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Source link: http://archive.mises.org/8413/is-deleveraging-bad-for-the-economy/

Is Deleveraging Bad for the Economy?

August 20, 2008 by

For most commentators, a major threat to the US economy is that banks are curtailing their expansion of credit in order to improve their net worth and hence solvency. This, it is argued, sets in motion a vicious process that leads to asset-price deflation, which for a given value of liabilities actually weakens banks’ net worth and makes them less solvent. In fact, by adjusting their balance sheets to the facts of reality, banks actually set up a process that permits sustained economic growth. FULL ARTICLE


Tim Kern August 20, 2008 at 9:02 am

Brilliant and concise. Thank you, Frank Shostak.

Matthew August 20, 2008 at 9:31 am

“If we have two bakers and each of them has saved nine loaves of bread, collectively we cannot have less then eighteen loaves of bread saved as the paradox of thrift implies.”

Could someone explain how the paradox of thrift implies that they collectively have less than eighteen loaves? I don’t understand the paradox of thrift well enough to see that.

Michael A. Clem August 20, 2008 at 10:14 am

Well, basically, the Paradox of Thrift states that if everybody saved more money, this would cause a deflation of monetary prices of assets(prices would go down), and thus, the banks would be poorer. But as Shostak pointed out, real wealth is in goods, not money, and the amount of goods wouldn’t change because of monetary savings. So, no, people would not be poorer overall, there would just be changes in monetary pricing.

Also note again that people don’t demand money to hold it, as such, but rather to use it in an exchange. Even if prices are going down, it doesn’t follow that people will start hoarding money
I guess I’m just not understanding ‘demand for money’. Some people who talk about it act like an increased demand for money is just about asking for and getting more money to spend. But only beggars and the Fed can do that–the rest of us can only get more money by earning it or borrowing it. So is that what they’re talking about? Borrowing more money? I had thought that ‘demand for money’ was about how much money people decided to hold instead of spending.

Matthew August 20, 2008 at 10:28 am

Michael A. Clem:

So to clarify the Paradox of Thrift issue, it says that as the bakers save more loaves of bread, it causes their prices to go down in monetary terms, and since prices (not real savings) are what’s important to those who subscribe to the PoT, you somehow end up with less than 18 loaves, as measured by prices?

Regarding demand for money, my interpretation of his meaning in the article is that the only purpose of money qua money is to spend it, i.e. use it as a medium of exchange. Ignoring things like the aesthetic beauty of gold coins, one does not acquire money for the purpose of holding it. A profit-seeking person will either exchange the money for something that has consumption utility, like a loaf of bread, or he will loan the money to obtain more of it later. The only time one acquires money (ideally) is if he intends to exchange it for something else in the near future.

JIMB August 20, 2008 at 11:47 am

I don’t agree that holding money balances is different than saving. The economic actor has chosen to store their unconsumed surplus in money, which is, economically speaking, non-specific title to goods.

While this correction needs to happen, it should not be made worse by a systemic collapse of debt-money. Nor should it be made worse by regulations that lock up credit or cause greater uncertainty of payment or collateral (suspension of foreclosure, etc).

A significant improvement would be the authorities immediately remonetizing gold and distributing gold to banks as reserves replacing a portion of their treasury holdings. The gold should also be made redeemable on demand at market prices against existing deposits so that individuals can then hold gold “at their bank” and be assured of a sound asset should the authorities decide to inflate (they are definitely not inflating – contrary to a lot of articles here on Mises.org).

The authorities need to allow a substantial number of entities to fail and step in only to support a smaller number that reasonably can make it to sustain the debt-money pyramid. Unfortunately, debt money backed (ultimately) by treasuries means corrections become a political question, not one of market-based discipline. But that is the system we have right now …

re: By putting the money under the mattress, an individual doesn’t engage in an act of saving he is just exercising a demand for money.

Donald Lingerfelt August 20, 2008 at 12:02 pm

Dear Dr. Shostak,

I must say that I enjoyed your article today very much. You have a way of breaking down the issues to their basic tenets, making them understandable to everyone. I have been reading the article on Mises.org now for over 10 years and you are one of my very favorite writers. Thank you.

Jake August 20, 2008 at 1:30 pm

Thank you Mr. Shostak. As usual, another great and educational article.

To Michael Clem:

I speak under correction but my understanding of the “demand for money” is this.

Money is a commodity and as such, it is subject to the dynamics of supply and demand.

When the supply of money exceeds the demand for it (inflation), then the value of money will fall and prices will rise accordingly.

When the demand for money exceeds the supply thereof (deflation), then the value of money will increase and prices will fall accordingly.

The easiest way for me to visualize this is by thinking of an old balance scale. I imagine, for example, that one Krugerrand in the left hand bowl = 10 metal Dollars in the right hand bowl. (yes…just imagine that :-) )

Add 10 dollars to the right bowl and the bowl will drop. This represents the value of money decreasing with inflation and the bowl with the Krugerrand rising, representing rising prices.

Logically, the opposite happens when you now suddenly remove 15 dollars from the bowl of twenty, which represents deflation.

This is also the way I believe it works under the regime of Central Banks. They either tend to overshoot or undershoot. They never reach the equilibrium of price stability which they claim they have to achieve.

That’s why we can do without them. The market will remain closest to the balance point of the supply and demand of money.

Marek Kosecky August 20, 2008 at 4:13 pm

Thank you Mr. Shostak, another excellent article!

Without fiat currency/paper money, any savings is expressed by accumulation of some liquid commodity or stock of goods. However, in fractional reserve banking, it is possible to buy and push price up for one commodity, e.g. oil, without having to sell and at the same time push price down of another commodity. This is only possible because paper money created out of thin air is intruduced in economy. Without fiat currency, some of us speculators would see opportunity to sell oil and to buy cheap the commodity which is being sold by those buyers of oil.

I believe we will depart from fractional reserve banking at some point in our life :-)

Has any fellow reader tried to come up with some practical solution on how to do it ?

I doubt FED chairmans all around the world can simply stand out and admit the banking system is based on irrational principals, whereby money is created by banks out of thin air and not by savings. The chaos would be unprecedent.

I guess somehow turning banks overnight into institutions similar to mutual funds might help. Shares in these funds would serve Store of Value function of money at least for some time. Some popular commodity could be used as a Measure of Value, it will be anyway up to market participants to decide if it is going to be gold, barrel of oil, megaWatt, …

I believe we do not necessarilly need to use one medium to serve all functions of money.

Michael A. Clem August 20, 2008 at 4:16 pm

Money is a commodity and as such, it is subject to the dynamics of supply and demand.
Oh, I already used that in another thread post. ;-)
The main purpose of money is as a medium of exchange. No problem. People want money so they can use it to exchange for other goods. But money is also used by people as a store of value. They want to purchase goods at some point, but would rather save that money so that it can be spent in the future, not now. Would not both of these constitute a demand for money?

Dick Fox August 20, 2008 at 4:49 pm

Thank you for the article. It does make one think. I may have more comments on the substance after I have digested it.

My only comment for now is that it drives me crazy when people misuse the terms inflation and deflation. Mises went so far as to not use these terms because their meaning had been so distorted as to be meaningless. Using the terms for anything other than the value of money distorts meaning and discussion.

There is no such thing as “asset-price deflation.” Now assets may fall in price but price changes are not de/inflation. Implying that they are is very misleading.

Chad August 20, 2008 at 9:08 pm

Marek Kosecky: “I believe we will depart from fractional reserve banking at some point in our life :-) Has any fellow reader tried to come up with some practical solution on how to do it?”

If the Federal Reserve were to gradually start raising the reserve requirement for banks over the course of several decades, something they might be authorized to do whenever they choose, would that not help decrease monetary creation via fractional reserve banking?

For example, if the reserve requirement was gradually raised from 10% to 12%, then a bank would only be able to create and loan out an additional $733 for every $100 in reserve rather than an additional $900. Raising the reserve requirement to 20% would mean only an additional $400 could be (initially) created and loaned out for every new $100 deposit.

The system would still be inflationary (i.e., growing the money supply), but it would make fractional reserve banking less inflationary than it is now and even less in future years. It does not outright solve the problem, but it would decrease the scope or effects of it over time.

If the reserve requirement (or whatever the technical term is) was raised very slowly over time — let’s say 1% to 2% per year — I imagine that the market would be able to adjust to it without totally collapsing or otherwise freaking out. Sure, economic growth would probably slow down, but I imagine that the economy as a whole would become more stable over time.

Note that I welcome any corrections from others if I am misrepresenting the whole process. After all, I am still learning all this stuff.

ktibuk August 21, 2008 at 9:21 am

Good article but irrelevant because banks arent deleveraging or deflating. But instead inflating as they have never inflated before with the lead of the FED.

If they would be deleveraging that would mean a lot of them would eventually go bankrupt, but we cant see any banks really going bankrupt. Just ownership is being changed hands.

You dont need to look at some special indexes and M numbers to understand what is going on. You need to ask two questions.

Did the government stop the overspending, if not did they find another way to deal with overspending other than monetizing debt?

The answer to the first question is of course no.

And since there are no new taxes and no interest rate hikes, the answer to the second question is also no.

So we can conclude inflation is going on full steam. Government is overspending and they are financing the deficit by montezing debt.

Matthew August 21, 2008 at 11:53 am


I do not think that your assertion that the government is inflating wildly is correct.

1. Banks are really going bankrupt. IndyMac failed recently, and there are a large number of banks on the FDIC’s watchlist.

2. The government might be “overspending” but the Fed has not been monetizing significantly more of its debt than it has been in the past.

This is not to say that it won’t occur at any point in the future. It’s just not occurring right now.

Bruce Koerber August 21, 2008 at 5:11 pm

Throwing leverage into the mix is thought-provoking and it uncovers some new dimensions. Thank you Dr. Shostak.

Oil Shock August 21, 2008 at 5:33 pm

1. Banks are really going bankrupt. IndyMac failed recently, and there are a large number of banks on the FDIC’s watchlist.

Bank failures are a whimper compared to the savings and loans crisis. There was no deflation during that crisis.

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