The Endgame

May 12, 2016·Alasdair Macleod

And how we got here

There is a growing fear in financial and monetary circles that there is something deeply wrong with the global economy. Publicly, officials and practitioners alike have become confused by policy failures, and privately, occasionally even downright pessimistic, at a loss to see a statist solution. It is hardly exaggerating to say there is a growing feeling of impending doom.

The reason this has happened is that today’s macro-economists are a failure on the one subject about which they profess to be experts: economics. Their policy recommendations have become the opposite from what logic and sound economic theory shows is the true path to economic progress. Progress is not even on their list of objectives, which fortunately for us all happens despite their interventions. The adaptability of humans in their actions has allowed progress to continue, despite all attempts to discredit markets, the clearing centres for the division of labour.

Ill-founded beliefs in the magic of unsound money have been shattered on the altar of experience. Macro-economists are discovering that the failure of monetary and fiscal planning are becoming a policy cul-de-sac that has generated a legacy of unsustainable debt. Those of us aware of a gathering financial crisis are discovering that governments have tamed only the statistics and not what they represent.

There is evidence that central bank intervention began to irrevocably distort markets from 1981, when Paul Volker raised interest rates to halt the slide in the dollar’s purchasing power. It was at that point the free market relationship between the price level and the cost of borrowing changed, evidenced by the failure of Gibson’s paradox. That was the point when central banks wrested control of prices from the market. This is explained more fully below.

The errors have been multiple. In this article I explain how and why they have arisen. This knowledge is the necessary background for an understanding of how the financial and economic crisis that increasing numbers of us expect, is likely to develop, and what action we must take as individuals to protect ourselves.

Markets versus governments
The starting point for today’s errors is the belief that markets sometimes fail, and that monetary and/or fiscal policies can steer markets towards a better outcome. The modern incarnation of this myth started with JM Keynes, who by the mid-thirties believed he had enough cause to overturn Say’s law, or the law of the markets. So the roots of today’s crisis go deep, and originate long before Volcker’s interest rate hike in 1981.

Say’s law states that we produce to consume. Therefore, production is bound tightly to consumption, including deferred consumption, otherwise known as savings. And if someone consumes without producing, someone else has to produce the wherewithal. The medium of exchange that translates wages and profits arising from production into consumption is money, so we can say without contradiction that money represents the temporary storage of the profit from production, or ordinary people’s labour. It is an iron law, which invites trouble for any attempt to stimulate consumption.

There can be no net stimulation into the private sector economy by the state, because everything has to be paid for, one way or another. For simplicity, we will disregard cross-border government subsidies, such as foreign aid. When a government pays benefits to a group of individuals, it either borrows the money from someone else, or alternatively it creates the money out of thin air. In the latter case, the benefit payments are covered by the debasement of the existing money stock, which is a hidden tax on everyone else’s money. To argue otherwise, as do those who deny Say’s law, is a fallacy that relies on a concept of financial perpetual motion.

Keynes’s motivation was partly driven by his belief in the honest intentions of democratic government, and as we can glean from his writings, his emotional dislike of savers, the usurious rentiers who rake in interest without soiling their hands through honest work. In his General Theory, the first major work after Keynes was confident he had dispatched Say’s law to oblivion, he expressed his hope for the gradual euthanasia of the rentier, and that capital would be increased by communal saving through the agency of the State, so that it would no longer be scarce. The term, rentier, is itself a put-down in English, suggesting usurious lending. Keynes hoped that entrepreneurs, “who are certainly so fond of their craft that their labour could be obtained much cheaper than at present”, would be harnessed to the service of the community on reasonable terms of reward.

His General Theory is proof that Keynes despised markets, and did not understand prices (see Chapter 21). With his ignorance of this most fundamental element of economics and all the other half-truths that follow, the true purpose of this propaganda is revealed: the justification for state intervention and the end of free markets. It is a thoroughly bad book, yet it has become the bedrock of mainstream economics today, even for those who deny being Keynesians.

Upon this unsound basis, layer upon layer of further untruths have been built. When an economist conjures up a course of action based on these fairy-tales, the honest critic is at a loss where to start, because the thread of errors leading to the economist’s judgement has become so long and convoluted. Few are prepared to listen to a lengthy critique on this matter, so it is far easier for the layman and politician alike to assume that a scion of Oxford and Harvard must know what he is talking about.

It’s both the line of least resistance, and a cop-out. The language of modern economics takes us in so completely, we often don’t realise we ourselves perpetuate the mistakes. It is time for those who wish to understand the seriousness of these cumulative errors to draw a line, and to face up to them, because to not do so could be very expensive for those with assets to protect.

The root of the problem is in a misunderstanding of the nature of economics itself, and in the application of modern analytics.

The analytical mistake
The misuse of statistical information is a great evil, which has become increasingly prevalent over the years, taking a great leap forward in its destructive force with the development of computers. Computers are a wonderful facility, but they have come to replace soundly reasoned theory by advancing the role of inappropriate statistics, and their supposed mathematical relationships.

Mathematics is appropriate for the physical sciences, but wholly inappropriate for social sciences, such as economics. Maths has an important role in business: there is an essential role in book-keeping as a means of measuring any enterprise’s progress. But it is another thing entirely to attempt to banish the uncertainties inherent in future human action by mathematical means. A businessman who fails to distinguish between mathematics as an accounting tool and its lack of predictive value will not remain in business for long. Yet there is no limitation, seemingly, on the employment of mathematics in the less certain world of a national economy.

The mistakes, while subtle, are at least threefold.

Even if the capture of economic activity is total and correct at a past moment in time (which it never can be), it cannot be valid thereafter, because economic activity continually evolves. No economy statically churns on an unchanging basis. The information gathered by econometricians is not only incorrect thereafter, but it misleads state planners into believing they have the evidence to manage economic activity. Misused aggregates such as gross domestic product are just accounting identities, and not the measure of progress that so many believe.

Statistics are continually amended to show monetary and fiscal policies in the best possible light. Price inflation and unemployment numbers have evolved to the point where they do not reflect reality, yet because they are issued by a government department, they retain credibility. The result is the statistics have themselves been tamed, not what they represent.

Meaningless averages are routinely invoked as evidence to support state intervention and planning. Thus, the CPI’s “basket of goods”, and an “average wage” are not connected to reality and conceal the fact that economic actors are individuals with diverse needs and wants. Averages should not be used as analytical tools upon which to base monetary and fiscal policy.

It was George Canning, nearly two centuries ago, who said he could prove anything with statistics, except the truth. The attraction statistics confers for the slow-witted analyst is they avoid him having to apply original thought. It means he or she never feels the need to consider the underlying motivations of economic actors.

A good example of this error is contained in the Barsky and Summers attempt, published in The Journal of Political Economy in 1988, to explain Gibson’s paradox . Gibson’s paradox is the observed correlation between the price level and wholesale borrowing costs, and the lack of correlation between borrowing costs and the rate of inflation. The relationship came to an end in the late seventies in the UK, where it was statistically observed from 1730 onwards. Barsky & Summers incorrectly assumed it was a phenomenon of the gold standard, and then used a mathematical model of their devising to arrive at a partial conclusion, which they admitted would require further research. In other words, their method led them into a blind alley.

To be fair to Barsky and Summers, they are not the only high-flying economists who have failed to explain Gibson’s paradox. It was so named by Keynes after an earlier economist, and he also failed to resolve it. The evidence was plain and simple, but being unresolved Keynes simply dismissed it and its important implications as well. Milton Friedman also failed.

By putting myself in the shoes of an entrepreneurial businessman looking to finance his production, I found the paradox was easy to resolve and explain. The businessman’s calculation is comprised of the difference between his costs of production and the selling price for his product. What does he know of the prospective selling price? He knows what similar items sell for in the current market, and it is that that sets the level of interest he is prepared to pay to finance his production. That is why interest rates correlated with the price level, and not the rate of inflation, for the two hundred years in the original study by Alfred Gibson.

Unfortunately, this cuts across the cherished beliefs of monetary economists, who believe in the control of economic activity by managing interest rates and the expansion of the quantity of money and bank credit. For monetary policy to be valid, there must be a positive correlation between price inflation and interest rates, which Gibson’s paradox demonstrated was not true. I would also postulate that Keynes was not temperamentally inclined to understand the solution to Gibson’s paradox, because he cherished the belief that it is idle rentiers who demand usurious rates of interest and set them, not the borrower with his calculation of an investment return.

This is why it is vital to understand the motivations of economic actors, and to not hide behind the sterile world of ivory-tower mathematics. But we have become so used to statistical modelling, that even some followers of Say’s law are subverted. The confusion of accounting identities such as GDP with the indeterminate concept of economic growth is a case in point. And many are the times we read the writings of economists, who take dodgy statistics, and use them as the basis for an equation between disparate elements to create a relationship where none actually exists. You cannot say apples are pears, but you can say they are different. You can turn apples equals pears into an equation, if you introduce a factor that always represents the difference between the two. Nonsense, of course, but this is what economists routinely do.

A prime example is the fallacy of the velocity of money. The assumption is that a change in the quantity of money will change the level of prices. So, ∆m~∆p. But, it was found to the inconvenience of monetarists from David Ricardo onwards that prices p varied independently from the money quantity m, particularly in periods of less than an indeterminate long run. Therefore, the equation was modified to include another variable, dubbed the velocity of circulation to give it meaning, and it became the basis of Irving Fisher’s equation of exchange,


where M is the total amount of money in circulation, V is its velocity of circulation, P is the price level, and Q is an index of final expenditures. Presented like this, we are drawn into believing that the concept of money going round and round the economy is a concept with meaning. It is not. It has no more meaning than the interposition of a variable to make an equation between apples and pears balance.

Not once does the monetary economist stop to think that everything an individual makes from his production, besides a necessary cash float, is consumed, either today or at some time in the future. What matters is not the size of an individual’s cash balance, but the profit from his labour. That is the Say’s law relationship, denied by the monetarist.
Ignorance in academic circles over price theory, which after all is the bedrock of economics, is staggering. It is as if Carl Menger, who convincingly proved the full subjectivity of prices back in the 1870s, never existed. This is despite the fact that for all of us the exchange of the fruits of our labour, in the form of money, for the things we individually decide we want, is our most important daily activity.

We also ignore the fact that there are two variables in any price, changes that emanate from the goods or services being exchanged, and that of money itself. We are all aware of changes that emanate from goods and services. But few of us are aware that changes can also emanate from the money side as well. There is a reason for this. The role of money, traditionally sound money, is for it to be taken for granted. It allows us to value diverse products, and to account for our own production. It acts as the objective exchange value in a transaction. However, the purchasing power of money is never a constant and continually varies, the more so when it is unsound. So, the default assumption that all price moves come from the goods and services being bought and sold, is incorrect.

In the old days of sound money, when gold was freely exchangeable for paper currency, price movement from the currency side was fairly minor, even over prolonged periods of time. But in today’s paradigm of fiat monetary debasement, the movement can be considerable. Consider a situation where personal preferences for holding currency a shift towards zero. The price of a good which does not move when measured in a stable currency b, will shift so that the price measured in currency a tends towards infinity. We recognise this phenomenon when talking about Zimbabwean dollars, or Venezuelan bolivars, but our minds refuse to admit to the same dynamics operating for the dollar and the other major currencies used by advanced westerners.

Changing values for the currency may not be noticed much day-to-day, but they do interfere with annual comparisons, because the currency’s purchasing-power last year differs from this year’s. Neither does the law recognise any variance in a fiat currency’s purchasing power, a fact which central banks exploit to the full.

Central banks print money, and they license the banks to loan credit into existence. By ignoring Say’s law, they think they can stimulate demand by cheapening and expanding credit. For a time, this trick fools people, but repeated often enough they begin to lose confidence in the currency and alter their preferences against holding it, so its purchasing power declines.

The rate at which an inflating currency’s purchasing power declines varies from product to product, depending where the increase is applied. Since the financial crisis of 2007/08, it has been obvious that prices of financial assets have seen the bulk of monetary inflation applied to them, and prices of bonds and other securities have risen accordingly. The prices of ordinary goods and services have risen considerably less, but it is arguable how much. The officially tamed CPI has consistently recorded price inflation to be well below the Fed’s target in recent years, yet independent calculations, such as the Chapwood Index, records price inflation at about 9%. We cannot take any of these averages too seriously for the reasons mentioned above, other than to observe that price rises on Main Street appear to be significantly higher than state-sponsored econometricians tell us.

The monetary link between prices and the quantity of money is tenuous at best, and takes no account of intertemporal factors, such as where monetary expansion is initially applied. There is little attempt to understand the implications of changing preferences for money relative to goods. It is easy to see why not only the evidence, but also sound economic reasoning, warns us that modern macroeconomists, in their desire to do away with the law of the markets, have led us to the brink of financial ruin. What is surprising is economies have survived this persistent meddling based on inappropriate information for so long, but that is explained by the extraordinary capacity of human action to adjust to and accommodate government intervention.

The Consequences
The endgame is now shaping up. Central banks have progressively tightened their grip on markets since Paul Volcker took control of markets by jacking up interest rates in 1981. It was at about that time Gibson’s paradox failed. The result is that debt-driven activity, encouraged by falling nominal interest rates, replaced the market-driven activity demonstrated by Gibson’s paradox over the previous 250 years.

There are limits to excessive debt, and financial analysts are about to find out that the old adage, markets always win out in the end, is still true. The dominant market risk is over-valued government bonds, from which all other financial asset valuations flow. Therefore, a large enough rise in government bond yields is likely to create a systemic crisis in the banking system, which depends on these assets for loan collateral. The most vulnerable banks are in the Eurozone, where bond markets are at their most over-priced, and the banks most highly geared.

When yields on government bonds rise above an as yet unknown level, central banks will have a decision to take. Are they prepared to support the entire financial system at the ultimate expense of their currencies, or do they preserve the currency? The choice has become that binary, and any fudging of this choice is unlikely to prolong the survival of the global financial system.

When things have become this delicate, anything from Greece’s debt negotiations, Italian banking insolvencies, trouble in the physical gold market, or even just a bad statistic somewhere can act as a trigger. Brexit would certainly undermine European cohesion with potentially destabilising results, which doubtless is why all the great and the good are imploring the British electorate to vote to remain in. So far, central banks have been deferring all these problems successfully, so it will probably take something else to trigger the endgame.

A likely culprit is the accumulating effect of monetary debasement on the finances of ordinary people. Monetary inflation transfers wealth from savers to debtors, debtors who then generally invest it inefficiently. Government spending, financed by high taxes, also destroys private wealth. Monetary inflation reduces the purchasing power of ordinary people’s wages as well, an effect which limits their ability to consume. Governments of advanced nations are simply running out of their citizens’ wealth.

The transfer of wealth through monetary inflation is the unrecorded burden borne by the ordinary person. There is little doubt that it has affected the GDP number, which so far has shown disappointing growth in the majority of advanced nations. However, it has held up sufficiently to fool mathematical economists that there is no crisis, only disappointing growth. It bears repeating that GDP is only an accounting identity, which is increased by monetary inflation. Any offset by a price inflation deflator tends to lag the statistic, and given government desires to suppress recorded inflation, is calculated inadequately. Indeed, if one accepts that price inflation is actually far higher than that indicated by official measures of price inflation, adjusted GDP estimates in real terms have been contracting in most advanced nations ever since the financial crisis.

The situation in Japan and the Eurozone is worse than in the US, and the destruction of private wealth has been more aggressive. The paradox is that temporarily, the yen and the euro are strong, but that is unlikely to last. The reason the yen and the euro are strong is that liquidity in the shadow banking system is being squeezed by central bank purchases of government bonds, leading to an increase in cash demand as positions financed in these currencies are unwound.

The legacy of monetary and credit expansion since the financial crisis has actually led to a greater overall preference for holding money relative to buying goods. This is reflected in the increase in the level of bank deposits and checking accounts, the counterpart to the expansion of bank credit. In the US alone, bank deposits and checking accounts have increased from $2.33 trillion in July 2008, just before the Lehman collapse, to $10.17 trillion today, an increase of 336%, compared with an increase in official GDP of only 22% for the whole period.

The accumulation of this money is in fickle hands, being for the most part financial. It is what used to be called hot money. Having pumped up these hot money totals, central banks have been trying to bottle them up as bank deposits, so that in aggregate, there is no escape route from zero and negative interest rates, and also in the hope that financial stability will be maintained during the implementation of further “extraordinary measures”.

This raises a question, which no one appears to have seriously considered: what happens, when bank depositors stop increasing their preference for money relative to goods or assets, and begin to reduce it instead? The only outcome can be an unexpectedly sharp increase in the prices of whatever goods and assets the money is exchanged for, because sellers of currency will by far outweigh the buyers. In the past there has always been an escape route for investors from this problem, such as exchanging Argentinian pesos for dollars. This time it is the dollar itself, with all the other major currencies tied to it.

It is already leading to a financial move into commodities and raw materials, which started last December. Some key commodities, most notably oil, have risen in price substantially as a result. Sellers of dollars so far have been foreign governments, particularly the Chinese, and speculative traders. But the conditions driving relative preferences against currencies seem set to accelerate. Core inflation in America is already above the Fed’s target, and almost certain to go higher, so unless the Fed starts to raise the Fed funds rate soon and significantly, the pace of the fall in purchasing power for the dollar will almost certainly increase. That binary choice, to save the system or the currency, is looming.

Unfortunately, both the damage earlier monetary policies inflicted on the masses’ wealth, as well as the encouragement to the accumulation of unproductive debt by both private and public sectors, have between them eliminated the central banks’ room for manoeuvre. The introduction of a trend of rising interest rates, however moderate, will undermine overvalued bond markets, in turn triggering a new wave of debt liquidation by weaker borrowers. These are financial stresses that the Eurozone banks are particularly ill equipped to survive. They are so poorly capitalised and over-exposed to outrageously expensive Eurozone government bonds, it cannot be denied they are already an alarming systemic risk, even without a rise in interest rates.

The difference between today’s impending financial crisis and the last one is that the last one drove the ordinary public away from the uncertainty of financial commitments into a preference for monetary liquidity. This time, low wage earners and small savers will probably react the same way, at least initially. But the wealthier savers and speculators now dominate the system. They have been accumulating deposits and checking account balances since 2008, and are exposed to bank counterparty risk, a point which they will quickly understand if things start sliding. Therefore, fiat currency held in the banking system is the one asset corporations, investors and the rich will most likely seek to ditch in the coming months. Their preferences will work against not only the dollar, but all other currencies as well.

In short, growing evidence of price inflation and stagnant production can be expected to materially increase the risk of a global banking and currency meltdown. The best escape-route is ownership of anything other than purely financial assets and fiat currency deposits. No wonder the price of gold, which is the soundest of moneys, appears to have entered a new bull market.

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