Monetary Issues Made Simple Part 2

Back to Basics

In our last essay, we discussed Say’s Law and the general principle that goods exchange against goods, and that inflation is neither the result of a lack of supply or surplus of demand. Inflationary pressures are not a natural part of the market, but are instead a phenomenon with a monetary origin.

Let us look at a very simple system to make this point.

Suppose you belong to a simple hunter gatherer type tribe. You catch critters, gather fruit, and make clothing and tools out of hide and wood and stone and whatever else you can find. Either you provide for yourself or you make something or find something to trade for your needs. There is obviously no inflation or recession in such a system. At times, thing may be less valuable. For example, when berries are in season, it may take a lot more berries to trade for a rabbit, or when there are lots of bunnies they may trade for fewer berries, but there is no such thing as recession or inflation. Everyone either supports themselves or starves, unless they can find someone to support them.

Now, let us introduce government. Chief Og rises to power. Og decrees that his logistical skills demand too much of his time, so he and his staff of elders need to be supported by the rest of the tribe. To that end, he decrees that citizens must pay two rabbits each month, along with one antelope a year, or something similar. Now, this system has an advantage over our present system, in that it prevents anyone from thinking the government can create wealth. Og and his cronies are clearly a drain on the economy, doing no work and taking wealth. They may serve a valuable enough purpose that that drain is worth it. (I have always argued some government is essential.) However, when they give someone “their” rabbit, it is clear they did not create the rabbit, they are redistributing the rabbit caught by Ag or Em or Ot. At this stage, while limited to barter, there is no way to carry out the modern deception that somehow the government can create wealth, or even create jobs. The jobs are there because people need things, they are not a government creation*.

Now, let us complicate matters a bit. Og and his tribe settle down and start farming. They grow wealthy and there is some specialization. Farmers farm, craftsmen craft, rulers rule. King Og still exacts tribute, but he has to demand specific goods from each category of labor. To simplify this, he institutes money. He decrees that wealth will be measured in bushels of wheat. As a lot of wheat is grown, that makes it a good choice. It also is almost infinitely divisible, can be stored a long time, and is in demand, so it makes an ideal commodity money. Since Og is progressive and trained at the London School of Economics in his spare time, he decides a central bank makes sense. So he creates a government warehouse, where wheat can be turned in for a small papyrus token, stamped with Og’s seal, which represents a deposit of wheat. The state will honor such scripts, redeeming them for wheat on demand. But, as all taxes must be paid in such scripts, the merchants are happy to hold them, and so almost all transactions are now done in scripts rather than in barter. Some barter still happens, but by and large we have entered a monetary economy.

And with money, eventually the government discovers the theories of Keynes** and begin to think of what benefits they could derive from fiddling with the “money supply”. It probably doesn’t start that way, it probably starts as an emergency measure, but the move from barter to currency suddenly makes it possible to create money out of thin air. In countries with metallic currency this was usually done by debasing the currency, but there were other, less obvious methods. And regardless of the method, they all worked out the same in the end.

Using our example, let us suppose some nomads wander out of the waste and attack our fair town. To address the concerns of the citizens, King Og determines he will build walls around the city and recruit a number of professional soldiers, supported at public expense. The only problem is that the state treasury is a bit light. However, the people are in no mood to pay any more taxes, nor are they in the mood to hear it can’t be done. So King Og decides he will ask his warehouse master to print up receipts for a hundred bushels that don’t exist, and use them to pay for his public works. It works like a charm. Most citizens are used to keeping some wheat in the warehouse at all times, and the city is rich and free of famine, so there is never a time when there is not a substantial surplus of wheat. So, when he finds himself short paying off the soldiers later int he year, he simply creates a few more slips. And once again in a few more months.

And he notices something else, after he issues some fake receipts, the economy takes off. People start investing in bigger buildings, hiring a few helpers, clearing new land, all the signs of a growing economy. Of course, as the slips start circulating, and people realize there is more money in circulation, prices rise, eventually putting a brake on the growth, but for a short time the issue of new money seems to have a positively beneficial impact on the economy.

Now, with a more complex economy we begin to see what moderns might call economic slumps. Some seasons the harvest is better, some worse. Some years businesses are hiring help, other times they have to let go employees. There is no cyclical recession or boom-bust cycle (yet), as that is the result of repeated, regular monetary fiddling, but we do see periods where the economy is more or less active.

King Og, being a benevolent type, decides that he can apply his new found discovery to lessen the burdens of his people. So, during a particularly bad year, when the harvests have been bad enough that the farms can barely afford to pay their laborers and the brewers and bakers are taking on no new apprentices, he decides to engage in massive public works, funded largely by his new bogus receipts. To maximize the benefit, he plans to build for over a year, issuing the scripts piecemeal, buying supplies with new scripts whenever the economy shows signs of slowing. In short, he plans to act as a one man Federal Reserve board.

And for a time it works. The issue of new receipts is irregular enough no one comes to expect expansions of the amount of money in circulation, and modest enough that the increase in prices is not crushing, and not strong enough to wipe out the apparent benefits of the economic growth it inspires. Now, there are a few losers. A few frugal businessmen and farmers who stored away massive stocks of money for future expansion find the purchasing power of those reserves declining, meaning they need to save more. Of course, as it is easier to borrow due to the increased funds available, they may be able to make up their lost purchasing power that way, but it still means they now have debt they wouldn’t. And even less fortunate are those few older individuals who stored away a small fortune to allow them to give up work in their final years. Seeing their life savings losing value, they find they must return to work or hope for an early death.

But those complainers are drowned out by a general chorus of praise for Good King Og and his wise policy of public works. Everyone begins to attribute their prosperity to his sound policies, creating jobs for the poor and increasing the wealth of the middle class. And so arises the myth that the government can create jobs and increase wealth.

At least until the day all those receipts come due.

But let us stop there, and save for the next installment the consequences when there is a crisis of confidence in the currency.

* Unless people are absolutely satisfied with their lot, labor will always be in infinite demand. It is the one commodity needed for every product and the one which cannot be replaced. It can also substitute for almost everything else is some way. Only government interference, either through labor laws, minimum wage statutes, union laws, or monetary fiddling can create chronic involuntary unemployment. Oddly enough, most people think the government creates jobs, while the truth is the government is the only force which can prevent job creation

** To be fair, nominally conservative economists such as Friedman, are not opposed to tinkering with the money supply either, they just are less extreme than Keynes. Which is why I refuse to consider monetarists true conservatives. So long as they advocate managed currency, they are simply me-tooing the Keynesians, and as we know from various RINO eras, when conservative me-too liberals, liberals win, being more consistent in their beliefs. After all, if a little management is good, isn’t more management better?

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.

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About Andrew Sherrod 15 Articles
I believe government is not a "necessary evil", but rather a tool, just one that is very often misused. It should be kept small, and more importantly, local.