Mean Markets and Lizard Brains Read online

  Why do the surgeons require simultaneous exchange? They fear that if the exchanges are not simultaneous, then some of the donors might change their minds. Perhaps, for example, Mr. Jones might become unwilling to donate his kidney after Mrs. Jones has received her new kidney. Obviously, it is impossible to compel someone to donate a kidney against his or her will.

  To avoid this problem of failed exchange, surgeons require that all of the operations take place at the same time. The requirement for simultaneous exchange makes the actual operations much more complicated. Recall that each operation involves many medical staff. So the requirement to have four or more full medical teams working simultaneously is very challenging.

  Furthermore, simultaneous exchange prevents some swaps entirely. For example, a patient’s compatible donor might not be available until next year. If there were some way to store value over time, such swaps could take place. For example, a donor could give one kidney to a stranger now, and get credit for future exchange when the matching donor is discovered. Such swaps that involve delays are impossible if all exchanges must be simultaneous.

  Using his expertise on matching, Professor Roth is working to improve the quantity and quality of these exchanges between couples. His work has the potential to greatly improve the system, but is limited and complicated by the requirement for simultaneous exchange.

  Now imagine what the world would be like if all economic transactions required simultaneous exchange. A simple task like filling a car’s gas tank would require a negotiation involving delivery of some good or service to the gas station owner. Perhaps the most profound effect would be the difficulty retirement would bring about. During later years, most people spend years or decades living off previously accumulated wealth. The ability to store up favors of the magnitude required to retire would be impossible if all exchanges needed to be simultaneous.

  The world of simultaneous exchange is not mythical; it is called a barter economy. Before the invention of money, all human societies used barter. Even recently, some nonindustrialized societies existed without money. As the kidney example illustrates, the need for simultaneous exchange in barter societies places a serious damper on economic activity. Consequently, barter economies are less productive than societies that use money. Importantly for financial planning, barter economies make it very difficult to store up wealth to use in the future for retirement or other activities.

  The Form of Money: Rice, Cheese, Stones, Gold, and Paper

  Money is truly an amazing invention that lubricates economic exchange. As Milton Friedman writes, money in its current paper form is almost magical. With money, one is able to obtain real goods—food, drink, transportation, and housing—in return for flimsy pieces of paper. Furthermore, the ability to store wealth means that retirees can live for decades off their savings.

  I am reminded of the power of money when I travel to exotic locations. Emerging from a busy and frequently dusty airport, I am immediately able to get help from strangers simply by offering a piece of paper. These strangers are willing to help me because other people will, in turn, grant them valuable goods and services in exchange for the paper that I provide. Both transactions are made possible by the fantastic tool of money.

  For all of its wonderful positive effects, money immediately creates the potential for trouble that is not possible with barter. Recall that because of simultaneous medical operations, our kidney-swapping couples are sure that the other couples will do their part. In contrast, in any transaction using money, one side gives up something of immediate value in return for the promise of future value. Those who trade a hamburger today for a dollar they will spend next Tuesday (or 10 years from next Tuesday) risk the prospect that the dollar will lose some of its value before it is spent.

  Part of the risk of money lies in its somewhat ephemeral nature. Modern paper money has value only because others perceive it to have value. As Professor Friedman writes, “Why should they [dollars] also be accepted by private persons in private transactions for goods and services? The short answer—yet the right answer—is that each accepts them because he is confident others will. The pieces of paper have value because everybody thinks they have value.”3

  Unlike dollar bills, some earlier forms of money had intrinsic value. Rice and other grains were used in a variety of cultures.4 The recipient of “rice” money knows that even if everyone else stops accepting payment in rice, he or she can eat the money. For similar reasons, some northern European cultures used cheese as currency.5

  While rice and cheese solve the problem of future repayment, they have their own problems. They can be bulky, hard to store, and subject to decay. Imagine the difficulty of keeping your retirement account entirely in the form of rice, or hauling a giant sack of cheese to the car dealer. Other forms of money can improve upon these “commodity” currencies.

  Throughout the ages people have been willing to die and kill for gold. On the surface, this might seem ridiculous, as gold has very few actual uses (and cannot be eaten!). Gold has value not for what it can do, but because it solves many of the problems with commodity-based currencies like rice and cheese.

  If we were to imagine ideal money, what characteristics would we seek? Ideal money would be easy to verify, impossible to counterfeit, portable, and not subject to decay. Gold has been an important currency throughout human monetary history because it has many of these characteristics. It is scarce enough that small amounts have value, thus making it portable. It is relatively easy to detect fake gold, and gold does not rot when stored. This seemingly simple set of features explains why gold can launch (and sink) armadas, ruin friendships, and dominate dreams.

  For all of its advantages, gold and other naturally occurring forms of money still have problems. Residents on the Pacific Island of Yap discovered this through an interesting experience.6 This is an old story that has become famous because it is included in Professor Gregory Mankiw’s best-selling textbook (called simply Macroeconomics).7 (Professor Mankiw taught in the Harvard economics department and is currently the head of President Bush’s Council of Economic Advisors.)

  The residents of Yap use money called “fei” that consists of large stone wheels shaped liked coins that can reach up to 12 feet in diameter. These fei have many of the optimal characteristics of money. They are difficult to counterfeit and they do not decay. While the fei are not portable, they are stored in the equivalent of banks and do not get moved very frequently. The fei can change ownership without being physically moved. Because the society is sufficiently small, everyone knows who owns which fei, and consequently there is no risk of theft.

  Many years ago one of the fei was washed away during a storm. The people of Yap faced a choice. Should the person who owned the money be liable? If so, that person would suffer, but so would the whole society. As Professor Friedman has shown, the amount of money affects economic activity. Thus, a decrease in the amount of money would likely harm the overall economy. The residents of Yap decided that the lost fei should still be credited to its owner. So while the actual fei remained lost, all the residents simply acted as if it were still on the island. They kept track of who owned the fei and—many years later—this virtual fei still existed in everyone’s mind and was used in transactions.

  The story of stone money on the island of Yap illustrates the problem with any tangible currency. If such currency is used, then the ability to create money is taken out of the government’s hands. So in the case of Yap, the entire society would have had less money if the washed-away fei had been declared lost. In the case of gold, the quantity of metal is determined not by government, but rather by the foibles of discovery and mining technology.

  As we’ll see, government control of money is frequently the source of monetary misery. Nevertheless, few leaders want their economy to be subject to the ebb and flow of gold production. The United States was effectively on a gold standard from the Bretton Woods agreement in 1944 up until 1971. Because President Nixon wanted to
stimulate the economy, something that was difficult to do under the rules of Bretton Woods, he removed the fixed link between U.S. dollars and gold. Today, every major country has made a similar move, and money has been decoupled from anything tangible. We live in an era of so-called “fiat” money where the supply of currency is dictated by government command (or fiat).

  With the proper controls on counterfeiting, fiat money has a seemingly perfect set of characteristics. Fiat money is of known value, lightweight, and easy to store. Unlike gold, the supply of fiat money is controlled by the government and so can be modulated to fit economic needs.

  Shrinking Money: The Trouble with Inflation

  Economics is often characterized and summarized as “supply and demand.” When it comes to money, there are clear consequences to changes in supply. The residents on the highlands of Papua New Guinea learned this in the early part of the twentieth century.

  Papua New Guinea is a large island north of Australia. The coasts are populated with people who have been in contact with their neighbors in other countries for centuries. Soon after leaving the coastal region, the land rises steeply to a mountainous and elevated plateau that was thought to be too rough for human habitation.

  In the early part of the twentieth century, a group of Australians decided to investigate the highlands in search of gold. There are several fascinating aspects to this story. First, the highlands were far from empty, but rather contained close to a million people who had been almost completely isolated from other cultures for centuries. Second, the Australians brought a movie camera with them. This may be the only film recording of a first contact with a nonindustrialized people. Some of the original footage can be viewed in an academic movie appropriately titled First Contact. Third, and particularly relevant to our story, the people of the highlands placed a high value on seashells.8

  Why would anyone use seashells as a form of money? For most cultures this would be silly, as no one would exchange anything of great value for seashells. In the highlands of Papua New Guinea, however, seashells make as much sense as gold did for ancient Greeks. Almost completely isolated from the sea, shells in the highlands were scarce enough that small amounts had high value. It is easy to detect fake shells, and shells do not rot when stored. These are exactly the characteristics that make gold valuable all over the world.

  As long as the highlands were separated from the seashores, a seashell money standard made sense. However, it did not take the Australian gold miners long to understand the opportunity. There was some gold in the highlands, but it required hard work to extract. The Australians flew in planeloads of seashells they used to pay wages of the highlanders who mined the gold. The highlanders worked for seashells until shells became so common as to lose value.

  There is no question that the Australians exploited the Papua New Guinea highlanders, but the highlanders did not want to be paid in paper currency. With shells the highlanders could buy anything they wanted within their community; banknotes were worthless. This changed when the Australians opened up trade stores where banknotes could be exchanged for pots, pans, axes, and shovels. One of the original Australian miners, Dan Leahy, opened up a trade store and stocked it with a variety of goods. What do you suppose was his most popular item? It was the big “kina” shells used as part of courtship.

  The Papua New Guinea highlanders exchanged their hard work in return for money. These workers were hurt because their money came in the form of seashells, and the rapid increase in the supply of shells pushed their prices down. Thus, the decision to trade work for shells was made with an expectation of a particular value to the shells. The increased supply of seashells made this a rotten deal for the workers.

  The highlanders continued to value shells for years. This may seem silly, but imagine our response if extraterrestrials with unlimited quantities of gold came to earth. It would probably take us some time to prefer their paper money to gold.

  Inflation is defined as a loss of purchasing power for a particular amount of money. Before the Australians arrived, one beautiful shell had considerable value and could even constitute the bulk of the money paid to find a marriage partner. After shells became common, their value plummeted. Thus, the Papua New Guinea highlanders experienced a severe period of inflation. Those who had accumulated wealth in the form of stored shells saw the value of their savings devastated by the inflation.

  Residents of Weimar, Germany, in the 1920s ran into a similar problem. 9 People who accepted paper money in return for work or goods soon found that the paper money had no value. The magnitude of the German inflation is almost impossible to comprehend. In 1920, the cost to send a letter was under one mark. By 1923, the cost had risen to 50 billion marks! In this period, prices could double in a day.

  Based on stories like these, John Maynard Keynes quipped that in inflationary times, people ought to take taxis, whereas in noninflationary times, buses are preferred. His logic? You pay at the end of a taxi ride and at the beginning with buses. In times of hyperinflation, the later you can pay a fee, the lower its true economic cost. Similarly, in the inflationary 1970s, my friend Jay’s father taught him to always defer payment by using credit cards.

  My grandmother, who lived through the German hyperinflation, described some of its effects. As soon as the family earned a paycheck, she would immediately rush to a store to buy as much as possible before prices rose. My grandmother’s modest earnings for teaching converted into so many stacks of bulky bills that she used a baby pram to transport the cash.

  Stores could not change prices on goods fast enough to keep up with inflation, so some implemented a multiplication factor system.10 A grocery store, for example, might mark a can of soup at 10,000. The actual cost of the soup at the time of purchase would be the price (10,000) times a factor posted at the front of the store. So if the factor were 3, the soup would cost 30,000. This system allowed the store to mark up all prices immediately by changing the factor. A change from 3 to 4, for example, immediately increases prices by 33%. My grandmother told of the stress of waiting in line and fearing that the prices might be increased before she could pay.

  The effect on German savers was dramatic. Imagine someone who worked his or her whole life to amass a pile of savings. To be concrete, imagine someone who had stashed away 20 million marks. In 1920, this would have been a fortune, allowing a life of opulent leisure. Just three years later this fortune would not even come close to buying a single postage stamp. German savers who kept their money in marks were completely wiped out.

  No cloud, it is said, is without a silver lining. While some were wiped out by the German hyperinflation, others were made much richer. In fact, hyperinflation works to wipe out all debts. The Bible writes of “jubilee” years when all debts are forgiven: “Then you shall cause the trumpet of the Jubilee to sound . . . And you shall consecrate the fiftieth year, and proclaim liberty throughout all the land to all its inhabitants.” In a jubilee year, all debts are forgiven.

  Hyperinflation is an effective jubilee. For example, during German hyperinflation the total value of all German mortgages as measured in U.S. currency declined from $10 billion to under one U.S. penny.11 Debtors were able to pay off their debts with the wheelbarrows full of nearly worthless marks. Thus, one important effect of inflation is to hurt savers and help debtors (more on how to profit from this later). This could be considered good or bad, depending on whether one favors the savers or the spenders.

  While the erasing of debts helps some and hurts others, a second effect of high inflation is simply bad. Because of the uncertain value of currency, many people simply stop accepting money. Thus, the economy returns to barter with all the consequent inefficiencies of simultaneous exchange.

  So an economy like that of 1920s Germany can go in a full circle. Before the creation of money, all exchanges are done by barter. Then commodity money replaces barter with gold, and then with paper money. If the paper money loses value because of high inflation, the economy returns to
barter with its inherent inefficiencies.

  Goldilocks and Inflation that Is “Just Right”

  Goldilocks entered the house of three bears. In the kitchen, there were three bowls of porridge. Goldilocks was hungry. She tasted the porridge from the first bowl. “This porridge is too hot!” she exclaimed. So, she tasted the porridge from the second bowl. “This porridge is too cold,” she said. So, she tasted the last bowl of porridge. “Ahhh, this porridge is just right,” she said happily and she ate it all up.

  Just as Goldilocks liked porridge that was neither too hot nor too cold, economists think that the optimal level of inflation is neither too high nor too low. While high inflation has obvious costs, falling prices also have their “costs.” During a recent visit to Japan, my wife Barbara and I were discussing Tokyo rents with a friend. Our host told us that every year she meets with her landlord to discuss the magnitude of the rent decrease for the following year. Over recent years, prices of land have fallen dramatically, and consequently landlords have found it necessary to cut rents.

  Rent reductions may sound delicious, but the broader consequences can be quite negative. It turns out that falling prices can cause trouble. In fact, the Japanese economy has suffered from deflation since the bursting of its financial bubble in the late 1980s.