Monetary Issues Made Simple Part 4

Back to Basics

In the first three installments of this series, I described Chief Og, later King Og, and his move from barter to a monetary system, and the eventual discovery of fractional reserve banking and the inevitable government use of deficit financing supported by inflation. We also looked at the effects of a collapse of the government created boom. In this installment we will look at the first steps toward a fiat currency, the effects of continued inflation, including hyperinflation, the harm done by efforts to “correct” the ensuing recession, and the effects of the final move to a full fiat currency.

So, we now turn to Emperor Og. Having used his armies and his wealth to expand his single town into a multi-city empire, Og is beginning to establish the fundamentals of a modern economy, first and foremost, he has taken the first step in divorcing currency from commodities by creating an arbitrary unit. Rather than measuring money in bushels of wheat, which has a fixed and clear value, he has created the Unit, which he has defined as being 1/10th of a bushel of wheat. However, as the name does not clearly denote a quantity of commodity, it leaves open the possibility of future revaluation.

In addition, to help prevent bank runs, which tends to place a check on inflation, he has decreed that the bank will only redeem notes in multiples of 1000, so unless someone is cashing in 100 bushels or more, they will be unable to redeem the scripts for goods. This means that the people most likely to redeem their currency for wheat are the very rich and large investors, who are more open to government pleas for restraint, thus making it much easier to prevent impending bank runs.

With the environment set up to favor government inflation, Emperor Og sets his eyes upon yet another spending spree. Recalling his earlier success using public works to bolster the economy, he imagines that his earlier failure was only due to the ease with which citizens could be panicked into a bank run. Now that bank runs have been made more difficult, he thinks that controlled spending and moderate inflation may be the key to success.

And thus begins a regular cycle of inflation. As anticipated, the infusions of cash cause a surge in the market when they are released into the flow of commerce. And, also as anticipated, after a time, prices begin to rise to adjust to the newly created cash. And, as expected, the new rules about redemption manage to stave off the bank runs and crashes he experienced in the past. All told, Emperor Og is quite happy with himself, as it appears he has finally found the magic recipe for continual economic growth. The moment a slow down occurs, he starts sending out some new money, interest rates fall, new investment soars, and the economy recovers. It seems to be all benefit with no downside.

Until the unexpected happens. Emperor Og’s scribes come to tell him of an unprecedented event. In the past, when he released cash, prices rose by pretty close to the same percentage as the money supply increased. If he grew the money supply 1%, prices rose around 1%. However, now, the scribes have started to notice an increase even greater than the increase in money supply. A 1% increase creates instead a 2% or even 3% increase in prices. And, a few weeks later,  hey report even more startling results. Prices are now rising prior to the release of new credit. Even before the money supply is increased, prices are shooting up in anticipation. And interest rates are beginning to increase even more quickly. While the money supply has grown by a stead 5% per year, the interest rates are running 10% higher than before, and show signs of increasing even more.

What Og has failed to realize is that inflation does tend to produce a mechanistic response. The increase of the money supply tends to create a proportional increase in prices and interest rates. That is, when it occurs in isolation. But humans are thinking creatures, and seeing regular increases in the money supply, they rake steps to adjust for anticipated future increases. Whether the increases come on a regular schedule, in response to events, such as market slowdowns, or just occur randomly but consistently, the public will come to expect money supply increases, and to reduce the harm done by devalued currency, they will raise prices and interest rates in anticipation of future increases of the money supply.

This rise in interest rates troubles Emperor Og. Seeing interest rising, he knows very well that will cause a drag on the economy. In fact, he is already seeing it, experiencing something his London School professors argued was impossible: “stagflation”, combined rising prices and slowing growth. Emperor Og worries that if it is allowed to continue unchecked, his entire program will come crashing down around him, his endless cycle of prosperity will come to naught.

So, on the advice of his scribes, he starts a program of more rapid cash increases, hoping to drive down the rate of interest. Since interest is running 10% above the anticipated rate, he starts with a single massive infusion of cash, adding 20% to the money supply. However, it comes to nothing. At first the market responds as expected, a sudden surge of investment, a general boom. But, within days, the scribes are reporting the unthinkable. Prices have doubled, interest is running at 50% or more. By every sign the economy is in general collapse.

So, he tries again, releasing another 20% increase in the money supply, hoping to at least slow down the worsening interest situation. But again, the very small period of growth is followed by a disproportionate rise in prices and interest, and the situation looks even more grim.

Again, what Og fails to note is that people act upon expectations instead of only reacting to past events. So, while he increased the money supply by only 20%, the public expects, from past events and current conditions, that he will continue to swell the money supply by a fifth on a regular basis. So, rather than simply adjusting to the current increase, they adjust to the additional increases they expect in the near future.

Emperor Og is now desperate. He has no choice but to try to rein in the ever escalating prices. Interest rates have begun to move into four figures and prices are a hundred times what they were when his spending started and show no sign of decreasing. So, he listens to his scribes and scholars and decides to revalue the currency. To restore public confidence, he issues a new type of currency, the New Unit, valued at 100 of the old Unit. This is accompanied by promises that the new currency will be fully redeemable and that the money supply will be stable. It takes some time for the public to adjust, but the currency does eventually stabilize, with the New Unit pegged at 10,000 New Units per bushel of wheat.

Of course, as a consequence of the hyperinflation, many fortunes have been lost. Anyone who had savings in the form of the old currency have seen those savings disappear. Old people who created pension agreements with banks in exchange for an initial investment have seen those pensions lose all their value, until they now receive only pocket change. The economy has suffered from a long period without any serious investment or even expenditures on upkeep. But at last we are stable once more and the economy can start to recover.

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.