An Alternative Theory of Deflation

blackholeRecently, the Big, Scary Word™ in economics is “deflation.” Like most things in economics, deflation as a concept is a double-edged sword. On the one hand, deflation relates to an increase in a money’s general purchasing power. But, on the other hand, deflation creates a relative increase in the value of debt. So it tends to be pretty good for consumers in general, but not so great for those businesses or persons who carry significant debt.

Whether deflation is good or bad for an economy is debatable and, indeed, it is being debated vigorously. The odd thing is that economists seem to be unsure why deflation is taking place especially considering how much currency is being created. The money supply has skyrocketed in recent years so it stands to reason that inflation rather than deflation would be the major worry (and it has been).

I figured I’d take a stab at explaining the recent deflation phenomenon. My theory can’t be worse than anyone else’s, so why not try my hand, right? Well, actually it can be but I’ve never let that stop me before, so here we go…

When I conceptualized the innovation in The Currency Paradox, it was important that it be applicable to market-based economics as well as the profit incentive. The key with markets is that they work better when more and better information is available; the currency innovation I conceptualized makes markets “smarter” by making more essential information available for every transaction. Many aspects of market-based economics as they now exist are opaque and subjective; the innovation presented in The Currency Paradox introduces an element that would bring an unprecedented level of objectivity to market-based economics that is unambiguously quantifiable. Just as importantly, it is completely compatible with the concept of making profit. However…

What is “profit”?

Sure, the idea seems simple enough … I describe it in The Currency Paradox as a “convenience tax,” a surplus fee added to every transaction by anyone selling a good or a service simply for the act of making that good or service available in a convenient way. But, think about it for a second … the important distinction is that it creates a surplus as measured in money/currency at the end of most transactions. Now, from where does the money which creates this surplus come?

This can be answered in different ways like “capital gains” or “employment” but generally the money is associated to some effort attached to the repayment of credit. Why is that the case? Because the overwhelming bulk of money is produced as credit for the purpose of making profit by charging interest.

This creates an interesting conundrum because, as a result of the interest demand, every act of credit creation is a negative sum transaction. In other words, everyone who is issued a loan has to produce more dollars than the transaction itself produces. Hmmm…

Now, from where do those additional dollars which are expected to cover the interest on the loan come? In other words, from where do the extra dollars come?

This seems to be a serious problem because, generally, in order to repay a loan, a person or entity has to create value greater than the costs of operational and capital expenditures. This is generally done by setting a margin of profit for every item sold or transaction processed. However, those “profits” were themselves created as the result of loans which also, as a result of a demand for interest, were negative sum transactions from a money creation standpoint.

This is all a very roundabout way of stating that there is always a money deficit which increases (in fact, compounds) every time new money is created. Because of the interest demand, every time money is created by a loan transaction, it produces a net negative in the form of a debt. So the only way for old debts to be serviced is for new money to be created which means greater total debt. The effect is a system in which the dollars are, for all intents and purposes, cannibalizing themselves. The worst part is that profit, and all enterprises or entities which excel at generating profit, exacerbate the problem.

The logical net effect of this is a deflationary cycle. The profit incentive demands a surplus from the system that does not exist. To the contrary, the paradoxical effect is that, the more money that is created, the less money there is as a result of the demand for interest.

As I stated in The Currency Paradox, fractional lending isn’t really a problem; as long as all debits and credits cancel each other out, then managing the supply of money based on demand, even using fiat currency, should, in theory, not be an issue. Even the inflationary bias of fiat money should be able to be easily managed in a system in which debits and credit cancel out. However, interest seems to be having a massive deflationary effect; it requires debtors to repay money that doesn’t actually exist. Our entire economic system seems to be based on the premise of robbing Peter to pay Paul.

Once again, this is a problem that is solved with the innovation in The Currency Paradox. Because there is not any debt associated to it, all of the currency produced is, technically, surplus money. In theory, any interest demands can be fulfilled without creating a deflationary effect because the money is not created with any associated interest or other debt demand.

If I’m correct, then continued note printing and money creation will only exacerbate the deflation issue. Interest rate increases by central banks will also make things much worse. Considering the nature of how most money is created, a solution may be difficult. It’s possible that the deflationary cycle is like a black hole and we have crossed the event horizon.

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One thought on “An Alternative Theory of Deflation

  1. Pingback: The Deflation Phenomenon | The Currency Paradox

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