The Economics of Smaug
Forget about the divisions between saltwater and freshwater economists. The hottest debate in economics right now is about Smaug, the dragon nemesis in J.R.R. Tolkein's novel "The Hobbit."
Frances Woolley kicked off the debate by arguing that Smaug's capture of the Dwarven gold mine amounted to a policy of monetary tightening.
The full economic impact of Smaug can only be understood by recognizing that the dragon's arrival resulted in a severe monetary shock. … It is clear from a simple inspection … 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 difficulty with this view, as the first commenter on Woolley's post explains, is that while there might have been an initial shock due to the tightening, in the 150 years that transpire between Smaug's arrival and the beginning of "The Hobbit," the economy should have been able to adjust to the diminished supply of money. Real activity should have returned to pre-Smaug levels after the economy adjusted to the purely nominal shock.
Nick Rowe has a very complicated answer to this, applying New Keynsian economics to Middle Earth. I won't pretend that I fully understand what he's saying, but I think it amounts to this: Businesses concerned that Smaug's reign might be overthrown at some point would hesitate to drop prices to market-clearing levels, holding out for higher prices that will follow Smaug's demise.
Eric Crampton at Offsetting Behavior argues that looking at Smaug's arrival as a monetary phenomenon is offbase. The real shock to the economy was supply-side, not nominal.
The primary effect was a strong supply shock — thousands of very skilled Dwarven craftsmen were eaten. Dwarvish replacement rates are very low — they're more fertile than elves, but hardly reach human or hobbit ability to repopulate a land.
Next, the entire region around the Lonely Mountain — Dale and Lake Town — served to service the Dwarvish industry. Dale produced agricultural goods in trade for the Dwarves; Lake Town ferried on Dwarvish goods to the rest of Middle Earth. Absent the Dwarves, there was no reason to rebuild Dale. And LakeTown remained a commercial town linking the Wood Elves and surrounding region with the rest of Middle Earth, but at a necessarily diminished scale.
There's a lot more good stuff in the comments to Woolley's piece, including many arguing that it was not Smaug's monetary policy that caused the economic problems of Middle Earth, but the lack of communication about his future policy. And then there is this post arguing that Smaug saved Middle Earth from the inflationary policies of the dwarves, a Paul Volcker of Middle Earth. Similarly, Jim Leaviss at Bond Vigilantes wonders if the return of all that Dwarven gold to circulation resulted in hyper-inflation.
My own contribution to this debate begins by noting the availability of magic in Middle Earth. It seems as if it would be well-within the power of a wizard like Gandalf to simply create the gold lost to Smaug through alchemy. Yet Gandalf doesn't do this. Why not?
Gandalf's refusal to replace the gold Smaug snatched with gold created out of thin air has a real world counterpart in the refusal of U.S. government authorities to replace the wealth destroyed by Bernard Madoff's Ponzi scheme. The Federal Reserve could quite simply have replaced all the lost wealth through a series of keystrokes crediting the accounts of Madoff's victims. Yet this was never seriously contemplated.
The best explanation for the central bank's refusal to replace lost Madoff wealth is that this would create moral hazard. Investors would no longer police their investment professionals for embezzling because they would no that monetary authorities were standing by to help them avoid losses. The policy of monetary intervention would be criminogenic, encouraging more fraud in finance.
This is also why Gandalf refuses to use wizardry to make the Dwarves whole. He wants the good folks of Middle Earth to be vigilant in their own defense. The conquest by the dragon is but one example of the peoples of Middle Earth not exercising the proper degree of prudent self-defense. In preparation for the coming conflict with Sauron, Gandalf is fostering a culture of defense.
Note that Gandalf will only take this hands-off approach so far. Just as the Federal Reserve and the Treasury Department stepped in to ameliorate the effects of the financial crisis, Gandalf stands ready to act as a Wizard of Last Resort when the conflict with Sauron does finally materialize.
—By John Carney; Follow him on Twitter @Carney