Island Economics; Enter the Furbles
And I admit, I have only told half of the story. In the interest of preventing another worldwide disaster, let's return for another episode of Island Economics. Let's return to the heyday of "The Ledger" - that magic book wherein the Islanders could record their Promises to do work in the future, in exchange for a "Palm" which they could trade amongst themselves. When we begin, we have the familiar scene: when the Islanders were previously only bartering, there was a hut for each, a radio, some fishing nets, and a wheelbarrow. This is "economic balance", and in a system undisturbed, the economy automatically settles to the "neutral interest rate" the Fed so actively pursues. There is food, shelter, and services as everyone needs; not too much, not too little. What could be simpler? Enter the Palm Promises. When Palms are first introduced, life gets easier. Where they had been haggling over barter and fair exchange, now trade is simple. More gets done. With more time in the day and increased cooperation - called "division of labor" - the Island begins to lift itself out of subsistence into prosperity. They build a coconut storage hut and a little fishing boat. Everyone's life improves. They can even save - putting away coconuts for the off-season and recording the claim on their deposits in a Passbook Palm. Everyone benefits, no one suffers, and the GDP of the Island goes to new highs. Seeing this go so well, Mr. Howell is sure that as perfect as things are now, they would be even more perfect if there were just a few more Palms. But how? Every Palm is backed by a saved coconut or someone's promise to work. This is similar to the gold standard, where lending existed but was tied to a real commodity. Savings always equaled the money that was available to borrow, so the economy was self-righting: if people attempted to undertake too much, the short supply of Promises - "money" - drove up the price of money - the "Interest rate" - and made them realize there weren't enough resources available. When the price of projects increased, they were scaled back until they only undertook only what was possible given the available tools, savings, and time. Obviously, this "scaling back" is bad for business. Mr. Howell only makes money when he loans more Palms out and more people promise more things, not less. This "coconut standard" is stopping the prosperity that would be possible under an unrestrained system. For the good of all, Mr. Howell magnanimously undertakes to loan more Palms and collect more interest. He has an idea. Under this self-righting system in economic balance, savings are naturally prudent and the coconut storage hut is full. But no one can tell how many are there: only the keeper of The Ledger really knows. So Mr. Howell begins to loan more Palms - seemingly backed by the coconuts - than there are in storage. This goes well and no one notices. GDP continues to increase. If a little is good, more must be better so he loans more. This is Factional Reserve Banking. There are some real savings; however Mr. Howell, like our banks, lends out more savings than there actually are. Like all early inflations, the increase in Promises makes everyone feel wealthy. For what has he really done? They are double-counting the goods. The Islanders believe a Palm Promise is a claim on a coconut, a voucher for an actual good. But that good is not really there anymore, so in fact there are two claims on the same coconut, then three then ten and so on. This is similar to the present US fractional reserve system where with sweeps there are less than 1% of actual reserves supporting the trillions in written claims for those goods.(1) That's a hundred or even a thousand claims per actual coconut. In our system, the creation of unlimited money - because it is no longer backed by anything - lowers interest rates to an artificially low level, upsetting the former "economic balance" and creating an inflationary boom. But the Island is prosperous: GDP has increased because of it. So who cares? Enter the Furbles. The Islanders are working hard and getting somewhere. They look at their Ledger statement at the end of the week and believe they have 1,000 coconuts in storage. They have 1,000 hours of work owed to them from the other Islanders. They relax and say to themselves, "We have enough savings for a lifetime. So what are we going to do with all this extra money?" This is the Wealth Effect. When people see the number of the vouchers due them increasing year after year, and when they cash out some coconuts and feel sure the gains are real, they begin to focus on their less-necessary desires. This is the law of Marginal Utility. Ginger builds an ocean-view hut on the desert plains of the volcano. MaryAnn makes a hut with Basalt countertops. The Professor sees they are doing well and pursues less-practical inventions like his iPot. The Skipper makes a downhill 4-wheeler. Mrs. Howell starts collecting little animals called Furbles. And Gilligan? Well, Gilligan didn't save in The Ledger, so he didn't see his numbers increase. Instead, he does all the work. But what has happened here? Everyone is relaxed because they believe The Ledger. It says they have 1,000 coconuts a piece. However, The Ledger is lying. There really are only 100 a piece. The other 900 fractional-reserve coconuts? They are Inflation. But so what? Everyone is doing well. What harm can it do? Only this: and it's the smallest harm as well as the largest; it gives false signals to the whole economy. With the extra Palms Mrs. Howell believes she has, she buys Furbles. Seeing the price go up, MaryAnn jumps in and starts buying the Furbles first, knowing Mrs. Howell will buy from her at a markup. With prices of coconuts so low in comparison, the Skipper finds it doesn't make sense to keep the trees, as there is more money in Furbles. The Professor finds repairing the baskets and pulleys used in Guano mining is a waste of time compared to the Furble-service industry. Yet as the economy turns toward Furble-making, GDP remains strong. While the economy is flooded with Furbles until the huts filled with them, The Ledger shows ever-more profitable entries. The Wealth Effect - and The Ledger that greatly over-counts the actual wealth - insures Mrs. Howell never worries about how she can buy Furbles and food. It shows she has more than enough for retirement. But where does she get the money? Remember, back in the "Coconut backed" economy, if there weren't enough coconuts, prices rose until people automatically stopped. Why aren't they stopping? This is the broken "price signal" of monetary inflation. When Mr. Howell falsely inflated the supply of Palm Promises there was more overall income, and thus more "savings" written in The Ledger. The Islanders thought they had more than they did and could do more than was actually possible. Promises and optimism were everywhere. MaryAnn's FurbleFinder.com was showing huge positions in Furbles and the price remained consistently high. Her inventory alone was worth millions. So much so that she borrowed money against her inventory to open a Furble factory in Bugi-Land, run by the Terrible Bugi-men. Ginger borrowed against her desert hut, and since the money wasn't backed anyway, every time they borrowed against the false values, the money supply - and the numbers recorded in The Ledger - increased 10, 100, or 1000 more times! There weren't actual shortages, so MaryAnn, the Skipper, and Mr. and Mrs. Howell believed they had real wealth, so everyone borrowed to host lavish potlatches where they consumed the endless piles of saved coconuts. They even invited Gilligan. Mr. Howell's Ledger was so strong and MaryAnn's power so pervasive, that even the Bugi men began to loan to them, which created even more money, this time from overseas. With the help of the Bugis, they built ever-larger factories to make 4-wheelers, basalt countertops, and of course, Furbles. The Professor is entirely right: GDP had never been higher. Everyone's Ledger entry was full, factories were humming, and there is incredible capacity in Hut building, Potlatch Planning, and Furbles. And this is right where the US finds itself today...or rather, before July 16, 2007. There was an indisputable boom with wild prosperity. But in what? The false signals given by Mr. Howell's inflation had artificially raised the price of Furbles, telling all the Islanders to focus their attention there. But because there are only so many hours in a day and only so many Gilligans to work in them, that cannot happen unless the Island - the Economy - then ignores something else. And what Mr. Howell's false entries made people ignore was the real economy, the infrastructure. With the price of food so low, the trees were dying and production was down. While they have millions of coconut claims, they have eaten all the real, stored coconuts. This is similar to the worldwide food deficit, where the world has consumed more food than was produced for 7 years in a row leaving grain stockpiles at their lowest in 30 years.(2) Likewise, the Island's well needed work, but there was so much more money to be made in Fubles that no one got around to clearing it, like our decaying water systems. With low prices for so long, the Guano industry all but closed, and were a ruin of rusty buckets and decaying ropes, just like the world's mines and petroleum fields. With no sense of emergency, The Professor had been working on the iPot, like how the focus of our R&D has been diverted from things like agriculture and energy into Razor-phones and YouTube. "What harm could a little white lie do?" said Mr. Howell to himself, "No one will notice if I make a few extra loans on some coconuts I don't have." But they did notice. Believing themselves wealthy with false savings they didn't have, the Islanders unwittingly consumed all the real savings they did have. Is there overcapacity? Yes. In huts, haircuts, and Potlatch Planning. Entire nations, like Bugi-Land, now have economies based on providing for the Island, also believing the money was real.(3) Is there undercapacity? Yes. In all the things no one paid attention to in the boom, that is to say, everything one needs. Overcapacity in what no one needs, undercapacity in what they do. Again, if the Islanders try to withdraw their coconuts, there will not be enough real goods to fill the Promises recorded in The Ledger. This hyperinvestment in Furble Factories is what economists call the "misallocation of resources". The free market will work only if it's free, and that includes interventions which create false signals. Which brings us back to July 16, 2007. On that fateful day, MaryAnn, CEO of FurbleFinder.com, called another Furble house for a quote on her "Stern Bear" Furble - a longstanding favorite. The answer she got back disturbed her. She had her stock priced at 100 Palmies, but Furble House Co. was only willing to pay 80. The relentless supply from the massive Furble industry was overwhelming the Island's demand. She called out to another house, which offered her only 50. But her books, her inventory, the value of her company, the number of employees - they were all based on a Furble value of 100. In fact, with proportionately little production of necessary goods like fish and coconuts, the Island's whole economy was now based on a Furble value of 100. This is the "Mark-to-Model" problem that the financial industry is experiencing, where the new "Financial Economy" is likewise a disproportionate share of GDP. Being a smart Midwestern gal, MaryAnn knew the market price was always the real price, and sold. The secret was out. Suddenly everyone knew Furbles were worth 50 Palms and not 100. Some companies resisted the price-change, promising shareholders this was an anomaly that didn't concern them. Others tried to prevent price-discovery, saying while "Stern Bears" may be worth 50, "Goldie Bears" were still worth 90 or even 100. Although rating agencies could clearly see the market price, they refused to downgrade companies and prices, assuring people that all Promises remained AAA. But it didn't work. People who thought they had 1,000 worth of Furbles, equal to 1,000 Promises or 1,000 coconuts in storage - suddenly realized that had only 500, or even 10: (charts)
People realized their wealth, in "savings" - be it in stocks, bonds, or goods - were far less than they thought, and if any "savings" in stocks, bonds, or property were on margin, quite possibly below zero. They cut back. They stopped borrowing for Furble speculation and slowed spending on Potlatch Planners. This is similar to the recent disappointment in Christmas retail and housing sales. Hut Builders and Potlach Planners, fearing unemployment, stopped buying Furbles and Huts as well. Furble makers were laid off by the thousands, similar what Challenger, Grey, and Christmas have been reporting of the financial service, real estate, and mortgage industry.(4) With slowing demand, the economy now has the capacity to build twice as many Furbles than are needed. Prices teetered on a downward spiral. Or in Greenspanish, "The current credit crisis will come to an end when the overhang of inventories...is largely liquidated and...price deflation comes to an end ... Very large losses will no doubt be taken."(6) What to do? Mr. and Mrs. Howell desperately try to prevent this price discovery. They went on Island TV and said nothing should be priced down, that the Furble-based economy was "non-negotiable" and "robust". Everyone always needed ever-more Furbles, and the Bugi Men needed to sell them, so they simply had to keep buying more and more. Forever. The Howells even gave out 300 Palm Promises per person to buy more Furbles. This is the Keynesian view that an economic contraction is due to not enough demand. But there was demand - there was enough demand in Huts, Furbles, and basalt countertops to bankrupt the Island. The problem was LIES; the false signals sent by Mr. Howell's double-counting inflation and directing effort into useless Furble production many years ago. The economic contraction is the necessary process of repudiating the lies and discovering what's really going on, what people need and don't need, and what each is worth to them in dollars. It is when the system erases all the Promises that could not be filled because there were not enough time and resources... Promises that would have never happened under the moderate but true signal of a commodity-based currency. What harm can a white lie do? As it made everyone pay attention to everything they don't need, and neglect everything they did need, it can ruin the Island. Worse, as Bugi-Land and other economies depend on the artificial demand of the Island, it can ruin the World. This is why Mr. and Mrs. Howell are willing to do anything to prevent real price discovery and visibility of the Truth: if the Islanders even suspect the missing coconuts, the subsequent investigation and loss of confidence will shrink the size of The Ledger and the power of the Ledger-keepers until there is again adequate real savings and people again feel sure there is again only one promise per coconut. That is, until "economic balance" is restored. As Hussman explains, "Keynes essentially looked at recessions as points in time when people suddenly and irrationally decided to save more, so the automatic policy response was simply to get them to consume more."(5) But despite what Keynes suggests, the people are being rational - they suddenly realized that they own useless Furbles and no useable goods. Awakened to the truth of their situation, they rationally and rapidly decide that increasing savings from zero to some reasonable number is a necessity, by cutting all consumption if necessary. But as they stop taking new loans and pay off old debts, the Palms in The Ledger vanish as the Promises are fulfilled or defaulted on; or as Liu says, "When US homeowners default on their mortgages en mass, they destroy money faster than the Fed can replace it through normal channels. The result is a liquidity crisis which deflates asset prices and reduces monetized wealth."(6) This is Deflation. With the false demand removed, and even real demand curtailed by the rush to savings and safety, there is also massive overcapacity and all prices fall, not just Furbles. This is a Depression. It will end when people again have a safe level of savings according to an honest accounting, and with the false signals removed, they can again apply themselves to productive work. But while the plummeting value of Furble inventories and waterless desert huts creates a "reverse wealth effect", they are also collateral against loans. This makes The Ledger shrink further in a reinforcing spiral because Mr. Howell still needs a plausible number of coconuts visible as collateral. If people really knew how few assets there were backing so many Promises, he'd be ruined and the Ledger system would collapse. Without some collateral, he cannot legally make loans. So even though he wants and needs to, Mr. Howell cannot make enough new loans to offset his losses and maintain the money supply. To maintain even an illusion of having collateral, he had to borrow coconuts from the Bugi Men in exchange for 5% of the future Ledger. These are called "bank reserves" which is why companies like Citi and Merrill have borrowed "capital injections" - actually a sale of future profits at terrible terms - from places like Abu Dhabi and Singapore. They are selling their future, for themselves and the Island, into slavery. 5% of all future work - and rising - will now go to the Bugi Men. Which only shows there is no free lunch. The "prosperity" brought about by Mr. Howell's inflation never existed. It was a combination of cannibalizing real production on the Island and of selling the Island's future to foreigners. It was a brief carnival of "borrowing forward"; eating tomorrow's cake today. "Savings" need to be real, as it would be under a commodity-based system. Why? Because someday people will draw on their savings to consume them. Otherwise, why have savings? But when savings in paper Promises turn out to be empty claims on goods that don't exist, people turn to tangible commodities like food, oil, and gold. The Promises: Goods ratio contracts until Promises=Reality, wherever dollar point that may be. Should we try to stop it? Does it make sense to perpetuate more lies with inflation or government intervention? Or should we repudiate the lies and get to work on reality and creating real wealth as fast as possible? So what does this tell us as investors? Under the present system: a) the relative price of Promises is too high, and must fall b) the relative price of Real Goods are too low, and must rise which will continue until: c) all the "misallocation of resources" - the extra Huts, the Furble Factories - are broken up and the pieces are used to create something new and useful instead, bringing the Promises: Reality ratio back to a reasonable level. History shows that happens with stock averages near a 7 p/e ratio with a 6% dividend, and that it takes around 17 years.(6) With 7 years gone and a p/e dropped to 17 from 41, we're halfway there. Unfortunately, this may be the bumpy half. References: 1 http://globaleconomicanalysis.blogspot.com/2007/11/wheres-cash.html "Are Reserve Requirements Still Binding?" http://www.ny.frb.org/research/epr/02v08n1/0205benn/0205benn.html "Bank Reserves go Negative": http://globaleconomicanalysis.blogspot.com/2008/01/bank-reserves-go-negative.html 2 http://www.ft.com/cms/s/0/0c021878-5a16-11db-8f16-0000779e2340.html http://www.safehaven.com/showarticle.cfm?id=9165&pv=1 3 http://www.nytimes.com/2007/04/18/business/worldbusiness/18yuan.html?_r=1&pagewanted=2&oref=slogin 4 http://money.cnn.com/2008/01/03/news/companies/layoffs/index.htm?postversion=2008010312 http://biz.yahoo.com/rb/080127/britain_jobs.html?.v=1 5 http://www.hussmanfunds.com/wmc/wmc080128.htm 6 http://www.atimes.com/atimes/Global_Economy/JA26Dj04.html 7 http://www.zealllc.com/2003/dividend.htm Charts: http://www.safehaven.com/article-8044.htm http://www.fin.gc.ca/ec2007/ec/ecc1e.html © 2008 Eric Andrews |
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I received a letter from the Professor saying that I mischaracterized the
history of Gilligan's Island in my previous article: 
