75. Deflation Is Peril.

Deflation Is Peril.
Bob Komives
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When Economists see that the borrower will pay more for getting what she wants one month early, and the lender will let her have it provided she compensates him for the month that he will not have access to her payment, they say that time has value. The interest tacked onto the loan by the lender compensates him for that value. The interest paid by the borrower demonstrates the better-now-than later value for her. As the value of time goes up, interest rates go up. With higher interest rates, more people see value in lending, but fewer see value in borrowing. Reduced interest rates have the opposite effect. This simple description correctly portrays the dynamics of loans from the points of view of lender and borrower. Interest reflects the value of time and dynamically regulates the amount of borrowing.

From the perspective of the overall economy, interest serves a different but compatible function. To see that, we must return to the marketplace.

Imagine a simple marketplace with many participants who have businesses of equal size. The marketplace expands ten percent per year. Every participant, anticipating continuing success, borrows money at ten percent interest. Suppose that the borrowing exactly equals the total of money in circulation. Further suppose that the government did such a good job last year that it has a holiday this year. It will neither spend nor mint nor lend more money. Finally, suppose that all borrowers succeed in increasing their production ten percent as they had promised.

Everyone is happy at first; wealth has expanded ten percent. However, when it comes time to pay there is a financial crisis! Money has become scarce. People cannot find enough money to pay back their loans. Deflation sets in. Prices go down about nine percent as buyers now find much more to buy for every coin they hold. More than ten percent of the debtors lose the battle over scarce money and declare bankruptcy.

While the economy and everyone in it had done what was promised, the financial structure failed. It had not pumped in a ten percent increase in money so that monetary expansion could faithfully parallel economic expansion.

Deflation is peril to the monetary system. From the perspective of the overall monetary economy, we charge interest on loans to create financial pressure to expand the money supply --to prevent deflation. The interest attached to a loan is a purchase order from the real economy to the money economy requesting more money.

Keynesian economics recognizes the role of interest rates as seen from the perspective of borrower and lender. Raise interest rates and people will tend to borrow less. Lower interest rates and they will borrow more. Such financial manipulation works from time to time, but the practice ignores an economic current running in the opposite direction.

Higher interest rates may discourage investment, but their real purpose is to discourage only unproductive investment while accommodating a surge in production caused by a period of successful investment. This is a big difference. While the economy would charge higher interest when good investment presents a danger of deflation, economists have wanted to raise interest rates when there is a danger of inflation. Is it any wonder that national banks find their inflation-fighting and recession-fighting tasks difficult?

In my imaginary example of a simple but expanding marketplace interest fails to prevent deflation and bankruptcy because my assumptions do not allow it. That is not the real world. A national government that is not on vacation can infuse an economy with needed cash by minting and spending money. However, the public need to spend and the private ability to make productive investments do not necessarily coincide. A national government needs another way to get money directly into the private investment market. Typically, through some kind of central bank, government infuses more money by becoming a lender. In U.S. America the Federal Reserve and Treasury lend to private banks that invest in the expanding economy. Through direct investment and indirect lending the federal government avoids the peril of deflation.

:: Bob Komives, Fort Collins © 2006 :: Plum Local IV :: 75. Deflation Is Peril.  ::
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