INFLATION

Rising Prices and Shrinking Dollars

Return of the Inflationary Monster?

During the German hyperinflation of the early 1920s, banknotes had so little value that people had to carry money around in giant sacks. So worthless had the money become that one man who left a wheelbarrow full of money unattended for a moment returned to find that thieves had left his money but had stolen his wheelbarrow. While this story is funny, the hyperinflation itself was not; it wiped out the lifetime savings of millions of families.

My first experiences as an investor came in the inflationary 1970s. In those days, inflation was a mysterious monster ravaging the U.S. and global economies. When I was in college in the 1970s, my friends and I used to retire to the student lounge after dinner each night to watch Mel Brooks' classic comedy show, Get Smart. Because the lounge had just one shared TV, a form of adolescent democracy selected the channel. Other students who wanted to learn and not laugh sometimes outvoted my friends and me, and on some evenings we were forced to watch the nightly news.

When it came to inflation in the 1970s, the TV news was bleak. Every month the government would announce the growing rate of inflation. We sat and feared that we would not have enough money to enjoy life. Even presidents seemed impotent to defeat the inflationary monster. In 1974, President Gerald Ford manufactured millions of "WIN" buttons to exhort the American public to "Whip Inflation Now" (although he never told us quite how we were supposed to accomplish this task). In sour economic times, President Ford lost to Jimmy Carter in the 1976 election. President Carter in turn lost his 1980 election to Ronald Reagan—a casualty, some say, in the Federal Reserve's campaign to defeat inflation.

As shown in Figure 5.1, the 1970s' U.S. inflationary monster was tamed, and for the last two decades, the United States has enjoyed a low inflation rate. Stories of inflationary problems might therefore seem to apply only to those living in Latin American countries or those with a long memory. Recently, however, gold prices have risen dramatically, and the value of the U.S. dollar has declined substantially. These are classic signs that inflation might be building. What are the prospects for inflation, and what sorts of financial investments are likely to prosper?

As in most areas to do with money, the best insights on inflation come from Professor Milton Friedman. Winner of the 1976 Nobel Prize in Economics, Professor Friedman is the leader of the monetarist school that seeks to understand the financial world through the creation and removal of money from the economy.

The seminal work, A Monetary History of the United States , 1867- 1960, written by Professors Friedman and Anna Schwarz, states, "Money is a fascinating subject of study because it is so full of mystery and paradox. The piece of green paper with printing on it is little different, as paper, from a piece of the same size torn from a newspaper or magazine, yet the one will enable its bearer to command some measure of food, drink, clothing, and the remaining goods of life: The other is fit only to light the fire. Whence the difference?" 1

As Professor Friedman suggests, to understand inflation we must remove some of the monetary mystery. Accordingly, our investigation into inflation starts with an analysis of the reason we use money in its current form. In this journey, we begin by examining a modern market that does not use money at all.

stock quote ~ money maker
stock investment guide ~ forex platform
trade stock online ~ mad money
stock market quote ~ option trading
 

The Creation of Money: This Kidney Is Not for Sale !

Kidney transplantation is a potentially life-saving surgery that transfers a kidney from one person to another. Sometimes the kidney comes from a donor who has recently died, while many others come from living donors. Most people are born with two kidneys but can live quite well with just one.

My Harvard Business School colleague, Professor Al Roth, has become involved in improving the kidney transplantation system. At first glance, the situation seems quite simple and not applicable to the tools of economics. People in need seek a relative or friend willing to donate a kidney. Those needy patients who do not find a willing donor wait in line for kidneys from cadavers. Why is Professor Roth, an economist, involved in a medical process?

There are special circumstances that make the kidney market particularly problematic and appeal to an economist's special skills. Kidney donors and recipients need to match on a number of physiological mea­sures. So while a needy patient might find a willing donor in, for example, his or her spouse, tissue incompatibility may preclude a transplant. In these cases, a willing donor cannot help his or her loved one because of biological mismatch.

A potential solution for couples suffering from this mismatch is to find a complementary couple in a similar situation. In the simplest case, two such couples might find that they can swap organs. So, for example, Mrs. Smith wants to donate a kidney to Mr. Smith, but they are biologically incompatible. Similarly, Mr. Jones wants to donate a kidney to Mrs. Jones, but cannot. If, by chance, they are mutually compatible, the solution is to have Mrs. Smith donate to Mrs. Jones, and Mr. Jones to Mr. Smith. Thus, both patients get the kidneys they need.

This sort of "matching" problem is well understood by economists and is a particular area of expertise of my colleague Al Roth. In some of his previous work, Professor Roth helped reform the system of matching medical residents to positions at teaching hospitals. 2 Thus, the kidney transplantation system, which appears at first to be purely medical, has an underlying "matching" problem that has been studied by economists.

Such organ-swapping is legal, and it is beginning to happen. Here is a summary of a news story about one such arrangement (The Reporter, Vanderbilt University Medical Center , November 21, 2003 ):

The lives of two West Tennessee families have been changed forever by the generous act of organ donation, but not in the way they had originally planned. Kay Morris, 53, was to receive a kidney from her daughter, Melissa Floyd, and Tom Duncan, from his friend and neighbor, Patricia Dempsey. But, there was a positive cross match within each couple so the transplants couldn't take place. Debbie Crowe, Ph.D., an astute Nashville immunologist, discov­ered that by swapping kidneys between the two pairs, the transplants would work.

In this case, Melissa donated her kidney to Tom, a man she had not previously met, while Tom's friend Patricia donated her kidney to Melissa's mother. These organ-swapping arrangements allowed transplants that could not take place otherwise. In this case, two recipients received new kidneys that they could not have had without involving the other pair. Fantastic.

There are, however, some difficulties with kidney swaps. First, some­times it takes more than two pairs to find compatible matches. For example, Johns Hopkins recently performed a three-way swap. Involving more couples makes the matching process more difficult, particularly since donor and recipient need to be in the same hospital for the surgery. Second, surgeons who do swaps have a rule that all the surgeries must take place simultaneously. In the West Tennessee case, that meant four simultaneous operations (two donors, two recipients) and the Johns Hopkins triple swap involved six operating teams working on the three donors and the three recipients at the same time.

Why do the surgeons require simultaneous exchange? They fear that if the exchanges are not simultaneous, then some of the donors might change their minds. Perhaps, for example, Mr. Jones might become unwilling to donate his kidney after Mrs. Jones has received her new kidney. Obviously, it is impossible to compel someone to donate a kidney against his or her will.

To avoid this problem of failed exchange, surgeons require that all of the operations take place at the same time. The requirement for simultaneous exchange makes the actual operations much more complicated. Recall that each operation involves many medical staff. So the requirement to have four or more full medical teams working simultaneously is very chal­lenging.

Furthermore, simultaneous exchange prevents some swaps entirely. For example, a patient's compatible donor might not be available until next year. If there were some way to store value over time, such swaps could take place. For example, a donor could give one kidney to a stranger now, and get credit for future exchange when the matching donor is discovered. Such swaps that involve delays are impossible if all exchanges must be simultaneous.

Using his expertise on matching, Professor Roth is working to improve the quantity and quality of these exchanges between couples. His work has the potential to greatly improve the system, but is limited and complicated by the requirement for simultaneous exchange.

Now imagine what the world would be like if all economic transactions required simultaneous exchange. A simple task like filling a car's gas tank would require a negotiation involving delivery of some good or service to the gas station owner. Perhaps the most profound effect would be the difficulty retirement would bring about. During later years, most people spend years or decades living off previously accumulated wealth. The ability to store up favors of the magnitude required to retire would be impossible if all exchanges needed to be simultaneous.