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ISLAND
ECONOMICS
by Eric
Andrews
February 5, 2006
 With
the Iranian Oil Bourse set to open in a month, there has been a lot of
discussion about its meaning and consequences. A reasonable person might
ask, “What’s the difference what oil is priced in? Can’t you just
exchange currencies?” So for anyone skeptical about the existence of a
Petrodollar and the “Exorbitant Privilege” it lends via inflationary
extraction, join me on a little trip to a place I call: Gilligan’s
Island.
The Three-hour Tour:
As
you might expect, the currency of Gilligan’s Island is coconuts.
Through hard work, Gilligan, the Professor, and MaryAnn create real
wealth where none existed before. This is Productivity. Before long,
each collects a modest supply so they don’t have to go out every day.
This is Savings. This leads to the Howells, who won’t go anywhere
anyway, agreeing to become the guardian of the coconuts, guarding the
separate piles for a small monthly fee and marking it on a palm leaf.
This is Banking. The Howells soon learn to eat their neighbor’s
coconuts a little at a time without telling anyone, knowing that not
everyone will ask for their coconuts at once. This is Fractional Reserve
Banking.
Quickly
we find Ginger writing the Professor a promise for coconuts if he can
build her a hair-dryer. This is checking. Mrs. Howell pays Ginger for
fashion advice. And while they’re busy doing this, poor Gilligan
spends his days in the jungle collecting coconuts for other people. This
is Division of Labor.
With
me so far?
Let’s
pretend the Island has an exceptionally good harvest and the number of
coconuts doubles. Did anyone get richer? Not really. Quickly, what cost
one coconut last year costs two coconuts this year. But not evenly. The
first holders of the coconuts, the Howells, prosper slightly more
because they can spend the coconuts before the prices increases go
through. This is Inflation. Note that no one gets richer by it: they all
still live in huts on a desert island. Only the currency was
redistributed from the last holder to the first holder: from Gilligan to
the Howells. And this takes place even though the coconuts in storage
are untouched. This is the reason for inflation.
As it
happens, coconuts aren’t the only currency on Gilligan’s Island.
Neighboring Yap Island uses a certain stone as their currency which is
in much greater supply than coconuts. No one on Gilligan’s island has
any need for Yap stones, however, and Yap Islanders have no taste for
coconuts. Each currency is only good within its borders unless there is
specific trade between the two islands, and a little is set aside for
the times this might occur. This foreign holding is called a Currency
Reserve.
The PetroYap
Unlike
Gilligan’s Island, however, Yap Island is not lost. They know how to
get outboard motors and gasoline. Unfortunately for the Skipper, they
only accept Yap Island stones as payment. In fact because gasoline is
paid for in Yaps, all the neighboring islands use Yaps for inter-island
trade. This is called a Reserve Currency. Because gasoline is sold ONLY
for Yaps, it is a Petrocurrency.
What’s
the poor Skipper to do? To get enough gasoline, he has to get Yap
Stones, and a lot of them. He has to trade hard-won coconuts for Yap
Stones and store them on Gilligan’s Island while waiting for their
eventual use. Yap Island is now in an wonderful position: Yap Stones are
so much in demand that they can buy 3rd Island coconuts
cheaply while easily-found Yap Stones are considered precious, and Yap
Island quickly grows rich. This is called a Trade Deficit. The
artificial demand that enriches the Yaps and can extend their Deficit
beyond the usual bounds is part of the privilege of having the Reserve
Currency.
What’s
more, Yap Stones are not that rare. While the beach they come from is
guarded by the army of the Yap Island king, ever-more stones are sold
into circulation. Like the doubling of coconuts, this does not actually
make anyone richer, it merely redistributes the wealth to those who have
the stones first and who control the reserve currency--the Yaps--and
away from the other Islanders. This power to get goods by
inflation—and without work--is using “Exorbitant Privilege” of the
Reserve Currency.
By
now, Gilligan’s Island has hardly enough coconuts to live on and only
half as many Yap Stones as they need, while Gilligan AND MaryAnn are
working overtime and still falling behind because all the gains end up
in Yapland. This would be the 3rd world, including the
working man of the developed world, who are all in the same situation as
currency Last Holders.
Then
the Professor presents a bold idea: a third island is home to the
terrifying Bugi Men, pirates of the high seas. They are willing to
accept payment directly in coconuts. Now the Island has a decision to
make: will they remain under the unfair umbrella of Yap Island
inflation, or will they risk trading with the terrible Bugi Men?
As
you can imagine, Yap Island is not happy with this idea. If the Bugis go
around them, the demand for Yap Stones will decrease among the isles.
When the Yaps aren’t as needed, their value will fall. The power of
Yapland would fall and the price of coconuts would rise. And if that
happened, the Yap King and his henchmen will have to go back to working
for a living like Gilligan and the rest of the Islanders.
Now,
although this describes what the privilege is and why it would be
protected, some argue that these are free islands: they can exchange
Yaps for Coconuts at will. So why would it make a difference whether the
gasoline is measured in Yaps or Coconuts when the exchange price is the
same? You simply go to the Howells and they instantly convert your
Coconuts the same as if you always had Yaps.
Or do
you?
Itsy-Bitsy Bikini
The
Bikini Atoll is the rarest currency in the islands: there are only 12
known Atolls in circulation. This is fine because the Bikinis are so
small that few people can squeeze into one and still look good. But
Bikini needs gasoline too. Can they pay in Atolls?
No.
This is the definition of Reserve Currency. It’s the currency
different people agree upon. It’s utility depends directly on how much
it is used. If everyone takes Yaps for everything, they’re valuable.
If no one but Yaps take them, they’re far less valuable. Thus the
fewer items that are for sale in Yaps, the less Yaps are worth. If that
happened all the Yaps used on the other islands will be sold back to
Yapland, the only place anyone can use them anymore. This is the Utility
Theory of Money.
If
the Yaps return home, and the number of them on the island rises, their
value will decrease, and prices will rise. This is the Quantity Theory
of Money. Suddenly Yap Island cannot afford coconuts for themselves:
from 10 Yaps per Coconut, the Yap is suddenly equal to a Coconut. If
rapid, it is called a Currency Collapse; if slow, a Devaluation. Either
way, the falling exchange rate makes the Yaps very hungry and very
grumpy. What’s worse, the king can no longer mine the beach and sell
the free stones to the neighboring islands because no one wants them.
And he can’t sell them at home because the Yaps already have too much
inflation and if he tries to issue more, even Yapland might refuse to
use them. This is a Repudiation.
In
the case of Bikini, what are the sellers of gasoline—the Bugis or the
Yaps--going to with an Atoll? You can only spend it in one place:
Bikini. Nobody else wants them because you cannot trade gasoline in
Atolls, and in any case, have to spend them in the island limits, or go
find somebody who will. Because of this risk and trouble you have to pay
people extra to take them. This is called “friction” and leads to a
poor exchange rate, which keeps Bikini small and helpless. People want
Yaps because they are the most widely accepted and have the least
friction—that’s what makes it the Reserve Currency. So there’s no
point in pricing in Atolls or for the islands to stockpile Atolls
either.
A Bugi Raid
But
let’s pretend they did. If gasoline were sold in the tiny Bikini
Atoll, the demand for Atolls on the island would suddenly rise so high
that no one could buy gasoline at all. This is called Market Liquidity
or Market Depth. Why is this? Because after everyone on Bikini buys
gasoline, there are no Atolls left to buy anything else on Bikini. The
Bugis now have 11 of the 12 Atolls until whenever they feel like trading
something back. When the single remaining Atoll becomes the only way on
the island to buy gasoline, the gasoline market, and indeed the whole
Island market would seize up.
Let’s
suppose to get around this, Bikini takes the path of the Yap King and
starts issues 10 times more Atolls. The prices on the island rise.
That’s Inflation. But they sell them off for gasoline. That’s
Exporting Inflation. Nevertheless, they’re still too small to compete
with Yapland. The terrible Bugis, who now hold 110 of the 120 Atolls,
can suddenly buy and sell them back to Bikini, throwing the tiny
island’s prices into disarray. Moreover, Bikini cannot remove the new
Atolls from circulation without destroying their own prices and economy.
That’s Deflation, which could cause a Depression.
As
they cannot go back, Bikini gathers a Reserve of Yaps to protect
themselves, and for a short time, all is well in Bikini. Then due to a
nasty shipboard rumor, the Bugis lose faith in the Atoll, and suddenly
ship all 110 back to Bikini to buy the bigger, safer Yap, overwhelming
Bikini’s limited defense. This is the Asian Crisis. The Bugis make a
handsome profit not only on the Yap rising, but afterwards too, when the
islanders have to work harder because the price of gasoline in Atolls is
so high. Their hard work keeps the cost of living in Yapland pleasantly
low. This is Core CPI: the price of Island goods minus Gas and Coconuts.
Notice
that the tiny Islanders, who like the Skipper really have no need for
Yaps except for gasoline, are now forced to hold a large number of them
for protection from the Bugi raids, which only strengthens the Yap and
Yapland. The fear of such raids means contracts cost more if not written
in Yaps, and insurance on those contracts will be written in Yaps as
well, creating even MORE demand for Yaps. This is what defines a
“Major” Currency, and acceptance alone is what keeps Major
Currencies and countries “Major”.
And
because Yaps are good for gasoline--the one thing all islanders
needed--they become good for everything else. D batteries, copper wire,
and fruity margaritas are priced in Yaps because everyone knew that to
buy gasoline—the commodity of most utility—Yaps will be needed. If
Yaps OR Bugis can be used, Yaps will fall by ˝, while Bugis will rise
by the same amount…and so will the relative power of their countries.
The increasing acceptance of the Bugi as an alternate currency would
create market depth that slowly erodes the value of the present Reserve
Currency and the present Reserve Country. This is why it matters what
the Reserve Currency is, and what currency oil is sold in.
One
last thought: one way the Yap King can increase the demand for Yaps is
if the price of gasoline were to rise while Yaps remain the reserve
currency. If the price doubles, say from Y35 to Y70, the number of Yaps
needed to lock up gasoline deals also doubles, ironically keeping the
currency strong—but soaking Gilligan and MaryAnn. The only way to
prevent this is for the Island Professors to buy gasoline in Bugis,
creating open competition and reducing the need for Yaps. This is would
be called the “Free Market.”
What
will the Yap King do about the terrible Bugi Men? Will Gilligan ever
stop working so hard? Will the Howells ever work at all? Tune in next
week for another 3-hour tour on “Island Economics”.
© 2006 Eric Andrews
CONTACT
INFORMATION
Eric
Andrews
Buffalo,
NY USA
Email
The
opinions of FSU contributors do not necessarily reflect those of
Financial Sense.
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