The Economic Crisis

This week several Euro countries have been slashed to junk rating, and even Germany was not able to sell about a third of the bonds it offered -- no one was willing to buy them.  A diagnosis at Zero Hedge holds:

Since we have mentioned the “W” word [Weimar], we have an obligation to discuss what strategies best preserved the wealth of German investors during that dark period. (“Life was madness, nightmare, desperation, chaos,” writes Fergusson. We are not quite there yet – but we also note that sensible financial commentators have already begun to refer to Japan as our Weimar in waiting.)

Other, more valuable foreign currencies, for example. In 1923, that meant the US Dollar. This time round, since the Swiss National Bank has lost the plot, we would favour the Canadian and Singapore Dollars. Back then, the answer lay in gold, and we think it does this time, too, as the finest currency protection paper money can buy.

One can also consider gold and silver mining companies – John Hathaway of Tocqueville Asset Management has written very nicely about the “Golden Mulligan” being presented to investors who missed the gold bull on the way up.... 

Yale Economist Robert Shiller has suggested that one of the reasons for equity investors’ irrational exuberance in the 1990s (it was Shiller, and not Greenspan, who coined the phrase) was the fall of the Berlin Wall- which seemed to conclusively display the superiority of western free market capitalism over the discredited Soviet model. 

Now the superiority of the western model is so apparent that we have cash-strapped eurocrats looking to raise money from the Communist leaders of a country, most of whose citizens live in abject poverty. This writer is proud to call himself British; he would be disgusted to be regarded as European.

The two problems at the core of the collapse seem to me to be the idea of monetary manipulation as a way out of the crisis, and the idea of Keynesian stimulus as a way out of the crisis.  The two models are sometimes said to be in competition; in truth, they are mutually-reinforcing points of failure.

The problem is that both of these theories are wrong about the origins of wealth, and how wealth is produced.  Understanding that issue is the beginning of an understanding of how to build a stable system.

In spite of economics' reputation as 'the dismal science' (a nickname, as you recall, that came from Malthus' writings on population growth), it isn't actually a science but an art. In the arts, it is not uncommon to discover that a fashionable idea plays out badly in the end, and older forms are proven to be more valuable than we thought they were when we set them aside.

The problem with monetary theory is that it begins from an assumption that wealth increases as debt increases (because, according to the theory, 'every asset is someone else's liability' -- if I borrow money from you, my debt is a liability of mine and an asset of yours). The debt of the public sector is thus the wealth of the private sector (because we own the bonds). Thus, you can repair the economy by taking on more debt (which increases private wealth, allowing the private sector to stimulate itself by trading debts as if they were wealth).

Wealth doesn't come from debt, and in fact it doesn't come from money. Wealth comes from production -- a fact that Marx understood better than modern economists, with his labor theory of wealth. Marx's problem was that he tried to make labor account for all wealth, whereas in fact it accounts for only some increases in wealth. Marx was smart enough, though, to know that it wasn't money that creates wealth. 

If I have a factory or a farm that is producing wealth for me, I can take on a debt in order to expand my operations. According to monetary theory, wealth is created because I take on a debt to the bank, increasing the bank's wealth. In fact, wealth is being created whether I take on the debt or not -- it is the factory or the farm that is creating the wealth. All the debt does is allow me to expand the wealth-creating instrument faster than I could have done otherwise.

Now, if that is the case, the function of money is not to create wealth, but to serve as a store of value and an accounting mechanism for trade. Proper monetary policy would therefore be to sustain the stability of your store of value, so that trades and debts in that money are stable and reliable for those making such trades or taking on such debts. The political policies associated with such stability are counterindicated by all the best advice of modern economists, and therefore opposed to what the politicians would do if they could come to an agreement.

In America this is sometimes called the 'strong dollar' policy, but actually it's the pre-Federal Reserve policy.  The Federal Reserve was created to stabilize the dollar through monetary policy; instead the banks who lead it have used that as a pretense for profiteering manipulations that have cost the dollar 96% of its purchasing value since the creation of the Fed in 1913.  This is what we would expect to happen if we gave control of our wealth to professional gamblers, and indeed it is just what did happen.

The value of the dollar in terms of what it could purchase, before the Fed, actually was stable.  You can test this assumption with this calculator.  Put in an amount, say $100, with the starting year 1790 and the ending year 1890.  The value in terms of the consumer price index is almost the same.  Now go from 1790 to 1890.  Suddenly it takes over a thousand dollars to equal a hundred dollars in 1790 purchasing power.  

This is one of the three major problems with the global economy.  Once we have a stable currency, we can perhaps address the other two.  The first of these is the unsustainable nature of entitlements, both here and in Europe; and the second is that the modern technological economy has no place for many people who once could be gainfully employed.  (The link is to an optimistic counterargument; the facts regarding unemployment among the unskilled are surely known to all of you reading this page.)

The first two problems are given to conservative solutions; the last one really is not, and will require a new conceptual model from us.  The closest extant one is what the British used to call "outdoor relief," that is, government make-work that uses the unskilled even though it is uneconomic to do so.