A sideways look at economics
Once upon a time there lived a poor widow and her son Jack. So begins the tale you might well have heard, about the peasant boy who turned thief and giant-murderer. Jack climbed a beanstalk into giant country and stole a sack of gold coins, a hen that laid golden eggs, and a magical harp. But while he and his now wealthy mother lived happily ever after, things were not so easily resolved at the top of the beanstalk…
In the land at the top of the beanstalk there lived a giant and his wife, whose home lay in the shadows of a mountain. They were not the only giants inhabiting that realm; indeed, the kingdom stretched for many miles, bordering other giant nations to the west and east, and with other neighbours further afield, in lands that lay across vast oceans.
The giant nations functioned much like ours: they built houses and roads, went to work for and with each other, and traded goods and services. A long time ago, goods had been bartered for directly — a sheep for a cow, or a gold hairpin for a year’s worth of firewood — but this was an inefficient way to trade, and in their ingenuity the giants quickly came up with alternative methods of payment, using shavings of precious metals as an intermediary of exchange. But carrying around all this metal was cumbersome, even for giants, and having to keep a chest of gold hidden in your house did nothing for the feng shui.
So the system soon evolved further, with some giants specialising in keeping the chests for their neighbours, keeping track of how much each had with little slips of paper or coins of baser metals, that could be exchanged for the gold in their respective box. Being an enterprising lot, the giants quickly realised that as long as there was enough gold safely stored away and that everyone felt secure they could access their gold whenever they wanted, the amount of representative paper in circulation didn’t have to match the amount of gold exactly. So the gold box keepers started allowing giants to borrow more slips of paper than their amount of gold represented, charging them a fee for the privilege. Because they were lending against the security of the pooled gold resources, they paid out a fee to the giants with gold in their boxes. This allowed the giants to both produce and trade more than they had before, while the relatively fixed supply of gold kept prices from rising too high. As it soon transpired that there were economies of scale to having many gold chests in one place rather than just a few, one giant became the central holder of the gold. And that giant also became, therefore, the sole issuer of what we would call money, the quantity of which he controlled via what we call interest rates.
The giant that Jack met (and later slayed) was one such giant. As well as the country’s gold reserves, he also had a hen who could lay golden eggs, and a magical harp, which sang out announcements of his monetary decisions so clearly and sweetly that all who heard it understood perfectly — and therefore, behaving exactly as they should, ensured the decisions played out as the giant intended.
Then along came Jack, who, after being fed and protected by the giant’s wife (for our giant did indeed enjoy munching on the bones of Englishmen), repaid this kindness by stealing a big sack of gold. The loss was soon discovered by the giant.
“Fee, fie, fo, fum,” he said in alarm. “Where on earth have the gold coins gone?!”
The disappearance of the large sack of gold coins left the giant in a tricky position. Not only did this mean that there was less gold to back up the money in circulation (meaning fewer people could request their gold back at the same time), but with a portion of the gold gone, it meant he had to hike interest rates.[1] You see, the giant nations operated with fixed exchange rates between them, with the rates decided by the amount of gold in their coffers. (They had until then found this was generally quite useful, as it kept prices broadly stable over time and limited any fiscal excesses on the part of the gold-holding giant, but this view would soon change.)
And so the giant did raise interest rates; and alas, the higher rates cut into the disposable income of the borrowing giants who in turn reduced their consumption, while those giants with money to spare were incited to save more of it. Businesses cut back on hiring, and the giants who were now unemployed cut back on their consumption even further. Both prices and wages fell — and they might have kept falling if it weren’t for the magic of the harp, which kept people just optimistic enough that they believed prices would at least settle at their current levels.
That might have been the end of it, but as we know, Jack came back. This time he did not content himself with a sack of gold, but instead went for the golden-egg-laying hen. The immediate consequences of this theft were less keenly felt by the kingdom, but over time it eroded the financial position of the land.[2] Unable to replenish the supply of gold beyond what the giants could attract from their neighbours, our giant was forced to hike his rates again and again, well beyond the levels that the economic fundamentals would suggest. His wife suggested he let go of the fixed exchange rates and gold standard and allow the currency to float freely, but the giant felt this would embarrass the nation. His powerful harp kept the murmurings of discontent at bay, but as the people’s despair grew, he feared the harp’s magic would soon be overpowered.
It was the harp that alerted him one day that Jack was back, as it shrieked, “Master, a boy is stealing me!” The giant jumped up with a roar, and thoughts of the trials and tribulations of his kingdom spurred him on in his pursuit of the young boy he still did not know was the cause of his ruin.
“Fee, fie, fo, fum! Come back here, you thieving scum!” he shouted, as he followed Jack down the beanstalk. But Jack, so nimble and quick, was down the stalk with axe in hand before the giant was even halfway, and with three immense chops the beanstalk was cut, sending the giant crashing dead to the ground beside it.
With the disappearance of both the magical harp and its master, the kingdom no longer at the end of the beanstalk was thrown into further disarray. The gold system that the giants had grown so accustomed to had to be abandoned, as they all rushed to get their gold from a store they no longer deemed safe. New giants stepped in to take the place of the old, but the loss of the harp meant that they struggled to make their policies understood. One tried to solve the kingdom’s troubles by lavishly printing the paper slips that previously represented claims on the gold; but, while well intended, this ploy failed miserably, as the paper (no longer backed by anything) quickly lost its value and had to be continuously replenished at a faster and faster rate.
The hardships suffered by the giant nation as they tried to navigate a new monetary reality were many and varied. Over time things settled down, and the giants found that trust could replace gold in backing their currency — but did they live happily ever after? As they say, that’s a story for another day.
[1] Readers familiar with Mundell’s trilemma would say that our giant could have introduced capital controls instead of hiking rates; but as a dedicated proponent of free trade this never crossed his mind. A reader might also question why his golden-egg-laying hen couldn’t help matters; but unfortunately the eggs laid were very small, and usually only came at a rate of one a day, so this was not much help in the short run.
[2] In the fairytale as we know it, Jack’s thefts are committed over a very short period, but time works differently in giant country.
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