Gavin (selfishgene) wrote,
Gavin
selfishgene

Inflation

Imagine you are on an aircraft carrier with 4000 sailors on board. Each sailor gets issued 3 ration tickets every day by the paymaster. The sailor can then get a meal in one of the ship messhalls. The paymaster realizes he can issue an extra ticket to himself every day and get 4 meals. Nobody will notice. After a while the other officers begin to notice the paymaster is eating 4 times a day. He issues them with 4 tickets each day to keep them quiet. Eventually even the Captain is in on the deal. Meanwhile the chef has noticed that his stores are being depleted too fast. He is forced to cut the amount of food in each meal because the total amount has already been budgeted. As more people join the group getting 4 tickets a day the normal ration size has to get smaller.
Soon the ordinary sailors get annoyed by the small portions since they only get 3 tickets a day. The Captain orders the paymaster to give everyone 4 tickets a day since this is the easiest way to solve the problem. After a few days the paymaster starts the cycle again by giving himself 5 tickets a day. I am not going to follow that process any further. But we can analyze what happened in the first cycle. When only a few privileged people were getting 4 tickets a day, they received more than their fair share. Everyone else received less. Once everyone got 4 tickets, there was an equal share for all. However the ordinary sailors still got cheated. Also they will be cheated again when the new 5 ticket scam starts operating.
This is a description of inflation that clearly shows that the politicians and their friends benefit from inflation because they are effectively stealing from the ordinary people. Of course a real monetary inflation process is much more complicated but the general scam is the same.
[What do you think of this as a very basic introduction to inflation?]
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It seems like a pretty good introduction to me.

Then again, this is one of those subjects that seems so obvious to me that I don't understand why other people don't understand it.
I like it.

other

October 19 2009, 21:49:25 UTC 7 years ago Edited:  October 19 2009, 22:09:40 UTC

There are two things going on. One is that an extra ticket is being printed and being distributed to everyone equally, the value of each ticket has gone down to compensate such there is no change in their real wage. It's a change without a difference. Well, people think they got a raise. The second is where the paymaster prints off money for himself and that does decrease the purchasing power of money.
If inflation was automagically extended to everyone instantaneously there would be no problem. Of course there would be no incentive either, so it would never happen.
Oh ya, the story reminds me a little bit of Krugman's babysitting story</>a.
Why could those couples not simply extend credit to each other? If you are worried that you won't have a reserve of scrip you will simply offer to babysit for 3 hours in exchange for 2 hours of scrip. The market will fix itself. There is no reason for a central management system at all. A central management system may have theoretical advantages as long as they are perfectly honest but who will verify that honesty? If even one member of the community is dishonest that person will have a much stronger incentive than most to bear the 'burden' of management.
They could extend credit to each other in this example, effectively issuing their own vouchers. It works here because they have a double incidence of wants in this simplified story.

The price could adjust to "the recession" and the price could adjust such that there are fluctuating seasonal prices. The real world problem with this is that prices are sticky, that is, they tend to take a while to adjust in the short term. If prices are flexible, you're right, they wouldn't need to increase the money supply.
Good intro!

(1) I might add a line or two about how the decrease in ration size is gradual enough that nobody notices at first. But it's not a necessary addition; this stands as is.

(2) I might change it from "The Captain orders the paymaster to give everyone 4 tickets a day ..." to "As more and more sailors get in on the secret, the paymaster has to start issuing more bonus tickets, until everyone has 4 tickets a day ..." That forgoes the obvious question of, "Why doesn't the Captain just confiscate the extra tickets?" Inflation may be an intrusion into the market cycle, but it spreads through traditional market incentives: wealth (being "in on the secret") trickling out from the source.
I like point 2.
Well, the main problem is that it assumes a zero-sum game. This may be true for 3rd world economies that rely on subsistence farming and exploiting natural resources, but not in 1st world economies. In the US if you print more money the only direct effect is hurting the gov't's bond rating.
On the contrary the damage is immense, it just takes a long time to become obvious. Do you think the bailouts were a sign of a strong economy? They were a sign that privileged billionaires will get money stolen from middle class people. Exactly the same as the paymaster does in my fable. Of course the bailouts were done openly while inflation does the same malicious transfer in secret.
Most economists work for privileged institutions that get benefits from the central bank or the government e.g. banks, universities, large corporations. It is not surprising that those economists think the system is just dandy - it pays their salaries.
You leap too quickly to the anti-elitist theme. These "billionares" were just skimming off the top of a much larger bubble, driven by ordinary folks taking subprime mortgages and maxing out their credit cards. The money has been printed to create a soft landing in the economy (specifically the housing market) at the expense of some inflation.

It's true, billionares didn't lose their shirts when they probably should have, but the same can be said of millions of Americans who would not have been able to withstand a catastrophic retraction of the credit market (e.g., because they work for small businesses). And, unfortunately, this came at the expense of people who spend and save conservatively.

The best long-term solution is to phase out price supports for home building and reinstall the regulations on investment banks, so they don't go silly again and create derivative positions with systemic risk.

'best long-term solution' is to let careless people/banks/corporations go bankrupt. This serves three purposes, it punishes carelessness and it rewards careful people who can snap up cheap assets. It also gives notice that carelessness will not be rewarded in future.
The solution implemented does the opposite. It rewards the careless, punishes the careful and tells the careless that they will be bailed out next time too. Do you believe that regulation will be 'really strictly applied next time, honestly we really are serious now, no messing around, we mean it'.
If you have a serious argument as to why the same political forces which caused a bailout this time will not still be in operation next time, I would like to hear it.
Oh, if a similar crisis hits in the future, no doubt there would be a similar bailout.

Many careless people and banks have indeed been devastated -- except the largest of these, which were supported because if they had failed the credit market would have disintegrated.

I may have a different assumption than you: I don't believe the market is able to maintain an equilibrium on large enough scales, and this may permit runaway corrections. It is unfortunate that the careless have not had to confront their failure, but we can't afford it.

It's not surprising that the most powerful get off scot-free. Not just because they have political influence, but because the organizations they lead cannot be allowed to fail. Ultimately the flaw is the human need for a single person at the top ...
'credit market would have disintegrated' - this is a classic example of what Rand called a 'floating abstraction'. Markets are simply a summary of multiple transactions. If the credit market 'disintegrated' this could only mean that at some given moment few or zero credit transactions were taking place. This is presumed to be a bad thing as the designation 'disintegrated' shows.
In a free market theory it is presumed that if nobody is doing credit transactions then there is simply no demand for such transactions (or some coercive entity is forbidding them). [By demand is meant people want it and can pay for it. Mere wishes are not demand in economics.] So if there is no demand and credit is not forbidden then there are some possible reasons. Creditors are unwilling to lend to prospective debtors because they are deemed a poor risk or nobody wishes to take on debt because there is no profitable use for borrowed money. This may be an entirely accurate assessment of the economic climate. The solution is to wait until debtors see opportunities and creditors see solvent debtors. This waiting is deemed a supreme evil in Keynesian theory. In free market theory it just means the market is slowly adjusting to reality. When the mania for dot-com shares or mortgage bonds is seen by almost everybody to be excessive, people will start to think of other endeavors which require human and financial capital. Since human desires are endless there can be no lack of such endeavors - they just have to be ones which people will pay for (i.e. profitable).
Like an addict in detox this is painful but simply taking more drugs is only increasing the damage.
'maintain an equilibrium' is also pointless if it means maintaining unprofitable businesses. If a nation needs only x number of houses and the market mania has already built x plus 20% then to 'restore equilibrium' and allow the mania to continue, results in even more useless houses. This is a waste of human labor, materials and financial capital. Not to mention increased pollution (which is never a leftist concern when unions want a bailout).
A free market will never lack for employment of labor and materials and money. There is always something people want. If they have houses they want furniture or yachts or eco-vacations or something. It is true that the demand (hence price) of certain types of labor / materials / corporate structures / branding may reduce while others are increasing. This is unpleasant for those whose skills / investments are less desired but nobody should be guaranteed a high standard of living. If your skills are not currently bringing the income you once earned, you may deserve some modicum of sympathy but you don't deserve a bailout.
I am not one who is very concerned with the plight of poor people in Africa etc. But it seems absurd to give charity to people because they once made $50/hour and now have to struggle by on $30/hour. Not to even mention giving charity to people who have more money than the average African nation's GDP.
What I mean by "equilibrium" is the ability to price products in a consistent way, and what I mean by "disintegration" is an inability trade due to a sudden, widespread loss of liquidity.

In the mortgage crisis, large firms sold credit default swaps to one another to insure against mortgage failures. This was out of equilibrium because few understood the risk due to potential lack of liquidity, and so they failed to price the swaps correctly.

In hindsight, the risk was rather obvious: if someone who owes you money goes down, you end up without cash you were counting on, and then someone who was counting on money from you gets screwed too; etc. etc. You can say, sure, these people deserve each other and their failure is just a bubble (a transient phenomenon out of equilibrium) popping.

The problem is that these firms controlled so much capital that their paralysis due to a lack of cash would extend to the entire economy. Without secure banking and credit/lending people can't buy anything, businesses can't pay employees, and new businesses can't start -- doesn't matter what the fundamentals are (e.g., supply and demand for products). You always need cash.

The only way to undo the knot was guarantee the assets of the largest firms and flush the cash down the foodchain. The downside is that the gov't takes on the risk that the big firms could not calculate correctly, and the leaders of these firms just fail to get rich instead of losing their shirts.

The great lesson here is that even in a system made purely of voluntary contracts there is collateral damage because risk information is not only not transmitted, it's not always understood even by the risk-takers. And when the risk-takers are huge like AIG and Citibank, there is a lot of collateral damage.

Free markets are only efficient if risk/reward is comprehensible and transparent.
'Free markets are only efficient if risk/reward is comprehensible and transparent.' - I think it is clear that bailouts do nothing to enhance transparency and predictability. If corrupt markets demand more corruption to rescue them then that does nothing to recommend them to me.
I understand the temptation to smooth out temporary blips in the market. However, the main reason banks make these careless bets is moral hazard - they know that by means of inflation or bailouts the government will rescue them when things get tough. No central bank can credibly promise not to rescue big banks because their collapse would endanger the central bank itself.
Imagine you are at a casino in Vegas. If you bet your life savings you can win millions. If you lose the casino will return your money. Why would you not simply bet all the money you have again and again? It is heads you win, tails the taxpayers get screwed and you win anyway.
When American slaves were freed after the civil war there was tremendous turmoil and suffering. Many slaves wound up working for the same master on scarcely better terms than before - we still recognize the changes as an improvement for most slaves. In the same way dismantling the corrupt banking / monetary system would be difficult in the short term. In the long run most people will benefit from not paying to support incompetent billionaires. Everyone will benefit from investments made in productive enterprises rather than in careless speculation.

smandal

7 years ago

selfishgene

7 years ago

smandal

7 years ago

selfishgene

7 years ago

I think I have to question this analysis. The banks didn't have to give out sub-prime loans, and they certainly didn't have to go out of their way to sell them to people who hadn't in the first place been looking for them. But they did because they were making so much [imaginary] money on the derivatives that they never even considered for a moment whether the loan-holders actually had the ability to repay the loans. All the loans were doing was priming the pump. They'd make a loan, then effectively resell the same loan fifty times. It was a massive, upside-down house of cards, that only worked because they willfully closed their eyes to the fact that the relative handful of loans at the bottom of the upside-down pyramid were worthless.

The biggest banks, and their executives, made so much money off it that even after the crash, many of the executives behind the scheme are still laughing all the way to the bank. They're set for life. The large banks have profited enormously from having had the situation set up for them to gobble up smaller banks en masse. Sure, on paper, they took heavy losses absorbing some of the worst-hit banks ... but we all know that on paper, three or four years from now all those losses will have been written off the books as though they never happened, and they'll have made up yet more imaginary money off of imaginary securities to make up the losses.

At this level, finance is not about investing real money any more. It's a gigantic gambling scheme played with other people's money. Gains are privatized, losses socialized.
... so, what are you disagreeing with?

I agree that the executives made out well in the end, though this is more a problem of how executive compensation is structured than the banks themselves having done well in the end.

I also agree that there is a loss, at least in huge opportunity costs, from the gov't underwriting huge bundles of mortgages of which many are less than sound.

My argument is that given the situation as it stood, there was little choice but to bail out the largest banks to prevent a systemic paralysis of the credit market.

The question does remain, who need to be held accountable? Whose head must roll?
My point was that the meltdown was not driven by the people getting the sub-prime mortgages. The sub-prime buyers were just marks, suckers who were made loans they couldn't afford in the expectation that they would default on them and lose everything. It was worth the bank's resulting losses on the loans because they would make so much money off the derivatives — besides, the expected loan losses would be covered by CDOs, and they'd still end up with the properties anyway. The banks weren't counting on the housing bubble bursting, the properties becoming near-worthless, and the CDOs all getting called in at once including the ones they held. They all assumed they'd be able to keep the balls in the air, indefinitely, because they all assumed house prices would keep ballooning forever.
That's an interesting way to look at it: the people taking subprime loans were just patsies, and the issuers were just giving them out in order to make money on the derivatives; if the loan defaulted, the house would rise in value anyway and the issuer could sell it off later.

I see an obvious problem with this picture: why didn't the investment banks just buy the properties themselves, cutting out the middle man?

There's a simpler explanation: just as subprime borrowers were giddy at the prospect of their homes rising in value, betting their life savings (or at a minimum, their credit-worthiness) on it, so were the banks. They were making money on both ends issuing mortgages and securitizing the debt, without thinking what it meant. And, because executive pay was based on short-term earnings, the decisionmakers didn't have much of a reason to dig deep.

Don't attribute to evil what you can to stupidity ...

unixronin

7 years ago

smandal

7 years ago

unixronin

7 years ago

smandal

7 years ago

smandal

7 years ago

unixronin

7 years ago

selfishgene

7 years ago

unixronin

7 years ago

selfishgene

7 years ago

unixronin

7 years ago

I'd like it better if you used the metaphor of coupons at a whore house.
"A coupon used to get me half and half and now it only gets me half. :("
I like it. It demonstrates a concrete example of decreasing purchasing power.