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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 for-
ever by the generous act of organ donation, but not in the way they
Inflation 89



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, discov-
ered that by swapping kidneys between the two pairs, the trans-
plants would work.

In this case, Melissa donated her kidney to Tom, a man she had not pre-
viously 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, some-
times it takes more than two pairs to find compatible matches. For exam-
ple, 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 Hop-
kins 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 kid-
ney. 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
90 The Old Art of Macroeconomics



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 chal-
lenging.
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 transac-
tions 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.
The world of simultaneous exchange is not mythical; it is called a
barter economy. Before the invention of money, all human societies used
barter. Even recently, some nonindustrialized societies existed without
money. As the kidney example illustrates, the need for simultaneous
exchange in barter societies places a serious damper on economic activ-
ity. Consequently, barter economies are less productive than societies
that use money. Importantly for financial planning, barter economies
make it very difficult to store up wealth to use in the future for retirement
or other activities.
Inflation 91



The Form of Money: Rice, Cheese,
Stones, Gold, and Paper

Money is truly an amazing invention that lubricates economic exchange.
As Milton Friedman writes, money in its current paper form is almost
magical. With money, one is able to obtain real goods”food, drink, trans-
portation, and housing”in return for flimsy pieces of paper. Furthermore,
the ability to store wealth means that retirees can live for decades off
their savings.
I am reminded of the power of money when I travel to exotic locations.
Emerging from a busy and frequently dusty airport, I am immediately
able to get help from strangers simply by offering a piece of paper. These
strangers are willing to help me because other people will, in turn, grant
them valuable goods and services in exchange for the paper that I pro-
vide. Both transactions are made possible by the fantastic tool of money.
For all of its wonderful positive effects, money immediately creates
the potential for trouble that is not possible with barter. Recall that
because of simultaneous medical operations, our kidney-swapping cou-
ples are sure that the other couples will do their part. In contrast, in any
transaction using money, one side gives up something of immediate
value in return for the promise of future value. Those who trade a ham-
burger today for a dollar they will spend next Tuesday (or 10 years from
next Tuesday) risk the prospect that the dollar will lose some of its value
before it is spent.
Part of the risk of money lies in its somewhat ephemeral nature. Mod-
ern paper money has value only because others perceive it to have value.
As Professor Friedman writes, “Why should they [dollars] also be
accepted by private persons in private transactions for goods and ser-
vices? The short answer”yet the right answer”is that each accepts
them because he is confident others will. The pieces of paper have value
because everybody thinks they have value.”3
Unlike dollar bills, some earlier forms of money had intrinsic value.
92 The Old Art of Macroeconomics



Rice and other grains were used in a variety of cultures.4 The recipient of
“rice” money knows that even if everyone else stops accepting payment
in rice, he or she can eat the money. For similar reasons, some northern
European cultures used cheese as currency.5
While rice and cheese solve the problem of future repayment, they
have their own problems. They can be bulky, hard to store, and subject to
decay. Imagine the difficulty of keeping your retirement account entirely
in the form of rice, or hauling a giant sack of cheese to the car dealer.
Other forms of money can improve upon these “commodity” currencies.
Throughout the ages people have been willing to die and kill for gold.
On the surface, this might seem ridiculous, as gold has very few actual
uses (and cannot be eaten!). Gold has value not for what it can do, but
because it solves many of the problems with commodity-based curren-
cies like rice and cheese.
If we were to imagine ideal money, what characteristics would we
seek? Ideal money would be easy to verify, impossible to counterfeit,
portable, and not subject to decay. Gold has been an important currency
throughout human monetary history because it has many of these char-
acteristics. It is scarce enough that small amounts have value, thus mak-
ing it portable. It is relatively easy to detect fake gold, and gold does not
rot when stored. This seemingly simple set of features explains why gold
can launch (and sink) armadas, ruin friendships, and dominate dreams.
For all of its advantages, gold and other naturally occurring forms
of money still have problems. Residents on the Pacific Island of Yap
discovered this through an interesting experience.6 This is an old story
that has become famous because it is included in Professor Gregory
Mankiw™s best-selling textbook (called simply Macroeconomics).7 (Pro-
fessor Mankiw taught in the Harvard economics department and is cur-
rently the head of President Bush™s Council of Economic Advisors.)
The residents of Yap use money called “fei” that consists of large stone
wheels shaped liked coins that can reach up to 12 feet in diameter. These
fei have many of the optimal characteristics of money. They are difficult
to counterfeit and they do not decay. While the fei are not portable, they
Inflation 93



are stored in the equivalent of banks and do not get moved very fre-
quently. The fei can change ownership without being physically moved.
Because the society is sufficiently small, everyone knows who owns
which fei, and consequently there is no risk of theft.
Many years ago one of the fei was washed away during a storm. The
people of Yap faced a choice. Should the person who owned the money
be liable? If so, that person would suffer, but so would the whole society.
As Professor Friedman has shown, the amount of money affects eco-
nomic activity. Thus a decrease in the amount of money would likely
harm the overall economy. The residents of Yap decided that the lost fei
should still be credited to its owner. So while the actual fei remained lost,
all the residents simply acted as if it were still on the island. They kept
track of who owned the fei and”many years later”this virtual fei still
existed in everyone™s mind and was used in transactions.
The story of stone money on the island of Yap illustrates the problem
with any tangible currency. If such currency is used, then the ability to
create money is taken out of the government™s hands. So in the case of
Yap, the entire society would have had less money if the washed-away fei
had been declared lost. In the case of gold, the quantity of metal is deter-
mined not by government, but rather by the foibles of discovery and min-
ing technology.
As we™ll see, government control of money is frequently the source of
monetary misery. Nevertheless, few leaders want their economy to be
subject to the ebb and flow of gold production. The United States was
effectively on a gold standard from the Bretton Woods agreement in 1944
up until 1971. Because President Nixon wanted to stimulate the econ-
omy, something that was difficult to do under the rules of Bretton Woods,
he removed the fixed link between U.S. dollars and gold. Today, every
major country has made a similar move, and money has been decoupled
from anything tangible. We live in an era of so-called “fiat” money where
the supply of currency is dictated by government command (or fiat).
With the proper controls on counterfeiting, fiat money has a seemingly
perfect set of characteristics. Fiat money is of known value, lightweight,
94 The Old Art of Macroeconomics



and easy to store. Unlike gold, the supply of fiat money is controlled by
the government and so can be modulated to fit economic needs.



Shrinking Money: The Trouble with Inflation

Economics is often characterized and summarized as “supply and
demand.” When it comes to money, there are clear consequences to
changes in supply. The residents on the highlands of Papua New Guinea
learned this in the early part of the twentieth century.
Papua New Guinea is a large island north of Australia. The coasts are
populated with people who have been in contact with their neighbors in
other countries for centuries. Soon after leaving the coastal region, the
land rises steeply to a mountainous and elevated plateau that was thought
to be too rough for human habitation.
In the early part of the twentieth century, a group of Australians
decided to investigate the highlands in search of gold. There are several
fascinating aspects to this story. First, the highlands were far from empty,
but rather contained close to a million people who had been almost com-
pletely isolated from other cultures for centuries. Second, the Australians
brought a movie camera with them. This may be the only film recording
of a first contact with a nonindustrialized people. Some of the original
footage can be viewed in an academic movie appropriately titled First
Contact. Third, and particularly relevant to our story, the people of the
highlands placed a high value on seashells.8
Why would anyone use seashells as a form of money? For most cul-
tures this would be silly, as no one would exchange anything of great
value for seashells. In the highlands of Papua New Guinea, however,
seashells make as much sense as gold did for ancient Greeks. Almost
completely isolated from the sea, shells in the highlands were scarce
enough that small amounts had high value. It is easy to detect fake shells,
and shells do not rot when stored. These are exactly the characteristics
that make gold valuable all over the world.
Inflation 95



As long as the highlands were separated from the seashores, a seashell
money standard made sense. However, it did not take the Australian gold
miners long to understand the opportunity. There was some gold in the
highlands, but it required hard work to extract. The Australians flew in
planeloads of seashells they used to pay wages of the highlanders who
mined the gold. The highlanders worked for seashells until shells became
so common as to lose value.
There is no question that the Australians exploited the Papua New
Guinea highlanders, but the highlanders did not want to be paid in paper
currency. With shells the highlanders could buy anything they wanted
within their community; banknotes were worthless. This changed when the
Australians opened up trade stores where banknotes could be exchanged
for pots, pans, axes, and shovels. One of the original Australian miners,
Dan Leahy, opened up a trade store and stocked it with a variety of goods.
What do you suppose was his most popular item? It was the big “kina”
shells used as part of courtship.
The Papua New Guinea highlanders exchanged their hard work in
return for money. These workers were hurt because their money came in
the form of seashells, and the rapid increase in the supply of shells
pushed their prices down. Thus, the decision to trade work for shells was
made with an expectation of a particular value to the shells. The
increased supply of seashells made this a rotten deal for the workers.
The highlanders continued to value shells for years. This may seem
silly, but imagine our response if extraterrestrials with unlimited quanti-
ties of gold came to earth. It would probably take us some time to prefer
their paper money to gold.
Inflation is defined as a loss of purchasing power for a particular
amount of money. Before the Australians arrived, one beautiful shell had
considerable value and could even constitute the bulk of the money paid
to find a marriage partner. After shells became common, their value
plummeted. Thus, the Papua New Guinea highlanders experienced a
severe period of inflation. Those who had accumulated wealth in the form
of stored shells saw the value of their savings devastated by the inflation.
96 The Old Art of Macroeconomics

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