Transmission mechanisms do matter

I'm always astonished when someone argues that financial transmission mechanisms don't matter - that somehow money produced by the central bank magically "flows" to the real economy without restriction. I don't think this argument is remotely supported by the evidence: transmission mechanisms do matter, and when they are blocked, restricted or diverted, the effect of central bank reflation on the real economy is much reduced. I should be clear here that by "transmission mechanism" I do not necessarily mean banks: investors, companies, markets and fiscal authorities are all means by which money flows around the economy, and they too can restrict, block or divert the flow of funds from the central bank.

Here is Giles Wilkes arguing that transmission mechanisms don't matter, using Smaug the Dragon to illustrate his point. The deflationary effect of Smaug's gold hoarding has previously (and elegantly) been discussed by Frances Woolley. In this piece Giles takes her argument a stage further and considers the effect of Smaug's demise on the economy of Laketown (my emphasis):
After 150 years of scarce currency and falling prices, Bilbo and his dwarf friends would clearly cause a massive nominal shock by releasing such a huge stash of gold onto the depressed Laketown economy. Gold that over the decades had become far more valuable would see its value obliterated by the onrush of new currency, causing a massive inflation. Upon realising what was about to happen, any merchant with some small stash of gold would immediately buy everything he can get his hands on: goatskins, houses, fishing rights, you name it.  Anything to get rid of something that is about to collapse in value.
Given the depression the effect is likely to be electric in real terms. With rapid rises in prices and wages, any outstanding debts would become easier to service.  Bills would be paid with great eagerness, new working capital sought out. New investments would look far more attractive.  Asset prices would boom.
Indeed, if Smaug's gold was released in its entirety to Laketown, it would be highly inflationary. And Giles goes on to point out that the state of Laketown's banks has nothing to do with this:
Would it make any difference if there was no bank credit, because Smaug had incinerated the bankers? Or if the few banks remaining didn’t understand relationship lending? Or if Laketown had very low interest rates owing to the depressed state of trade and high risk aversion? Or even if the Laketown authorities were on an austerity drive?
I should think not.  Sluice the economy down with enough gold and there will be a huge stimulus.  And this would be the case even if none of it was owned by the people of Laketown.  Even if the dwarves gave none of it away, their huge potential purchasing power would have a massive effect.   Even if they were total misers, and spent little of it, what would you think if you were that merchant? You would not want to hold gold at the same price. That dwarf gold will come out somehow. 
The final sentence of this quotation is a fine example of the "magical thinking" that I complain about. Dwarf gold doesn't have to come out in Laketown at all, as I shall explain. But let's consider the question of gold distribution.

I highlighted "Bilbo and his dwarf friends" in the first quotation for a reason. Implicitly, Giles has assumed that Bilbo and the dwarves somehow distribute all the gold to Laketown in one go, causing a massive nominal shock. There are a number of ways they might do this:
  • They might advertise "free gold" to the people of Laketown, and wait for the gold rush. Clearly, as the gold is in a mountain with no wheelchair access, the principal beneficiaries will be the able-bodied. Additionally, unless Bilbo and his friends rationed the distribution, rather as supermarkets ration free offers to ensure everyone can benefit, the first to arrive would gain the largest amount and those who arrived last - the weakest and slowest - would get nothing. This approach to distributing Smaug's gold might be seen as rather regressive.

    Also, as it is a one-off distribution, we might expect that a large amount of it would simply be hoarded rather than spent: after all, when are the recipients ever going to see gold again?Alternatively, the beneficiaries might invest the gold - but not necessarily in Laketown businesses. After all, Laketown is depressed....they might be more likely to buy horse farms in Rohan or condominiums in Minas Tirith.

    So this approach would have some reflationary effect on Laketown, but I suspect nowhere near as much as Giles anticipates. 
  • They might blow the lot on a massive party. Perhaps this is where Bilbo got the idea for the Birthday Party at the start of Lord of the Rings? But the party would have to be both truly massive AND resourced entirely from Laketown suppliers for it to have the reflationary effect that Giles anticipates. After 150 years of depression, would Laketown suppliers be up to the job? I think not. After all, just look at the London Olympics, which is possibly the closest we have seen to a party on the sort of scale that would be needed.Was it resourced entirely from the depressed East End of London? No, it was not. Supplies came from other areas of the UK, and even from other countries. To the extent that the London Olympics had any reflationary effect (which is questionable), it was far more broadly distributed. The same would be true of a Laketown party. I imagine the Mirkwood Elves might have done rather well out of it, actually.

    Anyway, would the Dwarves want to spend their newly-recovered gold on a massive party? Anyone who has read the beginning of the Hobbit knows that Dwarves prefer to party at someone else's expense. Why on earth would recovering their gold change their attitude?
  • They might invest their gold in Laketown businesses. But these are Dwarves, and Laketown is populated by Men. I hate to be racist, but are Dwarves really going to invest in the businesses of Men, especially when they have a mine infested with Orcs to liberate? Surely they would be more likely to use the gold to equip an army to invade the Mines of Moria. Indeed, as anyone who has read the Lord of the Rings knows, this is exactly what they did. That gold would not go to Laketown - it would be diverted to the suppliers of goods and services to the army along its route. And much of it would be lost in Moria, of course.
  • And of course, since Dwarves are notoriously miserly, they could simply hoard the gold themselves. They could deny entrance to the mountain to anyone except Dwarves, and kill any Laketown residents (and hobbits) who attempted to burgle the mountain. One Smaug begets another.

In short, the liberation of the gold by Bilbo and the Dwarves would not necessarily relieve Laketown's depression, let alone cause the inflationary shock that Giles anticipates. For the gold to relieve Laketown's depression, Bilbo and the Dwarves have to actively distribute it in some manner that is not regressive and does not result in gold hoarding by Laketown people. And for it to be inflationary, it has to be deliberately directed into Laketown and nowhere else, so its effects are not dissipated*.

In fact, as Frances Woolley explains, the gold was shared out equitably. And the means by which it was distributed is all too familiar (my emphasis):
Upon the great worm's demise, the wealth it had stockpiled was shared between the dwarves and others who had contributed to the fight. Much gold was sent to the Master of Lake-town; followers and friends were rewarded freely. The result was an immediate increase in the money supply, and a rapid growth in overall economic activity.
So gold was not "liberated" into a free market. It was deliberately distributed by the Dwarves. And it went not to banks or markets, but to Laketown's equivalent of the government, which then further distributed it to, er, voters. It was fiscal stimulus directly financed by the central bank. Or - since the Dwarves are a foreign power - a Marshall plan.

But the future of Laketown, completely dependent on Dwarf gold, does not look bright even after the death of Smaug. The Dwarves would stand in relation to Laketown exactly as the US does in relation to Panama, Ecuador and the other users of the US dollar. Laketown's money supply would be entirely dependent on the generosity of Dwarves. I'm not sure this is such a great idea: Panamanians may think otherwise, but then they control a goods distribution channel that is rather important to the US. Does Laketown have a similar hold over the Dwarves? If not, they need to end this foolish dependence on Dwarf gold and set up their own fiat currency and central bank.

This is of course exactly what Sauron did. And the effect is striking. Seemingly limitless money poured into Mordor and its fiefdoms, generating a massive increase in production - of all kinds, including reproduction (the Orcs had a baby boom). Admittedly, the extent of his reflation is so huge that after his death Mordor would probably have suffered hyperinflation due to the collapse of his war-driven production engine. But that's another story.....

Related reading:

The Hobbit - J.R.R.Tolkien
The Lord of the Rings - J.R.R. Tolkien

* Mind you, dissipation of Smaug's gold more widely might be a good thing. After all, gold scarcity is a feature of Middleearth as a whole, not just Laketown.


  1. Frances, I’m similarly irritated by those who claim that transmission mechanisms don’t matter. However, can I suggest your time would be better spent criticising the real world advocates of the “don’t matter” idea, rather than those who spin fables about dwarves and gold?

    Market monetarists strike me as being a bunch who pay scant attention to transmission mechanisms.

    1. Fables can give important insights into the real world. As indeed this one does. Notice where we ended up - money-financed fiscal stimulus to regenerate a depressed economy. You should approve.

  2. If a bullet traveled from point a to b it doesn't matter how it transmitted. It doesn't matter that it went through someones head or foot on its way to b, just its destination. Its all the same according to market monetarists.

  3. You and I are on the same page here.

    Just spent a good portion of Saturday morning attending a seminar on Bank laws from 1997 till 2013, Basel III and CRD IV directive.

    One thing that pops to mind is the statement of the former ECB board member Panicos Demetriades:

    "The transmission of monetary policy in Cyprus, however, depends crucially on the health of the financial system."

    Substitute Cyprus with whichever country in the balkanized euro area and the above still holds.

    That was back in November 2013 after the ECB surprised markets with a rate cut, since then lending has decreased, credit availability has continued its decline unabated and inflation has dropped to historical lows which forced the ECB to announce more concrete measures (but still a case of too little too late) 2 weeks ago.

    As I mentioned earlier I spent close to 6 hours at a bank-related seminar I couldn't help but recall what the IMF said yesterday in its Article IV consultation on the Eurozone economy with regards to credit availability:

    Restore Euro area bank's balance sheet.

    To date no Euro area country has dared to do it, but they are more than happy to slap new regulations and capital requirements further depressing credit availability and therefore growth prospects.

    When the crisis began in the states in 2007 the USA (not saying that their policy actions were exemplary but compared to the European response they are light years ahead) embarked on an unprecedented stimulus exercise that saw banks offloading 3 trillion in ABS onto the FED, thereby reducing their risks.
    At this point it is worth noting that the top 2 beneficiaries of the ABS programme were Germany's Deutsche Bank (290bn received) and PIMCO a subsidiary of the German insurance Company Allianz (252 bn).

    In addition the FDIC stepped in and has liquidated more than 500 zombie banks as of today cleansing the system (including big boys such as Washington Mutual).

    It was only after the US economy regained its footing that US authorities decided to embark on tightening bank regulation and while Europe boasts more stringent regulation on paper in practise the US laws are more effective.
    It's no accident that the US do not want to include financial services/banks into the Trans Atlantic free trade agreement with the EU.

    Furthermore as of 2010 onwards banks in the US have paid roughly 100bn dollars in fines to the authorities.

    The US authorities did what every sensible person would do, put out the fire first and then consider additional fire safety measures. The Europeans did and continue to do exactly the opposite.

  4. I agree with you. The TM does matter, and it varies a lot with the state of the economy, not least whether or not one is at the zero bound to interest rates.

  5. Amazing post! I am always interested about the functioning of monetary system, but sometimes I have trouble getting through endless blog posts, papers, ecc.
    Well this was not the case.

    I have a question, just out of curiosity: you wrote "After all, Laketown is depressed....they might be more likely to buy horse farms in Rohan or condominiums in Minas Tirith.".
    Let's suppose for a moment that Gondor and Rohan has implemented controls on capital movements, so they don't allow capital inflows in their economies: what would happen then to Laketown depressed economy if all that gold has no way out? Would there be bubbles in some assets prices? Heavy inflation? What?

    Thanks :)

  6. If the dwarfs are giving money to the Laketown government the expectation must be that it will enhance the power of the government. As if it were oil or foreign aid except as a one off rather than permanent boost. This will distort the economy of Laketown to the short term benefit of its mayor though even he may be in trouble when, having bought the citizen's votes with windmill subsidies and handing out contracts for eagle carriers with no eagles, he is no longer able to keep up the goodies.


    I have been trying to get people to pay attention to the transmission mechanisms.

    They've been causing utter disaster in the US, because the current policy is to feed money directly into the hands of the well-connected banker thieves who caused the recession, and hope by magical thinking that this will somehow get into the rest of the economy.

    Ordinary people understand that this is a terrible policy. Economists and government officials, apparently, do not understand it. In a bizarre form of learned stupidity.

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