Bailing out the Titanic with a thimble..

I have recently been hatching a new theory...

Steve keen has likened the process of attempting to keep up the money supply to bailing out the titanic with a thimble. This is part of his argument for massive deflation.

Well I'm not so sure about it being the titanic that needs to be bailed out. And I'll illustrate it with a thought experiment. Imagine a simple primitive society with no banking, only gold coins used for exchange. People in this society spend their money on one of two things 1. Food. 2. Diamonds. The food they eat and the diamonds they like to wear as jewellery. They can make all the food they need with relative ease and so on average, on any given day, 90% of the coins in existence change hands diamond trading and only 10% change hands trading food. Now one day, God is looking down on this land and decides to do a monetary experiment on the people. He suddenly makes all the diamonds disappear, and at the same time makes 90% of the coins disappear (he does this evenly over the entire population in proportion to how many coins each person had in the first place). God then wonders, what will happen to the price of food? I suggest that the answer just may be "noting at all". The money supply might have shrunk by a factor of ten, but then the stuff they spend their money on has correspondingly shrunk at the same time.

Now I know that this fairy tale may have all sorts of problems with it in the details, but I just wonder if this type of phenomena might be going on to some degree in the real world right now. Maybe the diamonds could correspond to some types of (that mountain of) derivatives that have gone out of fashion. If this is the case then the reduction in some countries money supply may just be "diamonds and coins" disappearing at the same time, leaving the money available for the "food" (or should I say "everything else which are not derivatives") relatively unaltered. Well at least not nearly as altered as the reduction in overall money supply would suggest.

If I'm right then you may see the price of goods in the shops rise while the money supply shrinks... Come to think of it I don't know whether that scenario would be called inflation or deflation.... maybe there's no term for it. Perhaps it just needs to be called prices-rising-while-money-supply-shrinks.