Costs of deflation

I posted it as a comment to the previous thread.

Which are the sources of the costs of deflation?

1. Floor on interest rates
2. Destruction of credit
3. Price rigidities
4. Coordination problems

Let's see them in detail.

1. Floor on interest rates

The minimum nominal interest rate is 0%. It doesn't make any sense to pay less, because holding money is better than lending and losing it, although Mises said the contrary in Human Action.

If prices are stable, the minimum real rate is 0%. If prices are rising, the minimum real rate is higher than zero, so that by cutting nominal rates you can manage to have negative real rates, as we have now in Europe, especially Eastern Europe.

However, if prices fall, there is a minimum floor on the real rate, for instance 10%, equal to the deflation rate. This means that no credit contract between lenders and borrowers at less than 10% (real) can be made. This is equivalent to a floor on a price, and causes excess demand (people save, but no one invests) because it is non-market clearing price.

The appropriate theory here is that of price caps and floors, such as Mises's theory of interventionism, although it has nothing to do with interventionism strictu sensu.

It is wrong to argue that this cannot happen because an increase in consumer spending and a reduction in investment would reduce deflation. This process is by itself a recession.

2. Destruction of credit

Asset deflation (not price deflation) causes a reduction of asset values and nominal wealth, which may cause a reduction in lending. For instance, if I need a collateral to assure my lenders that I'm creditworthy (as in credit channel models of asymmetric information) the reduction in collateral value creates problems to me. However, this is at least partially compensated by the fact that also assets to buy are cheaper, so I can invest with less money, and production yields higher returns which foster higher investments.

A more serious trouble is that the banking crisis yields a destruction in bank credit, and the financial crisis yields deleveraging, i.e., a destruction of nonbank credit. In this case, the opposite effect of credit creation occurs: firms suffer a dearth in purchasing power and have no resources to invest. This phenomonenon was described by Strigl in "Capital and production" in 1934. The crisis destroys bank and nonbank credit, not banknotes, so this shift causes a reduction in the firms' purchasing power.

3. Price rigidities

Of course, price rigidities play a role. Normally a short-run role, but it depends on the structure of markets. For instance, if there are more unions, especially with coercive power, there are more rigidities. The same is true if the market is heavily regulated. In this case, unemployment can last forevere and an underemployment equilibrium can arise, as in Southern Italy, or East Germany, or the US during Hoover and Roosevelt.

4. Coordination problems

The banking panic is, well, a panic. The panic destroys habits and information, it makes market coordination more difficult, disrupting normal relations. The apex of the crisis is a moment of disorientation for the whole market, which can last (under normal conditions) several months. Because all price relations need to be rethought, and because relative prices need to change, the fact that also absolute prices change adds to the problem, especially if price rigidities cause relative price distortions by keeping some markets from clearing.

Besides, deflation may foster political problems, which we may call, following Robert Higgs, "Regime uncertainty".