“Matrix” Money

"The traditional immunity of advanced countries like America to a Third World-style crisis isn't a birthright... we are facing a day of serious reckoning." 

Robert Rubin, former Treasury secretary.

“However well founded an order may be, it always rests in part on a voluntary faith in it, a faith that, in fact, always marks the spot where the new growth begins, as in a plant; once this unaccountable and uninsurable faith is used up, the collapse soon follows; epochs and empires crumble no differently from business concerns when they lose their credit."

 Robert Musil, The Man Without Qualities

Economic and financial confusion

If you are not confused about the US economy you don’t know what’s going on.

We are told that the US is the most prosperous nation on earth, but if so why do we need more debt than anyone else? We are told that we have the most productive, flexible and dynamic economy in the world, but if so why are our goods so uncompetitive that our trade deficit is exploding? We are told that we have a strong dollar policy, but if so why has the dollar fallen by 30% in the last 4 years to multi-decade lows? We are told that we can spend a fortune going to war and still afford to cut taxes, but if so what is the basis of our financial control? Can we just borrow and spend money whenever we feel like it, without consequences?

Is it possible that there is some way in which we can reconcile all these apparent contradictions or could it be that we are being asked to believe a whole bunch of baloney in order to somehow keep a deeply flawed system or reality at bay?

Welcome to the world of funny money. Yes, those green bills you carry around are nothing more than paper promises, printed at will and near zero cost by your government. If what you are being asked to believe is beginning to stretch credibility then what value would you place on those promises? 

Fiat money system

Once a system has been in place for a long enough time, we sometimes forget that there is even a choice as to what system we should have, but of course we do. So let’s review what happened. The US adopted, many decades ago in 1971, a monetary system whereby the government has monopoly control of a paper currency, backed by nothing other than the government’s own commitment to limit its supply, so that the currency will maintain its purchasing power. The theoretical benefit of such a system is that the government has much more flexibility, as it can choose when to borrow, spend and print additional currency. This gives any government enormous ability to control the economy, through deficit spending and interest rates, as well as money supply.

Alternative monetary systems dramatically reduce the governments’ flexibility as the currency is much harder to create. Usually they involve a natural limit to the supply of currency beyond the manipulative capability of governments, such as gold.

Unfortunately, there is a serious flaw in the paper money system. Although we conveniently forget the lessons of the past, never in history has such a monetary system lasted. Never! In the end all attempts have ended up with a complete collapse or at least a massive devaluation of the currency. Why is this so? Well it probably comes down to a common human failing. Short term benefits are always so much more appealing than long term theoretical responsibility, particularly when in the long term today’s politicians are very unlikely to be held accountable.

Inevitably a government in power will spend or print a little more paper money than it should and find that as a result it has become a little more popular by boosting the economy or it has increased its power as government has expanded. Possibly it has achieved both at the same time. In addition it will soon find it has some new friends. The banking system likes paper money too as it enables banks to expand their balance sheets much faster too.

Some governments are better than others, but always the temptation is there to go a little bit too far. Over time both the government and the banking system just end up getting bigger and bigger. Indeed at some point the government gets so big it starts to pursue its own agenda, which many regard as far beyond its mandate and purpose.

Nevertheless it still has enormous power to manipulate the economy and influence public opinion, through its size and monopoly power of the currency, interest rates and deficit spending. Just so long as it can keep up general confidence in the economy and currency, it seems to have found the answer to any temporary setback or temporary loss of popularity.

 Enormous additional spending can always provide a further economic boost whatever calamity arises. So much so that even disasters like the drowning of New Orleans are regarded as an opportunity to further boost its’ spending, which the markets may interpret as a net economic gain. They cannot shake off the tax-and-spend, borrow-and-spend outlook of Keynes. Always, government spending is seen as the engine of prosperity. In this analytical framework, major disasters are regarded as allies of economic growth.

After a time, however, the government and banking system become much bigger than the economy really needs. There are limits to everything and at some point the economy becomes less and less efficient. The non-financial private sector, which is really the true wealth generator, is relentlessly squeezed by government and finance. Nonetheless government and finance have become so large and powerful they need to keep the dream alive by explaining why the economy and the currency are really doing very well, you just need to look at it in the right way. They can even prove that they are right by resorting to yet another round of enormous deficit spending that yet again makes the economy look strong at least temporarily.

Over time, however, they are just accelerating the long term economic decline by excessive deficit spending and money supply growth. They also find it is useful to encourage the private sector to ruin itself too. Debt expansion is encouraged by using excessively low interest rates and inflated asset prices. This once again seems to boost the economy and help the banking sector in the short term, but longer term also leads to ruin.

The rhetoric defending the currency and the economy starts to sound increasingly ridiculous as the economy continues to stumble despite all their efforts. A flawed economy needs constant and growing new sources of stimulus in order to at least appear to be healthy in the short term. Does any of this sound familiar?

The length of such a cycle can continue for years, decades or even centuries. It is anyone’s guess how long it can last in its latest US version, but one thing is for sure if history is any guide. This process ends in ruin for the currency. 

The Federal Reserve

The whole system is supposed to be managed by the Federal Reserve, but what does this really mean? Initially, the central bank is supposed to act as a guardian of the fiat money system so that it does not get out of control. But over time, particularly in a situation where the central bank has very limited political independence, the central bank needs to maintain confidence in the system and in it self, even as the system begins to self destruct. Its’ ability to control the system and take strong action is compromised by it’s need to continue to develop growth by whatever means and maintain confidence in the economy.

 As the system depends so heavily on growth and debt expansion it becomes increasingly essential to ensure inflation, otherwise the system cannot survive. Maybe they will not want to encourage very high levels of inflation, but deflation is considered a disaster for a fiat currency system. This is why the value of the dollar has fallen by 97% since the Federal Reserve came into existence in 1913. Prior to that for the previous 200 years deflation was more common than inflation. There was no Federal Reserve and the dollar held its value.

The chart below shows the 10 year moving average of inflation. Only for a short period during the great depression of the 1930’s and WWII was inflation negative since the Federal Reserve was introduced. Prior to that periods of inflation and deflation were much more balanced.

 

Summary

In the US today we are encouraged to follow economic behaviour that suits the monetary system that has been chosen decades ago, in order to keep a flawed system alive for as long as possible. The system needs us to believe that the economy and our own wellbeing are dependant on our adherence to a certain economic orthodoxy. It is as if we are living inside the “Matrix”, and are completely unaware of the truth that exists outside.

Ultimately, no government can resist the temptation of excessive deficit spending and money supply growth in a fiat money system, while individuals seem to have forgotten that borrowing and spending to the limit, while saving nothing for a rainy day has always been the path to ruin. What are we thinking?

An increasingly confusing and contradictory economic environment stems directly from the monetary system that has been chosen - fiat money, funny money, paper promises, or “Matrix” money, whatever you choose to call it. All the signs are that the current experiment is already somewhat mature, but the life cycle is measured in decades. We can not know when the current system will collapse, but we all need to be aware that history determines that it will.

In the meantime we need to make sure that we understand how life inside the “Matrix” works. As the paper money cycle matures it becomes more illusory and deceptive. Also, even if we do not know the timing of the demise of paper currency to some extent it does not matter. Just because you did not know when a hurricane was due, would you ever buy a house below sea level in a hurricane zone?

So if you can see outside the “Matrix”, why not reconsider your economic behaviour and assets in a new light. One day you will be very glad that you did.

 

 

 

 

 

 

Notice

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