Summary: What can The Hobbit teach us about central banking?The Hobbit is literature, not a lecture. So when people read the story, they’re looking for entertainment, not edification. Still, like any good story, it has elements that are quite realistic, for all the fact that it is fantasy. Tolkien was quite thorough in thinking through his alternate world. And so aspects of the author’s fantasy-world can be instructive to us in the real-world.One (rather fanciful) question some have raised is why the attack of the dragon Smaug should have effected Middle Earth’s economy some 150 years later. Was it the destruction of so much property? The scattering of the dwarves? Or something else? We know that it wasn’t the continued depredations of the dragon—Tolkien notes that Smaug rarely emerged from his lair at the time of Bilbo’s quest. By that time many of the younger folks in Lake-Town had never seen him. And other societies have seen periodic destructions of wealth and labor—from storms, from wars, from earthquakes—without going into an economic funk.Instead, many have traced the collapse of the Middle-Earth economy to the loss of money in their society. The dwarves’ treasure—and the dragon’s hoard—were immense. When the dragon removed that currency from circulation it created a monetary shock that rippled through the entire society. Absent a central bank, if the money in circulation is cut in half—or by 90 percent—prices and wages will have to fall a similar amount, if the production of goods and services remains the same. But debt contracts do not fall, and so there would be mass bankruptcy, liquidation, and disruption across society—just at the time when there would need to be mass re-building. The resulting debt-deflation would be similar to what happened in the US during the Depression—productive assets are left fallow, and the economy stagnates. It’s one more reason why our economy is better off today than it was 100 years ago: now we have a central bank to manage the money supply that can deal with monetary shocks.Still, it’s wise to consider that as the Fed constructs ever-more imaginative responses to our current economic problems: sometimes, there be dragons.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @GlobalMarketUpd
