Supply, Demand, Price Controls, Economics, Etc.

While I had the honor of compiling this week's Carnival of the Capitalists, one of the articles that was submitted (by Jonathan Wilde of catallarchy.net) was an analysis of an article by Paul Krugman about a babysitting co-op in the Washington DC area.

Now Jonathan did an excellent analysis of the article itself, one that I wholeheartedly recommend reading, and I do not plan to recreate his wheel, as it were. Instead, I want to use the article to help illustrate how inflation and deflation are both vital to a healthy economic cycle.

The biggest flaw that I saw in the co-op's scheme was that of price controls. The value of the coupon was pegged at 1 hour of babysitting per coupon. Period. It did not vary upwards in times of great demand; it did not vary downward in times of little demand. Consequently, the only tool available to influence the "economy" was the size of the money supply, which is not entirely realistic.

Jonathan also pointed out that they coupons used in the co-op were not true money, as their use was limited. They could only be exchanged for other babysitting services. In doing full blown economic effectiveness analysis, this would be a significant factor hampering the extrapolability of the results, but for the discussion I want to have, this isn't really a factor.

Hypothetically, let's eliminate the price controls in the co-op and create a given coupon supply. The number of coupons is a fixed number and their par value (or issuing value) is, as it was in Krugman's article, 1 hour/coupon. Further, we're going to say that there is no banking mechanism, no issuance of additional scrip, and no "virtual" coupons. Every coupon is paper, there is no credit, and every transaction is paid immediately in scrip.

Now when the coupons are first issued, people will freely exchange them for 1 hour of babysitting, just as the par value indicates. But what happens as we head towards winter and people decide that they need to start saving coupons, perhaps in anticipation of the State of the Union? The demand for babysitting services naturally declines, but the demand for coupons is still there. So how can people acquire more coupons?

Well, we have already prevented the co-op from issuing more coupons, so the value of the coupon should naturally begin to deflate. Coupons should begin to be valued at say 2 hours per coupon, maybe more. Eventually, prices will drop enough (coupons will buy more hours per coupon) to begin to stimulate activity again. People who want to collect and hoard coupons will have them become available and people who maybe have more coupons than they really need or who want to spend more time going out will begin to use more of them as they see the value increase.

Eventually, though, the spenders will need more coupons and the service providers will need to use the co-op services. At that point, the coupons start to flow the other direction and the value stabilizes at the new lower level.

But then what happens when the State of the Union comes up and everyone wants to go? Now you have huge demand and little supply. Prices will begin to rise (each coupon will buy fewer hours of babysitting) until a point is reached where there are enough people willing to spend the night at home working that the need is satisfied. That point may be at, say, 10 coupons per hour. Inflation will have eroded the value of each coupon substantially, but eventually there will be more people willing to work than that price level will support and prices will deflate back towards a reasonable level, followed by the whole process running its course again.

The cycle I've just described could be described something like this: contraction-bust-growth-boom. Look at a sine graph for a graphical representation of what
it would look like. It is a "perfect" cyclical model.

Unfortunately, the textbook, theoretical model does not exist in the real world, as we all know.

Let's look at what might happen if there was a bank involved in the process that was capable of creating and destroying scrip at will, not unlike the Treasury (although the Treasury does it through the issuance and open-market redemption of bonds).

In the contraction phase of the cycle, the bank could, as Krugman proposed in his original article, make more scrip easily available through low interest rates (maybe borrow 10 scrip, only repay 11) to help stimulate demand. It makes sense to do so, because it avoids the harsh effects of deflation on an organization (in this case the co-op), which has debt as part of the capital structure. The risk, however, is ending up in the dreaded liquidity trap where no amount of Keynesian pushing the string will stimulate demand.

During the boom part of the cycle, the bank could, attempt to contract the scrip supply by making it more expensive to borrow (say borrow 10 and repay 20), which would contract the scrip supply by the process of some people paying off their debts, while limiting the amount of scrip being created. This would help to avoid inflation by reducing the number of coupons available to chase after the limited supply of babysitting time (it limits how high up the demand curve the economy can go). The risk here however is that if people have been borrowing scrip to repay with scrip, it makes sense to encourage the continued rise in prices through further borrowing as it then takes less effort to repay the debt than the value received in incurring it.

Notice the similarities between the two. In the first scenario, we are expanding the money supply to encourage spending, thereby discouraging deflation. It is assumed that a little inflation is a better alternative than a little deflation. In the second scenario, the goal is to rein in inflation, but it is still assumed to exist.

In other words: inflation=good; deflation=bad.

Here are the two problems I see with that the actions of the bank. First, deflation is the monetary equivalent of a check and balance in the government. Deflation discourages the piling on of debt by making it more difficult to repay that debt down the road (imagine the person who borrows 10 coupons for 1 hour of services, only to have to repay 20 coupons in which they receive 1 coupon for every 2 hours of babysitting - a 40 to 1 ratio in hours).

Inflation, conversely makes saving less attractive by devaluing the worth of each coupon (imagine the person who hoards 10 coupons at 1 every 2 hours only to use them at a rate of 10 per hour - that's a 20 to 1 ratio). Too much of either extreme, savings or debt, is bad for the economy. Inflation and deflation are the checks against the extremes. By cutting out one, we remove one of the consequences of poor economic decision-making.

The second problem I have, is that constant inflation erodes confidence in the value of the scrip. You run into a scenario where people eventually ask what the point is of working for a coupon that will get you half of what you put into it, so they either remove themselves from the economy by transitioning to a barter system, or they immediately spend their earnings, regardless of the utilization value, in an effort to stave off the effects of inflation, when if fact they are simply exacerbating the problem (this is where it turns into hyperinflation).

In our economic system, we have virtually eliminated (on an economy wide scale, in certain industries the effects are still felt and even then I would argue that they are offset to a large degree by substantial productivity gains in those same industries) deflation as a real risk to business today. That's not good. There is no check against out of control borrowing and we're now starting to see the effects of an economy being strained under the weight of simply too much debt. I think that we're at a crossroads, economically right now. Our nice little 2-3% inflation rate has been outstripped by our mushrooming debt. If businesses start hiring large numbers of people again, I think we're going to see the inflation rate increase significantly. If they don't start hiring pretty soon, I think we're going to see debt induced deflation - which will not be pleasant at all, as each default will lead to more defaults as everything is based on a house of cards, where one debt backs another debt which in turn is backed by another debt which is backed by the original debt. Default on any one and the whole group comes down.

What really scares me is that a form of the circle may, in fact be what our entire economic system is based on. In another article from the Carnival, Mike Northover of Master of None did an excellent post on the Real Bills Doctrine, in which it is proposed that our currency is in fact backed, backed by commercial paper issued by corporations and bought and held by the Fed.

Before I go too far into this discussion, a little look at what commercial paper is. Commercial paper is basically an IOU written by a company in which they promise to pay you back x number of dollars plus interest in say 90 days. Commercial paper has absolutely no backing; if the company defaults there is no recourse - you're just out of luck. Generally, commercial paper is issued by the largest and most stable companies out there as a way of doing short term financing. It saves the companies on the costs of doing a bond issue and generally commercial paper is easy to roll over. It is usually attractive to investors because it offers a combination of decent return (due to the risk associated with no recourse) and relative safety from the short time period.

But what is the commercial paper backed by? It is backed by the full faith and credit of the issuing corporation. One of the reasons why commercial paper is considered to be such a decent short term parking place is because it is denominated in dollars. People like the perceived strength and stability of the US dollar, which is fine. But it means that to a degree, the value of the commercial paper is backed by the perception of the US dollar (GE commercial paper issued in Mexican pesos will not be as valuable to a Mexican as a dollar denominated scrip is to an American because of the perceived risk in the peso, even removing exchange rate risk).

And according to the real bills doctrine, the value of the dollar is backed, to an extent, by the value of the commercial paper. In other words, the paper provides some backing to the dollar, which in turn provides some backing to the paper. But so what, you say?

What happens in the event that some event shocks one side of the backing or the other? Say an active paper issuer like GE goes bankrupt? If real bills holds true, the dollar should lose some of its luster, which in turn would devalue the rest of the commercial paper, which would take the dollar down more, so on and so on and so forth.

Think it can't happen? It already has once. In 1970, the Penn Central railroad, then the largest issuer of commercial paper in the market, went belly up. It was at the time, the largest bankruptcy in US history. It can happen. It has happened. The question is, could our economy, if the value of our money is based on the real bills doctrine, withstand another shock like that? Luckily, in 1968 when we left the gold standard, we were about two years from the end for Penn Central. The Fed would have had an opportunity to avoid stocking up on PC scrip. But even so, the revelation of the true depths of the problem at PC came out in early June of 1970; by the end of the month they were in bankruptcy - and all the paper holders were SOL.

Today, if something like that were to happen, if real bills is at work (which I don't doubt it is), it could be a devastating blow to our economy. Particularly now that a number of companies are issuing Euro denominated commercial paper, which now adds in exchange rate risks on top of everything else. A blow to the dollar could dry up significant parts of the paper market, leading to more insolvencies, further hurting the dollar and putting us into a vicious circle until some sort of equilibrium is reached.

But here's something to consider that kind of ties together both parts of this post: We left the gold standard in 1968, Penn Central went bankrupt in 1970, and Nixon imposed price controls in 1972 that lasted until 1974. This all coincided with the beginning of the bear market of '70s and was followed by stagflation. It was nearly 15 years, until about 1983, before we were able to pull out of the issues caused by the events of the late '60s/early '70s. Recently, consumers and corporations alike have seen an explosion of debt burdens and we're now possibly approaching the end of the debt boom. Our economy is sick, there is no doubt about that (and before someone says look at the stock market, that is not a reliable indicator of the health of the economy.), what is in question is whether or not the sickness is getting better or worse.

I think that we've harmed our ability to rectify difficult economic circumstances by taking away one of our check and balance tools - deflation. It is a necessary evil to maintaining a healthy economy. Just a few months ago I was arguing the need to depreciate the dollar to try to export our way out of recession. The more I study the whole situation, the more I'm becoming convinced that we need a broad based deflationary environment for a short period of time to try to introduce a measure of rationality into the economy. The biggest obstacle I see is that we have accrued so much debt in anticipation of never ending inflation that deflation would be catastrophic to many. We may have inflated our way into a situation where we can no longer inflate, but we cannot afford to deflate like we need. We, too, may have hit a liquidity trap, and may be in for a long ride while the economy tries to absorb and/or wring out all the extra debt created money floating around out there. I'm not sure what's worse: rapid fire deflation where all the pain comes now and we can begin rebuilding, or a long drawn out economic collapse, like Japan has gone through for the last 10 years, where the pain just keeps coming and coming and coming in little increments for a long time before you can begin the process of rebuilding.

Do I have the answer? No. Just kind of thinking out loud here. And getting really tired of seeing supply and demand curves in my head.