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Q&A: Is Bankruptcy Really Deflationary?

Question

Bankruptcy

You've said bankruptcy destroys money and causes deflation. But consider the following: you loan me $10 and I buy $10 worth of gold, then give the gold away and go into bankruptcy. The $10 transferred from you to me to the seller of the gold. The gold transferred from the seller to me to the receiver of my gift. In our little economy, neither money nor product has been lost--the commodity has the same value and the money has the same value and neither product nor money entered or left the economy. The only thing that changed was that my obligation to pay you back was removed. But this does not affect either factor determining how much money is worth (the amount of money and the value of product in the economy). Decreasing the amount of "credit available" in an economy however, is destructive of money and therefore deflationary (as it results in a lower ratio of money to product within an economy).

Answer

Interesting example. It looks like I got the short end of the stick in this little economy.

The first thing we need to get straight is that monetary "inflation" and "deflation" are not about ratios at all, but only refer to increasing and decreasing the money supply. A lot should be cleared up simply by understanding that true monetary inflation and deflation have to do with the expansion and contraction of the money supply, distinct from the effect this can have on prices. While it is important to then extrapolate the potential effect of inflation and deflation on prices, it is crucial that you do not equate inflation or deflation with price movements. Prices can move for any number of reasons, including inflation and deflation, but are distinct from the expansion (inflation) or contraction (deflation) of the money supply.

Back to your example. Prior to the bankruptcy, you not only transferred the $10 to the seller of the gold, but you also still owed me $10 dollars and whatever interest I may have been due on that $10 (I do not typically lend my money for free--especially if, as you indicate, the initial default rate of our little economy is pushing 25% from the start!).

On my end, that $10 loan was viewed as an asset, as was the potential income from that asset. This is considered "money" under a broad definition (M3 under the different classifications of money). Until you defaulted and declared bankruptcy, our little economy had $10 in cash, some gold, a loan worth $10 at par value and potential interest on that debt of, let's say 10% per year for 5 years. But without a central bank, there is no other money than that which the seller of the gold now has--so the concept of interest on the money would have been impossible and either you or I would have been quite the fool for this loan.

In a real bankruptcy, your assets would be liquidated and any assets you hid or attempted to exempt from bankruptcy through gifts and non-market sales would be revoked, so I would likely get the gold from your friend in recompense for the loan on which you defaulted. I also did not notice any police in this little economy you created, so you and your friend who had the gold are likely in serious trouble of another sort!

Now, for this little economy of ours to more appropriately mirror the real world in which we live, we should introduce a central bank which creates new money to keep up with population growth, the borrowing habits of our government, and the proper functioning of the fractional reserve system. Therefore the concept of the interest on the loan would have the potential of existing with excess money being created to fund the interest.

(Quick but important side note: it is impossible in terms of moeny and in the context of a fractional reserve system to, at any given time, pay back all the loans and the interest on those loans created without inflating the money supply. Further indebtedness or printing of new cash is required unless bartering of assets is allowed to meet interest and principal demands. Since this creation of new money is typically an extension of credit, this creates a vicious, self-perpetuating cycle that causes inflation to be basically essential for the "proper" functioning of a fractional reserve system. In the long-term, this monetary inflation leads to price inflation.)

Whether you accept my economic example, which includes a central bank, or stick with your system, which more closely resembles a barter system without the introduction of any new capital, you end up with inflation in the creation of the loan in the first place. This act expands buying power in the present by borrowing against anticipated value in the future. The $10 is a new "asset" in the system that is to be paid back by the borrower in one way or another, and typically with interest. This is balanced with the creation of a liability against the borrower, but nevertheless the asset now exists for the lender. The seller of the gold has $10 to spend and the lender has an asset that could be sold or even borrowed against. This is inflationary as it has added buying/borrowing power to the economy.

If you default and successfully declare bankruptcy, this loan that was considered an asset may be wiped out along with any interest it could have produced. That is a reversal of the inflationary creation of the loan in the first place and would be deflationary by definition since it removes the buying power of that capital and interest from me, the lender.

Whether or not your friend gets to keep the gold would be irrelevant to the deflation question because the gold would have been in the economy whether it is in my possession as the lender or in his possession in collusion with you to avert the consequences of bankruptcy. The seller of the gold keeps his $10 and this would not be a part of the equation either--it is all about that loan, the additional buying power it created, and the interest that it represented, being wiped out.


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bankruptcy, borrowing, central bank, debt, deflation, inflation, money, Q&A

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