The Economic Libertarian

I recently posted an article about the Effects of Inflation and Deflation, and I focused on the question of who is benefited and who is pained by each. My analysis was of course not a complete breakdown of everyone benefited and pained by an episode of change in the value of money. There is always the question of what effects the government has. For instance, during an inflationary event, whoever the government pays first will be most benefited. This is a fertile grounds for a discussion on another date; today I am posting the continuation and explaining the effects of changes in monetary value on how we look at the future.

For the second area of this question is less easily understood, and this is the matter of economic calculation. This is the reason why banks become afraid to loan money when inflation concerns become significant. When it is hard to judge what the value of money will be in the future, people seek to do the less risky side of the action. If inflation is suspected, then everyone wants to be a borrower and nobody wishes to be a creditor. If deflation is suspected, then everyone wishes to be a creditor and nobody wishes to be a borrower. It is important to specify that the chief cause of imbalance here is not the existence of inflation or deflation. Year on year deflation encourages savings, and year on year inflation discourages them, these things remain true. Yet the source of the imbalance is the uncertainty. If there is 2% inflation every single year, then banks simply charge 2% over their intended rate of profit. If there is 0% inflation every single year, then banks charge their intended rate of profit. If there is 2% deflation every single year, then banks will charge 2% under their intended rate of profit. This last is because the deflation itself will be causing the value of the debt to appreciate. To the bank, the debt is an asset.

However, when one is not sure whether there will be 5% inflation or 50%, one doesn’t know where to set that price. Do you charge 5% over your intended rate of profit, or 50%? If you charge 50% over and you are right about the inflation rate, then you have done well. But if you charge 50% over and the actual inflation rate is beneath that, then few people will likely have been willing to pay such exorbitant rates, and you will have sat on the money uselessly (or even lost money due to staffing and other costs). If you charge 5% over and you are right about the inflation rate, then you will have done well. But if you charge 5% over and the actual inflation rate is above that, then you will have definitely lost money! This is the economic calculation problem. It is still exactly the same if the deflation of money is at issue. For a bank to charge the wrong interest rate will always mean (at best) less profit than they could otherwise have acquired.

Similar concerns exist for other businesses as well, of course. Indeed it exists for everyone. When the price of money is stable, or at least predictable in its movement, it is much easier to plan for the future one way the other.

Yet I explained that deflation is less dangerous than inflation, and I will reiterate it once more. The reason is that a dip into deflation would encourage saving and the gathering of cash instead of its consumption. This would in turn stimulate the production and maintenance of capital goods, lengthening our nation’s capital structure and leading to economic growth that is actually stable. There would be short-term chaos due to economic calculation issues, and short-term chaos due to businesses with debt-financing (but I repeat myself; that’s an economic calculation issue as well). Yet if the deflation became a persistent thing then it could not be blamed for any further troubles that may result. Year on year deflation should not be accused of causing depressed economies. Other sources must be sought to understand such problems.

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Fears of deflation are tremendously overstated. A persistent mild deflation would not be harmful. A stronger deflation would not be a catastrophe. Massive inflation is a more present danger than massive deflation; massive inflation is not only more likely but it would be harder to recover from than massive deflation. Neither situation is desirable. Persistence in monetary status is more desirable than either, and a persistent rate of change counts as persistence as surely as would absolute stability.

It must be understood that the oft-stated ‘chaotic consequences’ of inflation and deflation come in two forms.  The first form is the question of who benefits directly from them and who is pained by them, while the second form is an economic calculation problem.  I will address the question of who benefits first; it is the simpler of the two. The economic calculation problem will be addressed in a future post.

Holders of assets benefit from deflation and are harmed by inflation.  If you are holding a thousand dollars in cash, and there is 2% deflation, those thousand dollars are worth 2% more than they were before.  The same is true for all assets one possesses.  If you have stocks, they are worth 2% more than they would have been without the deflation (which might not be the same as being worth 2% more than they were, stocks being what they are).  Even your car is worth 2% more than it would’ve been, although it’s pretty sure to have lost value anyways.  Cars are fast-depreciating assets.  Finally, if someone owes you a thousand dollars at the start of the year and pays you at the end of the year, the debt at the end of the year will be 1020 dollars (effectively).  Therefore those who control assets are benefitted by deflation.  All of these things are reversed if there is inflation; the thousand dollars, the stocks, the car, and the debt you hold against someone else all lose value from what they would have had.

Holders of debts are harmed by deflation and benefit from inflation.  If you buy a house for $200,000 and there is 2% deflation that year, the debt will increase by $4,000.  If you are going into business and you fund your start with debt, that debt will become more onerous if there is deflation.  If you buy a car or use your credit card too much, these too will escalate in cost over time due to deflation.  Therefore debtors are harmed by deflation.  All of these things are reversed if there is inflation; the $200,000 house debt becomes effectively a debt for $196,000 from one year’s 2% inflation.  Although it bears noting that banks try to take account of inflation (and their own profit) by using interest, and that excessive or unpredictable inflation makes banks entirely afraid to offer loans.

There is one other, less often addressed arena in which some group directly benefits or is harmed by changes in the value of money and the way it changes incentives in favor of saving and holding assets.  Provisioners of staples are benefitted from deflation.  Provisioners of luxuries are harmed by deflation.  Staple goods are ones that must be consumed at regular intervals.  The desire to save money is not going to make a family go without toilet paper; deflation is often stated as something that will reduce the demand for consumer goods and that is true, but only for frivolous consumer goods.  People will still need to eat and they will still require certain consumer goods at regular intervals.  This is not going to increase sales of these goods.  However, the increased saving is not simply going to pool in people’s mattresses.  That money will go to capital goods, and thusly to lengthening the capital structure of the economy.  In what areas will it lengthen most?  It will lengthen most in staples.  Companies who provide staples will find investment sources more willing to deal with them, while companies which provide frivolities will find investment sources less willing to deal with them.  This effect is indirect but I propose it is nevertheless stronger than commonly held.

Now that we have addressed this, deflation looks different from how it looked when we began, and different from the common view. We see that the modern credit card economy and general policies of debt-financing in large organizations are severely hindered by deflation, and in that extent deflation would indeed cause chaos. However, we might notice if we are alert to the procession of cause and effect, that deflation is not strictly harmful per se. It encourages savings and discourages consumption, which in turn should promote economic stability and capital formation.

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An often overlooked aspect of economic growth is that it encourages market niches. There are some products for which there is always a market of one form or another; everyone must eat, after all. However there are many products for which there is only a market if the market at large is sufficiently wealthy. This is most prominently true in entertainment and leisure. Everyone wants entertainment, but if you have a small poor town in the middle of nowhere you won’t be hosting an opera house. Even if everyone in town loved the opera poverty can stand in the way. Worse though is if not everyone loves the entertainment. Many a small town in poor areas that I have seen have had a bar and/or a restaurant, plus a gas station and its meager stock, for the local acquisition of entertainment. Even this is a wild abundance compared to many periods in human history. By today’s standards it is a distinctive scarcity of entertainment.

The problem isn’t necessarily that it is bad entertainment. The half-rack of bestselling books and movies at the gas station may have earned their way onto the bestseller list. I don’t know, I don’t think I’ve ever read a bestseller, but millions of people seem to enjoy them. The restaurant may offer world-class food. Don’t laugh, small town hole-in-the-wall restaurants are still some of the best food experiencse I’ve ever had, and I’ve been to some pretty high-end restaurants in the cities. The problem is that people have a wide variety of tastes. Small town vendors have to appeal to the majority in all but the richest of small towns. They simply can’t afford to carry something for everyone.

Two things can change this. The first one is more or less universally understood. This one is population density and transportation, which I am grouping together under the term convenience. When there are more people in the ‘operating radius’ of a business, when that business is convenient to more people, it can profitably carry products that appeal to smaller portions of the market. A store specializing (for instance) doesn’t appeal to the majority of the people who live in a region. It doesn’t need to. It only needs to appeal to enough people. I’ve never seen a small town with a boardgame store, but in cities they aren’t that hard to find.

The second one is the actual point of this essay. As wealth increases, niche markets can be supported by fewer people. Everyone knows that rich people can indulge in their idiosyncracies. The eccentric wealthy are practically an archetype. What most people don’t realize though is that this effect also applies to those who aren’t what we commonly think of as “wealthy”. In areas of high population density, a small increase in wealth can translate to a large increase in interest in niche products. Large, that is, from the point of view of those who would distribute such items.

The wealthier an area is, the less convenience it needs to support niche products*. If it were dense with prosperity, a small town could support a boardgame store – or an opera house! When one acts on the scale of a city, where convenience already exists to benefit merchants, small changes can be huge statistically. As a city gets richer, new and stranger products become available. That’s one of the things I look forward to as an influence to bring us farther into the future. It is not merely that we need more technology, but economic growth itself means that more and stranger technologies can be brought profitably to market.

*The flip side of this is that the poorer an area is, the more convenience it needs to support niche products. This is part of the effect that creates cities in the first place. People crowd into populated areas to take advantage of goods and services that they can’t get at home, which makes it profitable to offer new goods and services, which attracts more people… et cetera until new people do not contribute enough new income to the city’s merchantry to encourage the offering of new goods and services!

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