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…..you 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