February 13, 2014


    I just came up with a model so elegant that it can be explained in a few minutes to just about anyone, but so powerful that it provides a compelling explanation of just about every major macroeconomic issue: Why depressions happen, how debt works, and what causes inflation. It’s so incredibly simple I at first thought I had to be missing something… but upon reflection, I don’t think I am. We had simply blinded ourselves with unnecessary complexity.

    The model has four people in it (which you can think of as “sectors” if you like):
    A farmer (firms)
    A citizen (households)
    A banker (the financial industry)
    The mayor (the government)

    There is only one good: Apples (real GDP).

    At the start, the citizen has 1000 apples and the bank has $1000. The farmer says that he can turn her 1000 apples into 1100, if she gives him the 1000 apples and waits a year for the seeds to grow. The citizen could just loan the apples, but suppose she doesn’t want to do that. (I’ll talk about why this would be a bit later.) So instead she wants to sell the apples, for $1 each. But the farmer doesn’t have the money, so he gets out a loan from (you guessed it) the banker. The banker loans him $1000 at 10% interest.

    So here’s the farmer’s plan: Buy the 1000 apples, grow them into 1100, sell the 1100 apples back to the citizen, and repay the loan. It should work, right? 1100 apples is worth $1100.

    But here’s the problem: There isn’t $1100. There is only the $1000 in the system.

    So if the farmer makes his 1100 apples and tries to sell them, one of two things must happen:
    1. The farmer can only sell 1000 apples. This is what we call overproduction. The citizen can’t buy the 1100 apples, because she only has $1000 and the price has stayed the same.
    2. The farmer sells all 1100 apples for $1000, meaning the price has gone down to $0.91 per apple. This is what we call deflation. All 1100 apples get sold, but at a reduced price.

    Either way, the farmer now owes $1100 but only has $1000 with which to pay it. So he can’t pay it; he defaults. He may go into bankruptcy, eliminating the entire debt. But now the banker has no money either; that’s a liquidity crisis. The system freezes up; everyone’s broke; the apples get wasted; we have a recession on our hands.

    What can the mayor do? Well, one thing he can do is lower the interest rate: Make the interest rate 0% (which we basically did in 2009), and now the farmer only owes $1000 and he can pay it back. (The banker isn’t thrilled, but at least he gets paid something.) But that might not always work, because what if the harvest was bad and now there are only 900 apples? Either the price must go up (stagflation) or the farmer isn’t going to be able to repay even at 0% interest (a liquidity trap).

    A better option (better even than lowering interest rates) would be for the mayor to print more money. Print $100, give it to the citizen; she buys 1100 apples, the farmer repays his loan; the banker is solvent and makes a nice profit; everyone’s happy.

    That’s not quite what we did in 2009, though. Instead, the mayor printed money and gave it to the banker. Now the banker has $100 and the farmer owes him $1100 but only has $1000 to pay; this hasn’t solved the problem at all! It can yield a temporary solution though, which is what happened: The banker loans the new $100 out to the farmer so that the farmer can now repay $1100. What happens when that $110 comes due next year? Uh oh… And maybe that’s why there’s a business cycle. We keep failing to solve the underlying problem.

    The mayor has another option too: He could print the money and buy the extra 100 apples himself. This is what we call a fiscal stimulus; the government buys up the extra goods that the people cannot afford. Notice that this only works if the government spends more than they take in, that is, a deficit. A balanced budget would be like the mayor taking $100 from the farmer to buy the apples with; that doesn’t solve anything.

    Of course, the mayor could make a mistake and print too much money. Maybe he prints another $1000 instead of only $100. Well now there’s $2000 in the system to buy 1100 apples, and we expect those 1100 apples to somehow sell for $2000, raising the price $1.82 per apple: monetary inflation. In this simple case that wouldn’t be too bad, but it’s not hard to see why in real life it can be pretty awful; not all prices adjust at once, and everything goes out of whack.

    Obviously the real world is far more complicated than this; there are a great many citizens, a great many goods, many firms, many governments and many banks (well, actually not that many banks). But the basic rules, I think, are the same. Production increases real wealth: 1000 apples this year become 1100 apples next year. But if the money supply fails to keep up with that growth, we get a recession.

    Moreover, increasing the money supply works differently depending on how you do it. Lowering interest rates is actually really a pretty awful way of doing it; yes, it kind of works, but it’s far from ideal. Printing money and handing it to banks works temporarily, but eventually those loans come due and we’re back in the same old mess. There is really only one solution that actually works: Print money and give it to people. The $100 could be given to the citizen, keeping prices stable and making everything work. Or, second-best, it could be given to the farmer, which allows deflation but keeps the farmer solvent (GM bailout, anyone?). But really the best way, the way that leads to the best long-run outcome for everyone, is to give it to the citizen.

    What would this look like in real life? It’s pretty simple, actually. Instead of buying toxic assets from the banks, the Fed could have loaned a big chunk to the Treasury to issue refundable tax credits to the entire population. Let’s suppose we increased the money supply by the same amount we actually did: That’s a whopping $2 trillion. Each person in America would receive a check for $6500; a family of four would get $26000. The mortgages would get paid, consumer spending would go back to normal, everything would start running again.

    Alas, we didn’t do that. And the question to think about is: Why not?

    The answer Occupy leans on (and they aren’t completely wrong about it!) is regulatory capture: The banker convinced the mayor to do what is in the banker’s favor, instead of everyone else’s.

    But I think there’s a deeper reason, and it has to do with the way that people think about money in general. We think of money as if it were a thing; we say things like “that money has to come from somewhere”. No, actually, it doesn’t. Money is not like gold or granite; there is not a fixed amount of it. Money is not like wood or water, where nature produces it. It is not even like cars or computers, where we construct it from raw materials. Money is a contract. It is a promise. We can make as many or as few of those as we like. Moreover, we can make them to whomever we like. If you start making promises you can’t keep, that undermines the effectiveness of later promises: increasing the money supply too fast triggers monetary inflation. But as long as you only make promises you can keep, you can control how many you make and to whom you make them.

    What exactly are we promising when we print a dollar? We’re promising a share of the world economy. There’s a certain amount of stuff out there; you get a piece of it in proportion to how many of these tickets you have. Adding more tickets makes each ticket worth a little bit less; but that’s exactly what you want, if more stuff is being produced. If I promised you 10% of the 1000 apples, you should get 100 apples. But if I make 1100 apples and still pay you 10%, I’m actually giving you 110 apples instead. Because money isn’t automatically aligned to the value of real goods, we have to make it so; and that’s what a central bank is for.

    Now, with this in mind, why use money at all? Maybe we should go back to a barter system: you can’t have a liquidity trap in a barter system. No, but you have other problems instead. In my simple model, loaning apples would work just fine. But now think back to the real world and all the billions of people and trillions of goods that are made. Do you really want to keep track of all those exchanges in real goods? “Okay Bob, Susan will give you 2 hours of dry cleaning, for which Fred will give her a bowling ball, which I gave him for mowing my lawn; in return, I want you to make me a pair of shoes.” That would be a remarkably simple case. It’s an awful lot easier for each of those items to have a price tag on it and everyone to exchange money as necessary.

    What about gold? Wouldn’t that work like barter? Actually, no. It works like money. In fact, it is money. It’s just a weird kind of money where you let your monetary supply be set entirely by the mining companies and commodities markets. The way barter avoids liquidity problems is by having no fixed numeraire: If you have extra horses, buy things with horses. If you have extra oranges, buy things with oranges. But once you fix the numeraire (you must buy things with gold) then you’re back to all the same problems as money, except now you can’t print more if you need it. This is why the Great Depression was so bad; we were stuck with gold as our money, and that meant we were helpless to stop prices from falling and firms from going bankrupt.

Comments (2)

  • Well explained, and I believe sticking with our current medium of exchange is better than the two alternatives you mention. I would be interested in your thoughts on e-commerce, especially bit coin.

    • I think Bitcoin suffers from the same basic problem as gold, which is that the money supply is unable to expand based on market conditions. We’ve already seen Bitcoin go through ludicrous rates of deflation—the first time in history where the word “hyperdeflation” has been worth using. Fortunately right now very few transactions are denominated in Bitcoin, so that deflation didn’t cause a lot of problems. But can you imagine what would happen if all our debts were in Bitcoin and suddenly the value of Bitcoins quadrupled?

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