(Or the Misadventures of Fisherman and the Cheeky Monkeys)
Imagine you are on an island – a single human being fighting for your survival. You were stranded here after an unfortunate boating accident, and until, or even if you are ever found, you must do your best to survive.
This is the Robinson Crusoe example so often used to illustrate an idea in economics, and I’m going to use it to explain how the boom-bust cycle works even within a simplistic one-man economy. Things get more complicated with modern economies that have highly developed specialization and division of labor, but the basic principles never change.
Your primary source of food are fish. Every day, you wade out into the vast ocean and spend several hours fishing. At first you would use a spear fashioned from a survival knife you had on you and a large and sturdy stick – but you found this method of spear-fishing to be very skill-intensive and not very efficient.
Whatever daylight you weren’t spending fishing, you would hunt for coconuts and the fresh water they had inside them, try to build simplistic makeshift shelters to protect you from the occasional storm, or relax in the shade of palm trees.
After weeks surviving like this, it occurred to you that using the twine and vines found in the small jungle on the island, you could weave yourself a net! Working long into the night, for three days you labored by firelight to create a net for fishing. By the end of the ordeal, you were questioning whether this was all worth the effort – and the net was so time consuming that it required you to forego some very tasty meals. You were worried you would starve – for this undertaking was a great risk.
But it paid off! You had created an excellent and sturdy fishing net that could be thrown across a school of fish, catching several in the net at once.
This taking of risk at great personal cost, with the potential of a huge payoff, was the first real act of entrepreneurship you undertook since settling on the island.
With this new item of capital, this labor saving device, you were capable of catching a day’s worth of fish in much less time than before. You calculated perhaps two hours based on the crude sun clock you had since built yourself in the sand with all the free time you now had available to you.
But as the days grew shorter and the nights grew colder, you began to realize that the seasons were changing. Your little makeshift shelter was no longer going to suffice. Moreover, you still needed a way of storing food for stormy days at sea when the fish didn’t go near the coast.
One day, walking through the jungle, looking for coconuts, you stumbled upon a pond of water. Looking inside, you realized this would be the perfect way to store fish. The next several days you would spend more time fishing than you needed to, and all the excess fish you would carry to the pond, where it would be able to survive for many weeks. This was your first act of savings, or deferred consumption.
There was only one problem with this plan – the pond was too deep to see the fish, and it was impossible to tell how many were stored. Thinking about this problem, you realized that the little pebbles you had been collecting on the beach could be used to represent fish. One pebble would equal one fish, and you would leave them in a neat pile near the pond, so that you could always tell how much fish you had stored away.
Though these pebbles were not a medium of exchange, they were nonetheless used to represent a certain amount of goods, or fish in the pond, and in our example are an analogy to money.
After a week of hard work, you realized you had a month’s supply of fish in the pond, and could now free your entire day for the task of building a shelter capable of withstanding the colder seasons to come.
Just in time, too, for stormy weather had chased most of the fish away into deeper waters.
But what you didn’t account for, in your crude and primitive savings account of a pond, was that your curious behavior was observed by some monkeys. Some very cheeky monkeys.
When you slept at night, the monkeys would collect pebbles, and add them to your pile. They thought it was a kind of game – they didn’t know what harm they were doing.
And so after two weeks of work, when you thought the time to fish was soon approaching, you looked at the pile and marveled – there were plenty of pebbles yet, and so, you thought, plenty of fish in the pond!
Instead of wrapping up your humble construction project in two weeks time, as you had originally planned, you decided to build an additional floor on top of the basic construction. Rather than start work on the roof of your house, you started collecting and processing wood to build another floor. You didn’t really need it – but a second floor overlooking the ocean would surely be a welcome relief on the island. The new floor added three weeks of additional work to your schedule, but the pebbles indicated you had plenty of food left.
It would almost make your unplanned adventure on the island into a vacation. Or so you thought.
For two weeks you labored on the second floor instead of building a roof, but as the time passed, you began to worry. Although there were plenty of pebbles, with every trip to the pond it became more and more difficult to find the fish you had stored there. What was going on?
Soon the day came when there were no fish left in the pond. You couldn’t understand what had happened, and a panic set over you. The cold months had already arrived, but because of your ill-advised project for a second floor, you still had no roof to shield you from the elements and to keep in the warmth.
You were in quite a quagmire. You had to abandon entirely your ambitious construction project, which without a roof would over the next months of rain begin to rot, and instead you settled for building a quick and small shack for minimal protection.
You would barely survive that winter – and it wouldn’t be until spring that you saw a cheeky monkey adding pebbles to your pile. But by then the damage had been done.
Now if this analogy isn’t obvious enough – the cheeky monkeys are the central bankers who print money ex nihilo, or out of thin air. They are also the commercial banks who engage in fractional reserve banking practices, which have the same net effect.
In both cases, money, which is a mere representation of goods – not the goods themselves, is created without the backing of any goods. Rather than come into existence as a representation of fish in a pond, the new money represents nothing.
But what it does manage to do is misinform our entrepreneur about how much savings he has previously deferred from consumption to continue his building project. An untrue representation of his savings causes him to undertake unduly ambitious projects which must fail – because they were made in error and the material goods simply aren’t there.
Thus the boom part – when rather than building a sustainable house our intrepid survivor set out on an unsustainable production path – must inevitably end with the bust, when he must abandon his unrealistic construction project and build himself something he can actually afford.
The boom-bust cycle can occur in any sector. The construction project was merely chosen as an analogy to recent economic troubles.
As this analogy aptly demonstrates, the economic bust is not the evil – messing with the pebbles is the evil. The economic bust is simply the inevitable and entirely necessary correction to a flawed course of economic development set about by faulty information.
We should never aim to demonize economic downturns, but rather consider how we can eliminate the ultimately wasteful and wholly unsustainable spending of the bubble period.
That solution will be the topic of my post on free banking.