The Abolition of Deflation

Modern economics has been a great experiment:

Economic history can be broadly divided into two eras: before Keynes, and after Keynes. Before Keynes (with precious metals as the monetary base) prices experienced wide swings in both directions. After Keynes’ Depression-era tract (The General Theory) prices went in one direction: mildly upward. Call that a victory for modern economics, central planning, and modern civilisation: deflation was effectively abolished. The resultant increase in defaults due to the proportionate rise in the value of debt as described by Irving Fisher, and much later Ben Bernanke, doesn’t happen today. And this means that creditors get their pound of flesh, albeit one that is slightly devalued (by money printing), as opposed to totally destroyed (by mass defaults).

But (of course) there’s a catch. Periods of deflation were painful, but they had one very beneficial effect that we today sorely need: the erasure of debt via mass default (contraction of credit means smaller money supply, means less money available to pay down debt). With the debt erased, new organic growth is much easier (because businesses, individuals and governments aren’t busy setting capital aside to pay down debt, and therefore can invest more in doing, making and innovating). Modern economics might have prevented deflation (and resultant mass defaults), but it has left many nations, companies and individuals carrying a great millstone of debt (that’s the price of “stability”):

The aggregate effect of the Great Depression was the erasure of private debt by the end of World War 2. This set the stage for the phenomenal new economic growth of the 50s and 60s. But since then, there’s been no erasure: only vast, vast debt/credit creation.

As I have long noted, in the end the debt load will have to be erased, either by direct default (or debt jubilee), or by indirect default (hyperinflation). Deleveraging in a credit-based economy, is very, very difficult to achieve, without massive damage to GDP (due to productive capital being lost to debt repayment). The irony is that the more central banks print, and the more the Krugmanites advocate for stimulus, the tetchier creditors (i.e., China) become about their holdings being debased, when the reality is that the only hope that they have to see any return on their debt holdings is for governments to print, print, print.

How long can America and the world kick the can? As long as the productive parts of the world — oil exporters, and goods manufacturers — allow the unproductive parts of the world — consumers and “knowledge economies” — to keep getting a free lunch. Keynesian economics didn’t abolish defaults in the long run — it just succeeded at making mass defaults much less frequent. My hypothesis is that it also made these moments of default much more catastrophic.

This is akin to the effects of dropping rocks on humans: drop a hundred 1-pound-rocks on a man over the course of 50 years  (at the rate of two per year) and he will most likely be alive after those years. Drop one hundred-pound-rock on him after fifty years and he will more likely be dead aged 50. Perhaps in reality it is not as extreme as that, but that is the principle: frequent small defaults, small depressions, and small contractions have been abolished, in favour of occasional very, very big depressions, contractions and defaults.

Where does that leave Keynesian economics?

Well Keynes was right that intervention can save lives, families and businesses. What Keynes and Fisher were wrong about is that stabilising credit markets and prices (resulting in the abolition of deflation) is completely the wrong kind of intervention. Government’s role during depressions is to preserve and stabilise the productive (i.e. physical) economy, to prevent the needy from starving, to prevent homelessness, and create enough infrastructure for the nation to function (and eventually, to thrive). The financial economy (and all the debt) should go the way nature intends — erasure, and resurrection (in a new form).

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Scientists Map The Rulers of the Financial Universe

It’s long been clear to some of us in the financial kingdom that a small clique of powerful companies control vast swathes of the global economy.

Now that mythos has been given some scientific credibility.

From New Scientist:

The idea that a few bankers control a large chunk of the global economy might not seem like news to New York’s Occupy Wall Street movement and protesters elsewhere (see photo). But the study, by a trio of complex systems theorists at the Swiss Federal Institute of Technology in Zurich, is the first to go beyond ideology to empirically identify such a network of power. It combines the mathematics long used to model natural systems with comprehensive corporate data to map ownership among the world’s transnational corporation.

The work, to be published in PloS One, revealed a core of 1318 companies with interlocking ownerships (see image). Each of the 1318 had ties to two or more other companies, and on average they were connected to 20. What’s more, although they represented 20 per cent of global operating revenues, the 1318 appeared to collectively own through their shares the majority of the world’s large blue chip and manufacturing firms – the “real” economy – representing a further 60 per cent of global revenues.

When the team further untangled the web of ownership, it found much of it tracked back to a “super-entity” of 147 even more tightly knit companies – all of their ownership was held by other members of the super-entity – that controlled 40 per cent of the total wealth in the network. “In effect, less than 1 per cent of the companies were able to control 40 per cent of the entire network,” says Glattfelder. Most were financial institutions. The top 20 included Barclays Bank, JPMorgan Chase & Co, and The Goldman Sachs Group.

As the world learned in 2008, such networks are unstable.

Or, as I put it this week:

One thing is clear:

A huge mountain of interlocking, interconnected debt is a house of cards, and a monetary or financial system based upon such a thing is prone to collapse by default-cascade: one weak link in the chain breaks down the entire system.