Deflation, borrowing, and economic growth

So one of the arguments against gold/commodity money is that the money supply would not grow as fast as the economy, and therefore prices would decrease. This would be bad for anyone borrowing money for anything, because they would owe more than they planned on. So borrowing would be discouraged (including borrowing by businesses for expansion), which would slow economic growth.

Focusing only on the question of economic growth, hat does everyone think about this?

The fallacy is this:

Harksaw:

they would owe more than they planned on

Since the drop in prices would be expected, it would already be factored in to interest rates, and therefore they would actually owe what they planned on.  On this, Mises said:

"If the opinion that the prices of all commodities will drop becomes general, the short-term market rate of interest is lowered by the amount of the negative price premium.  Thus the entrepreneur employing borrowed funds is secured against the consequences of such a drop in prices to the same extent to which, under conditions of rising prices, the lender is secured through the price premium against the consequences of falling purchasing power.

"A secular tendency toward a rise in the monetary unit’s purchasing power would require rules of thumb on the part of businessmen and investors other than those developed under the secular tendency toward a fall in its purchasing power. But it would certainly not influence substantially the course of economic affairs."

Let's say that a lender wants to lend money to a borrower at a rate of 4% before calculating for price deflation.

If there was 1% price deflation expected, he would then lend the money at 4% - 1% = 3%.

But what if the expected price deflation is 4%. Or even 5%. Would he then lend the money at 0% interest? Or would he pay the borrower 1% interest for the priviledge of holding his money?

Or would he decide not to lend the money at all?

You have exactly the same problem with inflation now. Government bonds (generally considered the interest rate paid on zero risk loans) are paying less than inflation - so why would people lend in such an environment? They're guaranteed to loose money.

Back to your question, however - if money was becoming more scarce with respect to other products/services in the market place and so deflation was running high (around 4-5%) then it seems only natural that interest rates (the cost of money) would go up as a result of it's increasing relative scarcity. However, this also means the price of other goods and services in the economy is going down for anyone with capital (i.e. anyone with savings). Certainly there won't be a lack of steel or wood or any of the other basic products required for businesses to operate and, in view of the fact that anyone with capital is seeing their buying power soar in such times, surely those people with capital would be well placed and would want to take advantage of their capital and put it to good use. Investment, after all, does not always require borrowing - people with savings can invest as well (and indeed people who've shown themselves capable of saving would seem like good people to trust with future investments since they've generally shown themselves capable of running surpluses and making profits).

If pepole with savings didn't feel they'd be able to make a greater return on investments than they'd be able to make just holding on to their cash then maybe they'd hold onto the cash. I can't really see a problem with this since prices in the economy will adjust to the [reduced] amount of money in circulation. The economy in general certainly won't have a lack of wood or steel or the real products required to start businesses and keep them running - if there's less money in circulation relative to the quantities of these goods then the prices of these goods will fall to account for that. Consequently, the businesses that need to use these resources should have no problem acquiring them providing such price adjustments take place - if businesses are unable to borrow money to buy these things then the prices of these things will fall to take account of that fact.

I think gold supplies increase at around 2% each year though, so your money supply would be increasing at 2% regardless of what the economy was doing. In view of that fact, can you paint a picture of the economy in which insufficient money was limiting economic growth? I certainly can't see a scenario in which insufficient money supply (increasing at 2% annually) would cause a recession... if the economy was stagnant or shrinking, and money supply was growing at 2% a year then surely people would fall over themselves to lend you money... Indeed, as soon as the real growth of the economy falls below 2% it's going to be very easy for businesses to procure loans.

Harksaw:

what if the expected price deflation is 4%. Or even 5%. Would he then lend the money at 0% interest? Or would he pay the borrower 1% interest for the priviledge of holding his money?

It is impossible that gold could be generally expected to appreciate at a rate higher than the rate of interest, since gold would then be a superior investment in its own right.  That would increase the demand for gold, which would in turn raise its price, until the return expected from hoarding it was reduced to a rate no higher than the interest rate.

That is true of any durable commodity with low storage costs.

Of course, in reality it might appreciate faster than the rate of interest. But such appreciation could not be generally expected, since the expectation would be self-destroying.

What, then if gold were expected to appreciate at its maximum rate, i.e. at the rate of interest?

In that case it would be unsuitable as money.  Its purchasing power would be rising so rapidly from year to year that economic calculation over time would be as difficult as it is in an inflationary environment.  Nor would there be any incentive to lend gold, except perhaps to save storage costs.

Gold would also be unsuitable as money if it were as common as dirt, or if it were so very rare that the entire world's supply could fit in a brick.

The advantages of gold are empirical - a matter of historical fact.  Gold has maintained its purchasing power for thousands of years.

Mine supply for the past 100 years or so has been rising at approx 1-2%, which is about the same as world population growth over the same period.

LanceH:

It is impossible that gold could be generally expected to appreciate at a rate higher than the rate of interest, since gold would then be a superior investment in its own right.  That would increase the demand for gold, which would in turn raise its price, until the return expected from hoarding it was reduced to a rate no higher than the interest rate.

if the increased demand for gold raised its price, wouldn't it then continue to give an even better return than the pure rate of interest? What would induce its appreciation to go back below the interest rate if everyone was clamoring for more gold? Wouldn't hoarding lead to even more price deflation (of goods/services in terms of gold) and exacerabte the situation?

It seems to me that the answer to this conundrum lies in the time-preference of investors. If people hoard gold, investment in capital goods would lessen, time-preference would therefore be higher, and the pure rate of interest would rise. Additionally, reduced capital investment would lead to slower growth, less price deflation (of goods in terms of gold), and a reduced rate of increase in the purchasing power of gold.

Or am I missing something here?

leonidia:

If people hoard gold, investment in capital goods would lessen

Only if the price of those goods did not (or was not allowed to) adjust to the new/lesser quantity of money in circulation. If the price of those goods can float down to account for the fact that there's less money in circulation then there's no reason to suggest that there would be any correlation between the amount of money in the economy and REAL demand for those capital goods. If the economy genuinely is expanding then REAL demand for those REAL goods will remain high. Surplus inventories of these goods relative to the money available to buy them will cause their prices to fall and people will invest in them just as much as they did before. Similarly, all the goods that the producers of those capital goods require would fall in price since there would be less money to spend on these as well.

Why would a change in the amount of money have any effect on the supply or demand of real goods. If it's ridiculous (and it is) to suggest that by printing money we can make the goods you can buy with that money less scarce then also the opposite is equally ridiculous. Monetary contraction does not imply any change in the quantity of real goods available nor of the real demand for those goods and the buyers/sellers will find a way of making a deal - I think most likely by way of a change in prices.

Essentially I think you've got it backwards. A change in the quantity of money in circulation does not lead to a change in time preferences. However the reverse could certainly occur - a change in time preferences could result in people spending more money or saving less and thus in a change to the amount of money in circulation. Time preferences drive velocity and not vice versa.

leonidia:

if the increased demand for gold raised its price, wouldn't it then continue to give an even better return than the pure rate of interest? What would induce its appreciation to go back below the interest rate if everyone was clamoring for more gold? Wouldn't hoarding lead to even more price deflation (of goods/services in terms of gold) and exacerabte the situation?

What you are describing here is a classic investment bubble, but one in which the medium of exchange itself is at the epicenter.  It is true that gold may well appreciate (that is, relative to other goods and services) at a rate higher than the rate of interest.  It is also true that a general EXPECTATION of such appreciation would itself raise demand sufficiently to bring about (very quickly) all of the appreciation that is anicipated, up to the rate of interest itself.  And it is even possible that the rate of interest will stretch under the pressure, as follows ...

leonidia:

If people hoard gold, investment in capital goods would lessen, time-preference would therefore be higher, and the pure rate of interest would rise.

This reasoning is sound, but for one flaw.  It is incorrect that lower investment in capital goods will necessarily change time-preference; normally the causality is the other way around.  However, time-preference is a two-edged sword.  The appreciation of gold might be so powerful as to induce people to consume less and invest more (in gold), which would indeed add up to a rise in the pure rate of interest.

What comes to mind is the stock-exchange bubble of Kuwait in 1982, which was financed entirely by post-dated checks (post-dated by one year). In early Spring 1982, share prices commonly doubled by the hour, while interest rates climbed to 300%.

People might indeed add gold to their investment portfolio at the expense of capital goods.  Gold in this context is meeting an investment demand rather than a demand for cash holding.  As Jimmy points out, the effect on capital goods is largely nominal rather than real, since their price in terms of gold has dropped.  There will, however, be an increase in real resources devoted to gold mining and to the melting down of gold jewellery.

After a time, gold appreciation will slow down, and may even reverse as people remove gold fom their investment portfoilio and return it to their cash holding.  Gold mining languishes, and non-monetary uses of gold increase. That is the pricking of your inverse investment bubble.

LanceH:

What, then if gold were expected to appreciate at its maximum rate, i.e. at the rate of interest?

In that case it would be unsuitable as money.  Its purchasing power would be rising so rapidly from year to year that economic calculation over time would be as difficult as it is in an inflationary environment.  Nor would there be any incentive to lend gold, except perhaps to save storage costs.

Lance, this is a very misleading way to look at things.  When gold appreciates against all other goods, it is really those other goods which are becoming cheaper due to increases in productivity.  It's not as though interest rates are first determined in terms of consumer goods and then a discount applied to gold.  It's the other way around.  There is necessarily a premium on the "real" interest rate expressed in terms of consumer goods whose future value is expected to fall.

The expectations that productivity will increase rapidly (prices will drop) does not in the least undermine the suitability of gold as money.  In fact, it is precisely this expectation that prevents over-investments in higher (long-term) factors of productions.  It is the soundness of gold that ensures that interest rate premiums expressed in terms of other goods will adequately reflect the expected future productivity gains in those industries.  Masking these productivity gains (using less sound money) results in malinvestment and is the cause of the business cycle.

Harksaw:

This would be bad for anyone borrowing money for anything, because they would owe more than they planned on. So borrowing would be discouraged (including borrowing by businesses for expansion), which would slow economic growth.

There is a hint of truth in the OP's statements.  Borrowing would indeed be discouraged (including borrowing by businesses for expansion) by those who are unable to generate a sufficient return to keep up with general productivity gains in their industry.  However, this would not slow economic growth.  It would only slow economic malinvestment.  Economic growth is the premise upon which prices are expected to continually fall and "real" interest rates must be kept at a premium.  So economic growth prevents economic growth?  I don't think so!  Economic growth (falling prices) just prevents businesses unable to keep up with the rate of economic growth from squandering capital in their uncompetitive ventures.

leonidia:

LanceH:

It is impossible that gold could be generally expected to appreciate at a rate higher than the rate of interest, since gold would then be a superior investment in its own right.

if the increased demand for gold raised its price, wouldn't it then continue to give an even better return than the pure rate of interest?

[...]

Or am I missing something here?

What rate of interest are you guys talking about? The rate of interest always has to be expressed relative to some specific good(s).  There is no market for some "general good" loaned at interest that would allow for the determination of some kind of "general"/"pure"/"real" interest rate.

If gold is used as money, then the interest rate is expressed in gold.  It is this gold interest rate that is determined on the market as a result of supply and demand for loans of gold.  It necessarily has to be larger than 0% for induce any supply to meet market demand.

The premium rate of interest in terms of other goods, or some arbitrary index of goods can be extrapolated based on future markets for those goods.  But that's only an abstraction that an entrepreneur would use to calculate if a particular business venture is justified.

Perhaps I wasn't clear to begin with so I'll try again.

If the rate of appreciation of gold (which is the same thing as the rate of price deflation for all other goods/services) goes above the pure rate of interest (not the market rate, but the pure rate) this will induce businessmen to cut back on investment in capital goods and increase their cash position (hoard gold), or possibly increase consumption. The cut-back in capital investment would have the same effect as an increase in time preference i.e. there would be a rise in the pure rate of interest. At the same time, reduced capital investment would eventually lead to reduced growth, which would cause prices not to fall as fast. (price deflation wouldn't be as severe)

Thus there would be two things working to cause the rate of appreciation of gold to drop back below the pure rate of interest:

1) The pure rate of interest would rise because of reduced capital investment

2) The price appreciation of gold relative to other goods would drop because of reduced growth and output (same thing as saying. a moderation in the rate of deflation.)

Therefore the rate of appreciation of gold would tend to always be less than the pure rate of interest, and the market rate of interest would always tend to be greater than zero.

leonidia, what is your definition of a pure interest rate?  Specific rates for specific loanable goods can exist based on individual time preferences for those specific goods.  But I can't imagine what a pure interest rate would represent or how it would come about.  Please explain what I've missed here.

A-R:

What rate of interest are you guys talking about?

I am referring to what in an inflationary environment is called the "real" rate of interest.  It is the nominal rate of interest offset by what Mises called a "price premium" which reflects the expected change in purchasing power of the monetary unit over time.

A-R:

The expectations that productivity will increase rapidly (prices will drop) does not in the least undermine the suitability of gold as money.  In fact, it is precisely this expectation that prevents over-investments in higher (long-term) factors of productions.  It is the soundness of gold that ensures that interest rate premiums expressed in terms of other goods will adequately reflect the expected future productivity gains in those industries.  Masking these productivity gains (using less sound money) results in malinvestment and is the cause of the business cycle.

If the price premium were just 1-2%, then I agree.  But the OP postulated that the expected rise in purchasing power of gold would equal the real rate of interest.  Who, then, would invest in time-deposits at 4% when they can get 4% by holding gold?  Where will the bank loans come from to fund your productivity improvements?

LanceH:

I am referring to what in an inflationary envrionment is called the "real" rate of interest.  It is the nominal rate of interest offset by what Mises called a "price premium" which reflects the expected change in purchasing power of the monetary unti over time.

Right, so it is some sort of extrapolation based on your personal preferences and expectations; not a meaningful accounting measure.  The monetary interest rate is what is determined on the market.  The real interest rate that you may calculate according to some index of goods just gives you an idea of how much you might earn from the combined choice of delaying consumption and loaning your money (sacrificing liquidity).

If the price premium were just 1-2%, then I agree.  But the OP postulated that the rise in purchasing power of gold would equal the real rate of interest.  Who, then, would invest in time-deposits at 4% when they can get 4% by holding gold?  Where will the bank loans come from to fund your productivity improvements?

The bank is paying interest on top of any gains you would make from just holding gold.  If the bank pays 4% interest and you expect those goods which you intend to eventually purchase to depreciate at 4%, then you are making 8% in "real" terms.  "Real" interest rates are based on monetary rates, not the other way around. The future is uncertain; there is always an opportunity cost to loaning money.  Money interest rates will always be positive.

This idea that high "real" interest rates will prevent the funding of productivity improvements is circular logic. It is those very same improvements that cause the "real" interest rate to be so high.  This will indeed discourage certain investments: those ventures which are unable to keep up with the expected level of productivity improvements.  Great!  Those are precisely the malinvestments which will fail to satisfy the demands of consumers.  It doesn't matter if economic growth is 1-2% or 10% or 100%.  Anyone who can't keep up should step aside for those who can.

A-R:

The bank is paying interest on top of any gains you would make from just holding gold.  If the bank pays 4% interest and you expect those goods which you intend to eventually purchase to depreciate at 4%, then you are making 8% in "real" terms.

No, the OP stipulated:

"Let's say that a lender wants to lend money to a borrower at a rate of 4% BEFORE calculating for price deflation.
...But what if the expected price deflation is 4%."

In other words, the nominal interest rate is 0.  The loan market in gold is at a standstill.

Let me rephrase my question.

The OP postulated that the rise in purchasing power of gold would equal the real rate of interest.  Who, then, would invest in time-deposits at a real interest rate of 4% (i.e. a nominal interest rate of 0) when they expect an increase in purchasing power of 4% by holding gold?

Where will the bank loans come from to fund your productivity improvements?

A-R:

It doesn't matter if economic growth is 1-2% or 10% or 100%.  Anyone who can't keep up should step aside for those who can.

It does