Sunday, January 30, 2011

On the Non-Neutrality of Money

A thought occured to me that I want to investigate here, but which I would like some input on, since these are only preliminary thoughts. Perhaps this idea has already been investigated. If so, let me know.

The thought involves the consequence of changes in money's value on investments and capital good creation, leading to consumer goods. It seems to me that under inflation, past investments will appear to be cheaper than present-day investments (and are in a monetary sense). Entrepreneurs will thus become convinced that more risks are worth taking, because the prices are trending upwards. Borrowing in particular will be attractive, because then you have set the price at the past price and, while there is inflation, the prices of consumer goods will be going up. This means that more profit is possible, since the past costs are less than they would be now, and the costs of capital were cheaper than they are now. Each step in the production process is more expensive as time passes, but one is encouraged to produce each step precisely because the capital good produced is worth more in monetary terms than its constituent parts (or even that good was in the past). Thus, entrepreneurs are encouraged to make more in the belief that they can at the very least get rid of the capital goods at a profit. All of this is doomed if deflation occurs.

Under deflationary conditions, each step is worth less than those before. Who would want to invest or create new products under those conditions? Certainly no borrowing would occur. The logic then seems to be to follow monetarist policies of steady money growth. However, there are a variety of ways that inflation can come about, and monetarist approaches may just contributed to excess inflation that distorts things further and can make a reduction in the inflation rate act like deflation (creating relative deflation in a particular company or set of related businesses).

What, then, is the real solution? Inflationary policies result in bubble economies poised to burst at the smallest fluctuation in the wrong (deflationary) direction, and deflation seems to discourage investment and the creation of a series of capital goods, as one knows the final product will be cheaper than the moeny spent to make it. More, there are going to be differences from business to business and sector to sector. The solution would then seem to be whatever system of finance that could create general stability and which would be able to respond to local conditions. There may be times and places where money demand is high, in others where it is low -- and thus the money supply will have to adjust to those local conditions. That cannot happen with a central bank. Is the solution decentralized free banking?

Of course, this conclusion may in part depend on whether or not I am right about the above, more or less. Which doesn't mean it's the only argument for free banking, to be sure. What I am more interested in, though, is whether my above analysis of what happens to decisions to invest and create capital goods is in fact affected by deflation and inflation, as I discuss above. Thoughts?
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