zlacker

I've wondered the same thing lately whenever someone here posits that defaults cause the destruction of money.

I'd love to see this properly explained, because it definitely has a counter intuitive ring to me.

>>jddj+(OP)
Whoever defaulted spent the money on something else, so it's still in circulation somewhere, just not in a form the original creditor can get hold of.

>>sidesh+a
That would be my intuition too. But if you go down almost any "this crisis won't cause inflation because..." rabbit hole on hacker news, you should see multiple unopposed claims that defaults lead to deflation through the destruction of money.

I'm pretty ignorant in this field, and usually I've been a day or so behind the posts (missing the window to press for more information), but I feel like there's definitely some contention there.

>>jddj+K
The difference is that it's the liquidation process from defaults that causes deflation, not the defaulting itself. Without the liquidation process, if you assume defaulting had no consequences, that's indeed inflation - as everyone is allowed to create money without consequence.

>>jddj+K
Here's how I would think of that:

Suppose I'm a bank, and I lend you $10 to buy apple tree seedlings. You spend all $10 on seedlings as promised.

The person who sold you the seedlings has $10. You have the seedlings. I have an expectation of getting $10 in the future, presumably from your sales of apples.

Because most people repay their loans, I'm confident I'll get the $10 back, and being a bank, my business is lending money. I might treat the $10 loan as $7 on my balance sheet when I decide how much money is safe to lend out.

Then the price of apples crashes. You come to me and say, 'look, there's no way I'll make $10 selling apples in the time I promised to repay you. Best I can do is deliver you the seedlings or sell them to my neighbor for $3 and give you that'. I grumble a little, but take your deal.

The person you bought the seedlings from still has $10. Your neighbor now has the seedlings and $3 less. I now have 3 real dollars instead of 7 hypothetical dollars. In other words, 4 hypothetical dollars disappeared. When I decide how much to lend out, I'll be basing that on $3 I know I have, instead of the $10 I thought I'd probably get back. I don't lend as much money to aspiring orchardists (orchardeers?), and the price of apples rises.

Edit: This fragility is probably a major factor why some people are so against fractional reserve banking (my counting hypothetical dollars as having value) but without that hack, there's no saying I could have lent you the original $10, so it's a bit of a double-edged sword.

>>jddj+(OP)
It works like this: imagine we create some new Bank. Customer A deposits his life savings of 1 million hackerbucks.

Now our Bank loans out 50,000 of those hackerbucks to Customer B. It does this by crediting her account with 50,000 hackerbucks, but notice that Customer A still has 1 million in his account - so now there's 1,050,000 hackerbucks in apparent existence - we've created 50,000 hackerbucks from thin air. If Customer B withdraws the loan money to go spend it, the Bank will have 950,000 in reserves and an asset worth 50,000 (the loan). Customer B will have 50,000 in cash.

What we've actually done is increase the "M2", one of the measures of how much money is in the economy.

If Customer B either repays the loan or defaults on it, that new money disappears. In the loan repayment case, the Bank goes back to having 1,000,000 in reserves, and in the loan default case the loan asset becomes worthless and it is left with only 950,000 in reserves (the other 50,000 is out there with wherever Customer B spent it).

>>sidesh+a
Sure, and that's just like a net effect of a gift from the creditor to the debtor, which doesn't have any effect on the money supply.

>>SuoDua+Z6
So in this case the business did not create as much wealth as intended (it produced apples which turned out not to be needed as much they had originally planned).

The default is a side effect of that outcome, not its cause.

>>bronze+r6
Thanks. I think this point has made it a lot clearer.

So sure, the loaned money might still be in the system in some naive sense, but value has been destroyed in the asset price? Suddenly a lot less money buys a lot more asset and that's where we find the deflation.

If I borrow 1M for an asset in good times and can't pay it back, the creditor gets the asset and probably gets a good portion of that 1M back. If that same scenario plays out in bad times and my whole street defaults on the same asset at once, there's a resulting fire sale and far more value is destroyed (including being wiped off neighbouring, non-creditor-owned assets of the same type) than money added by leaving the loan sloshing around somewhere else in the economy.

>>caf+H7
Thank you for clarifying.

So the bank's speculative asset loses value: I struggle to see this as money being destroyed as it wasn't actually money, it was an asset with a price attached to it which has now changed. In contrast to money sat in your bank account, the price was never redeemable (you couldn't go spend it on beer) unless you used that asset to get the debtor to pay you back (or convinced someone else it was worth buying from you as a speculative asset). You might as well say money is destroyed when share prices tumble. Maybe this is the point of such arguments, to make the case that money is no different to any other asset, but we don't tend to treat it like that in reality. Or do we?

>>caf+H7
If Customer B repays the loan, the new money disappears but the money made in interest stays. Eventually does a bank get to a point where it has enough real money, that it can lend it out instead of increasing the money supply?

>>sidesh+H9
Could you not see the $4 disappearing on the GP scenario?

>>marcos+LF
I can see that the bank ended up with $4 less than it planned to, but I don't see that as money being destroyed. It happened because the original estimate of hypothetical dollars was wrong. (Also if the hypothetical dollars are "money" then you're double counting it: creating $10 in circulation has required creating $17 overall which strikes me as poor notation to say the least). (Also if all had gone according to plan, the extra $4 would have come from the pockets of people buying apples. That $4 is still in circulation, either in the same pockets or it got spent elsewhere).

Suppose I buy a painting. I believe it to be an original Van Gogh so I pay $10 million for it. I then find out it is fake, and worthless. Was $10 million (of money) destroyed? Of course not, I just mis-valued an asset. Suppose it then turns out to be real after all. Owing to the fascinating history of this painting it is now valued at $20 million. Was $10 million of money created (relative to the moment when I originally thought it was a Van Gogh)? No. Was $10 million of wealth created? Yes as the world now has one more thing worth $10 million in it.

Money != wealth, even in the materialist sense where wealth consists purely of goods and services. Money is a metric we use to keep track of wealth, and in general it's considered helpful if that relationship holds, so if we're trying to maintain that relation rigorously the central bank should print another $10 million (or create it by making loans) to reflect our knowledge and appreciation of the Van Gogh - if it doesn't then the existing fixed quantity of money in the system will now be representing a greater quantity of wealth, causing deflation.

As I said in my other post I am not an economist by training. If the economists want to call this thing that got created/destroyed here "money" then I guess I should let them, but I would like to hear a good reason why it makes sense to do so, and I haven't heard one. Absent of a good reason I might as well call it haddock. Or, considering the OP was asking which things that could be explained better, we could acknowledge what any good programmer knows: part of a good explanation is choosing the right names for things.

>>sidesh+101
As I think of it, credit (what got destroyed) and currency (what was used to create the credit) are interchangeable - $10 of credit buys as many seedlings as $10 of currency, hence we think of them as one 'thing' - I might call 'money' the category including both, though I'm no expert in economics either and these might be nothing like the official jargon. But what does seem reliable is that destroying $4 of credit has the same effect on the price of apples as would destroying $4 of currency, though the latter is a more rare event.

>>sidesh+te
It's money in the same sense as the money that was created by the loan in the first place is money - it's not physical currency, but the insight is that the money created by financial means like this bids up prices in the same way as literally minting extra physical currency and distributing it would.

When that loan asset is written down the bank has to make up the difference from its equity - this ends up reducing the amount of loans it can write, so you get a contraction in the monetary supply.

So in the end, I guess the shorter answer is that a default destroys money in the same way that writing a loan creates it - you might well complain that no actual currency has been created or destroyed, but the argument is that it has a similar overall effect.