# Deflation, The Eiffel Tower Con & Banking By [Deep the fuckin Dip](https://paragraph.com/@khangky) ยท 2022-03-21 --- This article is from [Sahil Bloom](https://twitter.com/SahilBloom/status/1288506081455398913) which contains a lot of insights, if you find it helpful please give him a follow. Deflation --------- As often as the term "inflation" is thrown around, you've probably heard the term "deflation" just as much as of late. But what is deflation and how does it work? First, a few definitions. Deflation is the decline in the price level of a basket of selected goods and services. It can be thought of as negative inflation. It is typically expressed as a negative % and serves as an indicator of the increase in purchasing power of currency. The Consumer Price Index (CPI) and Wholesale Price Index (WPI) are the most common indexes for measuring inflation and deflation. While typically discussed on an economy-wide basis, we may see deflation in certain areas of the economy and inflation in others. In very simple terms, deflation occurs when there is not enough money chasing too many goods. This may occur from a contraction in money supply or credit (i.e. people are saving or banks aren't lending). It may also occur from accelerated tech/productivity progression. To illustrate how this works, let's use a simple story. Imagine the same primitive island society from our Inflation 101 example. On this island, they use rare seashells as currency. There are only 1,000 seashells on the island. The prices of goods are stable. An earthquake strikes the region, triggering a tsunami that washes over the island. In the aftermath, the islanders find that 500 of the rare seashells (1/2 of them) have washed away. There are now only 500 units of the currency, but the same amount of goods. What happens? So what we have is a 50% decline in money supply and no change in the supply of goods. Now there is too little money chasing the same amount of goods, so sellers of the goods lower their prices. Simple supply and demand. This is deflation in action. The same dynamic may have occurred if producers of the goods had discovered new technology that allowed them to produce more efficiently. The original 1,000 seashells would not have been able to keep up with the increase in goods. The impact of the deflation differs across the two types of islanders. Savers, who had stored seashells for later use, benefit as each stored seashell has become more valuable in its ability to purchase goods. Asset Holders may see the value of their assets decline. Central bankers worldwide have a massive fear of deflation, so they target modest levels of inflation. Why? Deflation may incentivize saving over spending. If you believe your money will be worth more in purchasing power terms later, you are more likely to save it. Central bankers tend to ascribe to Keynesian principles, which focus on spending as a critical driver of growth. In their minds, if deflation incentivizes saving, deflation is bad. So they seek the "Goldilocks solution" - with a level of inflation that is just right. This view, it should be said, is highly-contested. Given the current balance between the pandemic shock and the rapid increase in money printing, these debates have taken center stage. It is important for everyone to understand the basics. The Eiffel tower Con -------------------- In 1925, a handsome 35-year-old con artist made a fortune selling a famous piece of French real estate. The item for sale: The Eiffel Tower. Victor Lustig was always looking for his next score. Born in 1890 in Austria-Hungary, Lustig had built a vibrant career out of audacious scams and cons. He had a mesmerizing charm and possessed an air of nobility. He took to calling himself Count Lustig. ![](https://storage.googleapis.com/papyrus_images/c87e3fac32052f0d7421903c777664862a462a7e213419da674d58832a71ce8f.png) Fluent in 5 languages, he sailed on transatlantic ocean liners, scamming wealthy passengers along the way. But in 1925, he started to think bigger. While staying in France, Lustig read a newspaper describing the maintenance problems facing the Eiffel Tower. He had an idea. The Eiffel Tower was constructed in 1889 as the entrance to the 1889 World's Fair. At the time, it was the tallest man-made structure in the world. But by 1925, its annual maintenance had become a major national headache. Some French observers had called for its removal. ![](https://storage.googleapis.com/papyrus_images/b72d80bd0c83058998de945ff9e4d2a59e29a3a813658b1f86e74da936e30bc2.png) Victor Lustig had been looking for a big score. He had found it. He would sell the Eiffel Tower to the highest bidder! Lustig sent out invitations on forged government stationary, inviting a group of scrap metal dealers to a confidential meeting at a fancy Paris hotel. In the meeting, Lustig introduced himself as Deputy Director General of the Ministry of Posts and Telegraphs. He explained to the gathered men that the maintenance of the Eiffel Tower had become too burdensome. The French government wished to sell it for its scrap. One man, Andre Poisson, appeared to Lustig to be most likely to fall for the rouse. Poisson was extremely eager to elevate his status as a businessman and viewed this as his big moment. Like any good con artist, Lustig singled out his mark, arranging a follow up meeting. He told Poisson that he could guarantee the Eiffel Tower contract if Poisson were to pay him a bribe. Anxious to win the deal, Poisson agreed, paying Lustig the asking price plus a bribe in cash. Lustig is believed to have received ~250K francs (>$1M today). Quite a score! By the time Poisson realized he had been conned, Lustig was in Vienna, counting his money. Deeply embarrassed, Poisson never contacted the police or reported a crime. His scam still a secret, Lustig actually went back to Paris and tried to sell the Eiffel Tower...again! This time, he would not be so lucky. Police were informed and he fled to the US. He was eventually arrested in 1935 in New York and sentenced to 15 years on Alcatraz Island. When he died in 1947, his death certificate ironically listed his occupation as Apprentice Salesman. ![](https://storage.googleapis.com/papyrus_images/0a7dc781cf85887c4f57b1fc36c243c4961a604d20f8905fd481f8d42f4bc557.png) Banking ------- Banks are a critical feature of the modern economy. But most people don't understand how modern banking actually works. Spoiler Alert: It may shock you. ![](https://storage.googleapis.com/papyrus_images/a7121b8fb8fbbdfa816297cc8d43a16c4bad5aeda9370d912dcbb479dcc2b21f.png) First, a bit of history. Most historians believe the earliest forms of banking began to appear around ~2000 BC in ancient India, Assyria, and Sumeria. Ancient Greece and Rome expanded upon this legacy. But banking transitioned into its more modern form in Renaissance Italy. ![](https://storage.googleapis.com/papyrus_images/cfcd1e689de667ad2399f2e14c904155a5bd5d48ac90fd306d5e1b6d439b7f13.png) In its most basic sense, the business of banking is very simple. Take money from depositors (deposits), pay them interest. Lend money to borrowers (using deposits), receive interest. As long as the interest received exceeds the interest paid, the bank is happy / profitable. Historically, banks would maintain sufficient "reserves" (cash/metals) to give depositors their money back on request. This is prudent, but limits the ability to create credit and thus may stifle investment in an economy. So called "fractional reserve banking" changed that. Fractional reserve banking allows banks to only maintain a fraction of deposits in their reserves. If the reserve requirement is 10%, a bank with $100 in deposits only has to maintain $10 in reserves. To illustrate the beauty (and the beast!) of this system, here's a story. Imagine you arrive in a new town in California during the gold rush. You get off the train with $1,000 in your pocket (and boundless ambition!). You head over to the new CA Savings Bank and deposit the money into a bank account. You are happy. ![](https://storage.googleapis.com/papyrus_images/64f6bc01aeed5ac23f2ad045b012912bfd020e912e53b73e8de47eb920ed6065.png) CA Savings has a 10% reserve ratio, meaning it has to maintain 10% of your deposit in its reserves. It places $100 in its reserves and lends the remaining $900 to Judson Adam, who uses it to buy gold pans. The gold pan seller, Josiah Smith, deposits the $900 into CA Savings. CA Savings places $90 (10% of $900) in reserves and lends the remaining $810 to Jeremiah Black, who uses it to buy wheelbarrows. The wheelbarrow seller, Johnson Campbell, decides to keep the cash in his pocket. Let's take a step back and look at what has happened here. Your original deposit of $1,000 at CA Savings started this chain, but there is now $2,710 of "cash" in circulation. You: $1,000 at CA Savings Josiah: $900 at CA Savings Johnson: $810 in pocket The fractional reserve banking model enabled the creation of credit/dollars. That is mostly a good thing. Judson and Jeremiah received loans that allowed them to spend, invest in equipment, start businesses, hire, etc. The fractional reserve system enabled credit creation, which in turn sparked growth. So that is the beauty. What about the beast? Say there is an earthquake. You get nervous, so you ask CA Savings for your $1,000 back. Well, they only have $190 of it (10% reserves from the $1,900 in deposits received). They have to call in their loans (and halt any new lending) to meet your withdrawal. This is bad. If the bank is unable to call its loans to meet withdrawals, it may be insolvent. Panic ensues. Credit contracts. The economy slumps. The system can quickly unravel. This is a highly simplified example - closed system, very few depositors and loans - but the basics hold. So you see, the modern fractional reserve banking system is both beauty and beast. It enables the creation of credit, which may drive investment and growth. But it also opens the door to rapid contractions, which tend to be self-fulfilling as panic begets more panic. I was inspired to do this primer after reading a great thread from [@coloradotravis](https://twitter.com/coloradotravis). As he points out, the system relies on banks actually lending. If they aren't lending, dollars are dying. This article is from [Sahil Bloom](https://twitter.com/SahilBloom/status/1288506081455398913) which contains a lot of insights, if you find it helpful please give him a follow. --- *Originally published on [Deep the fuckin Dip](https://paragraph.com/@khangky/deflation-the-eiffel-tower-con-banking)*