Beyond Repair – This will not have a happy ending

The main problem with having discussions about economics and financial markets is this: People look at these complex phenomena through entirely different prisms; they use vastly dissimilar – even contrasting – narratives as to what has happened, what is going on now, and what is therefore likely to happen in the future. Citing any so-called “facts” – statistical data, or the actions and statements of policymakers – in support of a specific interpretation and forecast is often a futile exercise: The same data point will be interpreted very differently if some other intellectual framework is being applied to it.

Blue pill or red pill?

There is what I call the mainstream view, the comforting view. That is the world in which the majority of commentators and almost all policymakers live. If you want to be part of this world, you have to take the blue pill.

In the words of Morpheus: “You wake up in your bed and you believe what you want to believe.”

Or, if you don’t want to take the blue pill, you can simply continue reading the main newspapers and watch CNBC – it’s the same thing. The perspective from inside the Matrix is this: We are facing cyclical challenges. The economy is an organism, and it is presently not performing to its full potential. It is still weakened by a terrible disease (financial crisis), but luckily it is now recovering. But because the disease was so severe, the recovery is slow. Thankfully, the doctors – the governments and central banks – have learned from Dr. Keynes and Dr. Friedman and are providing ample stimulus to aid this recovery. The medicine is applied in such strong doses that many observers are afraid the treatment itself could cause damage to the patient. There is, however, no alternative to such drastic medication, and we have to trust that, as the recovery proceeds, the medication will carefully be reduced.

This is the comforting narrative. Comforting, because it’s the cyclical view, which simply means, “we have been here before.” It also contains, at its core, a naïve view on money: injecting money into the economy has only two effects: it boosts growth (that is positive) and it lifts prices (that is sometimes positive, sometimes negative). No other effects of money-injections have to trouble us.

Alternatively… may take the red pill, and “I will show you how deep the rabbit hole goes.”

The economy is in reality not some organism or a machine that has a definitive performance potential. The acting parts are not some neat, statistically observable aggregates – but individuals, or groups of individuals who form households or companies. All these actors have their own personal aims and goals, and they all use the decentralized market economy to realize their plans as well as they can. For those stepping outside the Matrix, with its comforting idea that everybody wants higher GDP and that when GDP is higher, regardless of how this was achieved, everybody will be happy – this appears scarily chaotic: No unifying objectives but a multitude of separate and often conflicting wishes and plans. Yet, on closer inspection, it is not chaos, as the actors can use market prices to plan their actions rationally and coordinate them.

Market prices are essential for this extended and decentralized division of labor to work. But sadly, market prices are constantly being distorted.

Most importantly, the constant injection of new money in today’s system of fully flexible paper money tends to depress interest rates and fool the market participants into believing that more voluntary savings are available than really are, and that resource allocations and asset prices are therefore justified that correspond with a very low time preference (=high propensity to save) by the public. These distortions have been going on almost continuously for the past 4 decades but in particular over the past 20 years.

The result of such distorted market signals is the accumulation, over time, of a tremendous cluster of errors, visible in the form of unsustainable asset prices, excess levels of debt, and an under-collateralized pile of inflated paper assets.

For those outside the Matrix, the red-pill-crowd, there is only one solution: The printing of money and artificial lowering of interest rates has to stop. This allows the coordination of decentralized individual plans to make again use of correct market prices (importantly, that includes interest rates). The result will be the dissolution of the accumulated misallocations of resources and mis-pricings of assets – this is going to be painful for a while but necessary for markets to function properly again.

Those inside the Matrix can’t see it that way. For them, the recession is not the collective realization that a cluster of errors has piled up, and the drastic revision of a multitude of individual plans in response to this realization, but simply a drop in aggregate activity of the economic organism. This requires more money injections. More stimulus! More medication! Depressing interest rates further is an important part of the treatment.

The red-pill crowd knows that this will not work. It will slow the correction of past mistakes – which, ironically, the blue pill crowd will interpret as a sign of stability – and encourage new activities on the basis of wrong price signals, which must ultimately lead to an even bigger cluster of errors – but this activity will be interpreted by the blue-pill crowd as the green shoots of recovery.

With dislocations piling up, the creation of artificial growth becomes ever more difficult.

The red-pillers view money creation differently from the blue-pillers. The effects of money printing are not just higher growth and higher inflation but, much more importantly, the distortion of relative prices and, consequently, the misallocation of resources.

The present crisis is not a cyclical phenomenon – as the blue-pillers believe – it is a systemic problem. It is the process by which the paper money system approaches its endgame. The blue-pillers are in charge of the printing press and the government. They cannot but continue printing money.

Continue reading at Paper Money Collapse


  • Samuel Eglington says:

    I agree with this analysis however there is an issue I hope you can explain for me. Quantitative easing has been refered to as basically printing money which would be inflationary. However it is really the buying up of worthless assets using credit thus preventing deflation and not creating inflation. If this fails is there a chance that there will be a period of very rapid deflation due to panic in the markets and particularly amonst the general public when they realise that the problem is not a shrinking slice of the wealth pie but that multiple claims have been created on their assets. Followed inevitabily by the neccessity to print the stuff to meet obligations that can’t be met by new credit when the system has broken down. Finally causing the inflation that people are now objecting to?

  • Sorry for the late response. I hope you are still following this. You raise a good question. Even those who believe that the endgame will be inflation sometimes think that we will get another deflationary set-back first. It cannot be excluded. The “natural” response of the system – if there was no intervention – would be to correct: balance sheet reduction, credit contraction, debt deflation. So we have inflationary versus deflationary forces. I am of the view that any sharp asset sell-off or any further bank problems would lead again to aggressive monetary easing. My hunch is that lasting deflation will not be “allowed”. It is straight through to inflation!

  • Samuel Eglington says:

    Thank you for your reply. I have been looking at The Debt–Inflation Cycle and the Global Financial Crisis posted by Prof Peter J. Boettke, on 4 May 11
    “Our central argument can be stated as follows: government spending intended to maintain stability, avoid deflation and stimulate the economy leads to significant increases in the public debt. This public debt is sustainable for a period of time and can be serviced through ‘pretend payments’ such as subsequent borrowing or the printing of money. However, at some point borrowing is no longer a feasible option as the state’s credit- worthiness erodes. This implies that the ultimate result of Smith’s juggling trick is the monetarization of the debt in order for the state to avoid bankruptcy. This too, however, is an unsustainable policy due to the threat of hyperinflation which has ravaging effects as evidenced by Russia and Germany in the early 20th century.”
    This being so how is the government going to “disallow” deflation? Deflation as I understand it is a reduction in the money supply relative to goods. Reduction in prices comes later in responce so there is never inflation and deflation but one or the other and establishing which enables you to predict future prices. Therefore the important question (that I don’t honestly know the answer too) is: is QE resulting in an actual increase in the money supply or is it preventing decrease? If it is just preventing decrease then according to Prof Peter J. Boettke this is unsustainable. So what will prevent deflation when QE can’t be sustained? As de soto and others have pointed out on this site market corrections tend to be sharp. The problem then is that the angle at which asset prices in particular come back to equilibrium is so steep that they never stop in time (hence the piss-poor case for more regulation)The time period over which the distortions have taken place also makes me fearful that the rabbit hole may go much futher than most people are willing to imagine. Assuming deflation can’t be contained for a period cash (the actual printed stuff) is actually a good thing to hold as its value would increase dramatically relative to goods (if held in a 100% reserve bank)even people who hold gold may have to sell it to gain access to neccesities as gold isn’t exchangeable for bread, heating oil and so on. The end game will always be inflation or hyperinflation or if we’re lucky default and a new currency based on gold and possibly grain reserves?! Figuring out what will happen en route and when is quite a challenge.

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