I would say, "sure, give me the pigs, and I'll give you ten IOUs, each worth one pig, signed by me." But then you change your mind, and say "okay, hmm, now you have all my pigs and I have all of these IOUs... I kinda want my pigs and my IOUs, because I love those pigs and they are my friends." I would say, "Sure, but I own the pigs now. And you own the IOUs. So if you want to take possession of your pigs and keep them at your home and enjoy their company, you will need to pay me a fee for that right. After all, I own the pigs now."
You might say "okay fine, I'll pay you one pig per year for the right to keep your pigs at my home. I'll even breed them and make more pigs, and i'll use the new pigs to pay your fee."
And I say "Okay cool. And you know what? You can pay me back either in Pig-IOUs or in actual pigs. It doesn't matter, and you can pay me back at any time. As soon as you pay me back all of the IOUs, or ten pigs, (or 5 IOUs and 5 pigs) our contract is done."
Now how does the village economy look? There are now ten pigs on your farm and you hold ten IOUs, each worth one pig. All the pigs are worth one pig and all the IOUs are worth about one pig as well (depending on my health and how much people trust me to pay). How did this happen? Where did the wealth come from? Is it "real?" If it isn't real, why do people accept it as if it were a pig? Have I not just produced ten pigs with the stroke of my pen? With a promise?
Note that neither one of our net worths have changed. You started with 10 pigs. You hold 20 pigs in assets, but owe me 10 of them, so your net worth remains at 10 pigs.
For simplicity, let's pretend my net worth starts at zero. I now own 10 pigs (residing on your farm) but I also owe 10 pigs -- I owe one of my pigs to each person who presents me with an IOU.
We have created a "pig backed" currency, and there is no inflation. Each IOU came out of "thin air" and is now traded at face-value because people trust me. This is the main way in which modern currency comes into the world, except that the pigs are now houses and cars, and I am called a "bank."
The second method for bringing new pig-bucks into the world would be me printing up some fakes and spending them on the town. This would cause inflation (a reduction in the value of the pig-buck). The first method outlined above, does not cause inflation as new pig-bucks (we'll call them piggies) hit the economy.
So there are two ways the piggies come into the world. One is via lending and the other happens when I simply make new ones and spend them in the village, hoping no one will notice, which will eventually lower the value of the piggies.
Now, what happens to the piggies over time if I do not issue any additional notes? They would fluctuate in tandem with the value of a pig, and they would also be slightly less valuable than a pig, depending on how much people trust me to keep my promise on those notes. As the value of the pig goes up and down, so too does the value of my piggies.
Now, what happens to the piggies over time if I do not issue any additional notes? They would fluctuate in tandem with the value of a pig, and they would also be slightly less valuable than a pig, depending on how much people trust me to keep my promise on those notes. As the value of the pig goes up and down, so too does the value of my piggies.
However, even though the value of real pigs and my reputation affect their value, the piggies would probably rise in value over time, and this has happened with previously issued old-world currencies, that rose as much as 25% above their face value. After issue, currencies tend rise in value (deflation) for a few reasons:
They are easier to carry, and there is no risk that the pig may die, and the notes do not need food or shelter or protection from wolves. They are easier to transport, store, and protect from theft and destruction. Further, they hold additional value because of their liquidity, which we will examine now.
Let’s imagine that another farmer comes to me and says “I like those piggy bucks you got there, they are a lot lighter and easier to carry around than pigs, and I was wondering if you could turn my cows into piggies as well.” And so I would estimate the value of his cattle; if he holds five cows and I see that people are generally willing to trade ten pigs for five cows, I issue him another 10 piggies and take possession of his cows. He also loves his animals, and I loan them back to him as well, and he agrees to pay me one piggy per year as a fee (interest) on the loan.
Let’s imagine that another farmer comes to me and says “I like those piggy bucks you got there, they are a lot lighter and easier to carry around than pigs, and I was wondering if you could turn my cows into piggies as well.” And so I would estimate the value of his cattle; if he holds five cows and I see that people are generally willing to trade ten pigs for five cows, I issue him another 10 piggies and take possession of his cows. He also loves his animals, and I loan them back to him as well, and he agrees to pay me one piggy per year as a fee (interest) on the loan.
Another man wants his home turned into piggies, and I estimate the value of his home based on its size, quality and location, and I judge that his home is worth about 50 piggies. Since he likes living in his house, I loan it back to him as well after trading his home for 50 piggy-bucks.
To see how liquidity plays an important roll in all of this, imagine I offer you the choice: I will buy your large boat by trading you my home, worth about 100 gold pieces, or I’ll give you the gold pieces. You would want the gold, not because you already have a house, but because it will be a lot easier to trade the gold. It is a more liquid asset. My home may sell for 100 pieces of gold, but it may take some time to find a buyer... so for this reason, liquid assets are more valuable to people than large, illiquid assets even if their last sale prices were identical. This is the other reason that piggies go up in value after being issued. They are much more liquid than the pigs, cows, and houses and so forth that generated them. It’s easier to spend one of your piggies than 1/50th of your house.
So, now that we see that the value of the piggies will be going up compared to pigs and cows and houses, is that a good thing? As it turns out, no, for several reasons. The first is that people have created contracts and loan agreements over time using piggies as a unit of account. So when a man agrees to pay another ten piggies next year, he doesn’t want to owe more next year than he thought. If it currently takes three chickens to trade for a piggy, but next year he finds that the value of the piggy has gone up and he must now trade four chickens per piggy, he has made an error last year and paid one chicken more than he thought. Deflation, is just as bad as inflation in this way.
Another reason deflation (rising piggy value) is bad is that it makes it impossible to issue loans to people at an interest rate below the deflation rate. So if the piggy is rising in value each year by 5%, and you want to loan piggies to your neighbor at 3%, that’s very difficult because you would have to pay him to take the money from you. If you wanted to charge him 3% you would have to pay him 2% per year that he holds your piggies. The lowest possible interest rate becomes the rate of deflation, unless you want to pay people to take your piggies, so this slows everything down and encourages people to stop making loans because it is more convenient to hold them and earn 5% than it would be to loan them out; the faster piggies rise in value (deflate), the less willing people will be to issue loans denominated in piggies. If piggies are rising at 20% per year, they cannot be reasonably loaned away at less than a 20% interest rate, and that rate will likely be much too high. People might be willing to make loans at less than that rate.
As deflation rates increase, the incentive to make direct loans rises. Instead of loaning you 1,000 piggies to buy a car, I would buy the car and loan it to you, and agree that you will pay me ten gallons of gasoline per year that you have it as interest payments, removing the need to deal with piggies at all. If the deflation rate is high enough, the value of piggies as a medium of exchange and a unit of account is completely destroyed.
It is certainly possible to make loans by paying people to take your money, but deflation leads to another problem; eventually one piggy will be worth as much as a house, and when an asset is worth that much it loses all of its liquidity value, and people can’t use it to buy pigs and cows and so forth anymore, so the value of the piggy as a means of exchange would eventually be lost to some cheaper, more liquid asset.
So, what is the solution to the deflation problem? Well, there are two solutions, actually. The first is for me to print up enough fake piggies and spend them in the village until they become so plentiful that their value drops back to what it originally was. This is a great way for me to make additional profits in my piggy manufacturing career, and it also helps to stabilize the value my product, the piggy. My goal in spending fake piggies would be to try to spend just enough so that deflation doesn’t happen, but not so much that inflation occurs. I want my piggies to stay the same value, relative to all other things, as much as possible.
Another reason deflation (rising piggy value) is bad is that it makes it impossible to issue loans to people at an interest rate below the deflation rate. So if the piggy is rising in value each year by 5%, and you want to loan piggies to your neighbor at 3%, that’s very difficult because you would have to pay him to take the money from you. If you wanted to charge him 3% you would have to pay him 2% per year that he holds your piggies. The lowest possible interest rate becomes the rate of deflation, unless you want to pay people to take your piggies, so this slows everything down and encourages people to stop making loans because it is more convenient to hold them and earn 5% than it would be to loan them out; the faster piggies rise in value (deflate), the less willing people will be to issue loans denominated in piggies. If piggies are rising at 20% per year, they cannot be reasonably loaned away at less than a 20% interest rate, and that rate will likely be much too high. People might be willing to make loans at less than that rate.
As deflation rates increase, the incentive to make direct loans rises. Instead of loaning you 1,000 piggies to buy a car, I would buy the car and loan it to you, and agree that you will pay me ten gallons of gasoline per year that you have it as interest payments, removing the need to deal with piggies at all. If the deflation rate is high enough, the value of piggies as a medium of exchange and a unit of account is completely destroyed.
It is certainly possible to make loans by paying people to take your money, but deflation leads to another problem; eventually one piggy will be worth as much as a house, and when an asset is worth that much it loses all of its liquidity value, and people can’t use it to buy pigs and cows and so forth anymore, so the value of the piggy as a means of exchange would eventually be lost to some cheaper, more liquid asset.
So, what is the solution to the deflation problem? Well, there are two solutions, actually. The first is for me to print up enough fake piggies and spend them in the village until they become so plentiful that their value drops back to what it originally was. This is a great way for me to make additional profits in my piggy manufacturing career, and it also helps to stabilize the value my product, the piggy. My goal in spending fake piggies would be to try to spend just enough so that deflation doesn’t happen, but not so much that inflation occurs. I want my piggies to stay the same value, relative to all other things, as much as possible.
And this isn’t an easy job. I don’t want to just peg my money to the value of a pig, because the value of the animals swings wildly up and down depending on how many farmers produce each year, new drugs, natural disasters and diseases and so forth. If the value of pigs fell a lot one year, I would have go take a bunch of assets and sell them for my piggies on the open market in order to remove some of those IOUs from circulation (in order to raise their value by lowering their supply). And the next year, when animals go up in value, I would have to print up more fakes, and all of this would just become a huge headache of fake notes and selling off my art collections from time to time.
So I decide that I will simply remove my piggies from the “pig standard.” I will no longer redeem piggies for pigs. However, I will still accept piggies for all loans on my books; in fact, I say that if you have a loan with me and you are borrowing any of my stuff, you must now pay me only in paper piggies. Real animals will not be accepted or redeemed. Some people think this is a bit strange, but there are so many people who have loans with me that they need those piggies in order to pay me, and the value of the piggies remains relatively stable because people need them to pay my interest payments, and they are used to the piggies and they trust me so no one is really that worried.
At this point everyone has become so used to piggies that they simply put up signs stating how many piggies it will take for them to trade cows, tools, food. clothes and other things. In the old days people would negotiate using other stuff. People might say “I’ll give you two chickens for your cow” and things like that, but now they just say “I’ll give you two piggies for that cow,” or the cow farmer may even post a price in piggies. He would put up a sign stating that the “price” of his cows is “two piggies,” because everyone uses piggies, they are so easy to carry, they don’t go down in value and they are pretty predictable. They are so liquid that people have forgotten about the old days of negotiating chickens or fish for cows that all of their financial ideas and calculations are based on only one asset -- piggies, and I like that.
I love my new situation, off the pig standard, because now I don’t have to deal with the constant fluctuations of the value of an actual pig, and I become very good at keeping the value of the piggy pretty stable. And now I get a little greedy. I start to print up a few more piggies than I should, and spend them in town, and I inflate the currency very slowly, so that it is barely noticeable. People begin to have grand discussions about the “causes for inflation.”
A man named Keynes is adamant in his opinion that inflation is caused in two ways that he calls “demand-pull” and “cost-push.” As he sees it “prices” (and by this he really means “number of piggies” required), go up when the total needs and wants of the entire village goes up. This he calls “aggregate demand.” He thinks that when people generally just want more things, the “prices” for all those things goes up. But I know this is pretty silly, because I know that prices are really just a ratio regarding a very specific thing -- piggies, and I know that I am personally in control of the value of my piggies.
I’ve been messing around with my little balancing act for years, trying to keep their trade-value stable. I know that when the demand for something goes up, people are willing to trade (pay) more of anything for that item. If suddenly it becomes very fashionable to have a white horse, people are willing to trade more of anything they have for those white horses. Dark horses, cows, pigs, chickens and gold all go down in value compared to white horses, because the guys with white horses won’t trade them unless you offer him more than yesterday.
I know that my piggies are just one of those assets in a sea of items that the white horse-owners will accept for their possessions, and I know that it isn’t just piggies that are experiencing inflation relative to the white horse. All things are inflating compared to the white horse! And when it comes to his explanation for “cost push” inflation, I think its just equally silly. If the “prices” for white horses go up, the guys who sell white horse-meat are going to have a rough time. They’ll have to trade more for those horses, and ask for more in trade if they want to make a living. All of this has nothing to do with my piggies, per se. They are only one of myriad assets available.
I know that my piggies are just one of those assets in a sea of items that the white horse-owners will accept for their possessions, and I know that it isn’t just piggies that are experiencing inflation relative to the white horse. All things are inflating compared to the white horse! And when it comes to his explanation for “cost push” inflation, I think its just equally silly. If the “prices” for white horses go up, the guys who sell white horse-meat are going to have a rough time. They’ll have to trade more for those horses, and ask for more in trade if they want to make a living. All of this has nothing to do with my piggies, per se. They are only one of myriad assets available.
