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.....
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.