Frederic Bastiat wrote the classical work "What is Seen and What is Hidden". Oddly enough, for once my work has nothing to do with that prolific journalist and economic thinker, but his title is so apt, I thought I would mention it. Instead, this essay owes a lot more to Lord Say, and his famous dictum that goods trade against goods, the production creates its own demand, and money serves only to obscure that. Now, Say was hardly the simplistic strawman against which Keynesians and monetarists argue, his only argument was simply that recession cannot occur because of a "lack of demand" or an "excess of supply".

Actually, if I can be allowed an aside, I would like to make an important distinction. Inflation is often misused. People tend to use it for any rise in prices and that is simply wrong. There is no "supply side" inflation. Inflation is always an increase of money supply driving prices. I suppose we could call the other "price inflation", but there really is no need for such a term. Price increases, while annoying for consumers, are always a transitory phenomenon, or almost always. In a completely open market, the high price will draw investment, increasing supply, and dropping prices. If the government interferes, closing competition or otherwise obstructing entry, substitute goods will draw investment and have a lesser, but similar, effect. The only way it can be a lasting phenomenon is if the government is so intrusive no substitution is possible, such as the energy market would have been had we ratified Kyoto. Otherwise the market will correct for any non-monetary rise in prices. Only monetary inflation causes the bad effects we attribute to inflation.

But that is an aside. What I wanted to discuss here was something else. The supposed "complexity" of the money market. Now, granted, with all the various ways money can be created, the many ways the government can manipulate credit, and the many ways investors, banks and others found to work around government regulations, the market is very involved, and it would take time to examine all of that.

But at its heart the market is simple. At least if we start from basics. Just as Lord Say said, the simple fact is, goods exchange against goods, even when that is obscured by money. Of course, when it is a commodity currency, such as gold or silver, or even tobacco or salt, the truth is more obvious. But even when we introduce meaningless government scraps of paper we pretend are money, the truth is I trade my good for your good, the money just allows us to simplify a number of intervening steps.

For example, if I make shoes and you make pies, I may try to trade my shoes for your pies. If you want shoes, very good. If not, I may have to trade my shoes for the pan you want, then trade the pan for pies. And if the pan maker doesn't want shoes, I may have to trade my shoes for some tin which I trade for an pan which I trade for pies. And there may be another several steps. money simplifies, as I sell my shoes to someone who wants them, and then use the money to buy your pies. However, the money just simplifies the transaction, I am still obtaining the money by trading my shoes and trading that money for pies. Goods are still trading against goods.

Let us look at a very simple system to make this point.

Suppose you belong to a simple hunter gatherer type tribe. You catch critters, gather fruit, and make clothing and tools out of hide and wood and stone and whatever else you can find. Either you provide for yourself or you make something or find something to trade for your needs. There is obviously no inflation or recession in such a system. At times, thing may be less valuable. For example, when berries are in season, it may take a lot more berries to trade for a rabbit, or when there are lots of bunnies they may trade for fewer berries, but there is no such thing as recession or inflation. Everyone either supports themselves or starves, unless they can find someone to support them.

Now, let us introduce government. Chief Og rises to power. Og decrees that his logistical skills demand too much of his time, so he and his staff of elders need to be supported by the rest of the tribe. To that end, he decrees that citizens must pay two rabbits each month, along with one antelope a year, or something similar. Now, this system has an advantage over our present system, in that it prevents anyone from thinking the government can create wealth. Og and his cronies are clearly a drain on the economy, doing no work and taking wealth. They may serve a valuable enough purpose that that drain is worth it. (I have always argued some government is essential.) However, when they give someone "their" rabbit, it is clear they did not create the rabbit, they are redistributing the rabbit caught by Ag or Em or Ot. At this stage, while limited to barter, there is no way to carry out the modern deception that somehow the government can create wealth, or even create jobs. The jobs are there because people need things, they are not a government creation*.

Now, let us complicate matters a bit. Og and his tribe settle down and start farming. They grow wealthy and there is some specialization. Farmers farm, craftsmen craft, rulers rule. King Og still exacts tribute, but he has to demand specific goods from each category of labor. To simplify this, he institutes money. He decrees that wealth will be measured in bushels of wheat.  As a lot of wheat is grown, that makes it a good choice. It also is almost infinitely divisible, can be stored a long time, and is in demand, so it makes an ideal commodity money. Since Og is progressive and trained at the London School of Economics in his spare time, he decides a central bank makes sense. So he creates a government warehouse, where wheat can be turned in for a small papyrus token, stamped with Og's seal, which represents a deposit of wheat. The state will honor such scripts, redeeming them for wheat on demand. But, as all taxes must be paid in such scripts, the merchants are happy to hold them, and so almost all transactions are now done in scripts rather than in barter. Some barter still happens, but by and large we have entered a monetary economy.

And with money, eventually the government discovers the theories of Keynes** and begin to think of what benefits they could derive from fiddling with the "money supply". It probably doesn't start that way, it probably starts as an emergency measure, but the move from barter to currency suddenly makes it possible to create money out of thin air. In countries with metallic currency this was usually done by debasing the currency, but there were other, less obvious methods. And regardless of the method, they all worked out the same in the end.

Using our example, let us suppose some nomads wander out fo the waste and attack our fair town. To address the concerns of the citizens, King Og determines he will build walls around the city and recruit a number of professional soldiers, supported at public expense. The only problem is that the state treasury is a bit light. However, the people are in no mood to pay any more taxes, nor are they in the mood to hear it can't be done. So King Og decides he will ask his warehouse master to print up receipts for a hundred bushels that don't exist, and use them to pay for his public works. It works like a charm. Most citizens are used to keeping some wheat in the warehouse at all times, and the city is rich and free of famine, so there is never a time when there is not a substantial surplus of wheat. So, when he finds himself short paying off the soldiers later int he year, he simply creates a few more slips. And once again in a few more months.

And he notices something else, after he issues some fake receipts, the economy takes off. People start investing in bigger buildings, hiring a few helpers, clearing new land, all the signs of a growing economy. Of course, as the slips start circulating, and people realize there is more money in circulation, prices rise, eventually putting a brake on the growth, but for a short time the issue of new money seems to have a positively beneficial impact on the economy.

Now, with a more complex economy we begin to see what moderns might call economic slumps. Some seasons the harvest is better, some worse. Some years businesses are hiring help, other times they have to let go employees. There is no cyclical recession or boom-bust cycle (yet), as that is the result of monetary fiddling, but we do see periods where the economy is more or less active.

King Og, being a benevolent type, decides that he can apply his new found discovery to lessen the burdens of his people. So, during a particularly bad year, when the harvests have been bad enough that the farms can barely afford to pay their laborers and the brewers and bakers are taking on no new apprentices, he decides to engage in massive public works, funded largely by his new bogus receipts. To maximize the benefit, he plans to build for over a year, issuing the scripts piecemeal, buying supplies with new scripts whenever the economy shows signs of slowing. In short, he plans to act as a one man Federal Reserve board.

And for a time it works. The issue of new receipts is irregular enough no one comes to expect expansions of the amount of money in circulation, and modest enough that the increase in prices is not crushing, and not strong enough to wipe out the apparent benefits of the economic growth it inspires. Now, there are a few losers. A few frugal businessmen and farmers who stored away massive stocks of money for future expansion find the purchasing power of those reserves declining, meaning they need to save more. Of course, as it is easier to borrow due to the increased funds available, they may be able to make up their lost purchasing power that way, but it still means they now have debt they wouldn't. And even less fortunate are those few older individuals who stored away a small fortune to allow them to give up work in their final years. Seeing their life savings losing value, they find they must return to work or hope for an early death.

But those complainers are drowned out by a general chorus of praise for Good King Og and his wise policy of public works. Everyone begins to attribute their prosperity to his sound policies, creating jobs for the poor and increasing the wealth of the middle class. And so arises the myth that the government can create jobs and increase wealth.

At least until the day all those receipts come due.

Eventually, Og will have printed too many receipts. It may be nothing in particular that sparks the crisis, but for our purposes, to bring the collapse a little faster, let us say there is a bad harvest, and on the following year, during planting season when much of the grain has been withdrawn, a terrible fire sweeps through the town, requiring huge rebuilding of many businesses and homes. As people present their receipts to the warehouse to recover their wheat, at some point the warehouse is found empty, while there are still claims outstanding. And so the whole scheme collapses.

People suddenly find their scripts are nearly worthless. As they are the only means to pay taxes they will still circulate to some degree, but at a tremendous discount, trading at a hundred to one discount or greater. Most trade, however, will be barter, or trade against physical bushels of wheat, rather than receipts. Economic activity will continue, but much more slowly. Almost all stored wealth will have been lost in the crash, as the receipts are now worth a fraction of what they were. Those who saved to expand their business or to start a new enterprise will find themselves with nothing. Things will slowly recover as people build up new stores of tangible wealth, but it will take time to return to the prosperity they once experienced.

As King Og slept through some of his classes at the London School he does not adopt the FDR or Hoover solutions, trade barriers, government interference, monetary manipulation and micromanagement of labor, and so the economy recovers. Accepting that maybe the creation of his bogus scripts was a bad idea, King Og decides to bite the bullet, tell the people the truth, and rebuild the economy in a most sensible way. Og begins to collect taxes in physical bushels of wheat, enacts austerity measures in the government, and thus accumulates a large surplus which he stores away, until he collects enough to redeem the remaining outstanding scripts. Having done so, he then begins to issue the "new bushel" a different currency, which he promises will be backed 100% with wheat.

With money back on a sound footing, and with everyone's losses restored, though thanks to inflated prices restored at a real worth less than before, the economy has largely recovered. Thanks to Og's new dedication to fiscal responsibility the economy continues to grow and prosper. His security measures keep the city secure, and being paid out of tax revenues rather than through monetary inflation, there is no more boom and bust cycle.

And that, in a nutshell is how a managed money supply gets us into trouble. The Keynesians, Monetarists and others, seeing only the boom think that inflation is beneficial***, and so they create the myths that inspired FDR to try to "prime the pump" with government "investment". It is a dangerous theory, as the truth is, quite simply, goods trade against goods. Creating more money only lessens the value of money in the system. For a time, the increased supply of money may loosen credit, creating the appearance of health, but it is more the rosy glow of incipient fever than ruddiness of real health.

Well, this has dragged on much longer than I expected, and my health is still not great, so I will cut this off for now. Next I plan to revisit Og as he tried to become Emperor Og. And, more importantly, as he learns the lessons of hyperinflation and the futility of trying to buy our way out of a recession (much like our current bailout plans). I may also visit Og's neighbor Ug who did not institute a central bank but meddled with a private bank system to show that the harm is in meddling, not in the way the meddling is done.

But we will see. For now we will leave Og and his subjects happy and wealthy, though I am afraid they won't stay that way long.

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* Unless people are absolutely satisfied with their lot, labor will always be in infinite demand. It is the one commodity needed for every product and the one which cannot be replaced. It can also substitute for almost everything else is some way. Only government interference, either through labor laws, minimum wage statutes, union laws, or monetary fiddling can create chronic involuntary unemployment. Oddly enough, most people think the government creates jobs, while the truth is the government is the only force which can prevent job creation

** To be fair, nominally conservative economists such as Friedman, are not opposed to tinkering with the money supply either, they just are less extreme than Keynes. Which is why I refuse to consider monetarists true conservatives. So long as they advocate managed currency, they are simply me-tooing the Keynesians, and as we know from various RINO eras, when conservative me-too liberals, liberals win, being more consistent in their beliefs. After all, if a little management is good, isn't more management better?

*** Actually, Keynes also proposed constant inflation as away to erode the absurdly high wages demanded by organized labor, but in that he was being rather obtuse. As everyone knows, labor responded by simply including COLA escalator clauses in contracts, thus removing that supposed benefit from an inflationary policy. And as that was the only legitimate claim in favor of Keynes' theories, it made his arguments entirely worthless. (The actual solution is to eliminate government mandated collective bargaining, as that will end such absurd contracts.)

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POSTSCRIPT

Sorry for taking such a simplistic approach, but I felt it was necessary. As I keep hearing that financial matters are too complex for ordinary people to understand and we just have to take it on faith that the bailout is necessary, I felt the need to show that monetary matters are hardly beyond the grasp of a clever teenager. (I know I read Greenspan's articles in favor of the gold standard in my teens, and The Case for Gold in my 20's and grasped them completely, so unless I am unusually wise, they aren't exactly the most taxing topics.) It is simply that there is so much jargon and so much focus on minutiae and senseless modeling that makes the topic perplexing. In its broad outlines, monetary theory is very simple. If King Og can grasp it, surely everyone of us can as well.