Help me understand deflation scenario (of fiat)

[bracek]

I like to think that I understand the (hyper)inflationary scenario that
could happen because of money printing, and how that would be "prefered" because it
is better environment for tax collection.
But that is exactly my problem,
I can't see how or why there is deflation scenario possible
if nothing else, because of ever increasing volumes of currencies.
Is deflation possible at this point in time and with todays circumtances ?
Who and how can withdraw that kind of volume from circulation ?

I found very little information on these questions :
How precious metals perform in deflation ?
Do they preserve purchasing power ?

If PM-s double price this year - sell half or hold ?
If PM-s double purchasing power this year - sell or hold ?

what to use next for wealth preservation, after PM-s bubble burst ?

What must happen for FED to increase interest rates ?
Would it be just a political decision or they "must" wait for something in economy ?

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[Revalin]

Is deflation possible at this point in time and with todays circumtances ?
Who and how can withdraw that kind of volume from circulation ?

If people perceive that the currency will be more valuable in the future they will tend to hoard it.  That reduces the amount in active circulation, thus increasing purchasing power and decreasing prices - IE, the currency's value goes up.  People see that and perceive that it will continue in the future, creating a feedback loop.  This cycle can be broken by carefully increasing the money supply but overdoing it can cause a crash, especially if it has been deflating for some time.

This is currently happening in cycles with Bitcoins (issuance cannot be increased), it was happening until recently with gold (issuance is limited by miners' ability to ramp up; I'm not in metals so I won't say if it's done or not), and it can easily happen to any fiat currency.

I'll leave the rest of your questions to the metals guys.

[Revalin]

Oh, I forgot to mention fractional reserve banking.  This is where actual deflation (instead of just increasing value) happens.

In most countries the majority of fiat is not issued directly.  Instead it is created through debt - as debt grows, the money supply grows, and the inverse.

During inflation (value loss) it is advantageous to borrow money (worth a lot now) and pay it back later (when it is worth less).  Generally interest rates are higher than the inflation rate, so it's not a free ride, but inflation partially subsidizes your loan.

During deflation your money is worth comparatively little now but it will be worth more in the future - so if you can you pay down your loans now (when money is easy to get), and have less debt load when money is more valuable (requires more work to get) in the future.

Since debt is money, everyone paying down their debt decreases the money supply - and thus causes self-reinforcing deflation.

[BubbleBoy]

Prices actually going down all across the economy is an extremely rare phenomenon. It might had happen 100 years ago, in the age of precious metals, but people nowadays don't realistically expect prices to go down, and they don't "hoard" money in order to buy more stuff later. You might see it in some asset classes, say real estate, but not enough to cause a generalized and significant price drop in the whole economy.

What actually happens when deflationary expectations set in is not really a drop in prices, but a sharp drop in the velocity of money. It's intuitive: if the total monetary mass changes hands half often than it used to, the total economic output of the economy halves, even if prices stay the same. Because of the lower aggregate consumption, businesses start failing and credit becomes scarce. Mass unemployment and underemployment ensues. People start to consider themselves "lucky" to have a job at all, setting in motion the recessionary feedback loop: households and business defer consumption and investment because they anticipate "hard times" ahead, and holding onto their savings, preferably in the most liquid form possible, becomes an issue of survival. This reduces velocity further, in a self-fulfilling prophecy.

It important to underline that people don't deffer consumption for the sake of speculation, i.e "money will be worth more in the future". Most economic agents are risk averse and they hoard money to ensure continuity and survival, not to seek future profit. That's why simply injecting liquidity (preventing price deflation thus denying the future profit) does not solve the economic crisis. As governments around the world grudgingly start to realize, economic recovery is an issue of confidence, pure and simple. Unlike inflation, you can't manufacture confidence in the printing press - you need good policies and credible leaders.

[bracek]

money velocity
sounds very reasonable, thanx,

I could not articulate that by myself, but i understand the concept

it was a pleasure reading above posts

[DeathAndTaxes]

In theory the perfect monetary policy (if you think you are god and can control an economy) would be 0% price inflation/deflaiton.  The money supply grows at same rate as the underlying economy and in aggregate prices remain the same.  $20 today would buy one ounce of gold just as it did 100 years ago.

Central banks tend to be wary of deflation because it is a far more difficult cycle to break.    Inflation can be easily controlled via interest rates.  Deflation not so much.  Due to that risk Central banks tend to hedge their bets (in theory) on a target of consistent modest price inflation to give them a buffer against a deflationary cycle.

Personally I think modern economies are far to complex for Central Banks to control via monetary policy and it is just a fools errand but they keep trying.

[johnyj]

Prices actually going down all across the economy is an extremely rare phenomenon. It might had happen 100 years ago, in the age of precious metals, but people nowadays don't realistically expect prices to go down, and they don't "hoard" money in order to buy more stuff later. You might see it in some asset classes, say real estate, but not enough to cause a generalized and significant price drop in the whole economy.

What actually happens when deflationary expectations set in is not really a drop in prices, but a sharp drop in the velocity of money. It's intuitive: if the total monetary mass changes hands half often than it used to, the total economic output of the economy halves, even if prices stay the same. Because of the lower aggregate consumption, businesses start failing and credit becomes scarce. Mass unemployment and underemployment ensues. People start to consider themselves "lucky" to have a job at all, setting in motion the recessionary feedback loop: households and business defer consumption and investment because they anticipate "hard times" ahead, and holding onto their savings, preferably in the most liquid form possible, becomes an issue of survival. This reduces velocity further, in a self-fulfilling prophecy.

It important to underline that people don't deffer consumption for the sake of speculation, i.e "money will be worth more in the future". Most economic agents are risk averse and they hoard money to ensure continuity and survival, not to seek future profit. That's why simply injecting liquidity (preventing price deflation thus denying the future profit) does not solve the economic crisis. As governments around the world grudgingly start to realize, economic recovery is an issue of confidence, pure and simple. Unlike inflation, you can't manufacture confidence in the printing press - you need good policies and credible leaders.

Good point!

And , the deflation/inflation is not happening everywhere at the same time to everybody,  especially with today's production model, some of enterprises can sit on tons of cash while others might be suffering long unemployment, commodities can have fast price rise while IT products keeps drop in price

So the current "one size fit all" monetary policy (e.g. either easing or tightening from top to bottom), when it solve problem in one part of the system, it will create problem in another part of the system. If the new money flow can directly injected into certain area which needed money most, then the whole situation can be controlled with much more flexibility and efficiency, and the regain of confidence is much quicker

For example, instead of inject money to buying underwater mortgage assets and save banks, put the money to jobless insurance program and ensure all the jobless people will have at least 10 years of jobless insurance, then the total consumption power of the nation will not change by too much, thus the economy will be easier to back on track

Someone might argue that these money will just be consumed and not generate any profit but that is a misconception, these money will surely generate profit for many enterprises which sold their products to those jobless people. It does not matter HOW money enter the system, but it does matter WHERE it enter the system

[molecular]

And , the deflation/inflation is not happening everywhere at the same time to everybody,  especially with today's production model, some of enterprises can sit on tons of cash while others might be suffering long unemployment, commodities can have fast price rise while IT products keeps drop in price

So the current "one size fit all" monetary policy (e.g. either easing or tightening from top to bottom), when it solve problem in one part of the system, it will create problem in another part of the system. If the new money flow can directly injected into certain area which needed money most, then the whole situation can be controlled with much more flexibility and efficiency, and the regain of confidence is much quicker

For example, instead of inject money to buying underwater mortgage assets and save banks, put the money to jobless insurance program and ensure all the jobless people will have at least 10 years of jobless insurance, then the total consumption power of the nation will not change by too much, thus the economy will be easier to back on track

Someone might argue that these money will just be consumed and not generate any profit but that is a misconception, these money will surely generate profit for many enterprises which sold their products to those jobless people. It does not matter HOW money enter the system, but it does matter WHERE it enter the system

You make a very good point!

This is precisely why an aggregated view of the economy (like looking at GDP) says nothing (or at least not much) about the health of that economy. The GDP might grow, but what's growing might be all the wrong stuff (crassest example: the GDP growth coming from running a war, which is not producing wealth, but destroying it).

I think this is a huge chunk of what's wrong with current monetary policies around the world. The policy-makers are actually blind as to the state of the economy they are trying to regulate. They're blindly pumping money into the economy (trusting some greed-driven criminal private investment bankers to decide where to put it) and then pointing to a 1% increase in GDP, saying: "everything on track, no need to worry, choose our party again next election".
The economy itself sees its price-finding mechanisms totally distorted by the cheap money injections all over the place and doesn't function properly and as a result misallocates resources.

The humongeous capital misallocations this produces will have to be cleaned out at some point. The longer it takes, the more hurtful this will be. A deflation will probably do the job just fine. After that it's probably hyperinflation, then new sound money (currency competition, bitcoin ftw!). Ergo my investment advice: during the possibly coming deflation, when you need cash, don't sell all your bitcoins.

[johnyj]

Another significant reason of deflation is the technology advance. It's not hard to imagine, at an extremely high tech level, robot will replace most of the human work, and that will dramatically reduce most of the people's income if today's "income based on work" model still used. Reduced income will surely cause deflation

[DeathAndTaxes]

Another significant reason of deflation is the technology advance. It's not hard to imagine, at an extremely high tech level, robot will replace most of the human work, and that will dramatically reduce most of the people's income if today's "income based on work" model still used. Reduced income will surely cause deflation

+1

Sadly given how little humans have evolved I think automation will lead to massive poverty rather than a post-scarcity utopia that it possible.

An interesting piece of fiction:
http://marshallbrain.com/manna1.htm

[realnowhereman]

Another significant reason of deflation is the technology advance. It's not hard to imagine, at an extremely high tech level, robot will replace most of the human work, and that will dramatically reduce most of the people's income if today's "income based on work" model still used. Reduced income will surely cause deflation

Actually, automation increases average productivity which increases average wage.

It used to take an army of people to farm a field; now it takes one guy and a tractor.  Those excess people are (over time) free to be productive elsewhere in the economy.

More production over the same number of people is higher GDP per capita, which is higher wages.

(I know, I know, I don't understand just how advanced these robots are going to be...)

[DeathAndTaxes]

Well slavery reduces wages to nothing (well minus the cost of maintaining the slave).

If I have robots which can build robots why would I pay you a wage?  As long as my slaves robotic workers can produce more revenue then they cost in upkeep then I have no need for paying wages.   Of course initially robots wouldn't be able to do everything but they will displace workers.  If those workers retrain to do the jobs that robots can't do then supply of available labor has increased relative to demand and wages fall not rise.

A modern day example:
You know one industry which employs massive R&D into improving automation?   The fast food industry.  It may seem counter-intuitive but labor makes up roughly 1/3 of the cost in fast food and is really the only component that can be reduced.  It now takes less than 30% of the workers to produce the same amount of meals compared to 20 years ago.  Obviously adjusted for inflation wages in the fast food industry have tripled to compensate right?

Automation increase WEALTH but wealth doesn't have to be passed on in the form of higher wagers.  It can simply mean more for the ownership class.  Wages are merely the price of labor.  If there is excess labor relative to demand then wages fall not rise.  Automation, robotics, exert systems, nanotechnology has the potential to displace massive numbers of workers. 

BTW I am not a socialist I own two franchises and that automation improvement has benefited me personally however I am able to look forward 50 or 100 years and see disruptions.

[realnowhereman]

Well slavery reduces wages to nothing (well minus the cost of maintaining the slave).

Slavery is not a good example; economic forces are suspended under slavery (well they aren't, they can't be; but the incentives are so skewed that we can't compare that situation to robotic automation).  Here's Ludwig von Mises from Human Action on why slavery is always doomed to failure:

The price paid for the purchase of a slave is determined by the net yield expected from his employment…just as the price paid for a cow is determined by the net yield expected from its utilization. The owner of a slave does not pocket a specific revenue. For him there is no "exploitation" boon derived from the fact that the slave's work is not remunerated…. If one treats men like cattle, one cannot squeeze out of them more than cattle-like performances. But it then becomes significant that man is physically weaker than oxen and horses, and that feeding and guarding a slave is, in proportion to the performance to be reaped, more expensive than feeding and guarding cattle…. If one asks from an unfree laborer human performances, one must provide him with specifically human inducements. If the employer aims at obtaining products which in quality and quantity excel those whose production can be extorted by the whip, he must interest the toiler in the yield of his contribution. Instead of punishing laziness and sloth, he must reward diligence, skill, and eagerness.… It is this fact that has made all systems of compulsory labor disappear.

If I have robots which can build robots why would I pay you a wage?  As long as my slaves robotic workers can produce more revenue then they cost in upkeep then I have no need for paying wages.   Of course initially robots wouldn't be able to do everything but they will displace workers.  If those workers retrain to do the jobs that robots can't do then supply of available labor has increased relative to demand and wages fall not rise.

Quite right.  That's why I look around and see that everyone has less money; lower wages and a worse life than before invented the car, farm equipment, production lines, the computer, the washing machine, the cooker, email, and fishing nets.

A modern day example:
You know one industry which employs massive R&D into improving automation?   The fast food industry.  It may seem counter-intuitive but labor makes up roughly 1/3 of the cost in fast food and is really the only component that can be reduced.  It now takes less than 30% of the workers to produce the same amount of meals compared to 20 years ago.  Obviously adjusted for inflation wages in the fast food industry have tripled to compensate right?

I can't speak to fast food wages; but I would be very interested to see a plot of the wages over that 20 years.  Also, there is no reason to suppose the wages of those that remain would triple to compensate -- we can't say without first finding what the displaced people went to do (remember wages are determined by what an alternative employer will pay).  We can say that the increased automation will have definitely have increased wages by some amount across the whole economy since GDP per capita went up.

Your logic is the same cry that has gone up after every single technological advance throughout all time.  Do I know what those displaced people will do?  No, but all the evidence of history is that they find something to do and we all get richer because of it.

Here's a question: when everyone has no job and wealth is concentrated in the hands of the few -- what will these robots be manufacturing/servicing?  No one will be able to afford their output.  Therefore, there will be no incentive to automate more.  As with all economics, the truth is that the two competing pressures will come to a balance.

[johnyj]

Here's a question: when everyone has no job and wealth is concentrated in the hands of the few -- what will these robots be manufacturing/servicing?  No one will be able to afford their output.  Therefore, there will be no incentive to automate more.  As with all economics, the truth is that the two competing pressures will come to a balance.

Good question. After each technology advance, there will be a period of high unemployment, until the structure change in society bring those jobless people back to work. These structure change never went easy and quick

Actually there is always a immediate way to re-balance: Reduce the working time

At10x higher productivity, the working time could be reduced to 1/10 of today, but still keep the same income. But today's model limited such possibility, those who have the work can not reduce their working time thus create more job opportunities for others, since they have already been fully occupied and if they stop work and get less paid, they will not be able to payback their mortgage. BTW, in the progress of productivity increasing, it is always the company and investor get the benefit, the workers will never get double paid if he double the efficiency

Take Nordic country for example, they have very high income tax for high income people, and redistribute the money into social welfare, thus keep the balance, but since they are mostly export based country, I don't know if this method works for all countries

[Haplo]

I think it would be relevant to point out that mechanization of factories actually produced a lot of jobs and put people to work anyway. The main reasons people get laid off today are:

1. Loss of consumer trust. Consumers are feeling the effects of the big banks stealing everything from everyone, and are not willing to discretionary spend. No spending = no business.

2. Loss of normal bank lending services. With the credit crunch and everything going greek, banks are stingy about lending, especially shadow banks and the small banks which support small business. No loans means less business can be done.

3. Other government programs such as the healthcare bill which make it difficult or expensive to hire and/or keep employees.

Nothing to do with advanced technology or even an overabundance of labor. Labor shortage is the natural state of any economy.

Also, "deflation" really doesn't apply to what's occurring in USD and EUR. There may be some price deflation as people spend less and less or as they withdraw funds from the market, however the primary trend is inflation, which at least as far as the US goes is coming back to greet us as soon as China, India and Russia are successful at killing the petrodollar. Right now most USD are floating around the world being used as "reserve currency" to buy oil. Basically, instead of prices going up in the US from our inflation, prices go up everywhere else. Eventually people will get sick of it and send us our dollars back, and poof $10 for a gallon of gas, $15 for a big mac meal.

Unfortunately, since most of the big governments are working together to manipulate the situation, there's not really a whole lot you can do except opt out of contaminated markets.

[realnowhereman]

Here's a question: when everyone has no job and wealth is concentrated in the hands of the few -- what will these robots be manufacturing/servicing?  No one will be able to afford their output.  Therefore, there will be no incentive to automate more.  As with all economics, the truth is that the two competing pressures will come to a balance.

Good question. After each technology advance, there will be a period of high unemployment, until the structure change in society bring those jobless people back to work. These structure change never went easy and quick

Actually there is always a immediate way to re-balance: Reduce the working time

All agreed; it was a rhetorical question.  I was trying to convince DeathAndTaxes that automation can't possibly continue to destroy all jobs in the way he outlines -- there is no incentive for a producer to carry on automating when his business is failing because his customer base vanishes.

Yours is an excellent point; I had forgotten that as an option.  It's quite conceivable that as robots take over more and more, that we get paid the same for fewer and fewer hours of work -- since one man with an army of robots can produce as much in an hour as an army of men in an hour.  Won't that be lovely?

Historically it has never happened of course.  There always seems to be new jobs for the displaced (once the job market adapts; I think the Austrian school differs from Keynesians in not viewing all workers as interchangable units -- and it is that more than anything else that gives rise to recessions)

[johnyj]

Imagine an island with 2 people and one market

A capture 2 fishes per day and B pick 2 baskets of fruits per day, and sell all their products to market in exchange of 1 shell per fish/fruits. And each of them consume 1 fish and 1 baskets of fruits, thus they earned 2 shells and spend 2 shells each day, total money supply is 4 shells

After both A and B's production efficiency increased, A can produce 4 fishes per day and B can product 4 baskets of fruits per day, now fishes and fruits will be abundant, and the sell price will drop due to insufficient money supply (only 4 shells chase 8 products), this is deflation, and money supply must also double to counter the effect

But even the money supply doubled, there is another problem: Both A and B can not consume that much products, they still need only 1 fish and 1 basket of fruits per day, so market will trash the extra fishes/fruits and keep the best half of fishes and fruits for sell for double the purchase price

If the quality of products are already very high, the best solution to avoid waste is that they still produce 2 fishes and 2 baskets of fruits per day using half the time, and take vacation for the rest of the day
 
So, with increased productivity, either the quality of life increased, or the working hour reduced, even both. This is an ideal situation and long term sustainable, but unfortunately the real world is far from perfection, the productivity difference exists everywhere, and today's society is based on a top-down pyramid structure, lot's of imbalances

[johnyj]

It's quite conceivable that as robots take over more and more, that we get paid the same for fewer and fewer hours of work -- since one man with an army of robots can produce as much in an hour as an army of men in an hour.  Won't that be lovely?

Historically it has never happened of course.  There always seems to be new jobs for the displaced (once the job market adapts; I think the Austrian school differs from Keynesians in not viewing all workers as interchangable units -- and it is that more than anything else that gives rise to recessions)

Actually if you look at Nordic countries, it is already happening, I think they work only 10 month per year, with some politicians even promote 6 hours of working per day.

But again, due to they are export based countries, their high output brings them enough income. IMO it is still a pyramid model (one rich people serve lots of other people thus make lots of money), if every country will take their approach, they might not be able to export that much

Take island example, if A's productivity increased by 4X, and B's productivity kept the same, A have 2 options:
1. A will work only 2 hours per day

2. A use that extra 6 hours to produce B's products and compete with B

In reality, the second option is more likely to be selected, and this will in turn result in the worsening of B's profitability, and since now A can produce B's products, the island really do not have the need for B, B will struggle to survive since he can not be self-sufficient by only produce one product

This scenario happens especially between countries. Between country A and B, there will always be custom tax or similar measurements to stop A from flooding the market with mass scale produced products

Can USA ask chinese people to work less per day so that they do not put so much pressure on the consumable goods thus create more jobs for USA? No, because it is the USA company actually designed those products and produce them in china and ship back, and those USA companies are profit driven, e.g. work as much as possible to please the investor

[BubbleBoy]

If one asks from an unfree laborer human performances, one must provide him with specifically human inducements. If the employer aims at obtaining products which in quality and quantity excel those whose production can be extorted by the whip, he must interest the toiler in the yield of his contribution. Instead of punishing laziness and sloth, he must reward diligence, skill, and eagerness.… It is this fact that has made all systems of compulsory labor disappear.

Sorry for the off-topic, but whoever believes the free market is somehow naturally inclined to reject slavery is a blithering idiot that knows very little about the principles of "human action". Coerced human slaves will absolutely and unequivocally produce economic goods that far surpass those supplied by animal or robotic laborers. Think about prostitution, think about scientists coerced by totalitarian regimes, think about human organs, to name but a few.

If I could buy you guys on the market, I would coerce you to solve captchas for 3$ an hour. That's a healthy 300$ a week/person. A 20 slave workshop would generate 50.000$/year minus expenses. I would select the biggest and strongest among you to guard the rest and whip you when you fail to meet your quota or the error rate is too high. How exactly would the free market undermine my system ?

[realnowhereman]

Sorry for the off-topic, but whoever believes the free market is somehow naturally inclined to reject slavery is a blithering idiot that knows very little about the principles of "human action".

The argument goes (I believe), that the slave will produce more when it is for his own benefit than when it is for his "owner's" benefit.  Therefore it would be worthwhile for him to "rent" himself from his owner for, say $5 an hour, and earn $10 an hour for himself elsewhere.  That difference is enough to eventually allow the slave to purchase themselves from their owner.

That's just a simplification of it; but it contains the economic argument: slavery is inefficient.  More production occurs when people own themselves and are rewarded for their work.

I believe the further argument is that America's civil war was not the most efficient way to end slavery.  Since 600,000 (excuse me if the numbers are wrong, this is from memory) people died in the war, it would have been cheaper for the federal government to simply purchase all the slaves and set them free.

Coerced human slaves will absolutely and unequivocally produce economic goods that far surpass those supplied by animal or robotic laborers. Think about prostitution, think about scientists coerced by totalitarian regimes, think about human organs, to name but a few.

I think you're making the wrong comparison here.  The question is not "does a slave produce more than a robot?" it's "does a slave produce more than a freeman?"

If I could buy you guys on the market, I would coerce you to solve captchas for 3$ an hour. That's a healthy 300$ a week/person. A 20 slave workshop would generate 50.000$/year minus expenses. I would select the biggest and strongest among you to guard the rest and whip you when you fail to meet your quota or the error rate is too high. How exactly would the free market undermine my system ?

Who can say?  The freemarket creates a lot of stuff that we don't predict.

Your system is generating $300 a week/per person from 20 people.  Let's say I take a different 20 people and pay them a good wage.  I pay them a good wage to work as, say, architects, doing creative work that could not be done if they were unhappy or constantly beaten.  I'll get $300 an hour from them.

It's a contrived example; but it's perfectly valid: your 20 slaves will have a set of skills that could be exercised more profitably at different places in the economy when they are free than when they are slaves.  That means they are worth more free, than not.  The free market will see to it that over a number of years, you will be driven out of business because of your inefficient use of resources.

I don't say that I'm right, I'm merely repeating the argument as I understand it.  And I do find it convincing -- slavery has vanished all around the world; and only the USA needed a civil war to sort it out (and there were alternatives as mentioned above).  To me, that's strong evidence that slavery inherently doesn't work.