Pardon my silly meanderings, but if I can’t write stupid stuff on this blog then what really is it for
Here are two short stories, reasoning about deflation and inflation from simplistic first principles.
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Satoshi Cove: a little allegory about deflation
There is a small unspoilt island called Satoshi Cove. For generations, the villagers who live there have led simple and happy lives. They survive by growing corn and raising chickens.
The island’s currency is a rare wild pearl, which glows a soft pink. The best swimmers on the island dive for these pearls during the stormy winter months.
Because the search is risky, and the pearls grow slowly, the supply of pearls only grows by a few percent each year. So the currency supply is quite stable. In addition to pearls, the villagers have invented simple forms of credit and barter.
One day, one of the islanders – a noted eccentric – learns how to turn chicken poop into a rich fertilizer by adding salt and other natural compounds. At first of the other farmers don’t believe him, but the ones who do are able to use the fertilizer to improve their corn crop. By using this new fertilizer, the average corn farmer’s harvest increases by 25%, and because chicken feed is also composed of corn byproducts, the average chicken farmer’s output also increases by 5%.
Thus this entrepreneur has invented something – a new fertilizer – which leads to meaningful growth in the island’s production of corn and chicken. This is productivity-driven growth.
Most of the island benefits from this entrepreneur’s invention:
The inventor becomes wealthy by selling the fertilizer he creates.
The islanders can produce and sell more corn and more chickens.
The prices of corn and chicken fall, which enables the average villager to buy more.
But not everyone benefits. A few islanders are hurt by this change.
In particular, lenders who have made loans to be repaid in real goods like corn and chicken are hurt. Corn and chicken are now more plentiful, and thus less valuable. If a lender is to receive 10 chickens in re-payment, those 10 chickens would now be worth less.
It’s important to note that not all lenders are hurt. Lenders who have made loans to be repaid in pearls, conversely, have benefitted, because those pearls can now buy more corn and chicken.
In a similar way, borrowers who have received loans to be repaid in pearls are also hurt. The prices of corn and chicken have fallen, but the borrower is still required to pay back a fixed number of pearls.
And just like the inverse of the lenders’ situation, not all borrowers are hurt — those who have borrowed loans to be repaid in corn and chickens have benefitted.
This is a small example of productivity-driven growth leading to deflation, in a very simple economy. We have removed many elements of a modern “real” economy – for example, the island doesn’t trade with neighbors, and there is only one form of currency (pearls) – but hopefully it’s illustrative.
You can very clearly see that deflation here, which is caused by a valuable new invention, improves the quality of living for most islanders.
The price of food falls, which allows people to afford more. The innovator becomes wealthy. It enables farmers to produce more. And most importantly, it inspires people to create and invent more.
Imagine if this pattern were repeated over generations. The prices of food would continue to fall. Perhaps they would find new types of crops to grow. Or new farm animals to raise. The island’s productivity and output would increase, and along with it, so would quality of life.
So why is deflation a bad thing?
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Fiat Reef: A little allegory about inflation
Now let’s talk about a similar island called Fiat Reef. In just about every way, it is a copy of Satoshi Cove.
The only difference?
Instead of an inventive entrepreneur who creates a new fertilizer, a creative and brave diver realizes that he can artificially grow the rare pearls by adding tiny grains of sand into the oysters. By doing this, he can double his own pearl output during each winter harvest. For simplicity’s sake, let’s assume he is just one of ten divers. So each season, the amount of new pearls discovered grows by 10%.
This is a form of financial innovation that leads to an increase in the island’s currency supply. This is a very simple and pure example of money inflation.
Now who benefits from this inflationary change to the island’s economy?
First and foremost, the inventive diver benefits. He’s literally created money. He harvests it first, and he can spend it to buy more corn and chicken.
As the money supply on the island grows, others benefit too. His favorite seller of corn and chicken benefits, because their customer is now much richer. And as those sellers make more money, they may raise the wages of their employees.
But importantly – not everyone benefits. Those who benefit most are those who are first to receive the money; the ones closest to the diver.
Moreover, many people are hurt by this change. In the same way that deflation hurt certain borrowers and lenders, inflation also hurts certain borrowers and lenders.
As the new currency trickles into the economy, the prices of corn and chicken begin to rise. And while some islanders are earning more, most of them aren’t. Thus they are able to afford less food.
In addition, because the money supply is growing faster than its usual pace, the purchasing power of pearls decreases. You can buy less with the same number of pearls. So everyone who has saved pearls will begin to feel poorer.
Now, the inventive diver was only able to increase the island’s pearl supply by 10% each season. But where this inflation really becomes problematic is when the other divers learn to copy his technique. Soon, the supply of pearls is growing 20%, 40%, and even more during each harvest cycle.
For a time, the divers themselves feel rich as kings, and spread the wealth to their family and friends and favorite farms. But then prices begin to rise faster and faster. If there is double the money, but no change in the amount of corn or chickens, then necessarily the price of corn and chicken will increase.
Eventually, what everyone wants to do is become a diver, and hunt for pearls.
On Fiat Reef, everyone is now incentivized to make more money, instead of making new things. Everyone wants to be a diver, or to be close to the divers so they get first dibs. Few islanders want to invent new fertilizers, or produce more corn and chicken.
In short, far more people are hurt by this change, which is an inflation of the money supply. Prices rise for all goods on the island. A few people win big. But the outcome is more complicated, and the long-term effects are more damaging.
Reality is more complicated than this simple example, and there are winners and losers on both Satoshi Cove and Fiat Reef.
But ask yourself which island you’d rather live on. Would you rather live on Satoshi Cove, where the goal is to invent and make great things, an island where output is increasing and prices are falling?
Or would rather live on Fiat Reef, where the goal is to become a diver and make more money, where prices are constantly increasing so it’s a race to see who gets the most money and buys the most things first?
Yes this is massively over simplified and exaggerated. The islands are closed economies with no trade and only one currency (pearls). Both deflation and inflation can hurt people.
But why is there such a gulf in public perception between the two? Why are we led to believe that deflation is so dangerous, and could potentially lead to economic collapse? Conversely, why are we told that some amount of inflation is not only good, but even necessary for our very economy to function? How did things get this way?
