Titolo

Seven Myths. Nay: Seven Follies (II)

4 commenti (espandi tutti)

If one assumes that the naive consumer expects his savings to be constant in nominal value (put under the mattress) then an inflationary environment advises to purchase durable goods out of savings while a deflationary environment advises to postpone.

Agree. Which is the case considered, in fact (I say "The deflation scaremongers, at this point, can only argue that households keep billions of hundred-dollar bills under their mattresses: they do not, but someone else does thanks to the policy BB&Co have enacted (more on this later). Etc ..."). I agree that that is the incentive, but unless people literally keep money under the mattress, which they do not, saving will turn into investment IF and WHEN the financial system functions, i.e. if and when banks lend. Should that be the case, you have the following: demand for consumption decreases and demand for productive investment increases, in a deflationary environment, leading to a change in relative prices. If the banks do not lend we have the problem. But the problem is the banks, not deflation, which is what I argue.

There is one other argument used by (moderate) inflation advocates that is missing in your post, unless I missed it.  Especially in period of crisis, but actually always, there is need to adjust salaries up and down according to demand, productivity, competition, etc.

Agree as well. I mentioned that too, but only in passing. Reason is that, right now, very few people if any argue the problem is that real wage are too high (but maybe it is, why not?) and should be reduced via inflation. I frankly doubt the problem to be too high real wages as, apparently, the whole mess originated with the fact that nominal wages were too low relative to the price of houses and the size of mortgages, so people stopped paying the mortgages. Put differently, measured in units of houses, real wages were too low. Now they have increased (prices of houses down, nominal incomes roughly constant). Hence, a general inflation in goods (not accompanied by inflation in nominal incomes) would reduce real wages when measured in goods other than houses. Is this what is needed? Maybe, but I cannot see the logic though.

In any case, the real problem is: assume you get inflation. How do you prevent nominal incomes from adjusting and nominal interest rates to do the same, leading to the inflationary spiral? That, to me, is the issue.  Thanks.

If I understand well the underlying hypotheses of the article are the following (in chronological order):
1)    deflation (whatever the cause) lowers consumption, which in turn gives rise to higher savings.
2)    the financial system works as it should.
3)    savings and investments go hand in hand (unless the consumer put his savings under his bed).

If all the above hypotheses are correct then the conclusion is that lower consumption expenditure is compensated by higher investment expenditure. Deflation is not an issue!

But since the financial system is in a shambles, we need to put the financial system back to work: “fix the financial system and that’s it”.

Hypothesis 1 (H1) is not controversial.
I agree that H2 is part of the problem but what to do about it is the most challenging task. 
However, I totally disagree with H3. It is a leap of faith to assume that higher savings automatically translate into higher investments. Firms do not invest simply because money is abundant on the capital markets (which is a necessary condition by the way) or cheap (which is the current situation). Firms plan their investments if they foresee new opportunities. I don’t see how firms can be optimistic in a deflationary environment and how banks should be enthusiast about lending when opportunities are scarce.

However, I totally disagree with H3. It is a leap of faith to assume that higher savings automatically translate into higher investments. Firms do not invest simply because money is abundant on the capital markets (which is a necessary condition by the way) or cheap (which is the current situation). Firms plan their investments if they foresee new opportunities. I don’t see how firms can be optimistic in a deflationary environment and how banks should be enthusiast about lending when opportunities are scarce.

Francesco, thanks. Your observation goes to the core of the problem, so let me anticipate some stuff I was planning to discuss in the future and try discussing the important issues you raise.

Your main point is correct, in the sense that firms' demand for investment may be particularly low due to expectations of a low demand for their goods. In fact, this is certainly the case in the construction sector and related sectors. It is also the case for various durable goods, cars in particular, which is why we have entered a recession. I would like to make clear that THIS fact I accept: we are in a recession for the reasons we all know. Recession means, among other things, that a number of firms will close or scale down and factors of production will have to find different activities to be invested in. I am not trying to deny this fact, I agree.

The issue is: does low inflation or deflation make the recession worse? That is less obvious. On the one hand, I agree, it may lower demand for consumption and increase savings, the effect of which I discuss below. You point to a second effect: firms may decide to postpone investments or cancel them altogether because deflation leads consumers to postpone demand that would be there otherwise. This I doubt, because deflation does not mean also lower selling prices but also lower costs of production. Hence we are back to the argument developed in the main text. As I said, theoretically there are circumstances in which this may happen ("bad expectational equilibrium") and if we are in one of those (rare) situations then fine, you are correct.

As I am suggesting, I also have that doubt and I believe there is an expectational problem. But, then, the problem becomes: how do we turn around those expectations? On the one hand, historical experience does not suggest this happens all that often nor it shows that, when it happens, it takes the form of a dramatic downward spiral. On the other hand, do we really believe that setting the fed funds rate to zero will reverse those expectations? For the reasons I said in the main text, I doubt this is the case. Again, if the issue is "expectations", then we should be focusing on the causes of these negative expectations, which current policy does not seem to be doing. Policy seems to focus only on deflation and seems also to be creating furthe panic of a "deflation spiral", which is insane. Because the prices of a large number of assets dropped and because the prices of many goods were too high (due to prices of assets that were too high) some prices will have to drop. Hence, lower inflation or mild deflation is unavoidable, and even healthy I would say. The problem, as I argue below, is to funnel savings/investments to the production of goods that people want to buy at profitable prices. If there is an expectational problem, it is there!

Now, let's get to the saving that deflation "creates" and see if this is damaging. Also here, I agree with you that the problem is: are financial markets, i.e. banks, working properly? The answer seems to be: no, they are not. But then, again, the problem is banks and financial markets hence, we should ask again, does the zero fed funds rate help to make banks work properly? Is deflation the reason banks are not working properly? Asset deflation certainly IS one reason, but that has already happened and there is nothing we can do with it: if it had not happened there would be no crisis to begin with ...

Back to saving. Saving by households must turn into investment or public demand for goods, unless either households keep their saving in form of fiat money stashed at home - of which there is no evidence so far (i.e. there is no evidence that the amount of outstanding cash is dropping and that people are withdrawing cash from banks to keep it home) - or banks stop lending and pile up excess reserves - which is instead what is happening. Short of this, there is no alternative.

Income that is not saved must either be left in the bank, as a deposit, or turned into some financial instrument. This either increases the demand for Treasury securities or that for private securities. In the first case households' saving is financing public expenditure, which is demand for goods and services. In the second case the households are providing firms directly with funds, which either leads to an increase in the stock prices (if households buy stocks directly, which does not seem to be a massive phenomenon these days) or makes it easier for firms to raise debt. Now, obviously, it is possible that firms do not use these resources and just pile up cash without spending it. But, again, I do not believe there is any evidence that this is the case. Will get back to this in future myths.

Further, and more important: the recession is due to the fact that lots of PREVIOUS investments have gone wrong, hence they were wasted. That's why we are all poorer than we (thought we) were and that's why there is a recession. Those wrong investments, are bygones, they are lost. In order to grow again we MUST invest in new activities, hopefully in activities that will produce goods people would like to buy at reasonable prices, not houses that nobody wants. Do we agree on this?

If we agree on these two points (i.e. (1) a piece of the old K is worthless, so productive capital is now K'<<K; and, (2) we need to build up new and better capital to produce new goods) then saving is useful and necessary because we need resources to finance these new and better investments. I agree that, for those investments to take place, new firms must be born or old firms must find products that people like. Nobody has the magic wand here, so nobody know WHICH goods will be worth producing. What is certain is that, IF someone finds those goods and believes it is the case to invest to produce them, this someone will need funds, i.e. savings. Further, whoever is trying to purchase these goods and carry out these investments will look at deflation with mixed feelings. On the one hand, it is true, it may lower the market price of the goods they are selling but, on the other, it makes the land they purchase and the equipment and materials they need cheaper. It is not obvious that, overall, the final effect will be negative: it depends upon which prices will drop more or grow less. Again, deflation per-se is not the problem for these people, the change in relative prices and the availability of savings that can be invested is. That's the way I see it.

Those wrong investments, are bygones, they are lost. In order to grow again we MUST invest in new activities, hopefully in activities that will produce goods people would like to buy at reasonable prices, not houses that nobody wants. Do we agree on this?

I definitively agree on those two points.

Further, whoever is trying to purchase these goods and carry out these investments will look at deflation with mixed feelings. On the one hand, it is true, it may lower the market price of the goods they are selling but, on the other, it makes the land they purchase and the equipment and materials they need cheaper. It is not obvious that, overall, the final effect will be negative: it depends upon which prices will drop more or grow less. Again, deflation per-se is not the problem for these people, the change in relative prices and the availability of savings that can be invested is. That's the way I see it.

I think that in a recession deflation and inflation have not the same consequences.
It seems that we agree on the psychological side of the story: with deflation consumers hold their fire, spend less and save more. This worsens the recession. Now  let us concentrate on firms. You say that under deflation firms face two opposing effects: a) lower output prices,  and b) lower input prices. I totally agree. On average, and without considering the varying degree of competition in those markets, there are winners and losers. But, I add, the overall cash flows stays the same  whether deflation or inflation (because of recession cash flow is of course lower than in a boom). So the average effect of deflation (or inflation) on firms’ expenditure should be neutral at best. But here is the catch, there are rigidities and anomalies in the system that make deflation a haunting presence during a recession. First anomaly: salaries and wage are less flexible than prices, so during a deflation output and input prices decline but not the price of the most important input of all, labour. Thus understood, cash flows during a deflation shrink most often than not (this does not happen with inflation). Second anomaly, both consumers and firms have debt, with a significant part that is fixed. Deflation makes debt more expensive if interest rates are fixed (e.g., 25% of mortgages and 100% of the US corporate bond index by the now defunct Lehman Bros), while it has a neutral effect at best for those debts with floating and adjustable interest rates. So deflation had another negative dimension. A dissenter would say that debtors’ losses are exactly compensated by creditors’ gains. But here we have another catch, while the total credit in the system matches the total amount of debts (for now I assume that the international investment position of the economy is zero) creditors are more concentrated or less dispersed than debtors, making the depressing effect on debt more widespread than the galvanizing effect on fewer creditors.

To sum up,
1) with deflation the screwed up psychology of  consumers depresses their consumption expenditure and gives an option value to their wait-and-see posture. But we have more savings and higher real wages, with less employment because of recession.
2) with deflation there are winners and losers among firms, the overall effect of deflation in term of cash flow is neutral at best. But deflation and wage rigidities make more likely a negative effect on cash flows, at least for a while. This is less likely in the US than in Europe, but still wage rigidities matter.
3) with deflation, debts with fixed interest rates (which is not a trifling amount) become more expensive, with a further depressing effect on top of the ongoing recession. Even if total liabilities equal total assets, debtors are more numerous than creditors (i.e., assets are more concentrated).

In the best case scenario deflation/inflation should not matter. In the worst case scenario, deflation depresses the recession even further. Why to risk then? 

And so far neither Phillips curves nor adaptive expectations have been taken into account. My feeling is that deflation is not the mirror image of inflation for psychological and balance sheet reasons. Deflation+recession hurts more than inflation+recession.