Hindsight can at times be rewarding even though one may not benefit from it.
When I began this blog, one of the first essays I wrote was: “Background of my contention – the how and why“. This piece was partly a venting exercise partly an honest explanation of how I arrived at the very personal conclusion that we are being set up for a world war. In this piece also, I state that I had already predicted doom once in the lead up to the Millennium and that, apparently, I had been wrong.
Today, in hindsight, I can say that I was certainly wrong. Nonetheless, I wasn’t wrong in the essence of my prediction as much as on the time line and the quality of the dynamic.
Ten years on, I am somewhat more informed on a number of aspects of the political and economic dynamics that I really was not aware of back then. First and foremost, “doom” is not an event. This is not something like the earth being struck by a meteorite bringing sudden total devastation. What I failed to realize then was that “doom” as I meant it, that is, a decline in wealth, breakdown of social order and, eventually, a world war, is a process. Granted, back then my construct did not contemplate a world war but I could see that a number of segments of society were being inexorably squeezed financially (very often willingly) and, for the life of me, I could not see the logic in the attitude of government nor, indeed, in the attitude of individuals.
Today, I am rather proud to show off this graph:
That is a chart of the S&P going back to 1980. It is a “relative” chart as opposed to a “nominal” chart. The nominal chart looks like this:
To understand the difference between the two charts and to understand the importance of the first chart, you must have a grasp of our monetary system.
If you’ve read some of the posts on this blog, my pet peeve is our monetary system. Globally today, we are all pretty much on what is known as a Fiat Monetary System. The defining characteristic of fiat currencies is that the value of each currency is predicated on the value of all the other currencies instead than on the intrinsic value that is related to the economy.
Very briefly, we only really have three choices in life. We can barter, we can adopt a monetary system that is based on some sort of intrinsic value (i.e. in ancient times they used salt, gold, silver or copper) or we can adopt a “fiat” monetary system.
Barter works fine but is too slow, too cumbersome and not flexible.
Value based money is great but is too slow. That is because as the economy expands the monetary base should expand too. But in a value based monetary system, you must locate, extract, convey, refine and distribute more ore before you can expand the money base. Hence the cost and time hurdles.
Fiat money is a fantastic concept. A fiat monetary system has no apparent material cost and certainly no temporal constraints because the money is created as needed by political mandate. In theory, fiat money could allow government to expand or contract the monetary base in real time as dictated by economic conditions. The concept is truly revolutionary and could be very efficient…
… if it weren’t for politics… to be exact, if it weren’t for Democracy…
The combination of fiat money and Democracy virtually guarantees that the monetary base will never be reduced regardless of economic conditions. Thus, in a fiat monetary system, inflation, defined as an increase in credit and money, is guaranteed.
And that’s where the cookie crumbles.
By adopting a fiat monetary system, government implicitly chooses to push inflation faster than underlying economic growth. If that were not the case, then we could very safely make do with a value based monetary system.
However, inflation is a devious beast. Inflation is exponential in nature and limited mathematically. Exponential because you need progressively greater degrees of inflation to obtain the same result (GDP growth) and limited because once the inflation component of GDP outstrips wealth creation, real wealth declines in aggregate until even the geometric expansion of inflation no longer has an effect on the expansion of GDP.
Thus, as government artificially pushes inflation into the system, not only does real wealth diminish but the credit markets expand accordingly. The consequence is that real (i.e. intrinsic) value gradually loses ground to “financial” value. The point at which underlying economic activity or intrinsic value no longer suffice to service the interest on the debt, that is the point at which inflation can no longer be expanded.
To see whether inflation is a deliberate policy of state, we can look at interest rates. Like the choice of monetary system, the power to set interest rates in the USA is given to an independent entity that acts unilaterally and arbitrarily; that is, the Federal Reserve sets interest rates as it sees fit. Manipulating interest rates is the most basic way to induce inflation in a monetary system. The next graph shows the interest rate trend for the past 30 years:
There you have it. The US government has deliberately and artificially induced inflation into the system. For more on this dynamic, you can look up this previous post
So now, why is the first chart above so important.
We’ve established and proved that by choosing a fiat monetary system government chooses, all be it unwittingly by and large, to push inflation faster than economic growth (GDP).
What remains to be proven is whether inflation can be infinite or not.
Economic thought and theory of the past century have been predominantly Keynesian and advocate just that; there is no limit to the quantity of inflation that can be induced by the monetary authorities.
However, if that were the case, then one would expect a degree of direct correlation between inflation and GDP growth. In other words, if truly the effect of inflation could be infinite, then we would expect that a constant rate of credit and money expansion would always correspond to the same rate of GDP growth. Let’s see:
This graph portrays the expansion of Government debt since 1980
This graph portrays the expansion of individual household debt since 1980
By my count, since 1980 government debt has expanded from roughly US$1Trillion to about US$12Trillion or an increase of well over 1000% – during the same period of time, household debt has increased from about US$1Trillion to about US$14Trillion or an increase of well over 1200%
So, since 1980, government and household debt has increased from about US$2Trillion to, at the peak a few months back, US$25Trillion… or an increase of about 1250% combined.
And what, you may ask, did we get for our very notable effort?
Since 1980, GDP has expanded from about US$6Trillion to about US$14Trillion…. or, by my count… drum roll… an increase of just over 100%
What???? … Surely, you may think, we have saved the rest?
Let’s see what government data says about what has been saved in the graph below:
And there you have it. As interest rates are manipulated lower, the government deliberately induces us to spend money first by using our savings then by taking on debt.
We have now objectively established that opting for a fiat monetary system is inherently and by necessity inflationary AND we have demonstrated how you always need greater degrees of inflation in order to induce the same rate of GDP growth.
Lets turn back to the first chart and let me tell you why it is so important.
Inflation induces an increase in the monetary price of goods and services hence of GDP. The inflation component of GDP progression is not due to an increase in productivity or intrinsic quality or tangible wealth; it is purely a financial phenomenon i.e. you devalue the currency so you increase the monetary price of goods or services.
Progressively greater degrees of inflation over decades also stimulate credit growth.
The trouble is that credit requires collateral; real intrinsically valuable collateral.
At the start of the cycle households and corporations pledge progressively all intrinsically valuable collateral. When that’s done, the financial sector has to come up with creative ways to keep extending credit to society. This is the point at which inflation begins to crop up in fewer and fewer sectors of the economy and, as the dynamic progresses towards its logical end, will be found mostly in the stock market and financial sector.
This is the point at which financial value begins to outstrip “real” value. A case in point of this dynamic is the alphabet soup of derivatives tied to the real estate market. The RE bubble was one of the last bubbles of the inflationary dynamic. When the RE sector started catching fire, real assets had already been pledged or destroyed since a long time. Thus, the RE bubble really got going on purely financial gimmickry where mortgages worth $1 gave rise to CDOs or MBSs worth $30, 40, 50 and in some cases $80 (i.e. Fannie Mae).
But gimmickry still needs a return on investment. Thus, you can only push gimmickry for as long as you can service the debt it depends upon. The moment the underlying economy no longer generates sufficient income to service the debt, the gimmicks have to be unwound.
And this is where people and corporations have been caught short.
Thanks to excessively inflationary policies and willful disregard of regulation, the gimmicks have gone on far too long and have generated financial value worth several orders of magnitude the underlying wealth. The BIS in its June 2009 biannual report estimates that total outstanding derivatives are worth US$500Trillion… that’s FIVE HUNDRED TRILLION DOLLARS worth of gimmickry as opposed to a world economy estimated at US$50Trillion and dropping very fast.
As far as I am concerned, this is the limit of the inflationary dynamic.
The reason the first chart is important is that it shows how disproportionate financial value as represented by the S&P has gone compared to real intrinsic value as represented by gold.
Was I wrong to predict doom in 2000? Yes I was in the sense that at the time I expected a quick degradation of social and economic conditions. But I was not wrong in the sense that it truly was the turning point that tipped us in what I think is going to be a dark age for civilization that will very likely take us into a world war.
A final observation. Emerging from WWII as victors and as the only country with any manufacturing capacity left standing, the USA were able to put their excess industrial capacity to rebuild global infrastructure thus taking care of one of the problems that caused the great depression in the first place. As the USA than went on to push still greater amounts of inflation into the US Dollar monetary system, by the late 60s their currency hit the buffers. Once again, as the instigators of the Marshall plan and as the then hegemon, the USA were able to sweep under the carpet their monetary problems by convincing other nations to abandon gold as reserve asset in favor of the US currency. In fact, still today, the US$ is is the reserve currency and the currency used in most transactions.