Mental Experiment

[blazespinnaker]

Finster provoked me, in his way, to post this:

Three guys on an island: one sells bananas, one sells carrots, and the other sells water. Due to how where they're on the island (the soil, geology, etc), they can only produce their particular commodity.

They have a currency called "Sand Dollars" which there aren't any more on the island. Say, they have 1000 each.

Let's imagine, for simplicity, that the bananas, carrots, and water are all required to live. They pay each other their sand dollars, and get their water and bananas, or water and carrots, or carrots and bananas,

Suddenly, there is an earthquake and the internet is invented, err, the geological composition of the island is re-arranged and everyone can easy get their own water, carrots and bananas. The price of DVD players, water, carrots, and bananas plummets.

Are the sand dollars now worthless? What if they now use the sand dollars to buy the tomatoes (not necessary to live, but quite tasty) that were on the island but only grow rarely.

If suddenly the tomatos are worth 4x what they were before, do we have a tomato bubble?

[Finster]

Re: Mental Experiment

Finster provoked me, in his way, to post this:...

Well it sounds like you got even ... considering that attempting your mental experiment just fried my synapses ...

;-)

[blazespinnaker]

Re: Mental Experiment

How so? I think the experiment is sound.

Productivity and globalisation could easily explain asset class "bubbles".

[blazespinnaker]

Re: Mental Experiment

To extend my thoughts on this, I've made some major investments in land in some depressed areas.

Yes, that's right, I'm buying real estate.

I'd buy art, too, but I have no idea what I'd do with it.

http://www.rgemonitor.com/blog/economonitor/155789

[Finster]

Re: Mental Experiment

How so? I think the experiment is sound.

Productivity and globalisation could easily explain asset class "bubbles".

The experiment may be sound, but that doesn't mean Finster's synaspes are ... ;)

FWIW, though, just based on the information at hand there are at least a couple of possible interpretations. For one, you say that "The price of DVD players, water, carrots, and bananas plummets. Are the sand dollars now worthless?"

In fact, plummeting prices are suggestive not of a currency falling in value, but a currency increasing in value. If the price of stuff falls, that means it takes fewer of our sand dollars to buy them, implying they have risen in value. So I would first ask you on what grounds you would even suspect the sand dollars have fallen in value.

For another, the thought experiment you pose assumes a commodity standard of value. The fact that it poses problems illustrates the difficulties inherent in a commodity standard. Changes in the real economy such as those you posit fundamentally have little or nothing to do with the value of a currency. If, due to changes in the real economy, the supply of a commodity rises, then its price should fall - and that fall is a real change in the value of the commodity, not of the value of the currency.

For these reasons, inter alia, I prefer a standard of value that has nothing to do with goods, but rather human time. Goods change in value with technology, productivity, war, peace, etceteras. Human time does not.

[Finster]

Re: Mental Experiment

How so? I think the experiment is sound.

Productivity and globalisation could easily explain asset class "bubbles".

Another poster PM’d me on the same point, raised in Bart’s M3 is back... thread:

I'd definitely stick with the population increase. The problem with the first is it gets into subjective judgments as to the amount or value of goods and services produced. It's Alan Greenspan's best friend, "productivity". And when known as "hedonics" also the best friend of Michael Boskin. Used to justify all sort of inflationary mischief.

A verrrry slippery slope you are on with those two ...

Finster, are you saying that the US money supply should not change in relation to production?

Why wouldn't that have the effect of deflating prices over time? i.e. same amount of money chasing more goods = lower prices on average?

Let's say it's 1900 and I'm in the market for a home. As it happens, I'm not interested in Henry Ford's new Model A. So I hang onto my money and wait for housing prices to drop as people shift money from houses to cars.

Except...I know the price will only go down! Why would I ever buy a house?

I realize that a full answer probably involves at least three dissertations, but your statement has got me thinking.

This would be an excellent topic for a thread, as the answer is very much debatable. I’d argue that prices for things should fall over time if due to the advance of technology and productivity it takes fewer man-hours to make something. If the real cost of producing something has fallen, then if there is no inflation its price should fall, too.

If by this definition we had no inflation, you’d buy a house because you wanted one … not because you just wanted to dump your depreciating dollars!

The point is not just academic. Alan Greenspan dramatically expanded the money supply on the pretext that "productivity" was holding inflation down. The inflation that affected first affected the financial markets, followed by the housing market, and now showing up in commodity prices, is the sorry result of that deeply flawed premise.

Greenspan was wrong. Productivity has nothing to do with either inflation or the lack thereof.

[blazespinnaker]

Re: Mental Experiment

The point is not just academic.

It is not merely academic, it is what the whole conversation should have always been about.

Alan Greenspan dramatically expanded the money supply on the pretext that "productivity" was holding inflation down. The inflation that affected first affected the financial markets, followed by the housing market, and now showing up in commodity prices, is the sorry result of that deeply flawed premise.

Why is it deeply flawed? Computers have amazingly improved efficiency. Huge increases in labour pools have kept wage costs down.

Greenspan was wrong. Productivity has nothing to do with either inflation or the lack thereof.

[/quote]

Well, the problem isn't so much inflation as it is deflation. If productivity is bringing down prices then you're going to have deflation, which is a risk to the economy. Some might argue this is exactly what happened in the great depression - productivity causes deflation which causes a dangerous spiral in the economy.

The same productivity miracle has occured again, however deflation didn't get a chance to happen.

[blazespinnaker]

Re: Mental Experiment

In fact, I think it's not entirely that hard to picture, you could imagine this great creative destruction occuring in the american economy as it transfers to the information economy.

One approach is simply to force everyone to ride the rails looking for computer programming jobs (which maybe they should have done, there are no shortcuts), or to utilize the massive inflation and dollar tribute as a way to tide the american economy over until it figures out how to enter into the next phase.

[WDCRob]

Re: Mental Experiment

I've been trying to logic my way through my own question to Finster (quoted anonymously above) and his reply, but the synapses have been much abused as a result.

If everyone knows that the value of a currency will appreciate in direct proportion to productivity gains they'd build the expectation of falling asset values into every purchase. Even in cases of a non-depreciating asset, the price would fall over time as the currency increased in value.

My first thought was that a 30-year mortgage for a home would become impossible. Who in a growing economy would agree to fixed payments 25 years from now that might be triple what they're paying today in real terms?

But the more I thought about it I decided the answer was that credit would change. No one would use credit to buy much of anything. Certainly not big-ticket items like cars and homes anyhow. They'd want to save and pay in today's dollars since they'd be worth less than tomorrows. Or, at a minimum, these loans would be much shorter duration.

Now I've come round to the idea that current asset prices would simply take the increasing value of the currency into effect like they do falling values now and nothing much would change, except that prices would be depressed.

Is the idea that the Fed should increase the money supply in lockstep with production increases to keep prices stable, not falling, because of concerns about the effect on credit (and growth??) if you don't adjust? What would be the effects on the economy of having people move to cash-based purchases and 5-year mortgages?

Finster, is your basic point that, whatever the motives, once you've got a changing money supply there are such incentives to cheat that everyone will eventually succumb and the currency will be devalued?

I suspect this topic is all Econ 101 (ok, maybe 201), so if I've missed out something obvious, apologies. WDCRob: asking the dumb questions so you don't have to!

Blaze, the problem I'm having with your thought experiment is that the productivity gain is a one-off due to an unforseen event. If you build it into expectations that productivity/advances are going to occur routinely, I think it changes the experiment.

[Finster]

Re: Mental Experiment

It is not merely academic, it is what the whole conversation should have always been about.

Yes. You get credit for bringing it into focus.

Why is it deeply flawed? Computers have amazingly improved efficiency. Huge increases in labour pools have kept wage costs down.

You’ve merely replied to my answer to your question by restating the question. We are not going to make much progress this way! Best I can do for now is to restate my answer. If computers are bringing the real cost of production down, then in the absence of inflation then prices should come down too. The logic is simple. Exactly where are you having a problem with that?

Well, the problem isn't so much inflation as it is deflation. If productivity is bringing down prices then you're going to have deflation...

Stop right there. Inflation and deflation have nothing to do with the real economy. If the real economy reduces costs through greater productivity, why should prices not fall? Why do you call that "deflation"?

Here’s another little thought experiment for you. Prior to Henry Ford’s introduction of the production line, it costs (say) 500 man hours to produce a car. Afterwards, it costs (say) 250 man hours. So the price of the car - in the absence of either inflation or deflation - ought to fall by 50%. If the real cost of producing a car fell by 50% and the dollar price stayed the same, that would mean you had the same amount of inflation as you would if the real cost of producing the car remained the same and the dollar price doubled - 100% inflation.

…, which is a risk to the economy. Some might argue this is exactly what happened in the great depression…

And they’d be dead wrong.

… - productivity causes deflation which causes a dangerous spiral in the economy.

The same productivity miracle has occured again, however deflation didn't get a chance to happen.

No. As Nobel laureate Milton Friedman once quipped, Inflation is always and everywhere a monetary phenomenon. By the same token, deflation is always and everywhere a monetary phenomenon. Changes in the real economy have nothing to do with either one.

Deflation is caused by inflation. The Great Depression was caused by the artificial overexpansion of credit after the Federal Reserve was created in 1913. People borrowed a lot of money that was basically created out of thin air within the banking system. It was not lent by real savers. The excess money went into buying things like stocks and real estate. When people eventually found themselves overindebted and began to pay back their loans, the excess money went back to where it came from - into thin air. There was no real saver getting his loan back. As a result, the supply of money and credit dramatically collapsed, driving up the value of the dollar. Because nominal wages did not fall rapidly enough as the value of the dollar rose, real wages skyrocketed, making the price of labor artificially high. This created a huge labor surplus, throwing millions of people out of work.

Result: Great Depression.

[Finster]

Re: Mental Experiment

I've been trying to logic my way through my own question to Finster (quoted anonymously above) and his reply, but the synapses have been much abused as a result.

If everyone knows that the value of a currency will appreciate in direct proportion to productivity gains they'd build the expectation of falling asset values into every purchase. Even in cases of a non-depreciating asset, the price would fall over time as the currency increased in value.

My first thought was that a 30-year mortgage for a home would become impossible. Who in a growing economy would agree to fixed payments 25 years from now that might be triple what they're paying today in real terms?

But the more I thought about it I decided the answer was that credit would change. No one would use credit to buy much of anything. Certainly not big-ticket items like cars and homes anyhow. They'd want to save and pay in today's dollars since they'd be worth less than tomorrows. Or, at a minimum, these loans would be much shorter duration.

Now I've come round to the idea that current asset prices would simply take the increasing value of the currency into effect like they do falling values now and nothing much would change, except that prices would be depressed.

Is the idea that the Fed should increase the money supply in lockstep with production increases to keep prices stable, not falling, because of concerns about the effect on credit (and growth??) if you don't adjust? What would be the effects on the economy of having people move to cash-based purchases and 5-year mortgages?

Finster, is your basic point that, whatever the motives, once you've got a changing money supply there are such incentives to cheat that everyone will eventually succumb and the currency will be devalued?

I suspect this topic is all Econ 101 (ok, maybe 201), so if I've missed out something obvious, apologies. WDCRob: asking the dumb questions so you don't have to!

Blaze, the problem I'm having with your thought experiment is that the productivity gain is a one-off due to an unforseen event. If you build it into expectations that productivity/advances are going to occur routinely, I think it changes the experiment.

WDCRob, your "dumb" questions appear to be making us think about some very important issues! I think one of the central points of confusion here is of mixing up issues having to do with the real economy and monetary issues. If your questions are forcing us to grapple with our confusion, they are adding greatly to our understanding.

It appears you are even answering your own question to a great extent. In the absence of inflation the interest rate on that 30 year mortgage would simply be much less, perhaps 1% - 2%. The lender would not need to demand an inflation premium. Also, your observation that "No one would use credit to buy much of anything." is true in at least a relative sense. In the absence of inflation, virtually all money borrowed by one party would be lent by another. So while there would certainly be many people using credit to buy things, there would be just as many saving the dollars they are borrowing. Credit supply and demand would be meted out in the real economy. For example, young people starting families would be the ones taking out the mortgages while older folks saving for retirement would be their lenders. In the capital markets, only those borrowers whose projects return a real economic benefit would be getting credit, and the investors in those projects getting a real return.

The artifical creation of money and credit out of nowhere by the Federal Reserve system throws a monkey wrench into this whole balance. More money actually gets borrowed by real borrowers than is lent by real savers, the difference being made up out of thin air within the banking system. This results in more borrowing than lending in the real economy. More consumption than production. But only for a while. The imbalance is always eventually corrected, often by some major financial or economic crisis. Today, the US is more indebted than any nation in all of history. Much of its apparent growth and wealth is illusory, having been borrowed from the future. When that debt is being repaid, the myth of economic growth coming from money and credit expansion will once again be refuted.

[jk]

Re: Mental Experiment

if i may intrude on this dialogue: no offense, but what i first thought to write was "dialogue of the deaf," not to impugn, but just to point out that you are talking past one another, instead of to one another. finster is dealing with inflation/deflation on a theoretical basis, blaze is looking more at actual systems. the difference between theory and practice here resides in the fact that prices and wages are sticky: they go up a lot more easily than they come down. it's hard to get people to accept wage cuts. instead the system is lubricated by a few % of inflation; wages can lag and be cut [almost] invisibly through the magic of the money illusion.

[bart]

Re: Mental Experiment

Deflation is caused by inflation. The Great Depression was caused by the artificial overexpansion of credit after the Federal Reserve was created in 1913. People borrowed a lot of money that was basically created out of thin air within the banking system. It was not lent by real savers. The excess money went into buying things like stocks and real estate. When people eventually found themselves overindebted and began to pay back their loans, the excess money went back to where it came from - into thin air. There was no real saver getting his loan back. As a result, the supply of money and credit dramatically collapsed, driving up the value of the dollar. Because nominal wages did not fall rapidly enough as the value of the dollar rose, real wages skyrocketed, making the price of labor artificially high. This created a huge labor surplus, throwing millions of people out of work.

Result: Great Depression.

Looks like its time a pick a nit or two. Per the actual data, the Great Depression and virtually every recession have been caused by relatively rapid rates of deceleration of money supply creation. Note that I'm using a broader definition of money supply than is normally used - I include things like credit creation and monetary base.

Here's the actual data from 1920-1940 and as you can see, the correlation is unmistakable.




My basic nitpick is that inflation does not *necessarily* have to precede deflation, even though in actual practice in the US it has. A significant drop in rate of money creation is enough to do it.



Here's a bit of a longer term picture, just in case, showing similar correlations and a fuller recession/depression picture:

[Finster]

Re: Mental Experiment

if i may intrude on this dialogue: no offense, but what i first thought to write was "dialogue of the deaf," not to impugn, but just to point out that you are talking past one another, instead of to one another. finster is dealing with inflation/deflation on a theoretical basis, blaze is looking more at actual systems. the difference between theory and practice here resides in the fact that prices and wages are sticky: they go up a lot more easily than they come down. it's hard to get people to accept wage cuts. instead the system is lubricated by a few % of inflation; wages can lag and be cut [almost] invisibly through the magic of the money illusion.

Excellent point. Especially for an 'intrusion' ... ;-) As long as one acknowledges that, there is no real divergence between theory and fact.

The point is nowhere as vividly illustrated as in the case of the Great Depression. As I pointed out a few posts back, the rapid rise in the market value of the dollar far outpaced the flexibility of nominal wages to adapt. Real wages rose, and the resulting artifically high price of labor does what artifically high prices always do - lead to a massive surplus of the commodity in question. Of course, when that commodity happens to be labor, we have a special name for it - "unemployment".

We need to be highly suspicious, however, of any temptation to hastily conclude that inflation is therefore good for the economy. If the problem is insufficent flexibility in nominal wages, then perhaps we ought to be rexamining some of our institutions and habits of thinking. Not trying to paper over it with devices designed to deceive.

[jk]

Re: Mental Experiment

If the problem is insufficent flexibility in nominal wages, then perhaps we ought to be rexamining some of our institutions and habits of thinking. Not trying to paper over it with devices designed to deceive.

good luck, senor quixote.