Yogi Berra’s quote could be dismissed as low-grade witticism. But he’s not actually that far from the truth. Milton Friedman once famously said, and I quote; “inflation is always and everywhere a monetary phenomenon“. But what does all this mean, truly? We talk so much about central bank policy, government fiscal policy, the Eurozone, Chinese growth story but why? While we dedicate so much time searching for answers to impossibly complicated questions, is it not worth answering some of the “simple” questions first? I use phrases like “hair of the dog monetary policy” and the fact the Fed must inflate away bygone sins of indebtedness. But what is inflation? What is debt? In fact, what is money and how is it different to currency or capital? Most people think they know the answers to such questions; debt, money, inflation … it’s all around us.
To add some humour, I’m unashamedly re-writing an old post I made back in 2009 called “Neanderthal Economics“. I’ve written hundreds of posts, but this was one which received a very large number of hits, much to my surprise. Let’s start from the very beginning…
Imagine you’re an alien and your Zork-Mobile landed on Planet Earth a few thousand years ago when people like us were simple, crude cavemen. You took to studying the economics of a caveman village.
Now remember, inflation is a monetary phenomenon, and money is effectively a simple, efficient exchange mechanism for “capital”. I’m throwing lots of words around here but we’ll come back to them shortly.
So imagine I’m a caveman with some assets: an egg, which a friend gave me, and a patch of land which I use to grow watermelons. I’m a pretty rich guy by caveman standards! Now imagine my chicken egg is worth the same to me as one watermelon. One could argue that an egg is the money or “currency” (there is a difference but now is not the time, that’s another story for another time).
Now if other cave-people shared my opinion that eggs and watermelons were of roughly equivalent worth, I could use the egg to buy a watermelon and or, indeed, vice versa. In fact, one could argue that there is on special type of money, real money: tradeable “things” or tangible “stuff” which is exchangeable and yet at the same time has “value” away from the world of finance – like oil, wood, stone, watermelons or eggs. Of course, I’m simplifying things greatly.
As cavemen and cavewomen, descendants of our race demonstrated a differential advantage over other species by the synergies they could work through sophisticated, multi-lateral communication. One of my caveman buddies might have turned to me and said: “listen, you’re really good at growing watermelons and I raise chickens, what y’ say I give you one egg for one of your watermelons every day for the next 6 lunar cycles?”And behold: the World’s first bilateral currency swap was agreed. Both eggs and watermelons were considered as currencies in their own right. Two parties have agreed to exchange currency at a given rate for a given time – it really is that simple. Additionally, I don’t have to worry about subsistence any more, I don’t need to rear chickens myself. So long as I grow good watermelons I can always exchange them for eggs or, indeed, other goods and services. I can concentrate on growing watermelons, which I’m good at, and get even better at it. This is a fundamental principle upon which all modern economic societies are based.
But consider this: if the exchange coefficient of the watermelon goes up from one egg to two eggs, then we can say that the “price” of watermelons has gone up (in egg terms): it is “inflating”. Another way to express this change is to say that the “price” of eggs is “deflating” in watermelon terms – as it now takes only half a watermelon to acquire an egg.
You with me so far?
OK. Put this into a modern context: if the “price” of an egg goes from one Dollar to two Dollars we could say either that the price of eggs has gone up in Dollar terms or, perhaps more interestingly, that the price of a Dollar is falling in “egg money”. This is a little unintuitive as we don’t often think of things that way, but there is nothing wrong with it – it’s a useful thought-experiment, there is nothing wrong with thinking about transactions in this way.
Now, notice that in our egg-for-watermelon currency swap, it may be a little premature to suggest that the value of watermelon has gone up – or indeed that the value of the egg has gone down. After all, eating an egg still has the same calorific intake as it always did, it is still “backed by chickens” (that is, it still takes one healthy chicken to lay an egg) and it still takes 3 eggs to make a cake – nothing much has changed in this respect! More specifically, there may be other currencies available – what about the cavegirl in the cave next door who has apple trees? So, while the price of a watermelon has gone up in egg money, we do not know the price deviations between eggs/watermelons and other “monies” that may exist in our caveman village. Of course, if the price of eggs go down sharply in relation to all other monies or capital, there may be some substance to the expectation that the value of eggs is changing (declining), not just the price.
Similarly, in a modern context, if the “price” of a Dollar falls in relation to all other forms of capital this is the same as the price of all other monies going up with respect to the Dollar, a unit of currency. We, of course know what this phenomenon is called, when we see prices of everything going up in Dollar terms, it is called INFLATION. In a similar vein to caveman eggs: if the price of Dollars go down sharply in relation to all other monies, there may be some substance to the expectation that the value of The Dollar is changing (the value of a Dollar is declining).
The key message behind the watermelon-for-egg currency analogy is that, there are limitless choices for how we transact, there is exchangeable capital all around us. I challenge the principle that “the World is not made of money”, or that “money does not grow on trees” – at a fundamental level, this is actually incorrect. Indeed, this simple wealth-exchange of groceries was actually how capital was distributed for many thousands of years (and it still is to this day, in many respects).
Now, let’s move the story on a little…
This type of barter-trading went on for many years until, one day, Mr Watermelon got fed up of carrying a barrow-load of watermelons every time he needed to go grocery shopping and decided to come up with an ingenious “system” whereby one could just use smooth stones or pebbles to exchange for goods. Interestingly, the pebbles were not much use to anybody per se, but they did serve as a fantastically efficient (there’s that word again) medium which helped the whole cave-village lubricate the exchange of goods. I could use one pebble to buy one egg and, because I knew that an egg had a similar market worth as a watermelon, I could also use that very same pebble to buy a watermelon, or an apple… I didn’t have to wait for my counterparty to want watermelons before we could transact… the options were endless! Trading thrived, the economy of the village was booming.
Now, watermelons are inherently backed by the labour and the earth used to produce them, eggs, one could say, are backed by chickens, there’s something tangible about where the “worth” lies in an egg and a watermelon. But pebbles … well, they aren’t backed by anything really. No, the pebbles were just an integral part of “the new system”, a system for which we were making the rules up as we go along – and so, behold, the first fiat currency was born.
Things were going well until one bright spark of a caveman (let’s call him Alan) realized that there was a beach a few miles down the coast where one could acquire millions of such pebbles. If he could bring back bucket loads of these pebbles, he would be able to buy anything he wanted from anybody without having to do much work – he’d be living “the life of Reilly”(*). In fact what was to stop anybody doing this? Well, soon the word spread and quickly the cavemen found that the “price” of one egg went from 1 pebble to 2 pebbles, then 3 pebbles and then 10 pebbles … and behold… the first bout of hyperinflation was induced.
What is interesting about this caveman inflation is that, while we may choose to measure it in terms of the price of capital goods going up. Fundamentally, it was nothing to do with the goods themselves. Inflation was about the supply of currency (pebbles) going up.. and thus the value of currency (pebbles) going down with respect to other forms of capital or money. Inflation is always and everywhere a monetary phenomenon.
Suddenly, the stone-faced Neanderthals were stuck between a pebble and a hard place. Because of sneaky Alan, Money Supply of their Monetary Base went through the roof, pebbles were everywhere – they were trash. Eventually it got so farcical that a single egg required a whole bucket full of pebbles – which kinda defeated the purpose of not carrying watermelons around in the first place. Volatility increased and pebble prices ebbed and flowed for a while, but eventually, at the extreme, cavemen lost confidence in the fiat currency and shunned pebbles as receipt for their goods. In this environment, I’d rather have eggs and watermelons than pebbles, people were literally dumping pebbles on the street, a nickel wasn’t worth a dime any more … and behold… the World’s first currency crisis was born. Eventually, the cavepeople, realised the folly of their ways, because pebbles had an unlimited supply, the entire economy was prone to manipulation, so they reverted to transacting in more “stable” currencies with limited or “predictable” supply.
(*) a particularly relevant phrase which I think is quite apt in the current circumstance. “The Life of Reilly” is a phrase that comes from late 19th century in England when the “Reilly Clan” of County Cavan in Ireland began to mint their own currency which (bizarrely) became legal tender in England. They could simply print money in Ireland and hop on a boat and spend it in England! Thus a freely spending gentleman was referred to as a man “living off his Reillys”! Thought, you’d enjoy that little inflationary tid-bit!