The world of Round Hill consists of two distinct countries with two distinct economies separated by one gigantic ocean. The sun rises on the Independent Republic of Hamlin in the east and sets on the Democratic Nation of Stuart in the west. For more than 200 years, free trade, low taxes, open markets, stable currencies and minimal government intervention benefited all. The citizens of Stuart and Hamlin prospered.
One day, a fertile iron mine in the heart of Stuart runs out of ore. So Hancock Steel, the nation’s largest integrated steel producer, must turn to other sources. Unfortunately, the next great domestic iron deposit rests 2,000 miles away. Transcontinental rail freights aren’t cheap. Hancock’s production costs rise. To stay profitable, management pushes these costs to the end-user. Steel prices double.
The Garland Motor Co. depends on Hancock’s refined cold-rolled products to produce lightweight body panels for its automotive fleet. Steel prices dramatically affect the auto industry’s bottom line. Higher domestic prices force Garland to import less expensive steel from Hamlin producers.
Hancock’s sales plummet. Layoffs ensue. Steel workers with mouths to feed form a union. They lobby their national politician. The politician needs their vote. He asks for a few favors. Within days, the Democratic Nation of Stuart slaps a tariff on Hamlin steel. Garland Motor reverts back to Hancock. The steel union celebrates.
The SUVs rolling off Garland’s assembly lines now cost more to produce. Car prices double. Unfortunately, most consumers can’t absorb the price hike. They turn to cheaper imports from Hamlin. Garland’s sales drop. The company cuts costs. Once again, layoffs ensue.
Unemployed autoworkers quickly lobby political support. Their politician acquiesced on the steel pact. Now he demands mutual legislative support. Stuart slaps Hamlin with another tariff.
Now the good citizens of Hamlin get testy. For years, trade between the two countries prospered. But Stuart’s protectionist ways inflame national pride. The citizens of Hamlin demand retaliation.
You see, for years, Hamlin has reaped the benefits of Stuart’s abundant forests, forsaking local producers. But no more… The Independent Republic of Hamlin retaliates with a massive tariff on imported timber. Hamlin’s high-cost producers rejoice.
Unfortunately, construction costs rise nationwide. New home sales fall. Layoffs now engulf mortgage brokers and construction workers. The entire Hamlin economy slows.
Meanwhile, Stuart’s logging industry contracts. The cycle continues. Prices on all economic goods and services (steel cans, cars, houses, etc.) continue rising the world over. Both economies contract. Unemployment rates rise. A global recession results.
Once again, the world turns to politicians for a solution. Elected officials in both countries reach for the quick fix. They appease the unemployed via subsidies (taxpayer money).
Unfortunately, there’s no such thing as a free lunch. For the sake of maintaining a balanced budget, subsidies require more government revenue. More revenue means more taxes. Higher taxes inhibit domestic growth. Less growth means fewer jobs.
Unemployment rates keep rising. The citizens of Stuart and Hamlin find themselves back at square one.
However, a Stuart-educated economist – let’s call him Cain – steps up to save Round Hill from total economic meltdown. He suggests that massive deficit spending (on public works) will increase aggregate demand. Laidoff workers from the mills, factories and forests will build roads, bridges, schools and dams. The unemployed will effectively be hired in service to the state. They’ll use their wages to buy houses and cars. In turn, these industries will demand more iron, steel and lumber. The whole economy prospers. The recession ends. The government effectively solves the paradox of full employment.
It’s simple, Cain explains. Think of deficit financing as using a credit card to get you through a rough month.
Stuart’s legislative body takes the bait. Stuart’s treasury revs up the printing press. Within weeks, the government awards contracts to engineering firms nationwide. With the push of a button, corporate bank accounts are overflowing. The construction industry takes off. Everyone in Stuart receives a paycheck. Cash seemingly falls from the sky.
The first two years are bliss. But eventually, the 1-1 gold parity of Stuart’s currency (the bandit) feels the heat. The printing press has injected too much paper money. M3, Stuart’s fullest measure of the base money supply, keeps growing at a 12% per year clip. The market now requires two bandits for a single ounce of gold – effectively lowering the bandit’s value by 50%. Prices for milk, bread and eggs start rising. In fact, they begin rising faster than domestic wages. Inflation fears start to percolate.
But currency devaluation brought some unanticipated benefits. Stuart’s export industry re-emerges. The cheap bandit means cheap exports sail from Stuart ports. More exports create more jobs. More jobs mean more votes. Political pressure to keep the money flowing keeps rising like the waters that carried Noah.
Stuart’s president, Robert Chatham, faces a dilemma. On one hand, unemployment rates have reached historic lows. The economy keeps humming. On the other, inflation fears keep mounting. Saving the bandit will ensure the emergence of inflation’s ugly cousin: deflation (the opposite of inflation, promising a decrease in the general price level). Recession will surely follow.
Chatham’s dream of a second term falls like a dead leaf in a dry wind.
Meanwhile, across the sea, cheap imports from Stuart cripple Hamlin’s industrial base. As Stuart’s economy takes off, Hamlin’s unemployment rate soars to record highs.
Hamlin’s politicians have no choice. They quickly follow Stuart’s lead. Seemingly overnight, Hamlin precipitates currency devaluation. Depreciation ensures currency parity once again. Imports from Stuart subside.
In a perfect world, the two countries would save their respective currencies. But they live in an imperfect world. As do we.
June 11, 2008
P.S. Although the story you just read is fictional, real economic policies function in a very similar way. Right now the U.S. is trying everything to stay out of what appears to be an inevitable recession. While they may not be able to steer around the recession, there’s no doubt that the government will soon be flooding the markets with cash. And there are certain “lifeboat” stocks that will be benefiting.