Smaug and the questionable relevance of “transmission mechanisms”

A few months ago, the Internet sensibly zeroed in on the real question posed by the second Hobbit movie.  “The Desolation of Smaug” clearly refers to the gigantic monetary disturbances brought about by the greedy lizard. CNBC and Slate were amongst many who followed up on Frances Woolley’sobservation about the depression Smaug caused over Middle earth when he took away so much currency.

After 150 years of scarce currency and falling prices, Bilbo and his dwarf friends would clearly cause a massive nominal shock by releasing such a huge stash of gold onto the depressed Laketown economy. Gold that over the decades had become far more valuable would see its value obliterated by the onrush of new currency, causing a massive inflation. Upon realising what was about to happen, any merchant with some small stash of gold would immediately buy everything he can get his hands on: goatskins, houses, fishing rights, you name it.  Anything to get rid of something that is about to collapse in value.

Given the depression the effect is likely to be electric in real terms. With rapid rises in prices and wages, any outstanding debts would become easier to service.  Bills would be paid with great eagerness, new working capital sought out. New investments would look far more attractive.  Asset prices would boom.

Would it make any difference if there was no bank credit, because Smaug had incinerated the bankers? Or if the few banks remaining didn’t understand relationship lending? Or if Laketown had very low interest rates owing to the depressed state of trade and high risk aversion? Or even if the Laketown authorities were on an austerity drive?

I should think not.  Sluice the economy down with enough gold and there will be a huge stimulus.  And this would be the case even if none of it was owned by the people of Laketown.  Even if the dwarves gave none of it away, their huge potential purchasing power would have a massive effect.   Even if they were total misers, and spent little of it, what would you think if you were that merchant? You would not want to hold gold at the same price. That dwarf gold will come out somehow.

The debate about the potency of monetary policy in a depressed economy is a perennial; not least since the Crash, but going back at least 50 years to the monetarist counter revolution.  Mishkin in his tome distinguishes two types of evidence in this debate.  ”

Reduced Form” evidence resembles Underpants Gnome thinking:  step one: lots more money, step two: ????, step three: higher NGDP.  The mechanisms don’t matter. The evidence accumulates by people observing how prices and money supply move together.

“Structural Model” evidence tries to specify mechanisms. It it a bit like what the Bank attempted when it first explained QE and monetary policy in general. It talks about lower rates, higher asset prices, that sort of thing.

Thinking about Smaug leads me to prefer the former way of thinking. How would all his gold boost Laketown?  The honest answer is “somehow”.  Would it be lower rates, higher asset prices, more consumer spending, expectation of higher prices elsewhere, a wealth effect, a balance sheet effect, a cheaper currency helping exports, banks becoming more eager to lend?  The right answer is: I don’t know, but it would happen.  Just as it happened when FDR went off gold (devaluing dollars).  It worked through some channels, but not others.  It is probably doing the same in Japan right now.

I am not normally a fan of Underpants Gnomes, nor of the Bank’s reasoning.  But in this case I would back it against the criticisms of those who say “My model says QE can’t work”.  In extremis, permanent money injections clearly work, whatever the other circumstances.   I have no doubt QE could have been done better; it could clearly have been communicated better. But the Bank’s confidence seems well founded.  The only problem is that for long periods they have implied that QE would be extremely temporary, which changes everything.

Mishkin ends this specific chapter with clear “lessons for monetary policy”.  He chooses:

  • Don’t associate the easing of monetary policy with a fall in nominal rates
  • Other asset prices than short term debt convey important information about the monetary policy stance
  • Monetary policy can be highly effective in reviving an economy even when short term interest rates are near zero.

Fancy that. He doesn’t even say you have to kill a dragon first.


Published by freethinkingeconomist

I'm former special adviser (Downing Street 2017-19, BIS from 2010-14), former FT leader writer and Lex Columnist, former financial dealer (?) at IG, student of economic history, PPE like the rest of them, etc, and formerly in my mid-40s. This blog has large gaps for obvious reasons. The name is dumb - the CentreForum think tank blog was called Freethink, I adapted that, we are stuck now.

12 thoughts on “Smaug and the questionable relevance of “transmission mechanisms”

  1. But of course any boom would be followed by a bust as the fact that gold wasn’t real wealth came clear (eg 17thC Spain).

    Now suppose Gandalf had used his powers to release shale gas or even harness whatever mystical, probably nuclear, power source a flying, fire breathing dragon must have. That would have brought about an industrial revolution in Laketown and probably all of Middle Earth.

  2. To go back to your original example… given that Laketown was destroyed by fire and had to be rebuilt, wouldn’t this dampen down inflation?

    As you may be able to tell, I don’t know much about economics, I just like The Hobbit.

    1. Hi

      I think the opposite. They would need to buy building materials and labour. They would have a lot of money to do it, and the supply of those things would have been damaged. I think both effects would lead to higher prices.

      I suspect this normally happens in reconstruction periods: high monetized deficits to fund new capital

    2. Not to mention that the Dwarves, the Mirkwood Elves and even Bilbo also get shares of the treasure, leaving less for the humans to rebuild Dale with.

  3. I believe they are called Cantillon effects when it matters who gets the money first, for the overall macroeconomic outcome. Disputed whether they matter much

  4. Killing Smaug doesn’t liberate the gold, it restores it to the Dwarves. If the Dwarves then hoard the gold themselves, the effect for the people of Laketown is precisely zero. Your story hangs on the idea that the Dwarves would party at their own expense. But if you remember the beginning of the book, the Dwarves prefer to party at someone else’s expense. What makes you think this would change?

    1. More likely to spend when one has it to spare.

      However my point that real wealth comes from technological progress is clearly indisputable. In Middle earth and this one.

      Tolkien was a member of Britain’s academic middle class whose hatred of the wealth creating middle class did and does us great damage. Throughout the books any sign of technology is a sign of the bad guys. Indeed the ring itself – something that gives you great power but is addictive and changes your character from being an honest feudalist – has been widely seen as an analogue of human progress.

    2. “If the Dwarves then hoard the gold themselves, the effect for the people of Laketown is precisely zero.”

      It is just like the Fed making new money but keeping it inside the Fed. The effect is precisely zero, until it comes out, which it will.

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Freethinking Economist

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