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Posts Tagged ‘deflation’

Adjusting for Apparent Money – Part 1

Posted by publius2point0 on 2010/06/20


Continuing on the idea from the previous entry, we will track through what should theoretically happen when exchange system is used when money appears to deflate due to a decreased velocity of money. To make life easy, we will use the below model of the macro economy, rather than the rather complex (and still incomplete) image included in the previous blog:

We’ll say that we have three citizens of our economy, Jack, Alan, and Tina. Each month they spend $800 on food, clothes, gas, electricity, etc. which they purchase from Fnord Inc. They are also all in debt to the central bank, owing $50 each month to pay back a $500 loan. Their salary is $1000 per month working for Fnord Inc.

Balance Sheet
Month Apparent Money (per month) Debt Fnord Inc. Jack Alan Tina
Initial $3000 -$1500 $3000 $0 $0 $0

Unlike the modern world where the salary is pegged to a particular value, in the new system of doing things the salary is based on the value of the Apparent Money (AM) as it has tracked from month to month. We calculate the AM by adding all purchases. The initial value is set to $3000 as we assume that if Fnord Inc. is able to hire 3 people for $1000 each, they must have received $3000 in the previous month. Besides adjusting salary, we also adjust the amount of our loan payments — and in fact the total amount of debt as well.

In the first month, Jack, Alan, and Tina are each paid $1000. They purchase $800 worth of supplies, pay $50 in loan payments, and save the remaining $150. The total of all purchases in the economy for this month was only $2400, so we update the Apparent Money to that.

Balance Sheet
Month Apparent Money (per month) Debt Fnord Inc. Jack Alan Tina
Initial $3000 -$1500 $3000 $0 $0 $0
1 $2400 -$1350 $2400 $150 $150 $150

With an AM that is 80% of the previous month, Fnord adjusts the amount of salaries to match and pays its three employees $800, which is the same as their $1000 salary at current apparent inflationary/deflationary rates. At the current AM, the amount that is owed in debt is reduced to $1080 ($360 per person) and the amount owed is lowered to $40. Knowing that the amount of money in the economy has decreased, Fnord Inc. also lowers the price of all of its products by 80% and so our three citizens end up buying their usual goods for only $640 each, paying the $40 in loan payments, and save the remaining $120.

Balance Sheet
Month Apparent Money (per month) Debt Fnord Inc. Jack Alan Tina
Initial $3000 -$1500 $3000 $0 $0 $0
1 $2400 -$1350 $2400 $150 $150 $150
2 $1920 -$960 $1920 $270 $270 $270

Heading into the 3rd month, it’s worth pointing out that the $270 in our citizens’ savings is worth $421.88 at the value of money at Initial. They have made only two deposits, having expected to have saved $150 each month for a total of $300. Because the Apparent Money deflated, they have gained over a month’s extra savings compared the price at which Fnord Inc. is selling products during month 3. Subsequently, they each decide to splurge a bit and not save any money.

Balance Sheet
Month Apparent Money (per month) Debt Fnord Inc. Jack Alan Tina
Initial $3000 -$1500 $3000 $0 $0 $0
1 $2400 -$1350 $2400 $150 $150 $150
2 $1920 -$960 $1920 $270 $270 $270
3 $1824 -$736 $1824 $270 $270 $270

While this might seem mighty odd, in Classical Economics this is how the economy is meant to behave. A business is only able to pay as much as it has made, so if all revenue is less than all expenses, expenses need to be cut. Of course, in the real world, the amount of money being passed around doesn’t change by 80% from month to month and of course generally it inflates rather than deflates. When we save our money, in general day, instead of giving us greater power it becomes worth less and less as the money supply inflates. This encourages us to invest our money rather than save it. But as the money supply inflates, our salary itself drops in purchasing power. We need to get a bump in our salary periodically just to stay even. Using the AM measurement to adjust salary, your salary would grow slightly from month to month in a normal, growth economy.

But of course, sometimes the total quantity of purchases through the economy does drop, and at that point businesses have to cut expenses. In Classical Economics, this is handled by lowering wages, but in the real world it’s often handled by cutting employees as has been pointed out in previous blogs.

Increased Savings Equals People Laid Off

After the recession hit, there was a lot of call for banks and other large institutions to be more spendthrifty. One bank, I remember, had a tradition of throwing a big picnic for all of its employees once a year. The average citizen as well as the government all gave evil glares at this bank because of how wasteful they were being in a recession.

In the terms of Classical Economics, this makes some sort of sense. The true state of the economy has become clouded by various people and organizations doing a poor job of managing money, and so money needs to be withdrawn from those so that money can once again be safely spent on things which are financially sound. But in the terms of the real world, this is simply stupid. When the bank doesn’t throw its picnic, the catering company that was depending on the hundreds of thousands of dollars that it had gotten reliably each year for the last decade suddenly can’t pay any of its employees. They have to lay many or all of them off. Unemployment increases, which means that revenue to banks and all other businesses falls further. With decreasing revenue, but wages stuck at high levels by contracts, minimum wage legislation, etc. there’s no way that a business is going to hire on more workers.

Under the AM price adjustment method, however, as the call to save spreads across the nation and revenue starts to be cut across the market place, the cost of maintaining your employees stays consistent with revenue. Everyone is able to continue working and living, holding their money in savings and even having it gain in value the worse things get. When they are certain that measures have been taken to correct what was wrong with the economy to make customer confidence go down, the carrot of the increased purchasing power of their savings kicks in. They can buy a lot at cheap values, so the instant it seems like the air has cleared, people will want to get back into the market.

Of course, there will be some layoffs. The enterprises that were truly wasteful will be cut. But since corporations are saving their money as well, with those savings increasing in value, these laid off people are comparatively cheap to hire back for fiscally sound ventures.

The one interesting point of the AM adjustment is the treatment of loans. In the model laid out in Tying it all Together (Classical Economics), the amount of money paid back in loans is always equivalent to the amount that was loaned. If we continued to track the scenario of Jack, Alan, and Tina, however, the total amount of money paid to the central bank would not equate to the total loaned. To demonstrate, let’s presume that like month 1 and 2 that the AM deflated by 80% each month:

Balance Sheet
Month Apparent Money Original Debt (adjusted for AM) Owed (adjusted for AM) Remaining Debt (adjusted for AM) Before Payment Remaining Debt (adjusted for AM) After Payment
1 100% -$200 $50 $200 $150
2 80% -$160 $40 $120 $80
3 64% -$128 $32 $64 $32
4 51.2% -$102.40 $25.60 $25.60 $0

Adding the Owed column, the total paid was only $147.60. The AM adjustment scheme creates what I term fundamental money, inflating the economy. Given that all other recession-breaking schemes also create inflation of one sort or the other, this isn’t any particular travesty.

Revisiting Market Bubbles

To revisit the case of Jeff, Tanya, and Berkley that was laid in in Market Bubbles, we’ll show how AM adjustment’s creation of fundamental money solves the standoff created by a collapsing bubble.

1) Tanya borrows $50 from Jeff (the central bank). AM = 100%
2) Tanya buys comic books at above their true value from Berkley for $50. AM = 100%
3) Jeff confiscates comic books and sells them to Berkley for $10. AM = 20%

Since the market has adjusted to the amount that is being spent, down from $50 to $10, the AM has adjusted as well becoming 20%. At 20%, the amount that Tanya owed to Jeff ($50) becomes $10. Tanya has successfully paid off her debt and Jeff considers himself to be fully paid off. He doesn’t have to agonize over tracking down more money. At the same time, the $40 that Berkley has is now worth the equivalent of $200. The bicycle that he wanted to buy cost $120 at old prices. At prices adjusted for the poor economy, it only costs $24. With the $40, he can buy the bicycle that he wanted and go to work at the company that was too far away before.

4) Berkley buys bicycle for $24. AM = 48%

The salary being offered by the time he bicycles over will only be 48% of what it was, but since prices are also 48% of before, that’s perfectly okay. He owes nothing, and since neither Tanya nor Jeff are employed by the business, all of the money that he spent goes back to himself.

5) Berkley receives salary of $24. He spends all of it back on purchases. AM = 48%

If he takes all of his money out of savings and starts spending it, the value of the apparent economy will rise to $40 (80% of the original AM). Until someone goes into debt, it can’t grow any higher than that, so we can say that the market has fully corrected for the bubble. In Classic Economics, it should have corrected all of the way down to $0, but there’s no particular reason that it needs to do that. Ultimately, we left Berkley — who made wise economic decisions — in a pretty position compared to Tanya, who now has nothing. And we did so without stalling the economy.

On the other hand, we let Jeff off easy. He doesn’t have any outstanding debts, so he’s feeling fine to loan again. Of course, he had expected to be able to profit by $20 from Tanya, so in a sense he did lose out. But more importantly, he’s probably not going to loan to anyone trading in comics any more, and really that’s what we want. Ultimately, bubbles will always form and there’s no way to know where they’re going to happen. Plenty of very smart and respected economists thought everything was going fine right up to the moment that the housing crisis broke. You’re better off to fail around it gracefully than to live and breath by “Punish the evildoers!” Figuring out how the bubble happened and making sure it doesn’t happen again is where your attention needs to go. If someone was actually acting nefariously, criminal prosecution is the answer, not trying to milk a stone.

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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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Recession and Deflation

Posted by publius2point0 on 2010/06/05


What is, I believe, a little known fact is that during a recession, the money supply begins to deflate. As you should know from reading Tying it All Together, the amount of money in the land increases when people take out a loan, and shrinks as they pay it back until the true, non-deficit supply of money is achieved. Year-to-year growth in inflation happens because people are continuously taking out more money in loans than they are paying back to the banks. In a recession, however, people stop taking on new debts, and subsequently the only direction of money flow is back into paying off debt, shrinking the total money supply.

What this means in practical terms is that each remaining dollar is worth more. That probably sounds like a good thing to you. The problem, as John Maynard Keynes pointed out is that this means that value of things like labor and products should shrink — for instance, if the money supply has halved, if you were making $40k a year, you should now be making $20k a year — but people are too stupid to realize this and instead of lowering the price of their products or giving their workers a wage decrease, they lay off workers so that they can continue to afford their best workers at the same (but now overvalued) wage. They continue to charge the same price for products, figuring that the market will come back. In a recession, everything freezes as the money supply shrinks, instead of shrinking along with the money supply, which only exacerbates the situation.

A simple solution to this problem is to inflate the money supply directly.

Let’s classify there as being too types of money, fundamental and loaned. In the example given in Tying it All Together, I gave each of our farmers $1.20 to start with, for a total money supply of $120 in the whole land. That sum is our fundamental money supply. All other money is loaned, i.e it exists only as a fiction where we accept money made out of debt as having value.

At any point in time, the amount of money that each individual had could be doubled by simply physically going around and handing them new bills to that extent. If Billy had $10, he now has $20, and if Megan had $50, she now has $100. This can be done without anyone, not the government nor the banks, taking on debt, because the fundamental supply of cash to begin with was entirely arbitrary. The only issue is in maintaining the balance of wealth between entities, as upsetting that could wreak havoc.

Now, presuming that money will naturally flow the same way as it has previous, so that those who are good at amassing money will do so at the same rate as they have before, and those who lose money will similarly do likewise, periodic, small checks mailed around to the general populace will in effect raise the supply of fundamental cash, and wreak havoc because the amount (per person) is so small that it doesn’t unbalance anything to a noticeable extent, and of course it will soon find its way to its ultimate destination via the natural flow of money. By periodically doing this — giving enough time for money to settle — one can maintain or continue to inflate the economy (and devaluing the currency) to maintain a status quo.

There is essentially, no economic downside to this. Prices and wages are able to stay where people expect them to be so that they don’t have to feel like they have to take a pay decrease to get back into the system. The only end result is that if all debts were to be paid off throughout the land, the amount of money that remained after all debts were cleared would be higher.

And of course there is the secondary, potential benefit of sending about checks that the receipt of free money will spur people into getting back into the market and kick-start everything up again sooner.

On the Other Hand

It is worth noting, however, that all of this is predicated on the idea that people don’t and can’t understand deflation. That they don’t is certainly true, but it’s entirely in the province of the President and the Mass Media to inform them. It would be perfectly easy to tell businesses that the dollar is worth more and that, rather than laying off 10% of their work force, that they decrease salaries by 10%. Such a thing would likely also cause businesses to lower prices to match. In return, the amount of money that people had in savings would increase in value and give them motive to get out spending. This is the way the market is supposed to act to recover from a market crash naturally. Making it happen as it is intended may just be a matter of making people aware of what is happening and how it all works.

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