Sunday, October 14, 2012

Keynes and debt deflation

LK has a passage from Keynes that makes the point I made the other day in response to Garrett Jones's post on Fisher that while Fisher wrote a great article, debt deflation was widely known in 1923 by Keynes and certainly before him as well. Most Keynesians think of Fisher as one of their guys for good reason.


  1. I have to note a minor objection that Keynes in the quoted passage describes the effects of deflation that are generally harmful for the economy. Fisher (1932, 1933), on the other hand, describes a certain chain of events where distress selling, falling prices of assets and rising real debts lead to the downward spiral of the economy. It is not quite the same thing.

    1. I agree. Keynes is not talking about debt deflation at all.

    2. Roman P.

      He doesn't exactly talk about how the sales will lead to further falls in asset values (although the idea that that is lost on him seems implausible to me), but he does talk about people observing the fall in prices and engaging in distress selling in results, and he talks about rising real debts. I'm not sure what the difference is.

  2. There's so much wrong with that piece from Keynes that I don't know where to start. Replacing "deflation" with "inflation" everywhere would be an amusing first step.

    1. There is so much wrong with your comment that I'll just start with the question: do you understand how investment decisions are made?

      Imagine you have a $100,000 and you think about starting a business. You could invest in whatever you need for a business or you could put money in a bank. If you are rational, you are going to look at your rate of profits. If your estimated profits are, say, 5%, and you could put money in bank for 10% of interest, than it's a no-brainer that you'd choose a bank. High interest rates make low-profit investments unprofitable, so to say.

      But here is the catch: you want to know the real interest rate, which is the nominal rate adjusted for inflation. Real interest rate = Nominal interest rate - Rate of inflation. Or: Real interest rate = Nominal interest rate + Rate of deflation. As you could see, deflation makes things worse because it adds up to the real interest rate. During periods of inflation, money lose their value and so it's better to invest in real production. A factory is a factory, after all. During periods of deflation, it is better to sit on your money and get interest.

      Inflation and deflation are not symmetric in their effects.

    2. Certainly there is asymmetry between inflation and deflation. I agree with that, and your description of it. But that's not really what Keynes is saying, is it?

    3. Roman,

      I think it depends on the causes of deflation (defined here as a fall in the general price level). An increase in output will decrease the price of the marginal unit, but since the firm is selling more output profits shouldn't fall (the price of inputs also fall). Furthermore, if deflation is expected, bank contracts have historically had a built-in stipulation where the rate of interest adjusts for deflation.

      Problems occur if deflation is unexpected or if deflation is caused by a monetary contraction. But, usually it's difficult to distinguish between unprofitability caused by deflation and deflation cause by unprofitability. Most of the monetary contraction revolves around the liquidation of bank loans, or debt; if you hold a Mises–Hayek view, then a major cause is malinvestment. This doesn't make the possibility of "collateral damage" less relevant though, where "collateral damage" refers to drops in profitability caused by the nominal contraction.

      But, I don't think this is directly relevant to "Current's" point. Inflation can also re-distribute income to the rentier. This is one explanation, for example, of why the financial sector has multiplied its income, while wages stagnate. Inflation, and changes in the money supply, are directly related to the endogenous expansion of credit through the loanable funds market.

  3. Quick correction: I was too loose with formulas. The actual formula for calculating real interest rate is: Real = (1+Nominal)/(1+Inflation) - 1. But note that the point stands!

  4. Current: are we reading the same excerpt, the one that LK provides and our host is linking to? I am surprised that you would agree with me and disagree with J.M. Keynes who wrote pretty much the same things about the asymmetry between inflation and deflation.

    Jonathan: Selgin's views on the desirability of deflation are not something I am quite ready to engage now. I understand that real financial and industrial processes are quite more complicated and may result in complicated (re)distributions of wealth, but I think that the crucial point of Keynes that rising value of money obstructs at least some investment projects and so depresses economy still stands.

  5. I'm glad people want to talk about this, I think it's an interesting topic.

    Firstly, we have to differentiate between expected and unexpected changes. Suppose that the general population expects that prices will stay steady. In that case holders of nominal assets receive a windfall at the cost of everyone else (especially debtors) if prices falls. Similarly, if prices rise then everyone else (especially debtors) receives a windfall at the cost of nominal asset holders. From this we can't say anything directly about whether the rich or the poor will win or lose. That depends on the split between nominal assets and other assets that each group holds.

    If changes in the value of money are expected then things aren't the same. People can weight their portfolios in advance, to compensate for the expected change. But, everyone has to keep some amount of money to deal with unexpected situations. In the case of inflation those who must keep a large quantity to tackle this problem will lose out, their wealth will be redistributed to others.

    As Roman P. has said the cost-benefit analysis for an investment changes. If there is deflation then money becomes an investment choice. Money is no long just a means of holding a convenient store of value for indirect exchange. The most marginal investors, those who can't find better investments, will invest in money instead. Of course, there may be none of these investors, if interest rates are high enough and the rate of deflation in question is low enough then that's likely.

    Deflation will drive up the demand for money as money becomes an investment and with it cause prices to fall further if the demand isn't satisfied(through MV=PT). If there is inflation then what happens isn't symmetrical. People may try to economise on money holdings, and through that they will cause more inflation (again through MV=PT) if the reduction in demand isn't accomodated.

    Now, bonds, interest bearing savings accounts and the like come about through fractional reserve banking. They support investments because those balances are loaned out. If the demand for money increases then banks can accommodate by making more loans. Three problems remain, firstly, demand for base money - cash - could rise. Secondly, the central bank may not allow commercial banks to expand the money supply. Thirdly, banks may not be able to find enough profitable new investments. In that case banks may simply rearrange their balance sheets. During this recession in the UK the banks expanded the money supply, but they also contracted the supply of timed-savings. That meant that the total quantity of investments they made didn't necessarily go up, it sometime went down. Problems like this mean that Keynes 100% deflation example would actually be much worse than he says, borrowers would be unable to pay, banks would be bankrupted by it and the money supply would fall to close to the stock of base money. That problem isn't relevant for more modest deflation though.

  6. Part 2...

    Keynes points out correctly that holders or money benefit from deflation. He goes on to say that the "rentier class" also benefit. How? Owners of stock earn dividends, landlords earn rents and rents aren't like interest payments, they're prices. Rich people who own land and property will have some of their wealth redistributed to nominal asset holders. What Keynes says would make sense if "Rentiers" meant "nominal asset holders", but if that were the case the rentiers would not include landlords. Keynes goes on to castigate asset owners for being "inactive", ignoring the fact that accumulating wealth is why people do business. It is the end, and it must continue to exist for "traders, manufacturers, and farmers" to continue trading, making and farming.

    I don't think Keynes point about intermediate good falling in value is very good. After all, when there's inflation businesses have to deal with money (which is also an intermediate) falling in value. One isn't necessarily easier than the other.

    Roman P. writes "A factory is a factory, after all." I don't really agree. Capital assets, such as factories, are often quite specific in their purpose and location. The company I work for is expanding theirs by building despite the fact that there are two empty ones on the same industrial estate, that's because the factories are of different types. If people are prodded into investing to avoid inflation eating away at their wealth then their choices are begin compromised. It may be better if prices remain as they are, and the materials to build the factory remain in the ground. Then another factory could be made in the next year, or in a few years time that's more profitable. This could be the best course for both the investor and for society. Value isn't simply inhered in things by application of work to inputs, the output also have to be useful. (Like Jonathan I could talk about malinvestment or Selgin's productivity norm, but I think that's getting off the point.)

    Going back to the original topic of debt deflation, I don't think that in practical scenarios we should worry too much about money becoming a competitive investment, except in a very marginal way. I think there are three interesting aspects to it:
    * Would there be an increased rate of bankruptcies? If so would the disturbance cause real losses.
    * What is the propensity to spend on output of the creditors?

    The Keynesians here should really be interested in the last point. If creditors are more risk-averse than the general population and therefore likely to buy existing assets, or if they consume less of their income, then that will have an effect. From the point of view of short-run national income determination that could be the deciding factor.

  7. Daniel Kuehn, I'm afraid that I have to agree with Unlearningecon and Roman P. on this. Irving Fisher himself states that as far as he knows, there are no intellectual forerunners to his debt-deflation theory. He cites a section of Thorstein Veblen's The Theory of Business Enterprise as the "closest" description of activity relating to debt deflation.

    1. It's worth mentioning that by the time Keynes wrote "Treatise on Money" Fisher had already written about Debt Deflation. In "Theory of Money and Credit" Mises cites Fisher from earlier sources. Fisher describes it as far back as 1896 in "Appreciation and Interest".

      That said, I'm not sure if he originated the idea. I expect that it's much older.


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