What is going on?

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John Gall, in his terrifying systems engineering book The Systems Bible, offers a breakthrough insight: “All over the world, in great metropolitan centers as well as in the remotest rural backwaters, in sophisticated electronics laboratories and in dingy clerical offices, people everywhere are struggling with a Problem: THINGS AREN’T WORKING VERY WELL”.

This is true in Western economies more than, alas I must say, people realise.

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Unintended Consequences

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Energy is wealth. The Egyptians, following this near economic axiom, built the Aswan Dam in the 1960s to generate electricity to aid the poverty stricken Egyptians living in the region - most of whom were farmers, who made the little money they did by working the rich fertilised land on the banks of the River Nile. The key to the agrarian productivity of this region was the alluvial fertiliser that the Nile deposited annually on its floodplains. Regretfully, I must say, the policy makers sat in their 'dingy clerical offices' in Cairo did not realise that the building of the dam stopped the flow of sediment downriver - the sediment that annually fertilised the fields of the farmers. Crop yields, naturally, were sharply affected. To remedy this, that is, to replace the loss of natural alluvial fertiliser, synthetic fertiliser factories were built around the Aswan dam. Unfortunately, these new factories, built to merely replace the loss of natural fertiliser as a consequence of the construction of Aswan dam itself, required the entire electricity generation capacity of the Aswan dam. You would have thought this would have been noticed prior to construction, unfortunately, as Gall explains, reality is often more complex than it seems. The attempt to shape reality with reason when one yet understands reality could result in a nasty fright. Wanting to do good is different from doing good. Doctor's have a term for it - 'iatrogenic', meaning it is the medicine that worsens or in fact causes the disease.

This idea, in realm of economics and public policy, namely, to be humble in the face of complex systems, was argued most vehemently by Ludwig von Mises (1881-1973) and Friedrich Hayek (1899-1992) in the 20th century.

Mises and Hayek argued, put simply, that once you begin interventionist policy, the economic system becomes distorted and the system unbalances, causing unexpected second, third, forth and so on, order effects. This is when the all-important decision arises. This decision is A) realise your mistake and curtail your attempt to intervene in economic activity or B) try and control the second order effect your original control produced. Plan B, however, produces the infamous Hydra problem, which can best be explained with the Americans' experience in Vietnam, namely, that when the American's killed one Viet Cong, two more joined the North Vietnamese in outrage. What can follow, if Plan B is chosen, is a feedback loop of increased interventionist policies that, if never repealed, can only culminate into complete economic destruction. We in the West are far, far from such a situation, yet the symptoms of this economic sickness are present everywhere one looks. Socio-Economic systems are container ships, to avoid an ice-berg, you have to change course miles in advance.

Ludwig von Mises, offering his theory of the business cycle to those who would wish to manipulate money and credit, is akin to the geologist humbly warning Egyptian President Nasser that it may be unwise to build a dam upstream of a large population of farmers. Mises warned that it may be unwise to manipulate the pricing system by inflating the money supply. Mises’ theory, now known as the Austrian theory of the business cycle (ATBC), explains why the frequency and severity of economic and financial crises has increased, it explains why the money supply has increased at a faster, and faster, rate, it explains why wealth inequality has increased, it explains why real wages are being squeezed, it explains why geo-political tensions are rising. As this is the case, I argue it is is one of the most important theories to understand in the world today.

Systems, small, large and colossal, protect themselves. Some call it mother nature; others, God; others, individual responsibility. I say these are all the same thing. Whatever it is that moves the needle, systems clear themselves of that which will harm them, of rot, of weakness. If they don’t, they die. Micro-biologists call it phagocytosis. Darwin called it evolution. Economists call it profit and loss.

There always exists rot in economies - unproductive capital, failing businesses, ruined factories etc (not forgetting bad chefs). The issue is whether the rot is growing or not. Today, Western Economies are highly indebted (both sovereign and private), highly fragile, and inflationary, as well as caught in a constant cycle of boom and bust. Is the business cycle, and the aforementioned economic ills, normal? Is it inherent to capitalism? Mises argued it certainly is not. Instead, the business cycle (recessions) are caused only by governmental manipulation of the money relation, in other words, recessions are alone caused by the distortion of relative prices and the structure of production by the creation of money. We, then, can now understand why we have a seemingly never ending cycle, because the medicine policy makers apply to a sick economy, namely, counter-cyclical monetary policy, is the cause of the disease - to borrow the technical term from medicine defined above, monetary policy is iatrogenic.

John Maynard Keynes threw out any attempt to seriously understand why the recession occurred in the first place, partly because he could not read the cutting edge of economic science (happening in the German and Swedish languages in the late 19th and early 20th century). Keynes rather posed the question, how do we get out of one? By doing this, Keynes regressed economics by 100 years - if not more. Famously, Nobel Prize Winner F. A Hayek, a friend of Keynes', said that Keynes knew "very, very little economics", and, when Hayek told Keynes of his similarity to the theories espoused 18th century economists, Hayek said Keynes had never even heard of them, let alone read them.

On the issue of recessions, Mises and Hayek, instead, asked, why is it that the recession occurred in the first place? Mises understood that only by working out the cause of the economic downturn can one ensure the avoidance of a repeat return to the doldrums of economic malaise. On this issue, the aforementioned systems engineer John Gall would say, “The very word, “Bug”, suggests something worthless if not actually repulsive, something suitable only to be eliminated. Yet every Bug, no matter how humble, always gives us at least one important piece of information; namely, it tells us one more way in which our System can fail. Since success is largely a matter of Avoiding the Most Likely Ways to Fail, and since every Bug advances us significantly along that path, we may urge the following Policy: cherish your bugs, study them”. This is exactly what Mises did.

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The Austrian Theory of the Business Cycle

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Mises argued that arbitrary changes to the money supply caused a recession by distorting the pricing system, and thus distorting the structure of production. Unless monetary inflation continued indefinitely, those lines of production only began due to the distortionary effects would fail as market demand failed to align with market supply. Necessary microeconomic adjustments, namely, business failures, worker lay-offs, capital re-allocation etc, would occur in a recession, such microeconomic adjustments manifesting themselves into macroeconomic volatility. Below I give a very brief outline of this theory.

The inflation of the money supply distorts relative prices in the economy by reducing the interest rate and changing the real prices of economic goods in the market. This, skipping much of the explanation for brevity, leads to the misallocation of resources, or, as Mises defined it, to the creation of malinvestment. Malinvestment can be defined as economic positions only kept solvent due to the provision of artificially cheap money. Thus, once the government ceases creating money, or the economy runs out of real resources (of which one is inevitable) then these positions would eventually become insolvent and would fail. Whole, or parts of, businesses fail, workers are laid off and capital goods and commodities are sold off, both released back to the market to be hired again by productive businesses.

As money is the universal medium of exchange, the arbitrary inflation of money supplies leads to an economy wide inflationary distortion of prices and thus misallocation of resources - explaining why there's a simultaneous 'cluster of errors' by businessmen.

The recession, rather than something to counter, is economic system swallowing the painful medicine of clearing malinvestment. Painful as it is, it must be welcomed. It is the system clearing itself of rot. Relative prices settle and find a “new dynamic equilibrium”, allowing the economy to return to a state of economic growth.

In short, then, the economic system organically acts to protect itself in face of distortionary and damaging inflationary forces.

As mentioned prior, the problem today lies in the fact that the cause of the issue, the creation of money, has become the supposed antidote. The risk of a feedback loop of perpetual inflation is real, pinning us to an ugly arrow of time. In another piece, titled 'The Big Short', I highlighted this risk of using expansionary monetary policy in face of economic downturns. The more monetary inflation, the more malinvestment. The more malinvestment, the larger the recession. The larger the recession, the more monetary inflation, and repeat. As Gall writes, “Positive Feedback into a large System is a dangerous thing. Remember, even though a System may function very poorly, it can still tend to Expand to Fill the Known Universe”. In 2000, the Fed owned $500 billion of US debt, in 2022 that number was $6,250 billion. The universe in which we are talking about here is financial assets in the US economy and somehow more and more of these are finding themselves on the Fed’s balance sheet. Maybe we are in a positive feedback loop of malfunction? Mises' business cycle theory explains that this, in fact, may be the case.

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So, what is going on?

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Fundamentally, the issue lies in the structure of our economic and monetary systems, namely, the existence of central banks and fractional reserve banks. This is because the present way they are structured, the ability for politicians and central bankers to avoid economic and thus political volatility by creating money is all too easy. Whereas this is the macro cause, lets say, what are the granular issues? The first is the issue of debt.

Studying economic history garners the insight that if the debt glut is sovereign, then the likely eventuality is inflation. Alternatively, if the debt glut is private, then the likely eventuality is deflation. That is to say, the sovereign entity will use its monopoly on money and credit to create money to avoid default and aid itself fiscally. This I need not support empirically. By doing this, a couple of things happen. Firstly, a veil is thrown over the true cost to the taxpayer of provisioning the government. Thus, monetary inflation is anti-democratic. Secondly, where an unhampered economy with a private debt glut would clear its debt (malinvestment) in a deflationary recession (as explained above), the manipulation of money and credit by the government means private entities also increasingly take out more debt as interest rates fall lower and lower and the real value of debt falls. Sovereign and private debt cycles therefore become inextricably linked.

If the monetary inflation is to stop, the malinvestment that has been created in the prior decades will fail, onsetting a downturn. No democratic politician will stop inflating the money supply for this is too politically costly.

Thus, the only other path is continual inflation. This, however, cannot go on forever. One day, it will end. A textbook case of hyperinflation arising from fiscal pressure is the case of post-revolution France in the period 1789-1796, as explored in my article titled Free Money, Free Markets, Free Speech, and Freedom.

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What is going on today?

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In the 1990s, according to Greenspan himself, the Fed eased monetary policy for no other reason than to reduce “balance sheet strains resulting from increased debt”. I merely ask the following. What, then, if not the cost of a debt glut, is to stop ever and ever increased indebtedness? If we respond to economic headwinds produced by the cost of debt with stimulative monetary policy, that is, the creation of money that lowers the real value of outstanding debt and reduces the cost of taking out and managing debt, we must ask ourselves the simple question; what economic behaviour are we incentivising?

In short, we are incentivising the economic behaviour that is the cause of the problem, and simultaneously undermining the productive capacity of the economy. We are undergoing plain and clear economic iatrogenesis.

Frankly, we have no idea how much dollar denominated debt there is, we certainty know it is in the hundreds of trillions. What were to happen, say, if interest rates increased to the previous (UK’s) 50-year average of 9.1%? Or even the previous 100-year average of 8.3%? What would happen, I would expect, is the onset of a recession, a scramble for dollars, and even higher interest rates - resulting feedback loop of liquidation and debt unwind, leading to what is ominously named a “deflationary debt spiral”. This would almost certainly occur. However, if the Fed responded to this dollar shortage as explained above by creating dollars (like Greenspan did in the 1990s) then the dollar shortage may ease, interest rates would fall, and highly indebted entities would find it easier to manage their debt. In short, economic volatility is reduced and the economy returns to at least what appears to be stable growth. But what is the cost of following this policy, again and again, for decades?

It is the role of economic history and sound economic theory to point out to the politician and the voter that continued monetary inflation means higher debt levels, more malinvestment, more economic inequality, a more fragile economy and financial system and lower economic growth. That is, everything we do not want.

Naturally, it is in the huge bond markets where much of this battle is and will be fought. Studying the financial repression of post-WW2 is a valuable use of time. Sovereign debt levels, paired with the monetary inflation rates of the previous decades, point me to conclude that real returns on bonds will, discounted with the correct hurdle rate, be negative. The Saudis know this. The Chinese know this. Many American's know this. Does the U.S government know this? Do they care? I argue they don’t, for they have the Fed, and it is the only entity that has the balance sheet (for its balance sheet capacity is infinite) that will willingly absorb treasuries at negative returns.

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Let’s pause, so what does this all mean? ?

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It means, simply, that monetary inflation will continue and will have to accelerate to ensure the US government avoids default and the economy avoids deflationary recession. The Fed (that is, the US government) is balancing the US economy (and therefore the global economy) on a knife edge. Policy makers can balance our global socio-economic system on this knife edge if, and only if, sufficient demand for the Dollar remains. For if it doesn't, price level inflation punishes Americans, and higher inflation causes further reductions in people's demand to hold dollars, in a feedback loops. If this price inflation is bad enough, then a political issue arises where voters demand policy that eases pressure on the price level by restrictive monetary policy. However, restrictive monetary policy is impossible to pursue in economic environments with significant levels of debt, at least for a sustained period of time, because the economic system meets debt sustainability issues and malinvestment failure. They are then forced to inflate again, despite the inflationary pressure. This is where the West finds itself.

Unless there is a U-turn in economic policy, that is, we swallow the deflationary pill and allow the clearing of malinvestment, then the current damaging trajectory the West is on will continue.

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The role of History and Austrian Economics

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History is useful, as is Austrian Economics, for both recognise the complexity of reality when so much of modern economics remains ignorant to it, and thus incompatible with it. When Larry Summers, Kennith Arrow and other renowned economists explained their economic models with their assumptions to some equally renowned physicists at the Santa Fe Institute, the physicists simply leant back and said:

“you guys really believe that?”

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“Yeah, but this allows us to solve these problems. If you don’t make these assumptions, then you can’t do anything.”?

To which the physicists replied:?

“Yeah, but where does that get you – you’re solving the wrong problem if that’s not reality.”

Whereas modern economic models assume you are thinking about the national debt and interest rates in 50 years while choosing between blueberries and raspberries at the super-market, that is, they deny the existence of complexity, and in doing so fail to study reality, history and Austrian Economics, instead, inherently have all the complexity of reality baked into it.

Einstein once said solutions to problems never come from the consciousness that created them, by that, I think he meant sometimes you must zoom out and be a sceptic. It is true, if we stop creating money there would be an extremely large deflationary shock. It is also true that creating money does not solve any problem, it instead delays it, and makes it worse by creating more malinvestment. You don’t avoid falling asleep on the road after 5 coffees and 16 hours by having another coffee. We must face the consequences that the pursuit of iatrogenic economic policy in the previous 10 decades has made necessary. To do that, we must find the political will to stand up to what is really occurring. The complexity of this issue is great, for we have so many other things to think about, be it geo-political risks, domestic political issues, as well as climate change. However, all these issues link to and are negatively affected, in the long run, by the issues I explore surrounding currency and debt. I address these issues in my forthcoming book.

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To conclude

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Gall teaches us that complex systems tend to produce complex responses (not solutions) to problems. Currency volatility and global recessions, resulting from arbitrary changes to the money supply, leads to protectionism that leads to trade war that simply is not solved by re-arming militaries. Widening wealth inequality is not solved by ‘taxing the rich’ and ‘giving it to the poor’. The debasement of peoples real wages in order to promote full employment and stop malinvestment from rearing its ugly head is not solved by embracing a policy of universal basic income. Many economists are trying to find complex responses (that are not solutions) to problems in all the different (hundreds) types of economics nowadays. Very few, instead, are putting forward the possibility that a large part of the solution to our many socio-economic issues may be in the simple idea to just stop manipulating the system that the complex world uses to order itself, that is, prices. Unfortunately, in economics, you cannot prove your opponent wrong, you can only convince them of it. This question, I address in my article, Information dissemination, Informational frictions, Money, Debt and Economic Systems.

History and Austrian Economic theory are clear, never can you solve problems or increase your wealth by creating money, alas, it is exactly what we are doing. To highlight the role of the historian and the (good) economist, I finish on the wise words of Gall, who offered his ideas “in the hope and faith that a knowledge of the natural laws of complex Systems will enable Mankind to avoid some of the more egregious errors of the past.” With hit pieces claiming “inflation is your fault”, with rich and smart Western countries mulling over broad price controls, and with countries like South Korea banning short selling, I think we must look to history, for economics has currently failed us, to aid in our endeavour of avoiding the egregious errors of the past.