June 27, 2017

The Hobbit and Economics

Smaug's gold

Smaug's gold hoarding sheds some light on basics of international central bank moves and supply and demand. Illustration by J.R.R. Tolkien.

Frances Woolley of Worthwhile Canadian Initiative, a Canadian economics blog, presents an entertaining, short, and informative piece on The Hobbit and economics. The dragon, Smaug’s, hoard of gold is reminiscent of some hedge fund managers’ own stockpiles.

Smaug the dragon is typically viewed as a fiscal phenomenon, depressing economic activity by burning woods and fields, killing warriors, eating young maidens, and creating general waste and destruction. Yet peoples – whether elvish, dwarvish, or human – have considerable capacity to rebuild. Why did the coming of Smaug lead to a prolonged downturn in economic activity, rather than a short downturn followed by a period of rebuilding and growth?

The full economic impact of Smaug can only be understood by recognizing that the dragon’s arrival resulted in a severe monetary shock. On the left is shown Smaug’s hoard. On the right, for purposes of comparison, are the gold reserves of the Bank of England. It is clear from a simple inspection of these two figures that the amount of gold coinage Smaug withdrew from circulation represents a significant volume of currency. This would, inevitably, lead to deflation and depressed economic activity.

The interpretation of dragons as monetary phenomena is supported by the events occuring after the death of Smaug. Upon the great worm’s demise, the wealth it had stockpiled was shared between the dwarves and others who had contributed to the fight. Much gold was sent to the Master of Lake-town; followers and friends were rewarded freely. The result was an immediate increase in the money supply, and a rapid growth in overall economic activity.

One has to ask whether or not a more innovative monetary policy framework could have ameliorated the impacts of the dragon-induced economic downturn. If the peoples of Middle Earth had abandoned their gold specie standard, and switched instead to a paper currency, they could have revived trade-flows without sacrificing so many lives. Unfortunately, the lack of a central bank, or indeed any but the most rudimentary monetary institutions, was a major obstacle to currency reform.

Dragons come. The question is how to respond to them.

The Hobbit and economics may not seem to go hand in hand but Woolley does present a basic lesson in macroeconomics through an accessible medium. I’m not sure if he has economics or The Hobbit on the brain. Central banks, hedge funds, and retail investors will be concerned with gold’s price movements in 2013. It’s good to understand the fundamentals.

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