Friday, August 10, 2007

The Shell Game

As if things aren't uncertain enough in the financial market with the subprime lending market in shambles, the Feds are "Helping Us Out" by injecting $38,000,000,000 ($38 Billion for those of you who can't count zeros)

Where did they get the money? They pushed a couple of buttons and created it. The beauty of a fiat money system is that when we think we don't have enough, we simply print more.

What happens when money is simply injected in to the system by fiat rather than from some other, more tangible value? I illustrate the problem this way:

There is an island in the Pacific Ocean isolated from the rest of the world. Over time they developed a currency system to replace the barter system. Sure, you can trade a dozen bananas for a coconut but you might not need the coconut right now and you wouldn't want to carry it around until you do. Any moderately sophisticated society replaces barter with a common medium of exchange. In the case of this island, it was discovered that there is a relatively predictable quantity of seashells to be had on the island. Some would break and new ones would be found. Thus a dozen bananas or a coconut could be traded for two shells. Someone could give me two shells for my bananas and I can buy a coconut when it suits me best. The shells have no intrinsic value, it's simply agreed that they can be exchanged for other goods and services.

Then one day there is a terrible storm and the forces of nature conspired upon this tiny island nation. When the sky cleared and the waters receded, the natives discovered about 10 tons of shells had been pushed up on the shore. Villagers rushed to the shore to begin collecting as many of these shells as they possibly could. Instant wealth from the deep!

The villagers figured that they'd have enough shells to last the rest of their lives and they could retire in luxury. How quickly they became disappointed. The first few villagers that tried to spend their new found wealth were handsomely rewarded but heartbreak followed. The merchants who were working hard in their shops and could not gather shells wanted to share in this new found island wealth and wanted some extra shells for themselves lest they become instantly poor.

How did they get more shells that they did not collect? Simple, they raised prices. Suddenly, a coconut was worth 20 shells instead of 2 and the prices of other goods and services followed.

The villagers who collected the shells began to complain to the tribal counsel that the merchants were being unfair and forcing them to give up their new found wealth so that they still had as much as before. The tribal counsel acted and forced the merchants to keep their prices low so that others who did not gather shells could still afford the same goods and services. The merchants reacted by simply no longer offering their products. Laborers ceased working and with no where to spend their wealth, the shell rich soon had piles of worthless shells. If they really wanted something, they'd have to go to the black market where lawless rebels were selling goods for very inflated prices deep in the jungle away from the prying eyes of the counsel. Even some of the counsel members were spotted there and excused their presence of the basis of need.

Eventually, nearly everyone on the island was breaking the law. The counsel rescinded the price controls and allowed the merchants to set prices as they saw fit. Equilibrium was restored but the inflation was semi-permanent. Over the years, more shells broke than were found and in a generation the prices were back to pre-storm levels.

A few families were castigated for the practice of shell hording because they became rich later through the practice of loaning out their extra shells in return for even more shells in the future.