Reason for a New Age

Deflation Meets Savings

Posted by publius2point0 on 2010/06/14


In Recession and Deflation, I stated that the problem with recessions is that the money supply deflates because people are paying back loans instead of taking on new loans. While this may be true in a great enough recession and without inflationary policies on the side of the government, the actual money supply may stay constant or continue to grow and yet there will be a perceivable deflation in the economy.

Below, we have a chart of your average economy of a modern nation. Some interactions aren’t included, like the ability for the government to mail out checks for a certain amount of money, but the primary ones are. Generally speaking, the money supply can only decrease in two ways, by loan payments exceeding loans, or by imports exceeding exports. Otherwise, the money is essentially trapped in a never-ending loop, bouncing around from place to place. But, while that is true, money can appear to disappear.

Say that Bill works for a company named Widget Inc. Every day, Bill is paid $1. When he gets home, he buys a widget from Widget Inc. for $1. In the space of year, Widget Inc. has made $365 dollars. Now, that might sound silly to count up the profit that Widget Inc. made like that when in reality Bill and Widget Inc. were simply passing the same $1 bill back and forth, but that is how the economy works. Making the same dollar bill loop through the system faster causes the appearance of everyone having a greater amount of money. If the loop moves slower, it appears like there is less money. And of course the same thing as lowering the frequency is if you lower the amount. If Bill swaps to buying the 50¢ widget instead of the usual $1 widget, then Widget Inc. only has 50¢ to pay him until he goes back to buying the more expensive version. In either case, where they trade less often, or they trade a smaller amount, the end effect is the appearance of there being less money for everyone.

In a recession, this is where the majority of money disappears.

Your average person takes out fewer loans, lessens his investments, purchases less, and targets his money towards savings and loan payments. With less money coming in from investments and purchases, businesses lower salaries by laying people off and paying lower returns on investments. To some extent, this should make the banks flush with money, but they don’t really have anywhere to put that money. Holding money is worthless if you can’t do anything with it. A bank can invest money in business (not pictured), but during a recession, a business is unlikely to go seeking investment money, and any spare money they get otherwise, they are fairly likely to simply use it towards paying off loans.

Theoretically, though, deflation shouldn’t be an issue. When Bill pays less, his salary lowers, and Widget Inc. is able to produce widgets for a lower price. When, one day, Bill decides to use the extra money that he’s squirreled away to buy two widgets, his salary goes back up, the price of widgets goes back up, and everything is back to how it was. And in fact, because Bill has money in savings, as prices fall, he has an incentive to go out buying and restart the economy. It should be a self-correcting system. However, reality has shown this to not be true. Recessions can last for decades, and if they continue for long enough one can postulate that they might even ruin the competitive spirit long-term, at which point there really is no schedule for return.

In Recession and Deflation, the issue that was pointed out was that when businesses corrected for lowered income, they did so by reducing employees, rather than reducing wages. This is problematic because people who are unemployed, regardless of how much they have in savings, aren’t liable to get out there spending. People who have retained their job are too anxious about their future employment to go out and buy and invest. What we want is for salaries to reduce rather than for people employment to be reduced. But this runs up against the problem of contracts. For instance, if I have taken out a loan for $100, and am obligated to pay $1 per day until it is all paid off, if the economy deflates to where there is only $50 in the whole economy, I can never pay back my loan. And yet, when you factor in the value of a dollar before and after the economic deflation, it might be that if I only paid back 10¢ per day for however many more days I was supposed to pay back my loan, I’d have paid back the full original value plus. But because we are obligated to pay back an unreasonable value, a hard $1 per day, I can’t accept a lower wage. The employer has only the option of laying me off, or continuing to employ me at a exorbitant price (compared to the amount of money that is flowing in the system).

Our system where we lay down 20-30 year  plans where we don’t factor for the changing money supply is where everything is broken. When we employ people and pay their salary we don’t take how much we promised them and then calculate how much a dollar is worth at the time of payment versus how much it was when they were hired, and that’s the sort of thing we should be doing. Essentially, it’s like if you were to trade dollars and rubles and to just blithely continue to treat them as having the same exchange rate for years and years until everyone discovered that it wasn’t true, and everyone went into a panic where half of everyone would lose tons of money if they proceeded to trade, so they simply sit still waiting for the ruble and dollar to match up again.

Keynesian stimulus might relieve this problem to some extent, but in spite of the name “stimulus”, it doesn’t appear to actually encourage people to go out and spend money. It creates the balance, but doesn’t create the incentive. If you have true economic ill or excess negativity, all of the effort put in to bring balance is all for naught. But, as said, all of this is to correct a problem that shouldn’t have been there to begin with. An exchange rate for dollars that accepts deflation and objective (savings-caused) deflation as parameters when it comes time to pay salaries, loans, and other contracted fees may be the answer to preventing all future recessions. The difficult part is, of course, figuring out how to track perceived deflation reliably and in daily or weekly increments.

However, as this idea is original to me, it’s very possible that I have not considered something.

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