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.