Interest in a gold economy, part deux

I came across this thought experiment on another website. I don't know the answer for certain, but it helped clarify a few things in my mind.

The key difference between our world and the hypothetical fixed-gold reserve world is that in the latter, money keeps getting more valuable. If I loaned out a one ounce gold coin, when that coin was returned to me, it would be worth more. There's a built-in "interest".

One might argue that because of this, there would be no nominal interest in such an economy: loan some money, and when you get it back, you receive more value. However, if that was the case, then nobody would loan anybody any money. That same interest could be earned by burying the gold in your back yard and digging it up later.

For loans to exist, there would be have to be some additional nominal interest on top of the "built-in interest". Because of the "built-in interest", the nominal rates would probably be lower than in our world, though actual interest rates ("built-in" + nominal) would probably be similar.

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We can make a general statement that the rate at which money becomes more valuable in such an economy is the rate of growth of that economy. As goods and services become more plentiful, yet the amount of money stays constant, money becomes more valuable. The rate of growth of the value of money would have to be close to the rate of growth of the economy.

So why would anybody loan out any money in such an economy? He would have to believe that the debtor has the means to outperform the general economy. That's the only way the creditor could be paid back a greater return than he could get by burying the gold in his back yard.

Thoughts?

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Break it down into supply and

Break it down into supply and demand and remember that individual people have different preferences. Even now, there are borrowers who are both willing and able to pay very high interest rates for loans. They don't actually do it because they don't have to. In an economy with deflating money, these people would make up the borrowers. People who are willing to borrow at a low interest but not at a high one simply would not be borrowing money at all in a deflating economy. But the ones willing to borrow at sufficiently high interest would still be borrowing. So there would still be demand for loans in such an economy - just not at much.

As for lenders, the situation is like what it is now. Today people have a choice between keeping their money and lending it at interest. Some prefer to lend it at interest. In a deflating economy, same thing.

So while deflation would change the composition of lenders and borrowers and therefore affect the interest rate (the market equilibrium price of a loan), it would almost certainly not completely eliminate willing and credible borrowers, and would not obviously affect willingness to lend in any particular direction.

A factor I neglected is that

A factor I neglected is that an economy with improving productivity should help borrowers to pay off loans. This will boost demand for loans. For example, suppose the nominal interest rate in a deflating economy with improving productivity is 2%. If deflation is (say) 3% because correspondingly the annual increase in productivity is also 3%, then in real terms, the interest rate is 5%. But a typical borrower will in a year be making 3% more in real terms (ie 0% more in nominal terms) than he makes today, improving his ability to pay back the loan compared to a borrower in a static economy. Relative to his ability to pay it off, the 5% real interest rate is similar to a 2% real interest rate relative to a borrower whose productivity, and therefore income, is not improving.

The gold coins would still

The gold coins would still have interest since interest comes from positive time preference. Any consumer good is worth more today for consumption today than it's worth today for consumption next year.

If you were to loan out a gold coin today for one year at no interest, you are making at least two sacrifices for which you need to be compensated.

First, you are taking a substantial risk that your coin will not or cannot be returned next year.

Secondly, every day that you hold your coin over the next year gives you an option of making a beneficial use of the coin, whether it's to exchange it or to turn it into toothpicks. If you loan it away, all of the possible uses of unkinown value have disappeared.

Regards, Don

It is a psychological problem, a problem of scale.

If a person has $10,000 in his pocket he may give $1,000 to charity but if he only has a dime he might be reluctant to give a penny.

Not to start a new thread, but Cryptonomicon is half consumed

and I find the story quite compelling, the jumping between major character threads and time differences, jolting, and the level of detail bordering on the obsequious.

Just thought if anyone else felt similarly at the half way point?

The detail is the fine wine

It's meant to be savored. Stephenson is a brilliant thinker, not just a writer. When he studies something, he understands it fully, and when he writes, he wants to show that he understands it fully, and tries to get the reader to understand it fully.

I can't say that I understood cryptography completely after reading the book, but certain things I did understand better. For example, his demonstration of continuous plotting of someone's head's altitude as he walked around London could create a map of the city was pretty cool (I'm going from memory so I probably got the details wrong). As was his showing how to create a digital computer without transistors.

Finished the book, very enjoyable

so what other Stephenson title is recommended? Is there any sequel to this book? The ending left me wanting more.

There's a "prequel" trilogy

I put prequel in quotes because the trilogy contains some ancestors of the Crypto characters but is otherwise unrelated.

But if I were you, I'd read _Snow Crash_ next.

On interest -- nominal and real

Real interest refers to the amount paid for the privilege to use resources now rather than waiting (or forgoing). I sense that real interest rates are high when there is a lot of competition for resources – that is, when many people perceive a big difference between the expected difference in outcomes between using resources now and waiting/forgoing.

Nominal interest reflects real interest plus adjustments for inflation/deflation.

Yes, I’d expect to find deflation in a world with a fixed amount of currency and a growing economy. But it is unclear to me that this dynamic would have any bearing on real interest rates, or real rates of economic growth. I'd expect that people would still lend and borrow on pretty much the same basis as they would today -- that is, charging a nominal rate of interest that reflected the real rate adjusted for the anticipated rate of inflation/deflation.

What difference does inflation/deflation make? In theory, none; people should be able to adjust their expectations accordingly. But I am aware of three provisos to this conclusion.

1) The act of making adjustments is not costless. Where I live, my employer doesn’t have to maintain a staff to constantly adjust employee salaries every month; no one cares if direct deposit happens at 12:01am or 11:59 pm; my landlord is ok with the excuse that the check is in the mail, provided it really is in the mail. None of this is true in environments with high inflation. Coping with “nominal” inflation/deflation causes people to bear real costs.

2) Even if the rate of inflation/deflation is conceptually irrelevant, the predictability of the rate of inflation/deflation is not. Imagine that you enter into a contract for a monthly delivery of goods/services at a constantly-increasing price matching the expected rate of inflation. Suddenly inflation levels off. Now you’re locked into paying above-market prices for some goods/services, placing you at a competitive disadvantage relative to your competitors. This example illustrates that the problem arises due to the inability to predict the rate of inflation/deflation, not to the rate of inflation/deflation itself. Yet most discussions about the problems of inflation/deflation are really problems about the inability to predict inflation/deflation.

3) Evidence shows that people anchor their expectations to numbers -- such as the sizes of shoes or dresses or paychecks or house values – and are unwilling to adjust their expectations with respect to those numbers. In economics, people say that wages and home prices are “sticky.” A degree of inflation permits shoe buyers/dress buyers/employers/homebuyers to see sizes creep up and prices creep down in real terms without forcing anyone to confront this psychologically difficult reality. Allegedly, this silly-sounding dynamic facilitates real transactions.

Is “stickiness” a big deal? Yes, especially during times of deflation. I want to buy Joe’s farm, make capital improvements, and increase its productivity. But I’m not going to pay more than the farm’s current market value. And Joe can’t accept that the current market value is less than the amount he had become accustomed to believing. (Also, Joe borrowed money and used the farm as collateral. The farm is now worth less than the loan balance. The bank can’t accept this fact. So long as Joe refrains from selling the farm, thereby confirming that the farm is really worth less than the amount of the debt secured by the farm, the bank can live in denial that its loan is not really secured, and the bank can refrain from reporting this fact to regulators and the financial industry, etc.) But, of course, Joe knows that he’s on thin ice here. Joe isn’t going to make capital investments in a farm he thinks he’s about to lose. In the long run both Joe and the bank will likely have to confront the new realities. But in the meantime resources are stuck in suboptimal uses.

It’s not surprising that people don’t like losses. But what is remarkable is the degree to which people’s reluctance to recognize losses that have already occurred hurts society. Some argue that the reason both the Great Depression and our current recession are so long is because of “stickiness” -- people’s inability to predict/accept the new market value of their goods and services.

What difference does

What difference does inflation/deflation make? In theory, none

I was under the impression that the issuer of currency uses his freshly minted ex nihilo notes to bid against those of us who must trade goods and services to obtain notes. Thus, inflation benefits the issuer of currency at the general expense of all who receive money in trade.

Or, to recast your quote: "What difference does counterfeiting make? In theory, none." Does counterfeiting make an economic difference?

Good point

Ok, "none" is too strong a term. I meant to say that the transactional problems posed by inflation/deflation mostly correspond to the inability to anticipate the rate of inflation/deflation, and differ from the issue of real interest rates.

Old hat

Johnathan,

This is old hat. I've read about this in published books. No need to rehash. Pick up some Austrian economics books.

I've commented on many blogs on this subject, so I'm kinda getting tired of the repetition. When a commodity becomes a money it becomes a token for exchange of goods. In a pure commodity based monetary system the person who saves that commodity is in fact lending out the resources that he created to earn that commodity money. He is in a way acting as an entrepreneur who has invested in the ultimate indexed investment. Should others squander his (and all other hard money holders) traded resources then the value of money will go down, and the money "horders" will lose on their indexed investment. Wereas if the resources are invested wisely the the value of the commodity money goes up and when spent the "horder" gets his cut of the increased productivity that he provided the resources to achieve.

So hoarders are actually investors. They invest the saved products they produced as inputs into the entire economy. They suffer the consequences of that investment via consumption based inflation or reap the benefits of that investment via productivity driven deflation. What could be more fair?

All without the danger of some middleman pulling a Ponzi scheme on them, or fund fees, or trading fees, or taxes. Nor with any required minimum balance, or minimum investment.

It's the perfect investment scheme for the poor (as has been pointed out numerous times) and does not have the danger that the return on investment will be out of line with the actual underlying goods. By definition the amount of goods to be earned or lost from inflation/deflation will match the excess consumed or produced.

Not old hat

Now something that is not old hat is a method I thought up for achieving a gold based sub-economy within our own without having to do something as silly as seasteading. Not that it was the motivation for the method. It was just an outcome.

Problem is that the method takes too much discipline and would conflict with existing ideological notions people have. Clashes with things like Christianity, and atheism.

Of course, like most imagined systems it would probably fail in practice. Plus it would take a lot of effort to get going. Which is why I haven't bothered. I'm risk adverse at this point in my life.