Tuesday, February 17, 2009

More on inflationary and deflationary expectations

Now, in a prior posting I mentioned the fact that economic cycles naturally lead to creation and destruction of money via the normal actions of bank lending. That is, in an up cycle with inflationary expectations, banks lend money and reduce their cash reserves (reserve ratio), which in turn creates money via the action of fractional reserve banking (lower reserve ratio = more money in the economy, going from 15% to 10% reserve ratio increases the money supply by 150%). Banks expect that lending money will create much profit for them, and thus lend money. They have inflationary expectations -- i.e., that in the future the money they have in their vaults will be worth less, so they might as well lend it out now. Potential borrowers also have inflationary expectations -- they see themselves as having higher income in the future and see that any money they have now will be worth less in the future, so they spend money they've previously saved (thereby reducing the effective reserve ratio and increasing the money supply) and furthermore they might as well borrow money now and pay it off with tomorrow's higher income. By having inflationary expectations, they make it happen -- the money supply is inflated.

Now let's contrast with today's cycle. Banks have deflationary expectations -- they believe that their money will be worth more in the future than what they can get by lending it out now in a down economy, thus they don't lend. Similarly, borrowers have deflationary expectations -- they believe they will have lower incomes in the future, so they don't spend money or borrow money, they save it instead. If they save it in the bank, the bank isn't lending it out so they're increasing the reserve ratio and thus deflating the currency. If they store it under their mattress, the money is no longer in circulation buying goods and services so again they're deflating the currency.

All of this is not some vast conspiracy. All of this falls out of the entire concept of fractional reserve lending. The money supply inflates as banks lend, until people are all borrowed out and start defaulting on loans. Banks slam the brakes on lending then because they have deflationary expectations, which then causes people to have trouble buying stuff like cars and houses, which in turn causes lost jobs which cause other people to have deflationary expectations. Sans government intervention, the usual result in the past was massive transfer of assets from the middle class (the debtor class) to the upper class (the investor class, which bought the assets of the middle class at bankruptcy or foreclosure auction for pennies on the dollar), and then years of misery as the now-impoverished populace tries to survive despite there being no jobs or anything. The only reason the nation survived this cycle prior to government intervention was because of two factors -- first, massive gold and silver strikes resulted in re-inflation of the money supply at critical junctures (this back in the days when gold and silver were used as money), which then led to inflationary expectations and the resumption of bank lending and borrowing which in turn reduced the effective reserve ratio and re-inflated the money supply even further, and secondly, the US was largely a nation of farmers prior to the 1900's and farmers could simply wait out the downturn -- they weren't going to starve to death, and their capital equipment wasn't going to decay to uselessness in the few years before the next big gold or silver strike re-inflated the currency and caused inflationary expectations once more.

Nowdays, money isn't gold or silver and the money supply can't get re-inflated simply by a gold strike happening. Instead, money has to be printed and re-injected into the economy in a way such that it gets circulated rather than just disappearing under a mattress or into a bank vault where it does nobody any good (see my previous mattress money discussions). Even buying gold or silver bullion gets the money back into the economy, so if you want to buy gold or silver coins and stash them under your mattress, there is no macroeconomic bad effect -- you're not hurting the economy in any way, indeed, by increasing the incomes of gold and silver traders who then increase the incomes of salesmen who sell you this stuff over the phone and so on and so forth, you're helping the economy. Now, on the microeconomic side buying gold or silver right now is a bone-headed move because the whole point of buying commodities is to buy low, sell high, and if you buy now you're buying high and will probably end up selling low in the future, but from a macroeconomic point of view buying gold or silver isn't hurting the economy (assuming there is not a shortage of gold for use in the electronics industry and elsewhere due to your actions). Of course, there's the downside that any offers you find to sell gold or silver to you are probably scams, but that's another story entirely, and will be addressed in "You can 't eat gold, Part III" at some point in the future...

-- Badtux the Economics Penguin

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