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when the banks run out of money that is also money not being able to move where its needed.

we can call that "flexibility" if you prefer.

The point is if you have zero supply inflation, liquidity shocks are magnified.

there's no decentralized way to solve the problem, the best we can do is pick a small stable number to cushion liquidity shocks.

satoshi jr 2d ago

OK let me try to steelman your argument.

Company a has liabilities due soon and must be financed. It usually does so by taking loans from a bank which is repaid by the proceeds from the final good they produce.

There's a extrinsic shock that suddenly made company b unable to repay their loan to the same bank.

Because of this the bank is unable to finance company a at the same rate.

In a elastic money supply a government can increase the ms to increase the amount of currency units to reduce the cost of capital and stabilize prices so that company a can finish their production and the damages of company b failing is minimized.

If you want to avoid a gov as money supply creator a bank could also just increase their own currency units

Essentially you moved the risks of failure out of bank a into the currency in both cases.

Sound right?

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Hanshan 2d ago

That's certainly a thing that could happen.

not sure what you mean "risks of failure out of bank A into the currency in both cases"

I don't think it quite addresses the point that we're talking about, the entire system and how it's going to avoid liquidity shocks, demand shortages and deflationary contractions on a hard money.

but for the sake of the discussion we can go with this 👍

satoshi jr 2d ago

Cause if you can't make money to lower the price of capital either company a has to pay a higher rate and or the bank has to realize the losses from company b failing.

The price suppression from money supply changing means that the currency now has more units than before compared to a underlying collateral so its more likely to fail or if its fiat the purchasing power of the currency gets debased.

Well isn't this what you're referring to in terms of a liquidity shock? When company a is unable to finance its production due to the money destroyed? Deflationary contraction is just this situation rippling through an economy right?

What do you mean by demand shortage? Demand of what?

Hanshan 2d ago

gotcha.

I think this example is specific to liquidity shortages and solvency. it doesn't quite describe a deflationary contraction, although this scenario would ripple out throughout the economy in the case of a deflationary contraction.

there's just more different assets, institutions and examples to bring up to describe "deflationary contraction" more completely.

maybe another way we could clarify what I mean and tie it back to the Lightning Network

suppose your bank has illiquid assets (bonds or real estate something) that it could sell at a loss to cover their liquidity crunch. so they're technically solvent but they have a liquidity problem. so the network is divided and the friction causes a liquidity problem.

(not saying that onchain versus LN is this bad, just saying it's *like this)

"demand shock"

I just mean the other side of the equation from "liquidity crunch." demand goes down, reducing liquidity. the pattern could begin with negative demand because of a crop failure or a pandemic or whatever.

satoshi jr 2d ago

OK for your collateral example I think you're misunderstanding the real issue of liquidity.

In our current system there's 2 main issues.

1 collateral rehypothecation, there's more claims on the collateral say mortgages cause bonds have more issues. There's more claims on the dereivarive instruments from the mortgage than the value of the underlying real estate.

2. The value of the underlying is fundamentally a stream of future dollar's. Which is all debt.

The problem isn't that illiquidity is some artificial aberration from the market. Where the price of the distresset asset is wrong.

Its that given the increased risks in the market caused by the shock your assets are actually worth less. The market would clear just fine if prices could adjust.

The reason we can't is that market clearing Price of all the debt based assets would be 0, or very close.

So in your example they actually aren't solvent system wide because as liquidations happen all the leverage which is more than the assets that got liquidated would cascade.

In my example company c can't get a loan and fails because company a couldn't pay their debts.

Your interpretation is that this is a market failure but what it really is that these companies are really actually insolvent at the new cost of capital. They're supposed to fail.

Demand of what would fall?

Demand of. capital increases during liquidity shocks. Demand of real goods and services also unaffected in first order effects.

I literally don't known what you mean