From an Austrian economics perspective

April 13, 2008

I came across this interesting post on reddit, enjoy:

We have a farmer, a carpenter, a tailor, and a lumberjack. Each year, each person produces 40 units of production. The money supply is fixed at $100. Each person has $25 stuffed under the mattress. Twice a year, one worker will pay $5 to another worker for 5 units of the other workers production. In other words, each person has a yearly demand for 10 unites of clothes, food, furniture, and lumber at current prices. Each person owns a house, which , if sold on the open market, would command a price of $10.

One year, a technological improvement allows everyone to produce 10% more. The demand curve hasn’t changed. That means that every producer will drop their price slightly so they can sell 11 units to each person instead of 10 units. The money supply has not changed at all, but we have economic growth and an increase in the standard of living.

Let’s say each person has a child that enters the workforce. Now there are two carpenters, producing a combined 80 units, two lumberjacks, etc. This increase in production will force each new producer will enter the market with a decreased price in order to acquire market share. This will decrease everyone’s wages. However, since the price of all goods decreased, purchasing power has remained the same. The total production of the economy has increased, per capita standard of living is the same, and per capita money supply is the same.

Now imagine Helicopter Ben throws $100 out the window and everyone grabs an equal amount. Assuming everyone’s preference for savings versus consumption remains the same, and demand curves remain the same, prices will find a new equilibrium at exactly double the existing price. The numbers all change, but the standard of living and amount of production is exactly the same.

Finally, imagine we increase the money supply by giving the lumberjack $10 every year. The lumberjack spends this money on goods, driving the price up. The lumberjack ends up better off, because he has more goods. Everyone else has the same amount of money, but prices are higher, so they buy less. Everyone else is worse off. Note, that if you combine printing money with technological advancements, people’s real wages would remain the same, while the benefits of the technological advances are being funneled to those who get the newly printed money. This is a perfect description of the past 30 years.

Furthermore, people realize that their savings are becoming worthless. A $1 of savings used to be worth 1 unit of production, but now it can’t buy that much. However, the price ratio between one unit of production and a house remains the same. Thus people decide to put their money in housing, to preserve it’s purchasing power as the value of a $1 erodes. Presto, you have an asset bubble. Again, a perfect description of recent economic history.