In our last installment we examined a barter economy and its transition to a simple monetary system. We also saw how, with the introduction of paper currency, the concept of fractional reserves and explicit monetary manipulation were introduced and the examined initial effects of the same. Having taken our economy to the brink of a crisis of confidence, let us pick up there, and see what happens when too many receipts are presented for redemption.
Eventually, Og will have printed too many receipts. It may be nothing in particular that sparks the crisis, but for our purposes, to bring the collapse a little faster, let us say there is a bad harvest, and on the following year, during planting season when much of the grain has been withdrawn, a terrible fire sweeps through the town, requiring huge rebuilding of many businesses and homes. As people present their receipts to the warehouse to recover their wheat, at some point the warehouse is found empty, while there are still claims outstanding. And so the whole scheme collapses.
People suddenly find their scripts are nearly worthless. As they are the only means to pay taxes they will still circulate to some degree, but at a tremendous discount, trading at a hundred to one discount or greater. Most trade, however, will be barter, or trade against physical bushels of wheat, rather than receipts. Economic activity will continue, but much more slowly. Almost all stored wealth will have been lost in the crash, as the receipts are now worth a fraction of what they were. Those who saved to expand their business or to start a new enterprise will find themselves with nothing. Things will slowly recover as people build up new stores of tangible wealth, but it will take time to return to the prosperity they once experienced.
As King Og slept through some of his classes at the London School he does not adopt the FDR or Hoover solutions, trade barriers, government interference, monetary manipulation and micromanagement of labor, and so the economy recovers. Accepting that maybe the creation of his bogus scripts was a bad idea, King Og decides to bite the bullet, tell the people the truth, and rebuild the economy in a most sensible way. Og begins to collect taxes in physical bushels of wheat, enacts austerity measures in the government, and thus accumulates a large surplus which he stores away, until he collects enough to redeem the remaining outstanding scripts. Having done so, he then begins to issue the “new bushel” a different currency, which he promises will be backed 100% with wheat.
With money back on a sound footing, and with everyone’s losses restored, though thanks to inflated prices restored at a real worth less than before, the economy has largely recovered. Thanks to Og’s new dedication to fiscal responsibility the economy continues to grow and prosper. His security measures keep the city secure, and being paid out of tax revenues rather than through monetary inflation, there is no more boom and bust cycle.
And that, in a nutshell is how a managed money supply gets us into trouble. The Keynesians, Monetarists and others, seeing only the boom think that inflation is beneficial*, and so they create the myths that inspired FDR to try to “prime the pump” with government “investment”. It is a dangerous theory, as the truth is, quite simply, goods trade against goods. Creating more money only lessens the value of money in the system. For a time, the increased supply of money may loosen credit, creating the appearance of health, but it is more the rosy glow of incipient fever than ruddiness of real health.
Well, this has dragged on much longer than I expected, and my health is still not great, so I will cut this off for now. Next I plan to revisit Og as he tried to become Emperor Og. And, more importantly, as he learns the lessons of hyperinflation and the futility of trying to buy our way out of a recession (much like our current bailout plans). I may also visit Og’s neighbor Ug who did not institute a central bank but meddled with a private bank system to show that the harm is in meddling, not in the way the meddling is done.
But we will see. For now we will leave Og and his subjects happy and wealthy, though I am afraid they won’t stay that way long.
* Actually, Keynes also proposed constant inflation as away to erode the absurdly high wages demanded by organized labor, but in that he was being rather obtuse. As everyone knows, labor responded by simply including COLA escalator clauses in contracts, thus removing that supposed benefit from an inflationary policy. And as that was the only legitimate claim in favor of Keynes’ theories, it made his arguments entirely worthless. (The actual solution is to eliminate government mandated collective bargaining, as that will end such absurd contracts.)
NOTE: This is a reprint of an old essay first published in the, now defunct, Random Notes blog, and later reprinted in the still extant Ghost Squirrels blog. Typos have been corrected, some minor changes made to content and some reformatting has been done.