Sobering thoughts about the price level

Money’s key function is means of exchange (beats bartering). Most money is created by the financial system. When it creates a loan, ‘new’ money is created. (A new entry is created in the asset ledger of the financial institution, which is the loan that you need to repay. A similar entry is created on the liability side. This is the money, drawn against the financial institution, that you are enabled to spend. Because of fractional-reserve banking, this is ‘new’ money, it doesn’t come from the financial institution’s existing money holdings e.g. deposits.) OK. Now run that process in reverse. In other words, the balance sheet of the financial institution shrinks, i.e. there is net loan repayment, whether because people are trying to reduce their debts or because the financial institution itself needs for prudential or regulatory reasons to increase its capital/asset ratio. Money is destroyed.
All else being equal, this would be deflationary. Why hasn’t it been? Many people are tempted to look at the foundational component of money in the economy, which is ‘base money’, ‘central bank money’, ‘high-powered money’, m0, they’re all synonyms. This is the money created by the Fed. And yes the Fed has created legions of this money in the wake of the aforementioned financial institution balance sheet shrinkage a.k.a. de-leveraging. But this has not been effective (at least so far — that expansion of m0 is a huge source of worry for some). There is no appetite to ‘pyramid’ new money (loans) on top of this base money, resulting in this money just accumulating in the banks’ own balances. To see this, it is imperative to look at measures of money supply which include such bank-created money.
So why no deflation? The reason is that government spending has created new money. The financial system writes it the loans and thus the new spending power, which is injected into the economy. Fiscal deficits have propped up the price level. Which brings me to the “sobering thoughts”. If this process is now likely to go into reverse or at least to abate, it is hard to believe that the price level will not fall. This may be an ideologically gleeful outcome for some people, i.e. those of the Austrian school, but do not be fooled. Deflation in the presence of nominally contracted debt is a nightmare scenario. And no person of the pro-deflation school has yet been able to explain away that particular dilemma.
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3 Responses to Sobering thoughts about the price level

  1. Anonymous says:

    Will you please define “nightmare scenario” as you describe in your next to last sentence?

  2. Scott says:

    “Deflation in the presence of nominally contracted debt is a nightmare scenario.”

    As Irving Fisher famously observed, deflation pushes debtors to the wall. They default, which makes their banks default. This becomes a catastrophe.

    There is another problem with deflation, also to do with asymmetry. Labour can suffer some modest inflation (i.e. not demanding a wage increase). But it cannot stand a wage cut, regardless of what is happening to the price level. The result? Employer is driven to bankruptcy, and labour is priced out of the labour market.

    Because of this nominal debt contracting and ‘money illusion’, deflation is bad news.

  3. Scott says:

    Forgot to mention the potential implication of the stresses that would arise under a deflating price level. Democracies won’t accept it. The trouble is that the solutions to these acute stresses could be distinctly illiberal. I think if you survey the multitude of policy pathways tried in the 1930s you get a picture of what is possible. What disturbs me most is that the weakest members of Europe in the 1930s were also being encouraged to honour their debts and to do so at the original exchange rate. ‘Fair enough’, you might reply. But doing so required limiting trade to officially approved transactions and selling fx revenue to the government at the overvalued official rate so that it could use this to pay off its fx debts.

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