An Answer to a Monetary Riddle
By David Henderson
Last quarter, I received the following “riddle” from a student in my class:
It’s a slow day in some little town……..
The sun is hot….the streets are deserted.
Times are tough, everybody is in debt, and everybody lives on credit.
On this particular day a rich tourist from back west is driving thru town.
He stops at the motel and lays a $100 bill on the desk saying he wants to inspect the rooms upstairs in order to pick one to spend the night.
As soon as the man walks upstairs, the owner grabs the bill and runs next door to pay his debt to the butcher.
The butcher takes the $100 and runs down the street to retire his debt to the pig farmer.
The pig farmer takes the $100 and heads off to pay his bill at the feed store.
The guy at the Farmer’s Co-op takes the $100 and runs to pay his debt to the local prostitute, who has also been facing hard times and has had to offer her services on credit.
She, in a flash rushes to the motel and pays off her room bill with the motel owner.
The motel proprietor now places the $100 back on the counter so the rich traveler will not suspect anything.
At that moment the traveler comes down the stairs, picks up the $100 bill, states that the rooms are not satisfactory, pockets the money & leaves.
NOW,… no one produced anything…and no one earned anything…however the whole town is out of debt and is looking to the future with much optimism.
Here’s monetary economist Jeffrey Rogers Hummel’s answer:
There are several ways to think about this intriguing example. But they all must recognize that these transactions have made no change in any of the parties’ NET wealth. True, at the beginning each resident has a $100 liability. But each also has an offsetting financial asset of $100. At the end, they all have neither. So the $100 bill acts as a clearing mechanism.
If you want to think of the town as a distinct economy, then the rich tourist has temporarily increased the town’s money stock by $100. In effect, he has made a short-term loan of a new $100 bill, increasing liquidity. The $100 provides the residents with a medium of exchange that allows them to clear their offsetting debts.
Or if you broaden the economy to include the rich tourist, his short-term loan has provided liquidity through increasing the transactions velocity of money. If the rich tourist hadn’t provided the loan, any of the residents could have accomplished the same result by borrowing $100 cash from someone else. No new final goods and services were produced (they had been produced already). But borrowing from the tourist may have cost less interest (zero percent) than otherwise. (I’m ignoring the possible complication that the hotel owner only gets a zero-percent loan by embezzling: using the tourist’s deposit without permission.)
Either way, the $100 cash would have been unnecessary if the residents had a central clearinghouse. The fact that the hotel owner seems to know that the $100 bill will come back quickly suggests they already had everything necessary for an informal clearing, and didn’t need the bill in the first place. The hotel owner could have gone to each party in succession, offering to take on their debt if they cancelled his.
Nonetheless, the example illustrates Mises’s point that increases in the efficiency of the clearing system reduce the demand for (increase the velocity of) money. A clearing system is an alternative way of providing medium of exchange services. In fact, in my classes I use a similar example with fewer parties to illustrate the nature and benefits of a clearing system. At the limit, a perfectly efficient clearing system would be an all-encompassing network of computerized barter making money completely unnecessary. So your student’s intuition is partly right. What the tourist’s short-term loan has produced is monetary services.