Deflationary race to the bottom
Apr. 18th, 2013 09:43 am![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
davvIn the vein of the standard quip that anybody who defends himself in court has a fool as a client, I'm tempted to say that anybody who produces theories on economic matters he stands to benefit from (or lose greatly from) is also a fool -- for the same reason.
And then I turn around and do just that, although this is more theoretical than most.
Say you have a world where exchange between units of value is frictionless, so you can change from one to another at your desire. In this world, people would move their money to the units that deflate the most, so that the money they hold will appreciate as quickly as possible.
However, this causes a severe problem. Because this unit has won the competition in being as deflationary as possible, people are loath to actually use the money for anything. The cost of a good is not just the face value cost, as it were; the cost is also the appreciation that is lost as a consequence of being down that amount of money. Thus, people will hoard the unit. This will cause a slowdown of the economy until it is no longer possible to keep the appreciation going. The ultimate consequence is that the economy stops working, and the unit of value, well, loses its value in short order.
(After this happens, the severely undervalued unit could then spur investment again and the cycle repeats.)
If I'm right about the race, that means that frictionless currency exchange (with perfect liquidity) contains in itself a contradiction, and we would be better without it. It also sets sharp limits to what an uncompelled currency can actually do. If some unit X is not deflationary, people will prefer a unit Y that is, and it has no way of compelling people to disregard that. And so we do, indeed, have a problem.
Ultimately, this is an observation about externality with respect to currency exchange. A participant making use of an inflationary or static unit makes trade easier for everybody else (by keeping the economy working), but it is in every participant's rational self-interest to move to a more deflationary unit.
And then I turn around and do just that, although this is more theoretical than most.
Say you have a world where exchange between units of value is frictionless, so you can change from one to another at your desire. In this world, people would move their money to the units that deflate the most, so that the money they hold will appreciate as quickly as possible.
However, this causes a severe problem. Because this unit has won the competition in being as deflationary as possible, people are loath to actually use the money for anything. The cost of a good is not just the face value cost, as it were; the cost is also the appreciation that is lost as a consequence of being down that amount of money. Thus, people will hoard the unit. This will cause a slowdown of the economy until it is no longer possible to keep the appreciation going. The ultimate consequence is that the economy stops working, and the unit of value, well, loses its value in short order.
(After this happens, the severely undervalued unit could then spur investment again and the cycle repeats.)
If I'm right about the race, that means that frictionless currency exchange (with perfect liquidity) contains in itself a contradiction, and we would be better without it. It also sets sharp limits to what an uncompelled currency can actually do. If some unit X is not deflationary, people will prefer a unit Y that is, and it has no way of compelling people to disregard that. And so we do, indeed, have a problem.
Ultimately, this is an observation about externality with respect to currency exchange. A participant making use of an inflationary or static unit makes trade easier for everybody else (by keeping the economy working), but it is in every participant's rational self-interest to move to a more deflationary unit.