Putting Down the Lighters (Again)

"Certain signs precede certain events." - Marcus Tullius Cicero

First, I must apologize to Maxwell -- I don't mean to pick on his post about burning our wallets again, but the events of the day have turned my mind back to the subject of money, its value, and some of the more interesting ramifications thereof.

I am speaking, of course, of the new report released today by the Bureau of Labor Statistics, which can be found here.

In short, March's inflation rate (as determined by the Consumer Price Index for all Urban Consumers - the "CPI-U"), when adjusted for seasonality, was negative. Granted, the change in the CPI-U was small - only -0.1 percent - but let us examine the reasons behind the change.

The report indicates that most of this drop came from the decline in energy prices - particularly fuel oil, natural gas, and motor fuel - which led to a 3 percent drop in the energy index. The food, housing, apparel, and transportation indices also showed a drop, although transportation was the only one of these which posted a change of more than 1 percent.

When removing food and energy from the CPI, though, we see a slight positive change of 0.2 percent -- over sixty percent of which, according to the report, comes from an 11 percent increase in the index for tobacco and smoking products.

So, why should we care about this? In short, this is exactly what I was talking about the other day. For people like myself, who are in relatively secure jobs, with a relatively low, essentially fixed income, the deflation that is occurring in some areas of the economy - particularly for food and fuel - is beneficial. I mean, we're getting to the point at which storing your money in your mattress is almost becoming a profitable investment.

So why is deflation often seen as one of the four horsemen of the apocalypse? I had no clear idea myself until I began researching the subject a few weeks ago, and the answer is one of those things that seems so obvious in retrospect. In the simplest terms, the answer is 'loans.'

In short, anyone who has borrowed money in the past, with the requirement of paying it back tomorrow, suffers during periods of deflation. As the 'value of money' (for those of you who care, I mean, the price of money in terms of real goods) increases, the 'cost' of paying back that debt increases. A loan which would have originally cost 'one 24" flat screen TV,' or 'one additional R&D scientist' to pay back may now cost 'one 42" flat screen TV,' or 'two additional R&D scientists.'

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But how does this relate to the original issue, that of burning our wallets? Well, Maxwell's argument has a definite place, and there is often value to controlling inflation by, essentially, destroying currency (or otherwise keeping its supply limited). The problem with this is that the destruction of currency is an example of what is known as the 'Prisoners' Dilemma' in economics.

Two men are captured by the police, who have only limited, circumstantial evidence against both of them. Both are offered the option of confessing, and turning on their accomplice. If neither confesses, they serve a year in a minimum security facility, and if both confess, they both serve three years in a minimum security facility. If only one confesses, however, he gets off with only probation, while his partner receives 5 years of jail time.

Thus, the best overall outcome, from the perspective of the prisoners, occurs when no one confesses, and the worst occurs when they both confess. The problem, though, is that if the two cannot coordinate somehow - and more importantly, if they cannot commit themselves to some strategy - it is in each man's interest to confess, regardless of the other's actions, and thus we expect them to end up serving three years each.

This situation - in which individuals have a strong incentive to a way contrary to the 'greater good' - can be seen in countless everyday examples: US bank runs, prior to the establishment of the FDIC; arms races between enemy powers; people throwing trash on the ground, rather than in trash cans.

The last is a particularly interesting example, because it goes against our intuition. How many of us, when trying to get away with something like this, have been asked (perhaps by a parent), "What would happen if everyone did that?" The answer, of course, is that the place would be a mess, and thus we shouldn't litter. But the problem is that it doesn't matter -- regardless of whether everyone else does it or not, it's still in our best interest to take the easy way out.

Of course, this doesn't always happen, because we've found ways of dealing with these problems. Often, government is the solution - we force everyone to contribute, by way of taxes, and then hire others to take the costly actions for us, and we all end up better off. Social conventions, guilt, and other 'punishment mechanisms' also may serve this role.

But to get back to the subject at hand, we have one of those exact situations with the issue Maxwell describes. If inflation is destroying the value of the money we all hold, we will end up being better off - in some sense - if we can remove some of the currency from circulation. The problem with this is that, regardless of whether others burn their money or not, as long as my money isn't completely worthless, there is a strong incentive for me to hold on to it.

Of course, there's always the possibility that Maxwell had all this in mind when writing his earlier post, and that the entire article was simply an 'investment' of sorts....

- Tiro