation and deflation, part I

  1. Les Denton says:

    wow – I clicked on your name to thank you for a post about IE9 and MobiPocket Creator. Sincer from both me and my wall for ending the headbanging. I stumbled upon your WWIII blog coincidentally. I am writing a fiction book about this and am very interested in your viewpoints. Thanks again – for both.
    Les Denton

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