A Quick Lesson in Economics
By: Perry Jones
Tags: Federal Reserve, Politics, Macroeconomics, Economics

A Quick Lesson in Economics

A quick lesson in economics; so easy even a…

Let’s say you are at an auction. Perhaps there are as many as 100 other people there also. This auction features rare painting, unique artwork and period pieces. All of it is very fashionable and very valuable. But this auction has a couple of unique rules.

1. You only have 25 dollars to bid with.

2. You can only use that 25 dollars to bid. You cannot use your own outside or other people’s money.

3. You may not group with anyone else to form a bidding club or pool.

The first piece comes out. The curator describes the piece and the artist and how meticulously and lovingly the artist has worked on this one piece over the last 2 years. The auctioneer then begins the auction. people look at each other as the bidding begins. The auctioneer starts the auction at 5 dollars. After all, everyone knows that each person in the room only has 25 dollars with which to build and it is believed that many people may want to acquire more than one piece of art.

A hand goes up. The bid is 5 dollars. A nod from a gentleman in the corner raises the bid to 7.50. A matron in a comely dress raises the bid to 10 dollars. The auctioneer continues his spiel but there are no further bids. The delicate piece of art is sold to the woman for 10 dollars.

Another piece of art is presented. Again this astonishing, valuable piece is described in complete detail. It is considered highly valuable; one of the most highly valued pieces at this auction. Again the bidding begins; 5 dollars, 6 dollars, 7 dollars, 10. The bid finally rests at 12 dollars, nearly half of what any one person can spend in the room.

The next piece, a rare commodity, is presented. The auction begins at 7 dollars and quickly increases to 15 dollars. At this point it slows to a crawl but continues its upward climb. At 20 dollars there is another bidding war and the price finally reaches the maximum of 25 dollars. A very pleased young man has won the auction. Being the sole bidder at the maximum allotment, he is very pleased to be able to take this distinguished artwork home.

The lesson to be learned here is that no one individual can bid anymore than 25 dollars. No piece of artwork, regardless of its estimated value can be worth any more than 25 dollars because that’s the maximum that can be spent on any one piece.

This is what happens in a zero inflation economy. The prices of commodities and goods remain connected to the price of the currency. Only extraordinary events in supply or demand or outside factors can influence the price of the artwork in the room. Of course, a zero inflation economy is impractical in a modern world of fluctuating supply and demand from one market to another, but price hikes and shortages would not be dependent upon the value of the currency, they would solely be dependent on factors Other than the value of the currency.

Now let’s say a wealthy gentleman enters the room. He gives each person in the room an additional 25 dollars. The rules are adjusted permitting each person to bid up to 50 dollars. And so they do. The auction continues but the prices of artwork sold have increased. Does this mean the artwork has increased in value? Did the inherent worth of the art suddenly jump up in value? No, the artwork is still made of the same material. The same artists still created their beautiful pieces. And the time involved in creating each piece has not changed. The only thing that has changed is the amount of money in the room. More money equals inflation; nothing else can affect inflation. Only the money supply in the marketplace establishes the rate of inflation.

We are back at the auction. This time, instead of entering the room the wealthy gentleman stands just outside of it. Each person in the room has their 25 dollars but each hour they are given another dollar. Not only that, but the wealthy gentleman outside of the room has declared that whatever the price of a piece may rise to, within “reasonable” limits, he will guarantee that the winning bidder can borrow the money to cover the difference.

What happens now? The auctioneer, the auction house owner and the curator meet for a hurried conference. they understand that each person in the room will receive 1 dollar for each hour that passes. They decide to extend several breaks to extend the duration of the auction. This alone will put more money in their pocket. The auctioneer, auction house owner and curator also decide upon an additional strategy: Over time, they can raise the initial bid on each piece — within “reasonable limits.” After all, the wealthy gentleman — an uncle of several people in the room — has guaranteed to loan the money for a winning bidder to purchase a piece they really like by allowing them to borrow the money. The auctioneer, the auction house owner and the curator all resume their positions. The auction house owner stands at the back of the room, a big smile on his face. He knows this can only end in his favor as he sneaks a glance at the rich uncle beside him. After all, the rich uncle has guaranteed to lend enough money to pay for any artwork purchased by a winning bidder. The auction begins anew.

What can we expect to happen? Several things will happen including one we may not have anticipated. First, the first piece of art does indeed begin at a higher bid, 7 dollars rather than the customary 5 dollars for a rather ordinary piece. The people in the room, not entirely certain of how this process will play out bid warily. This piece goes to 20 dollars, a little high perhaps but still within the range of the maximum it could have been. The next piece is also introduced at 7 dollars. Bidding goes a little higher with each piece until the magic 25 dollar limit is passed. The next bidder bids 27 dollars and glances at his uncle who nods his head, his bid will be covered, acknowledging his bid he wins the bid. The auction continues.

The auction continues and more and more people bid on each piece. More and more people become accustomed to the process; the old way of bidding is becoming a forgotten memory. The auction seems to be taking on an almost game like atmosphere. With the guarantee of the rich uncle at the back of the room, bidders feel encouraged to bid the price of the art higher and higher. Because the rich uncle has guaranteed their bid, the bidders bid more and more with some even bidding more than their 25 dollars and borrowing 25 dollars or more from their uncle. The auctioneer, the auction house owner and the curator are of course, quite pleased because each of them will receive a portion of the profits.

As the auction continues, the auctioneer begins each bid at a slightly higher bid than the previous bid — at a price he feels is “reasonable” If the rich uncle at the back of the room indicates the bid is unreasonable, the auctioneer lowers the bid until the wealthy uncle agrees that the bid is reasonable. This newer “reasonable” starting point is always, of course, a bit higher than the previous initial bidding price.

What we see is this: with the rich uncle guaranteeing the price of each purchased artwork, it is inevitable that the price of the artwork will rise over time. Another event we may not have expected is that some people bid everything they have, knowing that anything they “really” need or want will be covered by the rich uncle. They are discouraged from saving money because they know their rich uncle will cover their needs, and they are encouraged to spend money freely to generate a higher standard of living. They are also encouraged to borrow money freely to increase their “income.” But their income is not actually increasing, it is in fact declining, because their money buys less and less at a rate which cannot keep pace with the increases.

Others not only bid everything they have, they also borrow heavily from the rich uncle simply to achieve more expensive artwork. With this more expensive artwork, the winning bidders can now proudly display it, proving to themselves and their neighbors not only how important and special they are, but also how successful they are at the “game”.

An unintended consequence and perhaps one that will escape our attention is this: because the rich uncle has lent money to the winning bidders, the winning bidders have used the artwork they have won as collateral for the loan the uncle provided them. In essence, the uncle now owns nearly all the artwork in the room. All the assets have transferred to the rich uncle while much of the cash has transferred to the auctioneer, the auction house owner and the curator. The winning bidders are essentially left only with loan notes which they must pay back to their uncle. The winning bidders can enjoy their fine artwork, they may display their artwork proudly, but they are all living on borrowed time because the rich uncle is the true owner of the artwork and may call in the loan at any time.

To complicate things further what if the auctioneer, the auction house owner and the curator are all working in conjunction with the rich uncle? Wouldn’t these four then split all the cash and all the assets between them leaving the bidders with worthless pieces of paper? Now what would happen if at some point — after the majority of bidders find themselves indebted to the uncle but still borrowing heavily — the rich uncle suddenly stops supplying the bidders with more money? The auction probably won’t stop as a few dollars are most likely still in possession of many people in the room, but the affect would be to cause a large downturn in the process. prices may drop, more and more people would find themselves “inactive”, unable to participate in the auction because the weight of the debts is too heavy and the income they were receiving was only borrowed money from their uncle. In order to raise cash, the bidders can sell their few pieces of artwork to the auction house. This then transfers some of the artwork back to the auction house where they can hold it or sell it again at auction as they see fit. After a time, the uncle begins loaning money again and the process begins anew. With the auction house and the uncle working together, these “boom and bust” cycles can be initiated at regular intervals calculated to move the most amount of assets and cash to both the rich uncle and the auction house partners.

Does this sound anything like our economy today? Doesn’t this represent what is going on with rising costs in health care? Is this the cause of rising costs in higher education? If the government stopped loaning money to schools and hospitals, for healthcare and tuition, we may experience a difficult period in which we need to relearn the rules of personal finance and the principles of a new economy, but in the long term, it would be much better for us as a people.