lunedì 5 luglio 2010

Deflation, no pros, but almost inevitable.

I wrote a comment on this post by Prof. Rizzo.

I just add a note: when I say "normal market response" I don't mean it is good because it is natural, but that it is inevitable.

There are a couple of differences in the Austrian and Monetary Equilibrium frameworks I have to check, I'm reading Yeager now, before forming my own informed opinion. Here's the comment:

Prof. Rizzo:

“While some distortion may be introduced by anti-deflationary monetary policy, this pales in comparison with the catastrophe of outright, significant and prolonged deflation.”

I’m worried of entering a heated and verbose discussion, given the risk of appearing a troll, but I disagree. I’m also worried because my contribution is verbose, too.

1. I consider the extension of the financial system (monetary multipliers included) to be a mainly endogenous phenomenon, given external constraints like the supply of gold or the monetary policy function of the Fed. If the boom causes the financial and banking system to overshoot, the recession needs to check and counteract this overexpansion. This has been called deleveraging: from a monetary point of view, however, it is deflation. It is endogenous to the business cycle, thus it is a normal market response, although painful.

2. The fear of deflation appears to be mainly based on a single event: the Great Depression. The 1873 depression hardly existed in real terms (I downloaded some paper on the subject on JSTOR, but I haven’t read them thoroughly yet), or the 1920 recession, which was severe but short-lived (I don’t know much about XIX recessions). I base my analysis on Cole and Ohanian’s papers: a historical unicum calls for a specific explanation, i.e., an exception to general models.

Given (1), I’d consider impossible for an economic system whose “normal” monetary multiplier is ten, which however during the boom overshooted to twenty, to do without deflation. I generalize this: the same is true for financial leverage and many others risk indicators, it is true for both banks and shadow-banks, because it is a credit problem and not a money problem. This secondary depression is likely to have a greater real effect than the mere liquidation of malinvestment, as said by Strigl in “Capital and production”, and by Hayek. But it is a short-lived phenomenon, the Great Depression excluded.

So, what can be done to avoid deflation? Monetary equilibrium analysis assumes that the problem is an excess demand for money, but the problem at the peak of a long boom is an excess of almost everything: risks, leverage, mismatches, malinvestment, malintermediation… M1 is too high with respect to M0, M2 is too high with respect to M1: the recession brings normalcy to these aggregates.

Friedman and Schwartz had a similar opinion: in “Monetary history of the US” they argued that the Fed, by guaranteeing liquidity to the national banks, succeeded in increasing the efficiency of gold use, albeit at the cost of increasing the fragility of the whole financial edifice. If something has risen too much, it needs to fall.

So, I reach point (2). I’m convinced that the Great Depression has been a historical unicum: Cole and Ohanian convincingly argued that it was caused by Hoover’s and Roosevelt’s policies of cartelization, sindacalization, nominal wage preservation, etc. This was also Phillips, McManus and Nelson’s thesis (one of them, better) in “Banking the the business cycle” and the beef of the argument against Hoover in Rothbard’s “America’s Great Depression”.

Shall we fear deflation on the basis of the experience of the Great Depression? It depends on which interpretation of its severity and length is correct. I don’t consider it a relevant proof of the dangers of deflation: its persistence had other causes.

Hayek was thus doubly right: in saying that the deflation is painful and in saying that resource mobility is key for a quick recovery: if the latter holds, however, the fear of the former can be greatly relaxed.

3 commenti:

  1. Could you elaborate on why deflation should be painful? Sticky wages or something else?

  2. Well, there are various channels.

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

    1. Floor on interest rates

    The minimum nominal interest rate is 0%. It doens't make any sense to pay less, because holding money is better than lending and losing it, although Mises said the contrary, probably in a moment of folly, 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 on the real rate, for instance 10%. This means that no credit contract which transfers credit from lenders to 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.

    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 instnace, 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.

    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 a panic. The panic destroys habits and information, it makes market coordination more difficlut disrupting normal relations. The apex of the crisis is a moment of disorientation for the whol market, which can last (under normal conditions) several months. Because all price relations need to be rethought, and because relative price 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.

  3. Blogspot dice che ho commentato ma non vedo nulla.

    Ci ho fatto un post.