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After Black Friday,1929, the United States was the most powerful nation in the world; a newly opened agricultural giant, a mining titan, and an industrial powerhouse with hard-working, well-educated people flooding in from the countryside, clamoring for work. New railways ran passenger trains over 70mph, while electricity, telephone and radio swept into the remotest corners of the nation, allowing efficiencies formerly only dreamed of. –And GDP had fallen 25% while industrial production was cut in half. Why was this? Tune in for the special Sinkhole Street edition: of “Island Economics” As we open our episode, we find our newly shipwrecked travelers have built huts, planted coconut groves, and using the Professor’s wheelbarrow to make ever-increasing improvements to daily life. However, life is not idyllic. With everyone working on their own projects, it’s been hard to coordinate help. Ginger is trading another jar of kava with the Professor, but the Professor has too much already but doesn’t know how to tell her. Mrs. Howell has brought the Skipper a basket of taro, which he happily accepts as a gift, not realizing it was meant to be payment for building the new Howell Hubby Hot Tub Wing. MaryAnn has been hiding in her hut afraid she’s behind on the gifting people have given her. And Gilligan is out working for Mr. Howell without getting anything in return. In short, no one can tell where they stand in a deal. Ginger traded a basket of bananas for making MaryAnn a dress, but the bananas are turning brown and she’s sick of them. MaryAnn trades coconuts with the Skipper for weaving a new roof but they look small and green; is The Skipper trying to pull a fast one? The Skipper can’t understand why MaryAnn is upset when coconuts were twice as hard to get this week. This is life in a cooperative barter society. As the negotiations get more complex and specific, less and less is accomplished: clearly something must be done. They hold a committee. The Professor says that what they need is a cooperation-o-meter: a method to measure how much they are helping each other. Then they can make sure everyone knows what they are trading and can get a fair deal. On the mainland that yardstick would be dollars, but there aren’t any dollars on the Island. So how to keep the trading of cooperation straight and fair? Mr. Howell has an idea. They may not have money, but they do have ledgers: he can keep a running tally of cooperation. When someone wants something done, he can issue a “Loanie” on a special leaf called a “Palmie”. The Palmie gives the bearer the right to call on a certain amount of cooperation from the others. They agree and the plan works swimmingly. In no time, the Island is more productive than ever, and no one has to eat brown bananas or green coconuts. What’s more, using the Palmies as a marker, everyone can focus on what they do best: the Professor can invent, the Skipper can fix, MaryAnn and Gilligan can work, Ginger and Mrs. Howell can dress up, and Mr. Howell can keep the books. Because keeping the ledger is work too, Mr. Howell takes a small percentage of Palmies from each Loanie he issues for his time and for holding a position of national trust. As the Palmie plan moves forward, the Island soon forgets what life was like in the dark ages of barter. In fact, Palmies become so secure, they begin to issue their promises further and further in the future. The Skipper arranges for Gilligan to help him with next year’s harvest. Ginger arranges for a 10 year Loanie to build a bigger hut—all she has to do is promise to “check-in” with them twice each month for the next 10 years. The Professor even develops a Credit Derivative Swap (CDS) that will insure the Loanie’s value between them in case of rescue to the mainland. Life is good. This is the efficiency of division of labor using monetary exchange, which allows quicker, clearer, and more certain cooperation between people. Things are so prosperous, in fact, that Mr. Howell finds that even his modest percentage on every unit of cooperation on the island has ballooned quite a bit. He had charged 6%, but so much was getting done, he lowered his rate to 4%. Finding more people were taking out Loanies at 4%, he lowered his rate to 2% and found Palmies rushing out the door in a wave of new promises to cooperate ever-further in the future. In fact, so many Palmies had been issued that if you added up the hours in the day, 24 hours a day, for a lifetime, there were about 22x more promises than time to fill them. Uh-oh. Someone hasn’t been keeping the books properly. This is similar to the Dow P/E of 22, (a 22:1 ratio of promises to delivery, measured in years, or 22 years to earn enough to make the price equal to value) or the Derivatives market which using only listed contracts is still 7x world GDP according to the BIS. Or that off-book derivatives have been estimated as high as 60x world GDP. Or that US total debt is $48Trillion or 480% of GDP. Promises, promises. Mr. Howell sees something amiss, but ignores it for quite a while. Finally, seeing the books line up less and less well each day, he gets politick and asks Mrs. Howell to help him. Maybe it’s just a math error—maybe they can hire 1,500 accountants for 2.5 years and straighten it out. Instead Mrs. Howell charts the trend which looks something like this: Letting out too many promises:
The level of promises (debt) has doubled in 10 years, while incomes haven’t changed. What’s worse, the ability to fulfill those promises has not increased at all—there are still the same 7 islanders and their capital improvements. In fact, their capital improvements like the roads and the wheelbarrows are worn out and need repair. Terrified at losing their new prosperity to the ravages of truth, Mr. and Mrs. Howell resolve not to let anyone look at the national books. It could spark a crisis of confidence in the power of Palmies to represent future cooperation, and cause The Ledger—and the interest income they derive from it—to disintegrate. But it’s gotten so large it can’t be hidden. MaryAnn starts asking how Mr. Howell can loan out her time 22 years from now in 2029. Won’t they be rescued by then? The Professor’s insurance-swap business finds the math doesn’t work: at a rate now doubling every five years, it will be less than 6 years before the Island-wide promises doubles every month, then two weeks, then 7 days, then 3. The Skipper notices that due to the huge float of promises the Howells have, Mr. Howell’s hut is now as large as all the others combined, similar to the increasing size of the US financial sector vs other business sectors. Even Gilligan is asking questions: how come he’s working all the time filling his promises, but getting less now than when they used to barter? Uh-oh. Seeing these questions, Mr. Howell declares a “Book Crisis” and “Book Holiday” on Loanies and Palmies and flees to the golf course. Mrs. Howell politically goes to his side to help bury the books on the 8th green and keep them buried until 2027. During this golf-intensive “Book Crisis” and “Book Holiday”, no Loanies are written so no Palmies are issued. Nevertheless, all previous promises remain. Getting Palmies to fill one’s promises becomes harder and harder. This is a Deflation and Depression. The huts are still there, but no one can arrange to have them fixed. The coconut groves remain, but no one can organize how they should be picked. The wheelbarrow lays in the corner, but no one can borrow it without a Palmie as rental. All the Palmies are now going to support The Ledger rather than marking the cooperation among themselves. Everyone is standing around not working while there is the same old work to be done. And so they enter a time in the Island’s financial history known as “The Great Sinkhole.” Like the US in 1932, the Island still has everything it had before. All the food, the buildings, the tools, the warehouses, the ships, trains and telephones. All the mines, canals, fields, and pipes, all the power plants and lines. All the skill and all the work. So what happened? Like Gilligan’s Island, the people had lived with Palmies so long they forgot how to cooperate without them. How to manage their own affairs without an intermediary telling them what they could and should do. And because of Palmie rules, what work they were doing was now going to The Ledger and not themselves. What’s more, because compound interest is so powerful the system cannot work unless the ledger matches the underlying reality: if the rate of divergence is a mere 4%, it would take only 18 years for the promises to be twice as large as the reality--just as we saw in the Great Depression, where industrial production was halved before it matched the real, non-debt-based demand, exactly in the 16 years between the founding of the Federal Reserve in 1913 and the Crash of 1929. Before 1913, the US had a commodity-based system or “Ledger”. In commodity-based systems an adjustment occurs automatically when promises increase, as the underlying commodity, such as gold or silver, becomes in greater demand. With increasing demand, more is created, yes--mined in the case of gold--but more importantly, interest levels rise (a high price of money) to slow down the system and keep the books—the promises—in line with the underlying reality--that is, with the real capacity of the economy to fill its promises. A commodity that cannot be counterfeited insures this happens, while a commodity least able to be produced on demand creates the greatest stability and surest economic feedback when demand rises due to excessive promises. This is one of the historical attractions to gold as the commodity of economic record and marker. Without a constant and certain feedback, the economy and the books--the reality and the promises—quickly diverge, and there must be a painful adjustment to realign them. This happened with the many crises of the 19th century, as well as the Panic of 1907, a financial run as serious as 1929, but which did not cause a Depression. Why? Let’s return to the Island where we find that this rerun is actually an alternate-ending DVD: In the first ending, the Howells retire the golf course and deny the problems. Using Mrs. Howell’s still-existing power to issue Palmies, they hire the Skipper as their enforcer to keep them safe from dangerous red-shirt rabble like MaryAnn and Gilligan. Knowing there is no way to right the books, they hide them until the inherent capacity of the island and years of hard work by the non-Howells slowly repays the promises issued. This is like the Great Depression or Japan’s “Lost Years”. In the Great Depression, the economy foundered for 12 years as bank deposits were lost, while bank loans remained. In Japan from 1991 to today, the government worked to keep well-connected banks and businesses solvent, using the Japanese taxpayer (through debt and public works) and the Japanese saver (through 0% interest rates) to fund 16 years of life-support for banks and businesses. In these 16 years on the island, everyone gets older and poorer, innovation and improvements stop, and the giant income-disparity between the Howells and everyone else make life tense and uncertain for everyone—the Howells and their enforcer included. Not a happy ending. In the second ending, the Professor does an island-wide tour revealing the math behind the Howell Ledger and speaking on the nation’s grave financial situation, similar to U.S. Comptroller David Walker’s speaking tours these last years. The Skipper and Professor grasp what’s going on with the “Great Sinkhole” and refuse to support the Howell Ledger. They default on the promises of the original Ledger and make another one under the same rules. Howell National Bank goes under, along with Sinkhole Street, Skipper Shipyards, and Professor’s i-Inventions, LLC. Since all the same people, goods, tools, and resources are still there, however, they quickly recover and rebuild the economy to the former level in less than 3 years. Howell National Bank is rebuilt along with Howell Hobnob Golf Greens, and life goes on as before. This is similar to the Panic of 1907 or the Argentine Peso crisis. By defaulting on promises that are plainly unpayable and allowing the books to be returned to reality all at once, 15 years and a lot of needless violence, tension, and even starvation are averted. In the case of Argentina, their financial system froze up and went bankrupt in 2001, defaulting on loans worldwide. In widespread economic disorder, the poverty rate doubled amid violent protests and rocketing crime. However, by 2004, loans were again openly extended to Argentina and the country was once again prosperous, unsaddled by the unpayable debt that had burdened the US or Japan. The third ending is not quite finished. In it, when the Howells go on vacation from writing Palmies and create The Great Sinkhole, the Islanders get together and ask themselves “What are we doing? We used to cooperate just fine without them. You still have your wheelbarrow and I still have the shovel. Let’s ignore Palmies and make up a new deal outside The Ledger.” The Skipper, disliking security work against the other Islanders, stops working for the Howells, who now cannot get anything done. The Howells are re-invited to the table and they all invent a new way to cooperate efficiently, instating more certain checks and balances to insure a lasting fairness everyone can live with. A new social compact is born, a Constitution, even. Is there historical precedent for this ending? We may overlook it, but various cultures have used widely different methods of cooperating, invariably based on free exchange, but with differing social perspectives concerning acceptable control, charity, and accumulated wealth. For example, the CEO/Worker ratio in the US was 42:1 in 1982, but is now 400:1.(1) In Japan in 1995 it was still 16:1. "I’m a little embarrassed about it," said CEO George David of UTX.(2) Recognizing this social custom is not a call for income redistribution, but an offer to claim our personal choice concerning what the community feels is moral and appropriate, that is, when people feel “embarrassed” and stop themselves, or others shun them and make them stop through non-support. For example, if shareholders felt it was excessive, they could simply sell any company who compensated their management at a rate over 16:1, bringing the practice to an immediate and painless end. This pay ratio can be as wide as the Middle Ages, or as narrow as the Kalahari Bushmen, but will always be what we collectively feel is acceptable. This is our decision about cooperation, but it also means that people only accept a system of cooperation that they feel it is fair and right. It shows that increased cooperation is the proper end and use of money, and that The Ledger--the system of cooperation-- must be fair by design and honestly upheld for the system to work. The flip side is that if it is not fair or not upheld honestly and consistently, the people will withdraw their support and the system will seize up, making everyone’s life poorer. We see this in rich but corrupt governments such as Sub-Saharan Africa or the banana republics of South America. Then even the Howells cannot be safe and get things done. Luckily, people are natural traders and deal-makers, inevitably arranging to get things done if not prevented by force. So how could the US, an industrial and agricultural powerhouse, be rich in 1928 and poor in 1929? Why did Japan, a hyper-productive society and purpetual exporter, languish for 16 years? Put another way, how were people prevented from cooperating with each other to advance their own wealth? Why did they not release the old, unbalanced system and allow a newer, more honest one to assert itself? …But we’re out of time today. Tune in next time for another exciting episode of “Island Economics” References: 1 http://www.responsiblewealth.org/press/1999/shareholder_pr.html
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In
1928, the United States was the most powerful nation in the world; a
newly opened agricultural giant, a mining titan, and an industrial
powerhouse with hard-working, well-educated people flooding in from the
countryside, clamoring for work. New railways ran passenger trains over
70mph, while electricity, telephone and radio swept into the remotest
corners of the nation, allowing efficiencies formerly only dreamed
of. 
