Category - Economics and Politics

There’s not enough money to go around. Just print more, right? Wrong. The arbitrary creation of money inevitably leads to hyperinflation, the state of inflation rising at extremely rapid rates. A normal inflation level for the United States often hovers in the very low single digits while times of woe sometimes cause it to jump into the double digits, only to fall back in relatively short periods. With hyperinflation it is not uncommon to see inflation on the magnitude of thousands of percent.

How can that happen? Casting politics, exchange rates, and all other things aside, we will look at a ceteris paribus example. There are many things that can and do contribute to hyperinflation, however we will focus on supply and demand for this example.

Let’s assume that Bob and Phil are stranded on a desert island. They have divided the island down the center and each has control over valuable resources. Bob has control over all food and water, while Phil has control over all plants needed to fuel fire, build shelter, and other things (it’s an odd little island). Since both are in possession of numerous resources that have proven hard to barter over, they have agreed that clam shells are a good currency because of their surprising lack of availability.

Using this system Bob can purchase wood, vegetables, and other things from Phil and Phil can purchase food and water from Bob. Right now there are no supply problems and there don’t appear to be any on the horizon. Because of this the number of clams that Bob and Phil require of each other to purchase a given good remains relatively constant. For example, a jug of water may fetch 3 clams while a bamboo pole may fetch 1 clam. If bamboo or water suddenly grew scarce then we would see the number of clams required to purchase it start to rise, however for this example we’ll assume that all the resources remain at the same level of availability. That is, supply remains constant.

Now suppose Bob and Phil have just found a new batch of clam shells that has washed ashore, doubling the available clams in circulation.

Since the material wealth of both Bob and Phil has not changed with the innundation of new clams, the value of each clam cannot be tied directly to any given good. If the jug of water that used to be worth 3 clams remains worth only 3 clams, then Phil will be able to purchase more water than he did before because of the additional currency introduced into the system. This means that the items that cost more and are harder to come by lose value since there is never a shortage of clam shells to use for payment.

Queue the market forces.

Bob and Phil will inevitably realize that the additional clams in circulation can accommodate a price shift to help absorb the additional currency supply in the system, thus leaving the real price for each item the same. Given that the available currency has doubled, it is likely that both parties would eventually and voluntarily raise their prices to double what they were. This means that the real purchasing power of each party remains the same – what used to cost 3 clams now costs 6 to accommodate for double the clams in circulation. However neither party has expended or given up more than they ordinarily would have – they have only had to pay more clams, which are available due to the increased currency supply in the market.

Now assume that every time the tide goes up more clam shells wash ashore. In the beginning there will be a lag as Bob and Phil take time to realize the situation and adjust prices accordingly. However, there will come a time when Bob and/or Phil come to realize that every time the tide comes up, more currency will be available. If both parties realize it they will begin to preempt the influx of currency for every tide rise and hyperinflation will ensue. If only one party makes the tide-currency connection then they will begin rising prices in anticipation, leaving the other party no choice but to raise their prices in order to maintain the same level of purchasing power.

This will eventually lead to both parties understanding that there is a constant influx of currency into the system, prompting each of them to act in an anticipatory manner. If Bob and Phil are smart they will recognize the pattern and stop it well before they have to make multiple trips just to deliver enough clams to pay for the goods they need. They will likely decide that using clams as a currency is no longer a viable option and will find something else more stable to use as currency.

When you apply this same concept on the scale of an entire nation, it becomes evident how quickly hyperinflation can set in. When it was just Bob and Phil the inflation was mitigated slightly by the fact that the rise in prices was only dependent upon two vendors. In an entire nation there are many more speculators that help to influence the rise in prices, making hyperinflation materialize much faster. Add in a government that tries to mitigate economic problems by printing currency, the solidifying of hyperinflation is sure to follow.

The June Consumer Price Index (CPI) data is out and the results are as equally startling as in May 2008. Let’s go through the same exercise as last month, only with less explanation. If you want more explanation of how I arrive at these numbers visit the May 2008 post.

One note that I did get questions about though: I am including December 2007 in these calculations otherwise we would not see the change during January 2008. If we were to start with the January 2008 we would only see the change from the end of January 2008 until now. By including the December 2007 figure we are able to account for the change since January 1, 2008.

The inflation so far for 2008:

Southeast = [ ( 212.324 – 203.457 ) / 203.457 ] * 100 = 4.36%
National = [ ( 218.815 – 210.036) / 210.036 ] * 100 = 4.18%

Average month to month change in 2008:

	National CPI	Southeast CPI	National ?	Southeast ?
12/2007	210.036	203.457
01/2008	211.080	204.510	1.044	1.053
02/2008	211.693	205.060	0.613	0.550
03/2008	213.528	206.676	1.835	1.616
04/2008	214.823	208.085	1.295	1.409
05/2008	216.632	210.006	1.809	1.921
06/2008	218.815	212.324	2.183	2.318
Average			1.463	1.478

Estimated CPI when average change is applied to the rest of the year:

Est. Southeast CPI = 212.324 + ( 6 * 1.478 ) = 221.192
Est. National CPI = 218.815 + ( 6 * 1.463 ) = 227.593

Estimated inflation for 2008:

Southeast = [ ( 221.192 – 203.457 ) / 203.457 ] * 100 = 8.72%
National = [ ( 227.593 – 210.036 ) / 210.036 ] * 100 = 8.36%

And you thought last month was scary.

We have a pretty robust history of the economics of nations and have the ability to look back through the past to determine what worked and what did not and, more importantly, why. With this ability we can dive as deep or as shallow as we want in order to decipher the causes of long gone successes and failures and ultimately to promulgate lessons learned.

So if economics is ultimately based on math and we have a very long history to learn from, why is it so hard to get it right?

The answer is surprisingly simple: situations change. The many variants that go into the performance of any given economy (including the world economy) is exceedingly complex and must be diluted down to a manageable level. Queue the limiting factor.

The concept ceteris paribus is a basic tenet of economic study which roughly translates from Latin to “all other things being equal.” Most economic models are qualified with ceteris paribus to signify that other things will likely change that are outside of the control of the particular model or problem. Without isolating a specific instance the myriad of variables that go into economic forecasting, modeling would become far too complex for most of us to comprehend. We can see ceteris paribus come into play with a simple example.

In this example we will use the production possibility frontier (PPF). Without getting into too much detail, the basics of  the PPF are that countries, companies, individuals, etc., have an opportunity cost, the cost of giving one thing up for another, when producing two goods. So if China has an option of producing Corn or Semiconductors they are going to be naturally more inclined to the production of one versus the other. The PPF produces a curve that shows the trade off of producing one over the other. In our example we may see that for every $100 worth of corn produced they may only be able to produce $14 in semiconductors, all while using the same number of workers for each production choice.

This example is described under the terms of ceteris paribus since it does not account for all the other things that would and could change the output. For example, if  China found that the Taiwanese economy was doing poorly and that they could easily attract skilled semiconductor workers, they may see that the PPF shifts so that the production capabilities of semiconductors is higher than that of corn, making semiconductors a better economic production choice. Likewise, the example could be altered by the fact that a new wave of college graduates is about to hit the job market, many of which are highly knowledgeable about semiconductor development but who have no knowledge of agricultural techniques. Each of these situations, while relevant, dilutes the basic principle of the PPF and the illustration of the current situation of the country.

A more tangible example comes from the ensuing mortgage and loan crisis in the United States. Other countries have already been here and this is not new stuff. Yet we still find ourselves entrenched. Why? Because the other countries’ variables are different enough from ours that what worked for them may or may not work for us. Differences in legislation, culture, region, time of the year, and, possibly most importantly, consumer mindset all play a major role in how the economy reacts to any given situation.

So when we look to the past we naturally see things under the tenet of ceteris paribus – after all the past can’t be changed. Based on this we are note afforded the opportunity to study the past under shifting situations that accurately mimic our own. Instead we can only look to the past to serve as a guide post for what may happen. The rest is up to the actions and reactions of the many variables involved.