Why? If the dollar has been rising in value over the last 5 years at 5% and is expected to continue to do so, why wouldn't banks just issue their credit cards with a 10% interest rate instead of 15% to all those sorry saps who love to shop on credit?

Currently the best interest rate you can get on a mortgage is about 3% so the bank could do a reverse type ARM (it's not really an arm, but I don't know what to call it except maybe: Adjustable Principal Mortgage) where every 5 years, the balance of the mortgage is adjusted for the increase in value of the dollar.

Of course the bank (the house) is going to make out on the deal, like they always do, and you're not going to get a full adjustment, however, if someone wants a house.........they want a house.

You missed my point. Deflation makes it unlikely for loans to be issued at low rates. If deflation is at 5%, I'm never loaning money to my neighbor for less than 5%. Does that make sense?

I shouldn't have said impossible as there would be some demand for loans in a deflationary environment. But demand for loans goes way down because borrowers rationally do not want to pay back dollars that are more valuable in the future than they are today when they are not being compensated for doing so. Defaults would go way up as we have seen in the housing market where housing prices have fallen.

You could if you built into the loan contract my "Adjustable Principal Rate" clause that calls for adjusting the principal owed at certain intervals during the life of the loan, based upon the percentage of deflation or inflation over that time interval.

So why is this a bad thing? People save more and borrow less. Sounds like a good idea, not a bad one.

I am not doing a good job of explaining. Here is a blog post explaining why deflation is bad:
If all prices fall, it's a disaster. Falling prices means lower revenue and profit margins for companies, which as we know leads to layoffs, less hiring, stagnant wages, and outright pay cuts. Consumers with lower incomes have less money to spend, which tends to lock the cycle in place: With sales down, firms have to cut prices even more to get business. The worst part comes when everybody realizes that prices are falling, because nobody wants to buy something today if it will be cheaper tomorrow. That's why our housing market is such a disaster: When prices are falling, you've already lost money on your investment the day after your big purchase. Buyers would rather sit on the sidelines and wait for prices to bottom out.

Deflation also wreaks havoc with routine borrowing and other aspects of a normally functioning economy. For people (or countries, ahem) in debt, inflation actually eases the burden because the real value of fixed debt goes down over time. If inflation is 5 percent per year, for instance, your income keeps pace with inflation, and you pay $1,000 a month toward a fixed-rate mortgage, your nominal income goes up over time but your mortgage payment doesn't. So the mortgage effectively gets cheaper over time. The opposite happens with deflation, which makes debt more expensive over time. If deflation were 5 percent per year and your income fell at the same rate, the mortgage payment would take an increasingly big bite out of your paycheck.

That turns the basic machinery of the economy inside out. Under deflation, cash becomes a highly valued asset, since a 0 percent return is better than a negative one. Banks have no incentive to make loans, since they'd lose money. Defaults would skyrocket, exacerbating the problems we already know about: broke consumers, money-losing banks, frozen credit markets. Everybody would hoard cash and consumers would only buy essentials.

That's been the situation in Japan since 1995, a case study that economists have been paying a lot of attention to lately. The circumstances are different in the United States, but Japan is hardly a medieval society with illiterate central bankers. In other words, if it can happen there, it can probably happen here.
There are lots of technical lessons from Japan's battle with deflation, but the most important takeaway is that deflation is the economic equivalent of an STD: Once you've got it, you're stuck with it for awhile. "Prevention of deflation remains preferable to having to cure it," said Federal Reserve Chairman Ben Bernanke, in a long-ignored 2002 speech that's found new life as an ironic prophesy.
Bernanke and other Fed officials think they know what to do if deflation strikes, but they haven't had a lot of practice: Full-blown deflation hasn't been a problem in the United States since the early 1930s, when widespread fire sales caused overall price drops of about 10 percent per year. So they'd rather deal with inflation, which is common enough that it essentially comes with a dog-eared troubleshooting manual. The Fed, of course, doesn't get to decide what problems it has to confront, as the last few years have shown us. Maybe they'll get one more chance to show their creativity in crisis.

Here is another study:
http://www.aei.org/docLib/March%202009%20EO-g.pdf

To be honest, there was just so much wrong that was written that getting into addressing it would be way too much rehashing of topics that have been discussed at length already -- most of it already having been debunked/dispelled in many other threads in this forum. I'm sure that was many other peoples first impression as well.

The feeling is mutual.

As far as the long post right above mine by seattle about deflation being bad, I for one am aware and glad that many people think like that, as it is good for my investments. It's standard pundit rhetoric though.

The government or its supported monopolies should not encourage or discourage making or taking loans; doing so is a form of central planning.

You're still missing the point that loans below 5% would not be possible.

Suppose 100 people each own a $200k home free and clear. They want money so they each go to ABC bank and the bank trades the title for a 100k line of credit with interest, crediting debtors 10 million total and starting to spin up interest. But say ABC bank doesnt have 10m cash, they just have titles to homes. But part of lending 10m is that they have to make the cash available on demand. I agree that right now the bank has about 20m in titles so its true that their assets can usually meet their liabilities if given time to liquidate.

So, if I understand you correctly, you say its no problem because ABC bank can always meet their obligation. But the problems I see are: unfairness and hazards.

Unfairness: Basically with only say 1m in their vault, they are able to spin out interest as if they owned 10m, earning 10 times as much. And even though they can get other lenders to help with this [and if it is really bad, the central bank], overall I feel it is unfair that the government backs these private businesses. Like take deposit insurance. I guess most people only care about whether they get paid back and when they are assured of that, their problems end. But I think it is a serious problem and it is unfair that banks can spin more money in interest than they hold liquid.

For example 5 people deposit their gold bar at my place. I print 5 receipts and then go use the 5 gold bars to invest and spin up interest. When anyone wants their gold bar back, I go buy a new one. I find this to be fraud because the agreement with my customers are that I am supposed to hold their gold bar, not make investments with it. If my investments go sour a small % of the time I just default. And it doesnt matter if the government guarantees my ability to always make good, infact its worse because it makes my risk tolerance way higher. I mean I guess its really good for me, because the depositors have no risk since the govt backs me, and I just spin up free interest from the deposits. But thats unfair.

Hazards: Basically even though the bank has 20m in titles and only 10m cash outstanding, maybe a tornado hits and their 20m in titles become nothing and they cant pay. Of course in reality they have insurance. But the point is the deposits arent backed by cash. Out of the 10m in the banks deposits, only a fraction of cash is there. And the government insures banks from failure, why is this? When I play on pokerstars all the player deposits are held in a separate account. That way when the **** hits the fan everyone gets paid. Why arent banks held to the same standard?

I am not saying I am right and admittedly I am not well versed on this subject, but can you explain these problems to me?

Uh, no.

5% deflation means that my held money buys 5% more in 1 year. If I make a 1 year loan at 4% nominal, then in 1 year I have 4% more money than I started with, meaning that I can buy 9.2% more than I could the year before. Last time I checked, 9.2% > 5%. There is still an incentive to make loans in a deflationary environement.

You really don't get it.

Incentive to make the loan is not the issue. it's incentive to borrow at that rate that disappears.

Real interest rates matter, because they are the ones that affect investment decision. To make it simple: should I buy corn seed now to plant it and get more corn seeds next year? Well, it depends if the yield in corn seed exceeds the interest I need to pay in order to borrow corn seeds now. The interest expressed in corn seeds, obviously, not in dollars.

But you can't borrow in corn seeds, you borrow in dollars. So the inflation/deflation of the value of corn seeds will affect your decision.

If you could afford to borrow in corn seeds with a 3% interest rate expressed in corn seeds, it means the rate you can afford in dollars is 3% + inflation. If inflation is minus 5%, the interest rate in dollars that you can afford is -2%, and obviously nobody will offer to lend you money at -2% since they'd rather sit on their money.

So because of deflation, productive investment will no happen. And that's bad.

Uh, wrong? Investment that is priced out is by definition not productive enough. Printing money to lower the interest rate does not change the amount of real resources; it just allows real resources to be diverted from more productive activities that could afford the real interest rate to less productive activities that are priced out by the real interest rate.

Price caps cause shortages. This is not rocket science.

Using your example above let's say that the borrower and lender agree that 4 percent is the fair rate (agreed between buyer and seller) of interest for all factors (risk premium, liquidity premium) except for inflation expectations for a one year loan of $100. Let's use three different price environments to price the loan. Scenario A. No change in prices, inflation expectations at 0. Scenario B A five percent increase in prices, inflation expectations at 5%. Scenario C a five percent decrease in prices, inflation expectations at -5% (or 5 percent deflation.

Scenario A.
Interest Rate: 4% (4+0)
Proceeds at Maturity: $104

Scenario B.
Interest Rate: 9% (4+5)
Proceeds at Maturity $109

Scenario C
Interest Rate -1% (4-5)
Proceeds at Maturity: $99

This is where the system breaks down. Lenders will not enter into the loan because the could receive $100 in one years time by not making the loan. The borrower won't accept the loan at zero percent because the rate of interest is not fair.
Deflation breaks down the financial systems. There are demand for loans but no way to price them leading to a decrease in financial activity and further price decreases creating a vicious cycle that is hard to break.

So, if I lend you some money worth $5 / dollar
and you pay me back some money worth $6 / dollar
+ interest

this is bad for me because?

Are you kidding me or what?

It's great for you, bad for me.

I agree. The market would encourage and discourage it.

What if you use your loan to make a profitable business and can pay off the loan and still be plenty profitable. Sounds like great for you, great for him.

Not sure what I would be joking about.

Under my scenario's A and B it is great for both. Under scenario C by definition it is not. I honestly don't think the Austrians disagree with deflation being bad. I wonder if people think of price deflation as consumer prices as opposed to asset prices falling. Sure it would be cool to get stuff cheaper but when housing prices are falling nobody buys houses, people that build houses lose their jobs, etc. I don't think there has ever been a period in history where falling asset prices has been good.

There is so much fail in this post that it is hard to know where to begin. First of all, in the absence of a fall in the supply of money due to confiscatory deflations or fractional reserve bank collapses, price deflation is simply indicative of the economy growing faster than the money stock. I.e. each unit of money buys more goods and services over time. That's a good thing. That's what economic growth is; people getting wealthier over time.

Second, your scenario above is completely arbitrary and constructed to produce nonsensical results. Prices coordinate supply and demand, including the supply of and demand for loanable funds. You've constructed a scenario where you arbitrarily claim that a negative price is the "fair" price, and then complain that said transaction will not occur. Of course it does not occur. Negative prices do not obtain in the real world; if you think you've identified a negative price, you have the buyer and seller backwards. The fact is that regardless of any endogenous inflationary or deflationary trend in the supply of a hard money like gold or silver, the market will equilibrate supply and demand in the market for loanable funds and arrive at a positive real interest rate, and projects that cannot meet the burden of this rate will be priced out, as they should be, so as not to waste real resources on less productive projects.

I think your purposefully being obtuse to the pretty simple zero lower bound problem.

Borodog tried to sound like a FED president, who uses phrases like "consumers are exhibiting a negative propensity towards risk" when all he had to say was: "Due to the increase in unemployment & lack of confidence in the economy of those still employed, consumers aren't spending at the rates we've seen in the past."

"A negative propensity towards risk" sounds so much softer than: "10s of thousands of homes are in foreclosure & those who work in the construction trade are either collecting unemployment or now on welfare, while those still employed wonder when they'll be next."

Kinda like: "shell-shock" vs. "post-traumatic stress syndrome" or "bi-polar" vs. "manic-depressive"


Only the FED spins it better than FOX !

Irony.

It is not a "problem" that prices have a zero lower bound.