Class Activity Macroeconomics

May 10, 2023

Money in a Prisoner-of-War Camp

Among the Allied soldiers liberated from German prisoner-of-war (POW) camps at the end of World War
II was a young man named R. A. Radford. Radford had been trained in economics, and shortly after his
return home he published an article entitled “The Economic Organisation of a POW Camp.”* This article,
a minor classic in the economics literature, is a fascinating account of the daily lives of soldiers in several
POW camps. It focuses particularly on the primitive “economies” that grew up spontaneously in the
camps.

The scope for economic behavior in a POW camp might seem severely limited, and to a degree that’s so.
There was little production of goods within the camps, although there was some trade in services, such
as laundry or tailoring services and even portraiture. However, prisoners were allowed to move around
freely within the compound, and they actively traded goods obtained from the Red Cross, the Germans,
and other sources. Among the commodities exchanged were tinned milk, jam, butter, biscuits, chocolate,
sugar, clothing, and toilet articles. In one particular camp, which at various times had up to fifty thousand
prisoners of many nationalities, active trading centers were run entirely by the prisoners.

A key practical issue was how to organize the trading. At first, the camp economies used barter, but it
proved to be slow and inefficient. Then the prisoners hit on the idea of using cigarettes as money. Soon
prices of all goods were quoted in terms of cigarettes, and cigarettes were accepted as payment for any
good or service. Even nonsmoking prisoners would happily accept cigarettes as payment, because they
knew that they could easily trade the cigarettes for other things they wanted. The use of cigarette money
greatly simplified the problem of making trades and helped the camp economy function much more
smoothly.

Why were cigarettes, rather than some other commodity, used as money by the POWs? Cigarettes
satisfied a number of criteria for a good money: A cigarette is a fairly standardized commodity whose
value was easy for both buyers and sellers to ascertain. An individual cigarette is low enough in value that
making “change” wasn’t a problem. Cigarettes are portable, are easily passed from hand to hand, and
don’t spoil quickly.

A drawback was that, as a commodity money (a form of money with an alternative use), cigarette money
had a resource cost: Cigarettes that were being used as money could not simultaneously be smoked. In
the same way, the traditional use of gold and silver as money was costly in that it diverted these metals
from alternative uses.

The use of cigarettes as money isn’t restricted to POW camps. Just before the collapse of communism in
Eastern Europe, cigarette money reportedly was used in Romania and other countries instead of the
nearly worthless official money.
Class Activity Macroeconomics
May 10, 2023

The Housing Crisis That Began in 2007

U.S. households gained a tremendous amount of wealth in their houses throughout the late 1990s and
early 2000s. The housing market was booming and the homeownership rate rose to a record level of 68.6
percent of households by 2007. But as people became more and more convinced that housing was a “can’t
miss” investment and housing prices spiraled ever upwards, mortgage lenders and homeowners began to
make some serious mistakes, which would lead to a major financial crisis.

As housing prices moved higher and higher in the early 2000s, many people found themselves unable to
afford to buy a home, because the monthly mortgage payments would have been too high relative to
their monthly incomes.

Specifically, the lending standards of mortgage lenders required that borrowers have sufficient monthly
income so that the monthly mortgage payment would not exceed a specified percentage of monthly
income. But as housing prices increased rapidly, mortgage lenders began making loans to people who did
not meet the lending standards. These people were known as subprime borrowers.

The subprime mortgage market grew rapidly. To compensate the lenders for the additional risk and
potential costs of lending to subprime borrowers, the interest rate on subprime mortgages was higher
than the interest rate on conventional or prime mortgages. In many cases, subprime lenders even
dispensed with the usual income verification of borrowers, thereby further subjecting themselves to the
risk that the borrowers would not be able to repay. In addition, some loans had creative features that
gave the appearance that the borrower could afford to make the monthly payments—at least for a while.
For instance, most subprime loans were adjustable-rate loans with a low initial interest rate that would
increase after two or three years in a process known as mortgage reset.

Why were lenders willing to offer these risky loans to subprime borrowers, and why were borrowers
willing to take on these risky obligations? To a large degree, the answer is that they expected house prices
to continue to rise rapidly for the foreseeable future. As long as house prices kept rising substantially, a
borrower who might otherwise have trouble making mortgage payments in the future could either sell
the house for a profit and pay off the mortgage or could borrow against the house’s equity value, which
would be higher as house prices increased further. So, both borrowers and lenders thought they were
insulated from risk.

The problem with subprime mortgages is that the borrower and lender are insulated from risk only as
long as house prices continue to rise substantially. In 2005, as mortgage interest rates across the country
began to rise, the rate of increase of house prices began to slow. In 2006, defaults on subprime mortgages
began to increase, as borrowers who had counted on rapidly rising house prices to bail them out found
that their houses were not worth as much as they expected. In addition, as mortgage resets began to set
in at higher interest rates, more and more borrowers could no longer make their monthly mortgage
payments and began to default on their mortgages. And as defaults began to occur in increasing numbers,
banks started to tighten their lending standards, so that by mid-2007, they were making few if any
subprime mortgage loans. But that, in turn, reduced the demand for houses, thus causing the increase in
housing prices to be even smaller. House prices even began to decline in some areas of the country in
2007 and by 2008 began to fall for the nation as a whole, as shown in Figure 7.1.
Class Activity Macroeconomics
May 10, 2023

Falling house prices caused a variety of problems, at both the micro level and macro level. Thousands of
households that had bought houses with subprime mortgages lost their homes through foreclosure when
they could not make their mortgage payments. Homeowners often found themselves owning homes
whose value had fallen far below the amount they owed on their mortgage loans (a situation that came
to be known as “underwater”), giving them the incentive to stop making mortgage payments and allow
their homes to be repossessed. Financial institutions lost billions of dollars on such deals because they
owned the rights to the mortgage payments, which would no longer occur. Since house prices had fallen,
whoever came to own the house, usually a bank, would usually have to sell it for much less than the
outstanding mortgage balance.

But what surprised many people about the problems in the mortgage market is that the impact was felt
even more broadly. It turns out that most banks had sold bundles of their mortgages in the form of
mortgage-backed securities (MBSs), and investors in MBSs suffered large losses. Once the losses began to
materialize, investors all at once tried to bail out of such investments, driving their prices to very low
levels. This, in turn, led to the financial crisis of 2008, when investors began to realize that many financial
institutions had lost hundreds of billions of dollars through mortgage-related securities. Panic ensued,
stock prices fell dramatically, especially for financial firms, and the government and Federal Reserve bailed
out many financial firms, as we describe in more detail in the Application “The Financial Crisis of 2008,”
Class Activity Macroeconomics
May 10, 2023

Question 1:

Since there were so many option to be used as money but why were cigarettes, rather than some other
commodity, used as money by the POWs?

Question 2:

How inverters came out of the housing crisis?