Deflation and credit compression for dummies
Save This Post as PDFThe goal of this post is to explain at maximally comprehensive level why everybody on the other side of Atlantic is currently afraid of deflation.
So, here you go. We will start giving the answer to a somewhat simpler question: how do banks make money from air? Suppose you are in possession of 100000 USD. As long as you keep them in your pocket, it is clearly impossible for a bank to make a profit using your money, but then bank offers you 10% interest rate, you start feeling weak and bring your money to the bank, say, 90000 USD. What you have now is: 10000 USD cash and 90000 USD deposit in the bank (which you can use of course paying in any shop with the bank’s plastic debit card). On the other hand the bank has your 90000 USD in cash.
At this point we would like to claim that the amount of money circulating in the economy was suddenly increased by 90000 USD. Where did they come from? They came from air or, more precisely, from trust – the bank is obliged to return your 90000 USD as soon as you ask, and you believe that the bank can return them any time you want.
Naively, the situation did not change much: bank’s obligations are not yet real money. If your 90000 USD are kept in the bank’s vault, nothing indeed is changed and amount of money in the economy was not increased. But how can be there a banker who decides to keep your money in the vault? Of course, he will invest them instead somewhere – for example, by offering a credit line.
Said and done: the bank will leave some amount of cash (say, 10%) in the vault and invest remaining 90% (81000 USD of your hard earned money) in some sector of economy or offer a credit. If you come to the bank and withdraw a part of your money, 10% should be a sufficient backup, since the probability that everybody will simultaneously decide to withdraw their money is quite small.
At this point, the total amount of money in the economy indeed increases by 81000 USD. Namely, your 90000 USD in cash became:
a) 90000 USD in bank’s obligations, b) 9000 USD in the bank’s vault, c) 81000 USD in obligations of a person (say, his name is Tom) who took the credit from the bank, d) 81000 USD in Tom’s cash. The total amount of money in the public sector (you and Tom) increased in 1.81 times, and demand on the market increased correspondingly – the economy got warmed up.
The main conclusion at this step is that contemporary “money” is more like an obligation of one person to pay with the real money to another person.
Ok, I hope I was clear enough to this point because what you will see at the next step is a mathematical model of deflation 
The model depends on three parameters: 1) amount (or better say fraction) of cash that people always want to keep in their pockets, 2) reserve, a lowest amount of cash that bank has to keep in its vault – this is determined by law, 3) “the level of trust”, amount of money that banks are willing to invest after filling the reserve. The only possibility in this model for the bank to invest is to offer a credit to people (then, this money is deposited back to their accounts) – sorry if this is oversimplified.
Let us see the dynamics of the total amount of money in the system:
Here, the purple line is the total amount of cash in the system, the red one is M2 (cash+bank’s obligations to return deposited cash+credit taken), X axis is time (in years), Y axis is total amount of USD (billions of dollars).
Exercise: check out what M2 means in the real world.
Suppose now that the level of trust is lowered somewhat (at t=5.0 years):
What happened here is that banks decided to be more cautious, to keep more money in their vaults and decrease amount of credits offered to people. On the other hand, people decide to keep more cash in their hands. At the result, M2 features quite a drop (more than 30%) – note though that the level of trust was not decreased significantly, people keep more than 60% of their money in banks and banks offer more than 80% of their cash in credits. This is what’s called deflation (or, better say, credit compression): the less the level of trust in the economy, the lower the total amount of money (M2) circulating in the economy.
Now, Bernarke says that he can solve the problem of deflation by printing more cash. Let us see what happens in our model after a single-time injecting of cash into the system:
As you see, injecting helped – for a moment – but then rapid M2 decrease then continued.
Finally, what if we return the level of trust to the initial one after 10 years?
As you see, M2 starts to grow very rapidly and stabilizes. The main conclusion one can make is that simply printing more money cannot resolve the crisis, what one ultimately has to do is to continue increasing the level of trust.
Via Sergey Schegloff (model and simulations are his as well)
If you liked the post, please kindly consider to leave a comment, subscribe to the RSS feed or get new posts sent directly to your Inbox. If you want to chat with me in real time, you can find me on Twitter. The posts below are probably related to the subject of this one:
- No related posts
Loading ...
No comments yet.