Question about deflation and possible economic scenario

[jerye]

Was just wondering how the economy would function around deflation. Note, I am not talking about BTC denominated in fiat money so we can disregard any BTC/USD fluctuations.

Suppose the world only had bitcoins as its currency, wages are paid in BTC, banks would give out BTC loans, etc. Suppose then that an individual takes a BTC10000 mortgage to buy a house. He works and makes BTC1 per day. Because BTC is deflationary,  his wages would be adjusted annually (in contrast to increasing wages in an inflationary economy) thus his wages next year would be BTC0.99 and so on and so forth. Suppose he has to consume and save some of his income, it becomes extremely difficult if not impossible to repay that loan. Is that scenario something that might happen if the economy was deflationary?

Also suppose a project required a huge sum of BTC, skyscrappers, infrastructure, etc, there would be no lenders cause they would be better off holding on to their BTC and if they charged an interest on the long, the debtor would be unable to pay it back.

Most of my economics professors believe that a deflationary economy is bad because at the margin (and economics is always about the margins) individuals would prefer to save instead of spend. Suppose a 2013 car cost BTC1000. The 2014 model is expected to be BTC900 and the 2015 model is expected to be BTC800. Any rational individual would postpone their purchase indefinitely and thus the auto industry collapses.

When a recession happens, stimulation of the economy can't happen due to the nature of BTC. Is there a reason why deflation might be good?

Reworded my question:

Assumptions:

• No fiat money exist.
• A finite currency such as Bitcoins are used in the economy.
• More goods and services are produced and consumed every period with population growth. This leads to deflation in the prices of goods and services denominated in Bitcoins.
• A utility maximizing credit provider (bank) charges an interest on loans, if not they would be no better off than keeping that available credit under their mattress.

Set up:

• 10 Bitcoins are the only currency that exist. Each divisible by an indefinite amount.
• 3 economies exist: x, y and z.
• x=y's endowment is 2.5 BTC.
• z's endowment is 5 BTC and is the most advanced economy and thus plays the role of the bank.

Now suppose x experienced a huge positive shock in its population numbers, in order to keep up, it now has to build a mega apartment that well exceeds its endowment of 2.5 BTC, in order to do so, it has to obtain a loan from z for 2 BTC. Because z is utility maximising, it charges an interest on the loan of 1% p.a. until it is fully paid. Because more goods and services are being produced worldwide while the currency is finite, deflation in prices happen at 0.5% p.a.. Suppose x now has built its mega apartment, because of deflation, the goods and services x can provide to y and z continues decreasing in prices while the loan it has to repay z continues increasing, how is it possible for x to pay back that sum? Won't they ultimately default?

Just something that I've been thinking about but have not figured it out yet. Would appreciate any comments.

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[Lethn]

In a deflationary economy you wouldn't need to take out loans to buy a house the majority of the time, never mind a loan for 10000, what people who don't understand deflationary economies don't realise is that not only do wages go down etc. but prices of basic commodities as well. This means you can buy more for less work and less, for example at the current rate of exchange I could buy a pretty good house at around 3000 Bitcoins. With that kind of price I won't have to work my whole life and take out a mortgage in order to pay it off if I were to work for the inflated paper money which would cost me around £100,000, that leaves more time to do what I want with my money rather than constantly having to set aside all my life to pay off the mortgage so some banker can get rich off it without doing any work at all.

Deflationary currencies are not as bad neo-keynesians make it out out be and most of the time there are pretty big gaps in their arguments, saving will replace loans if things keep going the way they are and small businesses etc. won't have to take out a loan in order to get started and expand. There's this strange logic used in defence of inflationary currencies as well where economists try to claim that the countries which produce stuff 'need' their money for work so they can consume exports but it makes no sense, because of course if the producing countries ditched the countries that trade for useless paper they'd have more free time and a nice surplus of goods to go with it that they can consume and trade amongst themselves.

[rhinospray]

In a word, according to you, in a deflationary economy wealth is created by time, out of thin air. If you just sit and wait, eventually you become rich. So, really you don't need to work if you don't want.

It's a pity Adam & Eve didn't discover this, by now everybody would be peta-millonaire and could do only the things they want to do, enjoy all the luxuries and a free life, and avoid harsh work.
 
I could spend my time at the beach resort taking the sun and drinking mojitos. And who would bring the mojitos? Easy, another peta-millonaire that enjoys bringing mojitos,  manufactured by peta-millonaires that enjoy fermenting sugar canne, cultivated by peta-millonaires that enjoy working hard at the fields.
 
No I think this is not going to work, not so many masochist peta-millonaires around. But I have an idea!! A robot will bring my mojito, manufactured by robots that process the sugar canne cultivated by robots. That is, SOLVED!

But wait, who is going to build the robot?

You begin to see the flawed logic?

The only reason that you are able to buy a house for 3,000 bitcoins is because you entered your deflationary paradise at let's say a rate of $10/bitcoin.  The deflation from $10/bitcoin to $100/bitcoin is caused by thousand of suckers pouring their $ into your paradise and getting progressively less bitcoins in exchanges. You know, there are many suckers in the inflationary hell, but even so, they are a limited resource. When all the suckers have entered, there is nobody to drive the rate up.

You could buy a little more time of deflation by letting a pool of suckers and make them reproduce at a fast rate, but then Earth is also a limited resource, and eventually you would run out of physical space.

When the last sucker leaves inflationary hell, deflation is gone. The paradise doesn't seems so special to the latest suckers. They only managed to get 0.0000000001 bitcoins because the last rate was $100000000/bitcoin. Of course, you are one of the most wealthy man in the world, and your merit was entering at the beginning. Economic hierarchy based in order of entry.  An ideal platonic world all people wish, right?.

Now, deflation gone, one of the suckers wants a house. To build the house 10 men have to work a year. To make the building materials 2 men have to work a year. To give you the house, the 12 men wants you to pay them a year salary. It seems you will have to work 12 years to pay them. 

So it seems pretty the same than happened in the inflationary hell, the only difference is that you were one of the first to enter this ponzi scheme that managed to redistribute all the wealth in the world, that previously was distributed proportionally to the work, intelligence and luck of each individual or of heir ascendants, by one where the distribution is proportional to the earlier you enter the paradise.  None is ideal, both end producing unjust distributions of wealth, but be sure that the world is not going to buy your plan to fuck them.

So, yes, it is as bad as neo-keynesians (where did you found that word, sure it was not studying economy) make it out and the one that have, not just gaps, but stadium sized holes in your arguments is you.

[Impaler]

rhino, jerye:  Yall should check out Freicoin (see my Sig), its designed to be less deflationary, ideally stable in value.

Economically the problem with deflation is that greatly increases burden of borrowing.  Say your a lender and have 1 BTC that is expected to deflate by 100% in a year, aka double in purchasing power (which historically only a fraction of what BTC has seen).  You lend the coin to Joe-the-Borrower and your so generous you don't even charge him any interest, so Joe spends the coin to buys capital, works hard for a year and makes some products that have an intrinsic value twice that of the capitol he expended.  Joe sells the stuff, but because their has been 100% deflation the stuff that would have sold for 2 coins a year ago now sells for just 1.  Now poor Joe must pay back the loan and despite his high productivity and his ability to double the value before deflation, his work has been for naught because the lender has taken everything.  Or has he?  

You mister lender still have just 1 coin, no better then if you had just kept the coin in your pocket, you haven't earned anything either, next time add some interest so you will be guaranteed a profit, if the lenders refuse you can always just keep the coin.  Oddly enough no one can earn anything unless they can come up with a business that has a higher profitability then the rate of deflation.  The higher the deflation the harder that is too do, Drugs and gambling come to mind as good candidates though, perhaps it would be a good idea to lend to people doing that next time, they might be able to afford to play some interest payments.

[bb113]

In a word, according to you, in a deflationary economy wealth is created by time, out of thin air. If you just sit and wait, eventually you become rich. So, really you don't need to work if you don't want.

I think there has been confusion over adoption of bitcoin and deflation (which is not set to occur for many years, the number of bitcoins is currently increasing). Clearly when people expect deflation they will be more careful in their investments and therefore demand you perform more useful work for less pay. This extra care taken in handing out the currency would encourage increased preservation of real wealth (natural resources) due to decreased waste of this wealth on unsuccessful/wasteful projects.

Oddly enough no one can earn anything unless they can come up with a business that has a higher profitability then the rate of deflation.  

Depending on the rate of deflation this could be a good thing. Once again the price spikes in btc we are currently experiencing are not due to deflation, but due to adoption, or at least speculation about future adoption.

[Impaler]

Deflation is a change in purchasing power of money, it can occur because of a decrease in money supply or an increase in demand for the currency, just because monetary base is increasing dose not mean were not in deflation.  BTC is clearly well into its deflationary and has been from the earliest days of trading at Mt.Gox and has been averaging something like 1000% deflation a year even after eliminating the bubbles, this would easily qualify as for hyper-deflation.

[bb113]

Deflation is a change in purchasing power of money, it can occur because of a decrease in money supply or an increase in demand for the currency, just because monetary base is increasing dose not mean were not in deflation.  BTC is clearly well into its deflationary and has been from the earliest days of trading at Mt.Gox and has been averaging something like 1000% deflation a year even after eliminating the bubbles, this would easily qualify as for hyper-deflation.

Any new cryptocurrency should start with approximately zero purchasing power and will undergo deflation as it becomes more utilized. It seems that deflation during the adoption phase is a necessary part of a successful cryptocurrency and not something to be complained about.

[rhinospray]

Any new cryptocurrency should start with approximately zero purchasing power and will undergo deflation as it becomes more utilized. It seems that deflation during the adoption phase is a necessary part of a successful cryptocurrency and not something to be complained about.

I have been playing with a design for a cryptocurrency that does not have those problems. Later this evening when I have time I will post my basic proposal for discussion

[johnyj]

Was just wondering how the economy would function around deflation. Note, I am not talking about BTC denominated in fiat money so we can disregard any BTC/USD fluctuations.

Suppose the world only had bitcoins as its currency, wages are paid in BTC, banks would give out BTC loans, etc. Suppose then that an individual takes a BTC10000 mortgage to buy a house. He works and makes BTC1 per day. Because BTC is deflationary,  his wages would be adjusted annually (in contrast to increasing wages in an inflationary economy) thus his wages next year would be BTC0.99 and so on and so forth. Suppose he has to consume and save some of his income, it becomes extremely difficult if not impossible to repay that loan. Is that scenario something that might happen if the economy was deflationary?

Also suppose a project required a huge sum of BTC, skyscrappers, infrastructure, etc, there would be no lenders cause they would be better off holding on to their BTC and if they charged an interest on the long, the debtor would be unable to pay it back.

Most of my economics professors believe that a deflationary economy is bad because at the margin (and economics is always about the margins) individuals would prefer to save instead of spend. Suppose a 2013 car cost BTC1000. The 2014 model is expected to be BTC900 and the 2015 model is expected to be BTC800. Any rational individual would postpone their purchase indefinitely and thus the auto industry collapses.

When a recession happens, stimulation of the economy can't happen due to the nature of BTC. Is there a reason why deflation might be good?

Today's auto industry is rely on loan based consumption, if you suddenly change to a saving based consumption, it will collapse for sure

But what if it relys on saving based consumption from the beginning? There will be no recession. That's the whole point of having an honest money. Debt based money will always cause recession due to mis-allocation of resource

People should not buy cars with the money they might earn from future income, and when their future income suddenly becomes uncertain, the auto industry collapses, that is what happened in reality

[rayt5]

One difference is people will almost certainly spend less money, and because of this the economy will probably be smaller in real terms. On the other hand, even though everyone would be poorer, it might be safer and more equitable. But I think everyone would end up with less because there's little incentive to invest your money in productive ventures if it appreciates in value by doing nothing.

http://en.wikipedia.org/wiki/Paradox_of_thrift

[justusranvier]

I used to hate these repetitive threads about deflation, but then I just started looking at them as a way to identify trolls to add to my ignore list so now they no longer bother me.

[rhinospray]

I used to hate these repetitive threads about deflation, but then I just started looking at them as a way to identify trolls to add to my ignore list so now they no longer bother me.

Funny, from wikipedia:

In Internet slang, a troll (pron.: /ˈtroʊl/, /ˈtrɒl/) is someone who posts inflammatory,[1] extraneous, or off-topic messages in an online community, such as a forum, chat room, or blog, with the primary intent of provoking readers into an emotional response[2] or of otherwise disrupting normal on-topic discussion.

Damm! I fed the troll. 

[nybble41]

In a word, according to you, in a deflationary economy wealth is created by time, out of thin air. If you just sit and wait, eventually you become rich. So, really you don't need to work if you don't want.

You are reversing cause and effect. With a fixed money supply, as Bitcoin will have in the long-term, price deflation is a consequence of wealth being created. The economy is growing while the supply of money remains constant, ergo the purchasing power of each unit of money increases. If the economy were not growing then you would have inflation, not deflation.

It's not exactly "just sit and wait", either. In order to gain purchasing power from deflation you have to hold currency, meaning that you earned currency in the past and are choosing to defer consumption. If this sounds familiar, it should; it's exactly like receiving interest on a loan or a return from an index fund. You have contributed to the general economic growth by putting more into the economy than you've taken out; your reward for that investment is that your currency grows more valuable over time.

When economists talk about the problems with deflation they're generally alluding to the Great Depression. The problem with that example is that it happens to be one of the only cases where there was a significant correlation between deflation and economic stagnation. Where deflation has occurred elsewhere, it has not generally been accompanied by any economic problems. What makes the Great Depression different is that the deflation was the result of a major decrease in the effective currency supply due to the runs on the banks and the consequent sudden increase in reserve requirements. Basically, the economic system was rotten to begin with, with liabilities far exceeding actual deposits, and the deflation and economic problems were both symptoms of that underlying rot being exposed. The deflation didn't cause the Depression; the collapse of the banking system caused both.

The other aspect of deflation that sometimes causes concern is that no one will invest in anything which loses money in nominal terms, even if the net purchasing power increases. With inflation you're more likely to see a nominal increase. The problem with that reasoning is that an investment which loses money in nominal terms in a deflationary economy with a fixed money supply is necessarily providing a below-average return; putting money into such an investment would decrease overall economic growth. In a word, it would be malinvestment. The same thing happens when the currency supply is deliberately manipulated to cause inflation, but in that case the necessary price signals aren't available, and thus malinvestment is practically guaranteed. (You would have to adjust for changes in the money supply--not price inflation--to determine whether the investment was a net gain.)

[niko]

Was just wondering how the economy would function around deflation. Note, I am not talking about BTC denominated in fiat money so we can disregard any BTC/USD fluctuations.

Suppose the world only had bitcoins as its currency, wages are paid in BTC, banks would give out BTC loans, etc. Suppose then that an individual takes a BTC10000 mortgage to buy a house. He works and makes BTC1 per day. Because BTC is deflationary,  his wages would be adjusted annually (in contrast to increasing wages in an inflationary economy) thus his wages next year would be BTC0.99 and so on and so forth. Suppose he has to consume and save some of his income, it becomes extremely difficult if not impossible to repay that loan. Is that scenario something that might happen if the economy was deflationary?

Also suppose a project required a huge sum of BTC, skyscrappers, infrastructure, etc, there would be no lenders cause they would be better off holding on to their BTC and if they charged an interest on the long, the debtor would be unable to pay it back.

Most of my economics professors believe that a deflationary economy is bad because at the margin (and economics is always about the margins) individuals would prefer to save instead of spend. Suppose a 2013 car cost BTC1000. The 2014 model is expected to be BTC900 and the 2015 model is expected to be BTC800. Any rational individual would postpone their purchase indefinitely and thus the auto industry collapses.

When a recession happens, stimulation of the economy can't happen due to the nature of BTC. Is there a reason why deflation might be good?

In many places, for most of the history, people were (or still are) living and building houses without taking loans with interest.
Examples: you could work, trade, and save enough for a house. Note, as long as economy is growing, so is the purchasing power of your coins. You could inherit part or all of the savings, or a house for that matter. You could get a house for free from the government. You could rent forever. Etc. Etc.

[nybble41]

Most of my economics professors believe that a deflationary economy is bad because at the margin (and economics is always about the margins) individuals would prefer to save instead of spend. Suppose a 2013 car cost BTC1000. The 2014 model is expected to be BTC900 and the 2015 model is expected to be BTC800. Any rational individual would postpone their purchase indefinitely and thus the auto industry collapses.

There are cases where postponing a purchase may make sense, but it isn't as simple as saying that constantly decreasing prices lead to indefinitely postponement and economic collapse. Presumably you're considering buying a car now because you have an immediate need for transportation. If you don't buy the car now then you'll need to find an alternative form of transportation. If the alternative costs more than BTC100, it makes sense to buy now rather than wait.

This is similar to the electronics industry. Despite general price inflation, ever since consumer electronics were first introduced there has been strong expectation that you will always be able to get a better device at a lower price if you are willing to wait a while. However, people still buy electronics, and the industry has not collapsed. A $100 good which you can use now is sometimes preferable to an otherwise identical $90 good which you won't be able to use for a year.

[Impaler]

The other aspect of deflation that sometimes causes concern is that no one will invest in anything which loses money in nominal terms, even if the net purchasing power increases. With inflation you're more likely to see a nominal increase. The problem with that reasoning is that an investment which loses money in nominal terms in a deflationary economy with a fixed money supply is necessarily providing a below-average return; putting money into such an investment would decrease overall economic growth. In a word, it would be malinvestment. The same thing happens when the currency supply is deliberately manipulated to cause inflation, but in that case the necessary price signals aren't available, and thus malinvestment is practically guaranteed. (You would have to adjust for changes in the money supply--not price inflation--to determine whether the investment was a net gain.)

Your confusing holding of money with investing, In any economy the only investments that will be funded are those that can make a nominal profit (X currency in, >X currency out), the holding of money always acts a cut-off for what gets funded but that floor can be well above (or below) the level ware an investment is actually productive in a material sense. 

In a deflationary economy investments that ARE actually productive in a intrinsic material value are financially unprofitable.  Say we plant one bag of corn and harvest 9 bags a year later, a 900% increase in real value, but if money is worth 10x more because of deflation it would have been more profitable to just pocket the money and not grow anything.  So in deflation under-investment is guaranteed. 

Now don't think that society will just magically 'discover' enough super-productive investments that can beat the deflation rate.  At any time all possible investments are something like a pyramid, a few highly productive, many more that are slightly productive, and Huge numbers of unproductive ones.  Deflation dose not change the inherent productivity of investments, it just cuts off a the moderately productive investments from being performed. 

This is the logical inverse of the argument that Inflation can cause malinvestment, because it lowers the 'floor' such that some investments look profitable even when destructive (consuming more value then they produce).  The correct monetary system is the one which puts the investment floor at the break-even point between productive and destructive investments, and for that to happen the money should be stable.

[johnyj]

And don't think that there will be either inflative currency or deflative currency, they will co-exist and suite different people's needs. You can spend the inflative and save the deflative

[jerye]

I used to hate these repetitive threads about deflation, but then I just started looking at them as a way to identify trolls to add to my ignore list so now they no longer bother me.

I'm sorry that you think that. I reworded my question to better reflect the puzzling situation I am trying to comprehend.

[justusranvier]

I used to hate these repetitive threads about deflation, but then I just started looking at them as a way to identify trolls to add to my ignore list so now they no longer bother me.

I'm sorry that you think that. I reworded my question to better reflect the puzzling situation I am trying to comprehend.

I wasn't talking about you, although I can see how that might not have been obvious from my post.

[nybble41]

In any economy the only investments that will be funded are those that can make a nominal profit (X currency in, >X currency out), the holding of money always acts a cut-off for what gets funded but that floor can be well above (or below) the level ware an investment is actually productive in a material sense.

Yes, we agree up to this point.

In a deflationary economy investments that ARE actually productive in a intrinsic material value are financially unprofitable.  Say we plant one bag of corn and harvest 9 bags a year later, a 900% increase in real value, but if money is worth 10x more because of deflation it would have been more profitable to just pocket the money and not grow anything.  So in deflation under-investment is guaranteed.

You're saying that any venture which results in an increase in real value is a good investment, which ignores opportunity cost. An investment with a 900% increase in real value is a bad investment if there is an alternative which would generate a 1000% increase.

Now don't think that society will just magically 'discover' enough super-productive investments that can beat the deflation rate.  At any time all possible investments are something like a pyramid, a few highly productive, many more that are slightly productive, and Huge numbers of unproductive ones.  Deflation dose not change the inherent productivity of investments, it just cuts off a the moderately productive investments from being performed.

I agree that deflation has no effect on "inherent productivity", but these "moderately productive" investments are actually destructive, not productive, because resources expended on them take away from even more productive investments. Thanks to prior saving, there is a certain amount of surplus available to be expended on various investments. If you hold on to your money, that surplus is available to be used by existing ventures, with an expected return equal to the rate of deflation. If you invest your money in a venture with a lower real rate of return, that portion of the surplus is no longer available to be used by the ventures with higher returns. The opportunity cost is thus greater than the expected return.

This is the logical inverse of the argument that Inflation can cause malinvestment, because it lowers the 'floor' such that some investments look profitable even when destructive (consuming more value then they produce).

Ah, but (price) inflation doesn't cause malinvestment. A money supply which is manipulated to cause inflation results in malinvestment. Assuming a fixed money supply, inflation signals that existing investments are averaging a negative real return. The correct response in this case is to cut back on consumption--a natural side effect of the rising prices--and look for new investments. If inflation is costing you 2% per year in real value, an investment which only loses 1% annually is a good investment (assuming you can't find anything better) and will actually bring up the average return.

If the inflation is due to manipulation, however, rather than negative economic growth, then that 1% loss may look good to an individual investor faced with a 2% loss to inflation, but it will bring down the average for the economy as a whole and reduce economy growth.

The correct monetary system is the one which puts the investment floor at the break-even point between productive and destructive investments, and for that to happen the money should be stable.

On this point I think we are in perfect agreement, though our interpretations of "productive investments" and "stable money" differ. I define "stable money" as money with a stable supply, i.e. free from manipulation in favor of inflation or deflation.