Saturday, May 28, 2016

Saturday Morning Musings - deflation

In an earlier discussion, kvd asked why deflation - a fall in prices for the goods and services we buy - was a bad thing.

If you look at the Wikipedia article on deflation, you can see that deflation is often associated with major economic shocks where cause and effect become intermingled. You will also see how conventional economic analysis has focused on changes to the money supply as a cause of deflation. Then, too, you have productivity effects where long term productivity increases cause prices for goods to fall.

Current worries about deflation are a little different. There is plentiful liquidity - the world is awash with money; global economic growth has slowed, but there is not a global recession; and yet, inflation is very low or even negative in many places. It's unusual, with central banks trying to increase inflation rates, something that would have seemed inconceivable a few years ago.

This post traces some of the effects of living in a deflationary world. Nothing profound. Just trying to work things out. For the sake of simplicity, I am assuming that deflation stays in the 2-3% per annum range.

Households know that things will be 2-3% cheaper in twelve months, their money will be worth 2-3%, so they save a little more, parking the money in the bank. There is a transaction cost to the bank in holding the cash and paying it back. If they were just holding the cash, they would want to charge the customer that cost plus a profit margin, a negative interest rate, as some central banks are doing.

The bank wants to lend the money, to make a profit.

As consumers save a little more, business sales drop. The firm knows that its input costs other than labour will be 2-3% lower at year end. It lags investment a little since capital equipment will be a little cheaper. Labour costs are sticky, so firm margins drop. The firm sees to reduce staff or lower wage rates to accommodate this. It borrows less.

Governments can buy a little more with a given dollar, but its tax revenues drop, in part because bracket creep has gone into reverse. Debt servicing costs on existing debt rises as a proportion of government revenue. Some indexed government payments such as pensions drop as indexing goes into reverse. Governments seek to pay back debt because this will save money later. Spending drops.

In the housing market, there is downward pressure on rents to bring them into line with falling price levels.  Those with existing loans seek to pay them back more quickly or to refinance to lower interest rates. Investors who have based their equations on the combination of rising rents with nominal dollar capital appreciation are especially affected.  

Banks facing lower demand for personal, housing and business loans lower interest rates. Loans become shorter term as the rising real value of money is factored into return equations. Credit cards remain, but credit card debt drops as consumers and business reduce their exposure. Credit card fees grow as cards become more focused on transactions. A new credit card structure emerges, with fees for those who just use the cards for transactions, discounted for those who who are use the cards for loan purposes and are still paying interest.

Share prices fall initially, but then stabilise. Dividends probably increase as a proportion of earnings since this gives investors cash that will increase in value.

At this point, I will pause and leave it to you to respond. I am sure that there are errors. And what about super funds?


Anonymous said...

inflation is taxation by stealth!

Dunno who said it - but I choose to think it was tanners, correcting me (yet again, in between rooting about in the garbage for his next fish to cook; I never forgot that :)

But he's mostly right, so - if inflation is taxation by stealth - what is deflation?

Jim says: Credit card fees grow as cards become more focused on transactions. A new credit card structure emerges, with fees for those who just use the cards for transactions, discounted for those who who are use the cards for loan purposes and are still paying interest

It has been estimated that the 'transaction value' of all activity in Australia is about $50Tn - trillion - annually. So what say, three things:

1) a 2% transaction tax on all debits, co-incident with:
2) remove from circulation all physical notes over $10 in face value
3) remove all federal, state, and local taxes, duties, fees - GST, the whole lot.

2% of $50Tn is $1Tn. Our federal budget is 25% of that. And physical $notes over $10 simply make it easier for the black economy to flourish - none of which is taxed presently.

Where am I wrong?


Credit card fees grow as cards become more focused on transactions. A new credit card structure emerges, with fees for those who just use the cards for transactions, discounted for those who who are use the cards for loan purposes and are still paying interest.

Anonymous said...

Apologies for my careless cut-and-paste-but-forgot-to-tidy-up post.

Still, in some ways, Jim's analysis is worth repeating...


Anonymous said...

Just leaving this link here for future reference:

So, what is $95.6 Bn per day multiplied by 365 days? (Or, to make it easier, add cheques, at $4.9 Bn daily, so now we have approx $100 Bn daily as of 2015)



Jim Belshaw said...

The money one is interesting, kvd, for I'm thinking that I should go back to cash. I certainly would if there were still a $2 note. Coins are the biggest bugbear of cash.

Twice last week I went out for lunch to places that did not accept cash. In both cases I had to go to an ATM, in one case paying a $2 fee. I paid a transaction charge for topping up my transport pass by EFTPOS and then I brought something at a newsagent and paid an EFTPOS levy there.

The number of eating places in my area charging only cash seems to be increasing. If you do charge cash, you save money.

Comments on your other point tomorrow.

Jim Belshaw said...

Following up now on the idea of a transaction tax on all debits, I was trying to think through how it might affect my behaviour. The pay that comes into account would be a debit to my employer, so 2% would be levied. I imagine my employer would reduce my pay by that amount. When I get the money, I usually transfer part to a higher interest account and then draw down. That would now incur a debit tax greater than the interest received, so I would stop that.

I would reduce my credit card usage since that would incur a double debit, when I spent and then when I withdrew money to repay the card. I get the tap fixed. I pay cash for that. Instead of the plumber buying the tap with a cheque or putting it on his account, he uses my cash to pay for the tap, thus avoiding the debit charge. The plumbing supply company in turn keeps a larger amount of cash on hand. For simplicity's sake, it might still need to order bits and run it through its bank account. However, it would use the extra cash to pay cash where it made sense, thus avoiding the charge. For example, some employees might now be paid in cash or it might use the cash to pay for electricity or other costs.

The net result would be a reduction in the number of transactions, an increase in the cash economy. Now you have postulated the withdrawal of larger banknotes to make avoidance more difficult. That would help, but there would still be considerable leakage.

Where it would really bite would be in transfers such as that between my bank accounts. A 2% universal debits tax would stop all the flows that now occur to take advantage of small price or interest rate differences. The net result would be a substantial drop in the volume of transactions, requiring a higher debit tax.

There would be some offsets because of the abolition of other taxes. For example, I have more money to spend. I buy more and invest more, if doing so in ways that will minimise the transaction tax. It would require detailed modelling to work out the net effect!

Anonymous said...

Jim, sticking with easily typed, round figures:

1) your pay would become gross, not net - 20-30% more?
2) the tap you purchase would be gst free - 10% less
3) the plumbing supply company has reduced its stock holdings by that same gst - 10%
4) and it pays no payroll tax - 3-5%
5) or rates, land tax on real estate it owns - ??%
6) all businesses gain via having no gst, state, or federal tax to calculate, on records they must keep.

Just to contrast, this is part of the gst legislation:

For the purposes of making a declaration under this Subdivision, the Commissioner may:
(a) treat a particular event that actually happened as not having happened; and

(b) treat a particular event that did not actually happen as having happened and, if appropriate, treat the event as:

(i) having happened at a particular time; and
(ii) having involved particular action by a particular entity; and

(c) treat a particular event that actually happened as:

(i) having happened at a time different from the time it actually happened; or
(ii) having involved particular action by a particular entity (whether or not the event actually involved any action by that entity).

I hope you read that slowly :)

Personally, I like that last bit - (c) (ii) - although for further obscurity, it should be amended to read (whether or not the event actually involved any action by that entity, and whether or not the event actually occurred, and at a time decided by the Commissioners' discretion)

- and you would complain about getting docked 2% ?


Anonymous said...

Just to take your own example a little further:

1) Say you are on $70K p.a. - your pay in hand just went up by $18k
2) Say 1/3rd of what your spend it on is GST-able - you just saved about $2300
3) Say you rent - your lasndlord no longer pays gst, land tax, council rates

Against that, assume you save $10k and spend the rest - it would cost you 2% of $60k = $1200.00

You mentioned that A 2% universal debits tax would stop all the flows that now occur to take advantage of small price or interest rate differences

That is a feature, not a bug - and it disregards the offset reduction in any taxation of profits made on such activity, stamp duties, etc. - all of which require recording and reporting and auditing - i.e. unproductive wages.


Jim Belshaw said...

So I have saved lots of money, some of which I would spend. I'm still struggling to see how government would get the money it needs. If I am much better off, who is worse off? I focused on the way that the volume of transactions would go down. That would require a higher tax to compensate, leading to further lower transactions There would have to be price effects?

Anonymous said...

Jim, why not you just worry about your $70k and let the government clip the ticket of the other $50Tn in transactions :)


Winton Bates said...

Sorry, I haven't been able to follow the comments. My mind seems to have been adversely affected by watching the leaders debate.

As I see it the main concern about deflation is its effect on debt repayment and balance sheets. With nominal incomes falling relative to debts, debt repayment becomes more problematic. With asset prices falling relative to debts, lending institutions become more concerned about getting their loans repaid. So, there is a squeeze on consumption and investment and lending institutions become more cautious.

Anonymous said...

Winton, I don't see the logic in your comment. It implies that bankers are happier being paid back in inflated dollars, rather than deflated ones? I think the problem is one of base:

Take a 25 year 100k loan in a 3% inflationary environment. The bank will receive less 'base worth' (purchasing power) back over the course of the loan. In a deflationary environment, won't the last 10k of repayments have more 'worth' in terms of what it can purchase (via those "falling asset prices" you mention) than in an inflationary scenario?


Anonymous said...

What I'm saying is, you can have a perfectly balanced set of books which will be signed off as 'true and fair' yet bare absolutely no connection to the surrounding reality.

Ten years ago (I'm making the figures up) you purchased a house for 300k by borrowing 200k. Today you have a house sellable for 1M and a loan balance of maybe 280k. If this was an investment property, and you sell it, you have made a 'book profit' of 700k, and the bank will get the rest of its 200k back.

But to replace that house with its equivalent, you will need to spend at least 1M and the bank will be happy to lend you 2/3rds - 660k.

Now imagine the same scenario, but with falling house prices (those "falling asset prices")

Who's ahead?


ps or "who's on first?" as Abbott & Costello used to riff about :)

Winton Bates said...

kvd: The problem lies in the transition. Using your investor example, the drop in house prices can mean debts exceed the value of the house (as is happening now for other reasons with units sold off the plan in Melbourne and Sydney). So, you have investors having difficulty repaying loans from their deflated incomes and banks unwilling to refinance their loans. There are a lot of forced sales and asset prices tumble for a while.

I think you can view it as an expectations problem. The problem is that people make borrowing and lending decisions in the expectation of inflation at around 2 per cent which are expected to "go bad" if we end up with inflation of -1 per cent..

We could eventually learn to live with moderate deflation. Some periods of prosperity in Australia (e.g. 1860s to 1890s?) have coincided with deflation.

Anonymous said...

Fair comment Winton, although timeframes play (as they should) some part in purchasing decisions and how to view the results.

My comment was more to the 'utility' of the asset being purchased - a house is a utility (a place to live) regardless of its movement in today-dollars. From the bank's point of view, that 'utility' is provided to its customers (in times of inflation) with an ever increasing need for the paper amount of money; in deflating times they assist the identical 'utility' with a reducing need for a paper amount of money.

Whichever, nothing much has changed in the actual 'utility' provided. The problem is partly confused by the present reporting process. We have become a nation of bookkeepers, not worthy shopkeepers, it seems.


Anonymous said...

Just a further niggle I would like to throw out for comment:

The bank lends money for an interest rate which must, if they are careful, cover your mentioned 2% inflation, plus the tax on the gross interest they charge, plus some further amount which is the bank's 'recompense' for providing the money in the first place.

The new owner must repay the loan in ever-inflated dollars, and reaps the entire 'reward' when he comes to sell. Tax free!

A more equitable system might be to introduce "co-mortgages", whereby the bank also shares proportionally in any realised gain/loss, again tax free?

Presently, it is all just margin lending, writ large, and distorted by the taxation treatments of the bank's as opposed to the owner's gains in any environment with non-zero movement in that thing called money.


Winton Bates said...

kvd: I agree with your first point regarding utility. The flow of services you obtain from the house you live in does not depend on market value. I get the impression that very few people check the change in value of their home from month to month or even from year to year. We keep getting leaflets in our letter box from estate agents offering free valuations, but we never take up the offer. There is not much point in knowing the market value of your home unless you are contemplating borrowing against it or selling.

Regarding your second point, I seem to remember lending arrangements under which the lender shared the capital gain were introduced in the 1980s in an attempt to make housing more affordable for first home buyers on low incomes. The arrangements encountered some problems. I can't recall why at the moment. Perhaps many borrowers lost their jobs in the 1991 recession.

Anonymous said...

Winton - look up "shared appreciation mortgages" on Wikipedia, for discussions (and pitfalls!) of this sort of concept.

Agree with you about checking daily house prices; useless :)


2 tanners said...

kvd invited me to make provision for myself (i.e. my old age). Most of the means for making such provision depend to an extent on asset appreciation including inflation, usually accelerated or enabled by borrowing. If a very large strut of every common investment strategy is kicked out, there'll be a lot of people who were trying to provide for themselves who will instead be worse off than those who made no attempt whatsoever.

The Japanese found this out when a housing bubble collapsed into deflation. Just before the bubble burst, mortgage rates were so high that newspapers were reporting intergenerational mortgages - grandpa was binding his son and grandson due to the length of the mortgage. Then came almost a decade of deflation led by the commonest "plain folks" asset - their homes. I have no idea what the end of the story was but whether it was bank failures, government bailouts or mass bankruptcies, someone was going to wear the pain.

I think it may just be the unfamiliarity of our systems with dealing with deflation that is a danger. Inflation, runaway inflation, stagflation - we've seen them all in Australia in the 1970s. For deflation, you have to go back a long way and some of it was based around monetary controls which saw no value in inflation.

Anonymous said...

Just to note:

March 2016 total value of ATM withdrawals: $11613 (millions)
Y/E Mar 2016 total value of ATM withdrawals: $140159 (millions)

- from RBA stats website


Anonymous said...

March 2016 total value of Cheques: $93150(million) Y/E Mar 2016 $1214230 (million)

March 2016 total value of Direct Debits: $1195409(million) Y/E Mar 2016 $14357517 (million)

These are quite large figures.