Peter Lyons: What the Reserve Bank has in common with The Wizard of Oz

A publicity shot from the 1939 movie The Wizard of Oz, starring Judy Garland. Photo / supplied

Opinion

COMMENT

We make sense of our reality through stories. I have come to realise how crucial storytelling is to teaching and learning. It's part of our evolutionary DNA. We are the storytelling primates.

There is a little-appreciated story of the magic and madness of money. I recently viewed a sad movie about Judy Garland. She starred as Dorothy in the original 1939 movie The Wizard of Oz. That movie was not based on a children's tale, despite appearances. It was based on a political satire about conflicts over money and who controls it in an economy. This conflict still continues.

Money is an entirely human creation. It is a very powerful concept that largely exists in our minds. But it has a huge impact on our existence. Money has value because we collectively give it value. Modern money is largely computer entries. Computerised debits and credits. Actual notes and coins are a very minor part of the modern money supply.

The Wizard of Oz was written by Frank Baum in 1900. It was a satire about the money problems plaguing the United States in the late 19th century. The amount of US dollars in circulation was tied to the amount of gold available. The US economy was growing rapidly but the lack of gold meant a lack of money in circulation. This was causing prices to fall, especially for farmers. Farmers were struggling because the lack of money in the economy was causing deflation, but the farmers' debts remained the same. They couldn't pay their mortgages. They wanted paper money to be backed by silver, as well as gold, so more money could be created allowing prices to recover. This created a bitter political fight.

Bankers are profit-driven like any other business. The problem is that if they collectively get their lending wrong, they can stuff an entire economy.

Peter Lyons

In The Wizard of Oz, Dorothy represented the average American citizen. Oz represented ounces of gold. The yellow brick road was the narrow gold standard that required any paper money to be backed by gold. The Scarecrow represented poor farmers and the Tin man represented factory workers. The Wicked Witches of the East and West represented the bankers. The cowardly lion represented the politicians of the day. It was a fable about money and who controlled it.

These days money is no longer backed by gold or silver. President Nixon severed the final link between paper money and gold in 1971. It contributed to a decade of massive inflation. Most modern money is created by bank lending. Central banks try to control this bank lending by setting short-term interest rates like the OCR. But this can be like holding a feral cat by the tail. Monetary policy is a very imprecise quasi science.

During boom times banks create more money through their lending which can magnify the booms. But during bad times banks often sharply decrease their lending due to fear of bad debts. This reduces the money supply and amplifies the downturns.

Humans love stories. But constant tales of greedy corrupt overpaid bankers are a little unfair. Bankers are generally human too. Bankers are profit-driven like any other business. The problem is that if they collectively get their lending wrong, they can stuff an entire economy.

The original function of most central banks was to act as "lenders of last resort" if banks stuff up their lending. This is what many central banks did during the Global Financial Crisis. They flooded their financial sectors with easy money. Their actions likely prevented another Great Depression.

Peter Lyons. Photo / supplied

But it hasn't solved the age old riddle that lies at the heart of economics. Cheaper money in the past decade has likely been the main driver of asset price inflation in property and shares.

The riddle is about determining the correct amount of money in circulation in an economy. The aim should be to prevent inflation in the prices of goods, services and assets and to avoid deflation. The Wizard of Oz was based on the drawbacks of using gold to solve this riddle. Eighty years after the film was released, our Reserve bank and other central banks are still struggling to solve this age-old riddle.

• Peter Lyons teaches economics and has written several economics texts.