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The Shell Game, Part I

Posted by Gonzalo Schwarz
March 29, 2011

PART I:
Imagine an island where the local currency is a type of beautiful shell. Everyone on the island has some, either collected over time or traded for through an exchange of goods or services for shells. The shells can either be worn for adornment or held to trade at a later date. The shells are rare. While they are difficult to find, it is known by the Islanders that more can be discovered on the beaches, and occasionally someone will work to collect one or two more, either to trade or to wear (or possibly to give to a sweetheart). Consequently, these shells are recognized to be the fruit of someone’s labor, either through the act of finding one, or due to having traded value for one. Some hard working Islanders have earned relatively more shells than others; some more frugal Islanders have accumulated more shells; some lucky Islanders happened to find their share of shells; and some unfortunate Islanders, owing either to congenital disabilities, injuries or sickness, or old age, receive stipends of shells as charity from their able-bodied fellows. There are occasionally Islanders who steal shells, but they are expelled from the island and shunned. Finally, there are always a few perfectly able Islanders who find it tiresome to work and produce and seek to live off of the guilt and alms of their productive brethren; reproachful stares and empty bellies inevitably win the day, however, and they soon find it within themselves to make their own bread, so to speak.
All is well on the island. Two shells buy a coconut; three will purchase a woven straw hat; a massage on the beach trades for four shells, and so on.
Then one day a mysterious group of men row to shore wearing Brooks Brothers suits and plastic smiles. They begin immediately to buy things of value from the Islanders, paying with shells that are identical in every way to those of the Islanders but which they seem to have in unlimited supply. (As it turns out they have come from a cargo ship that is carrying a massive load of shell replicas, Made in China)
At first the Islanders and the newcomers can’t be happier. The Islanders have found a fantastic new market for their goods and the Outsiders are enjoying the good life – sipping coconut milk while receiving massages on the beach, reading the Wall Street Journal with their eyes shaded from the sun by the brims of hand-woven straw hats. Each Islander can’t believe his luck, as his products sell out quickly and he works to replenish his stock. But just when the Islanders begin to feel rich, with shells piling up in their huts, something strange begins to happen.
Whenever an Islander would go to buy something, one of the Outsiders would be there trying to buy the same thing and able to offer more; or they might find that their neighbor’s store is out of stock, having already sold out to the Outsiders. On the rare occasion that there is a coconut or hat left on a shelf they find other Islanders in line trying to buy them as well. Because all of them are now wealthier in terms of shells, they can each afford to offer more shells than the last to purchase the goods, competing against each other with the indistinguishable shells of the Outsiders. With so many shells chasing the same (or less) amount of goods, prices begin to rise.
Of course, the shopkeeper who has just received 10 shells for a coconut that used to fetch only two feels rich and goes to celebrate with a massage on the beach. Unfortunately there is a line of the Outsiders and newly wealthy hat weavers already waiting; and besides, the price has gone up to 20 shells anyway, owing to the number of people seeking massages and the fact that the Outsiders seem to be willing to pay larger and larger amounts of shells. The Outsiders, it is noticed, are becoming fat on coconut milk, pale under the shade of their hats, and soft and doughy due to the constant kneading.
* * *
The Islanders have been introduced to inflation, and the inflation of their “money supply” has brought with it price inflation, its inevitable consequence. The Outsiders brought nothing of value with them, save the shells, and produced nothing once on the island. The Islanders know that “when the supply of any other good increases, this increase confers a social benefit; it is a matter for general rejoicing;” but the only thing increasing on the island is the supply of money. Even wearing the shells has lost much of its value as every islander now has enough shells to cover even their entire hut with shells; they now look commonplace on the women, and no longer signal the earning powers of the men. When the Islanders saw all of the shells that the outsiders had brought they felt as though they were about to become rich. But adding more money to the island’s economy, and increasing consumption in the short run as a result, has not been the boon to the island that the Islanders had envisioned when the newcomers first came ashore.
In fact, it has been the opposite. The Islanders have learned another lesson: that of Cantillon effects. When the Outsiders first began to spend the new money they were able to purchase goods at the prevailing price structure. As they spent, though, the available goods decreased while the cash balances of the Islanders increased. Wherever the Outsiders had spent their money first the prices had risen. The newly wealthy from that industry had then gone to make their purchases, driving up the prices there. The rise in prices spread throughout the economy as the number of new money units outpaced new production of goods and services. The last to receive the increase in income, those poor Islanders living on fixed incomes of charity, were found to be starving. The few shells they had been receiving in alms was no longer enough to buy food for the whole week, and by the time anyone had noticed and increased their stipends the prices had already risen again.

Food for thought:
At this point, is there anything immoral in the behavior of the Outsiders?
Are the Islanders acting irrationally by continuing to accept shells as payment for goods and services?
If the increase in the money supply is leading to problems on the island, what should the Islanders do now that they have realized this?

NEXT WEEK: Part II

Theodore Phalan is an economics student at George Mason University and a previous Sound Money essay contest winner.

Image by dan / FreeDigitalPhotos.net.

7 Comments

  1. "Maynard" McBrady April 23, 2011 6:40 PM
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    In essence, this example makes perfect sense, that is until you actually ask the all important question; How does reality match up with the theory?

    While you've succeeded in accurately and concisely portraying a very poignant (Though all together skewed; "pale and doughy"? Come on) example of hyper-inflation, and I'm sure to read your following two articles, I'd like to make the point (Especially to the person who suggested burning T-bills) that this "example" does not in fact match up very well with reality. The last time I checked, I couldn't walk down to the beach and "find' a hundred dollar bill.

    In fact, I would question whether or not the above example is a "monetary" or "barter" economy, and judging from the criteria I would place it firmly in the "barter" camp. If we can agree that this isn't in fact a "monetary" economy, I'm struggling to see the connection to reality.

    But wait, you may say, Can't you see the obvious (And again very skewed) connection between the "Outsiders" and the Fed? I could take the time to outline exactly where the differences are, but this is in fact the internet, and this is of course for the "lulz". Just because the Fed doesn't get the answer right 100% of the time, doesn't mean we should toss them out of the business of regulating our money supply.

    • Theodore Phalan April 25, 2011 5:48 PM
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      “Maynard,” Thank you for your well-thought out reply. I’ll try to take your comment point-by-point for clarity. First of all, the “pale and doughy” was just a joke referring to the fact that, since the Outsiders can purchase anything they want, and the only things “made” on the island are coconuts, straw hats, and massages, they were “pale” from being well shaded from the sun and “doughy” from being “kneaded” on the massage tables all day. Nothing sinister, just an attempt at humor.
      The rest of your questions seem to revolve around the “monetary” system I tried to create for the purpose of the storyline. Your confusion arises from the fact that I’ve tried to condense the transition from a naturally arising commodity standard to notes representing those commodities, to fiat notes representing nothing except the issuer’s promise to extract value through taxation to cover the debt represented by the notes. In the interest of keeping the story short and (somewhat) readable, I’ve tried to write it without all of the steps.
      So think about it like this. The shells are ‘gold’ and the Islanders can find more with effort, just like anyone can today. There may be less laying about or available to be panned in streams, but actually that is the point. It’s out there, you can get it, and as the price of gold (now above $1500) rises, it becomes more and more worth it to actually do it. The shells, at this point, are NOT Federal Reserve Note equivalent; that is a major point to understand.
      To your next camp, this is definitively NOT a “barter” economy, even if it is a bit confusing. The fact is that the Islanders were not trading e.g. a massage for a few coconuts, or a straw hat and a coconut for a massage, which would be barter. They are trading a medium of exchange, shells in this case, for things they want, and accepting shells as payment – not demanding payment in kind. When the Outsiders arrive they find an island economy using a commodity as a medium of exchange, as money.
      It would have taken too long to go through all of the steps (and I actually wanted to make an important point anyway) of shells to shell receipts to the receipts becoming the fiat notes and the shells being removed from the equation. I could have had fractional reserve shell banks and shell credit institutions, and so on, but there was no room, and who would have wanted to read it all?! The point was to show that if a “money” ceases to be scarce, or can be duplicated at will, it will lose it’s value. Just imagine in your head that if the Fed. Res. could “print” gold, wouldn’t we have the same objections and problems if we were forced to accept it? Extending the shell metaphor was just a technique to save space, but I think it’s valid.
      Finally, you’re right, there isn’t enough time, space, or … to write too much in a comment section, but since I wrote it I feel compelled to try to answer your (mostly unstated, but I’ll try to read b/w the lines) last point. The Outsiders in some way represent, not the Fed per se, but a central bank; they also represent a newly forming State with a security apparatus and burgeoning bureaucracy. One of the biggest problems with my device here of an island and “outsiders” is that in real life you can’t distinguish b/w the “Islanders” and the “Outsiders.” No one knows who is spending the newly “printed” money, and who’s really trading value for value.
      And the ultimate point (which comes a little later, and I tried to make clear in another post Toward Defining Inflation) is that there are natural, built in, immutable limits and self-regulating mechanisms in a commodity standard that do not exist for a central bank printing legal tender fiat “money.” Therefore the issue is not about complaining that “the Fed doesn’t get the answer right 100% of the time,” but instead pointing out that we don’t need to depend on an institution that isn’t getting it right (and I would argue that they “get it right,” for the economy as a whole, far less than 100% of the time, and usually only by accident, because that is not their goal). Therefore I say yes, let’s do “toss them out of the (very lucrative) business of regulating our money supply.”
      So you’re right, it doesn’t perfectly match up with reality, but I hope now you see what I was getting at. And one more thing. I’m behind on my interweb memes. What are “lulz”? And thanks for the comment, I hope it helps you and anyone else who may read this.
      -Ted

  2. Pingback: Atlas Sound Money Project » Blog Archive » Towards Defining Inflation

  3. Joe DiGirolamo April 5, 2011 10:31 AM
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    Very nice. Hyperinflation is a real risk as seen in Argentina and Brazil (I believe). Now that the islanders have realized this inflation with false (fiat) shells, I'm guessing they will have to move to a different currency or find another rare/ valuable medium of exchange. Bartering will probably be the first activity to come out of this (Until the 'double coincidence of wants' occurs on a large scale.) Nice article.

  4. Katia March 30, 2011 10:34 PM
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    Interesting!! So I wonder who did the islanders blame for their loss of purchasing power? Did they blame the greedy sellers, the shells, China, or the Outsiders? I think this is the essence of the Shell Game: the science of illusion.

  5. dtotheavid March 30, 2011 10:11 PM
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    THeo, well written and thought provoking. I hope to read more

  6. Aaron March 30, 2011 9:42 PM
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    This article is awesome! Couldn’t be more true in today’s society. Burn your Federal Reserve Notes…or just turn them into gold!