A parable of how to solve a financial crisis

 Lasse Lien posted a simple story about how a change in the money supply can reduce transactions costs and eliminate debt.  When the money supply increases, the circular flow of money tends to speed up.

A rich tourist came to a small town in the middle of the financial crisis. He went into the local hotel, placed a 200-dollar bill on the counter and went upstairs to check out what kind of rooms the hotel had to offer. In the meantime the hotel manager grabbed the bill, walked over to the butcher and used the bill to pay his debt. The butcher then took the bill to the cattle farmer and paid his debt to him. Next, the cattle farmer took the bill to the cattle feed supplier and paid his debt there. The cattle feed supplier then paid his debt to the local prostitute. The local prostitute brought the bill back to the hotel and paid her debt to the hotel manager. The hotel manager put the bill back on the counter. Then the rich tourist returns down the stairs and proclaims that he didn’t like the any of the rooms. He grabs the bill and leaves the city. A pity, but more importantly, the town was now debt free and optimism was back.

This story has Keynesian implications.  Debt cycles are one of the important reasons for recessions and cycles of optimism (or “animal spirits”) in Keynes’ story are another reason.  Plus, it is a story about the circular flow model of the economy.

Because this was posted on an Austrian Economics website, most of the comments criticize the story, but the critics are off the mark.  For example, one commenter complains that “money needs to keep appreciating.”  That’s ridiculous.  An appreciating currency is one that is suffering from deflation which fortunately has been a rare phenomenon since the Great Depression because deflation is generally harmful.

Normally we have a modest amount of inflation (a measure of the depreciation of money) and an unexpected increase in inflation gradually reduces debts and would serve the same function as the tourist’s money for wiping out the value of the debts.  Modest inflation and/or interest rates are irrelevant to the story.  For example, if everyone earned 10% interest (and paid 10% interest), it would make no difference. It would only complicate the story with irrelevant details that don’t fundamentally change the conclusion.

Another commenter objected that, “Everyone exchanged $200 owed for them for $200 owed TO them; this is a simple settling of outstanding accounts and didn’t affect anyone’s net position.”

Again, this too is a misunderstanding of basic macroeconomics.  Financial accounts always net out to zero (when the entire financial system is examined as a whole) because every debt is someone else’s asset.  My money only has value if others consider it to be a debt that they owe me.

Money helps reduce transactions costs and solve the dual coincidence of wants problem in the story.  Everyone in the story wants to get $200 from someone, but doesn’t know if he or she will ever get paid.  Meanwhile each person also is certain that they owe a debt to someone else.  If the loans were all legally due on that same day, everyone in this parable would have gone bankrupt if not for the unwitting loan from the tourist.

It is no accident that this story was written in the aftermath of the financial crisis because that was a similar situation.  There was financial gridlock because banks were unsure if they would get paid back the loans that they were owed and that prevented them from paying their depositors which prevented depositors from paying their debts too.  When the government’s TARP program bailed out the banks by effectively lending them cash, it ended financial gridlock and the economy recovered and optimism returned.  In the end, the banks paid back pretty much all the money to the government, so the net cost of the bailout to the US Treasury will be about zero percent (give or take a few).*  That is pretty much identical to the ending of the parable.

*The net TARP costs are “about zero” as of 2015, and I can’t give a definitive cost because the TARP program isn’t over yet, but the government projects that the net costs will be minimal.  Some moneys were not repaid, but other loans and investments made enough money in interest and capital gains that the bank bailout will probably end up making a nominal profit. The TARP funds were also used to subsidize some other sectors of the economy like the car manufacturers and home owners.  Some sectors have had lower repayment rates than the banks so the TARP program as a whole is expected to have some net cost to taxpayers, but even so, the total cost will only be a tiny fraction of the total bailout program of $700 billion.