Adam Smith talks about this phenomenon in Chapter IV (The Origin and Use of Money)
in The Wealth of Nations:
“By means of those operations [inflating the coinage], the princes and sovereign states which
performed them were enabled, in appearance, to pay their debts and
fulfil their engagements with a smaller quantity of silver than would
otherwise have been requisite. It was indeed in appearance only; for
their creditors were really defrauded of a part of what was due to
them. All other debtors in the state were allowed the same privilege,
and might pay with the same nominal sum of the new and debased coin
whatever they had borrowed in the old. Such operations, therefore,
have always proved favourable to the debtor, and ruinous to the
creditor, and have sometimes produced a greater and more universal
revolution in the fortunes of private persons, than could have been
occasioned by a very great public calamity.”
It follows, of course, that deflating the currency is favorable to the creditor and ruinous to the debtor; although I can't find where Smith says that, I think he does. In a sense it's worse: the creditor's losses in inflation are limited to the amount she originally lent.
Just to be clear, it's an argument against fiat currency as deflationary and inflationary shocks occur in those systems. The effects of deflation and inflation over time are countered with market-set interest rates -- higher savings and loan rates in an inflationary period and low-to-negative rates in a deflationary period. Yes, in a deflationary economy a (for example) -5.00% interest rate might be fair and would happen were it allowed.
Why would you ever lend money at a negative interest rate? You can always get 0.00% with virtually no risk just by socking the money away in a secure location. This is the heart of the problem with deflation (and deflationary currencies like bitcoin) - there's a 0.00% floor on the time cost of money.
Yes, you are right of course. The interest rate could not rationally go down below zero, but there would still be demand for loans during the deflationary period, so there would be other compensation (like equity in a business) in exchange for the load so that the risk/return would be proportionate to the risk-free rate of holding cash.
There will certainly be demand for loans, but the supply and demand curves for loans may not intersect anymore, meaning that no loans are made (because given a deflation rate of 5%, a nominal interest rate of, say, 1.5% (only a very small premium over the minimum risk-free rate of 0.00%) is still a real interest rate of 6.5%, which may be more than many of the loan customers are willing to pay.
In other words, deflation makes financing any risky enterprise much harder, so only the mostly highly profitable projects succeed. This makes sense, because in a deflationary environment just holding a pile of cash is a profitable endeavour.
Austrians don't advocate for a deflationary currency, they advocate for competing currencies. Rothbard, one of the "pillars" of Austrian Economics, even stated that The Great Depression was due to deflation not inflation.
Lots of people that scratch the surface of Austrian Economics immediately start shouting the ills of inflation and such.
Most "hardcore" Austrians I know would like a currency that's supply grew with economic growth. Economy grows by x measure then so does the currency, to keep it stable.
Thanks. I knew this was wrong as soon as it left my keyboard.
I guess the problem we're having is that the Fed's mandate is to keep unemployment low, not to expand the currency as the population expands.
I really don't understand how a currency supply is supposed to track growth, when one of the means of controlling currency expansion, the discount rate, can actually stimulate growth sometimes, right?
“By means of those operations [inflating the coinage], the princes and sovereign states which performed them were enabled, in appearance, to pay their debts and fulfil their engagements with a smaller quantity of silver than would otherwise have been requisite. It was indeed in appearance only; for their creditors were really defrauded of a part of what was due to them. All other debtors in the state were allowed the same privilege, and might pay with the same nominal sum of the new and debased coin whatever they had borrowed in the old. Such operations, therefore, have always proved favourable to the debtor, and ruinous to the creditor, and have sometimes produced a greater and more universal revolution in the fortunes of private persons, than could have been occasioned by a very great public calamity.”
It follows, of course, that deflating the currency is favorable to the creditor and ruinous to the debtor; although I can't find where Smith says that, I think he does. In a sense it's worse: the creditor's losses in inflation are limited to the amount she originally lent.