Theory of Everything: Part I
Posted originally on TBP on 25th April 2011 by Reverse Engineer in Economy
Tonight’s topic is a tough one. The bickering regarding precisely how the monetary system will collapse framed around Inflation and Deflation is getting us precisely NOWHERE. The reason for this I think is because it is mostly ex-post facto analysis of the money supply and asset values, and this bogs you down in conflicting numbers, many of which are not even certain to be valid given how the data is manipulated these days. So what I am going to try to do in this post is look at precisely how fiat money accrues value and how that attaches to physical resources, energy and labor to create an economic system. It’s a Theory of Everything kind of post, and I have no idea how its going to come out here as I begin. My objective in developing a TOE here is to try to get a better idea of how the folks in current control over the monetary system will behave as the system disintegrates. I am trying to figure this out, and I do not have an absolute answer, but writing about it helps me to frame the questions, and responses I get help me refine it. I am just “thinking out loud” as I go, and no besides everything I remember I haven’t done ANY research for this post. Its a thought experiment.
Now, I am using “disintegrates” with respect to the economic system not in the colloquial meaning of being hit by a Phaser blast and vanishing, but in a more pure concept of dis-Integration, where to be integrated means to be connected. The problem we are faced with at the moment is that Money is becoming less and less connected to Real Value. This is not simply because a lot of it is being “printed” by the various CBs around the world, but rather because it is becoming further disconnected from the value creation mechanism of the money itself. Lots of freely floating money in the market certainly should devalue it, but competing against that is what causes fiat to have any value at all, which is Interest. If you create more money but at the same time make that money more expensive in terms of interest, the money will retain value with respect to whatever it is buying. So the freshly printed money the Greeks need right now is still actually worth something because the interest rates they have to pay for it are skyrocketing upwards.
In the Fiat system as it has been pursued since around 1692, CBs have had a virtually unlimited ability to create money. Money is a great Lubricant for trade, it allows you to rise above a pure barter exchange mechanism utilizing a portable store of value. Whatever that store of value is has to be recognized as such all across the trading markets, which these days are global and interconnected via computers. It wasn’t always that way though, certainly not in 1692, at that time it was all Paper that had to hold value across the world. How do you go about making a piece of paper a valuable instrument of monetary transaction across societies? To do it, you need to have Banking Houses established in different societies which all recognize the paper as holding value. A note written by the House of Medici in Venice has to be recognized in the Mongol Empire as “Good as Gold”, so that when the Note arrives by Camel train with Marco Polo, the Credits it represents actually buy real goods for Ghenghis Khan, so he can buy more Saddles for the Mongol Horde and expand his Raping and Pillaging Empire a bit further. Needless to say, if you actually have control over the trade routes and have warehouses stocked with real goods those credits can buy, the Paper has very real value.
It is of course very important for anyone running such a monetary system based on Notes they create that they in fact do maintain real value to buy goods and services. It is not generally in the interest of a Bankster to create worthless notes, because once those notes stop functioning to buy goods and services, the Bankster is outta biz. It should be noted here that the TBTF banking houses which grew out of this era have NEVER allowed their notes to go completely worthless, although any number of small countries have been in some way shut out of the system and seen this occur. Argentina, Weimar Germany, and Zimbabwe are all examples of small countries who got shut out of the credit system periodically and saw their currencies completely lose value. All paper currencies amount to is a Note of Zero Duration with no coupon attached issued by the Central Bank of a local Goobermint. Long as it is respected internationally, it holds value to buy goods and services. When it is not, Hyperinflation results. As Jesse points out on Café Americain, Deflation, Hyperinflation and Stagflation are all possible outcomes for a collapsing monetary system, your main problem is to figure out how the politics will evolve to force a given choice.
As the Global system of trade grew in size and complexity, a mechanism needed to be created to both perpetually increase the Money Supply to match the growing population AND to insure that the notes they created would retain their value. How do you do that? You do it through the Bond Market, which essentially attaches all the Value a given society can create through its Labor and Natural resources to a Bond of the perceived value of those assets. So if a given country has a lot of Coal in the ground and Laborers to dig up the coal, you issue out a Loan in the form of a Bond to start money circulating to pay the laborers to dig up the coal, and attach an interest rate to that loan to in theory compensate for the risk involved in getting the project going. As long as you have new projects and new ways to use labor and natural resources to keep expanding, you can keep expanding the money supply and keep sieving back interest on the money you create, and of course if you have a monopoly on this money creation you get fabulously wealthy in the process.
The primary Debtors to attach here in this process are the Sovereigns, since they have the power to Tax the entire population on some portion of their productive enterprise. So for the most part, Sovereign nations have always been the biggest debtors. (This begs the question of why Sovereigns that can issue their own money have to go in debt to get it. That question is a whole other rant. Part II coming soon to a Theatre Near You.) However, through the Capitalist era, its also been possible to Loan large sums of money to individual Entrepreneurs and Corporations to build large scale projects, and then in addition to that the advent of “Home Ownership” in the post WWII years allowed large scale loaning of money in aggregate on the retail level to individuals. All 3 of these classes of Debtors accumulated a very large Debt through the post WWII years to finance further expansion of this system. It is this debt overhang now that is causing so much worldwide havoc with the monetary system, and it is not just in the FSofA. Every last country connected up to this banking system is in precisely the same pickle, even what appear to be net creditors like China. This because the savings they accumulated is mostly irredeemable debt. It is irredeemable debt that cannot be serviced anymore, because the growth necessary to service it simply is not happening. The lowest level debtors, J6P Home “Owners” are the ones being hit first here, because J6P is not getting ANY kind of Bailout. Stuff like HAMP is just smoke and mirrors to bail out the TBTF Banks, not J6P. The Sovereigns are being Bailed out, but the peripheral ones are seeing their Interest Rates rise to compensate for the risk that they won’t pay off and to maintain the value in the money they are being issued through the loans. The least affected so far are the TBTF Banks, which are being issued money at near ZIRP to speculate in the markets which they are not accountable for, it’s other Low Hanging Fruit who will eventually lose their shirts. Long as that speculation continues, regardless of whether these companies actually turn a profit the managers and executives can pay themselves quite well and the wheels keep turning on the bus.
The thing to remember here is that the CBs cannot keep issuing money in perpetuity, because if they do so the money will go worthless and no longer measure the value of what it is supposed to be buying. As the Sovereigns become increasingly unable to Tax enough money to pay their bonds, they will fail and I do not see it as likely that after anything bigger than about Portugal you will see the CBs bailing out Sovereigns. To do so, they would have to create valueless money, and that is not in their interest to do so.
Now, it is unclear as to whether Sir Isaac Newton as Master of the Mint back in 1692 really understood all the implications of a velocity based money supply of perpetual growth, but IMHO by the 1970s when Local Peak Oil was reached here in the FSofA and when all the bad Loans to South America made by my Dad and other apparatchiks of the system in the name of Chase Manhattan, JP Morgan et al went South, the folks running this system were quite aware of the flaws and that it had a limited lifespan. The last 40 years have been spent manipulating the system to consolidate ownership and further capture the political process, quite successfully. However, the whole ball of wax is now up between a Rock and a Hard Place GLOBALLY, which is why the idea Capital will take off and run for cover outside our own borders is IMHO ridiculous. There just isn’t anywhere to run now, all the sovereigns are in the deep doo doo, so the idea you can pull value from any of them through taxation is ludicrous. People are going to rapidly be moving to subsistence level almost everywhere, there is not going to be surplus to sieve anywhere. If the surplus does not EXIST, no financial instrument can make it exist. Of course, people can be starved out of existence to reduce demand, but they do not go quietly into that Good Night either. So this requires military action which draws down your own surplus, such as it might still exist. See the Roman Empire to understand this problem.
This still does not answer the question of how our Goobermint and Da Fed will behave as the debt default moves up the chain to the Too Big to Bail. This besides nation-states like Spain includes our own States like CA, IL, NJ, TX et al. They cannot issue high interest bonds to rollover the debt they already cannot afford to service, but with low interest there is no incentive for anyone to buy this debt. No incentive for anyone except Da Goobermint, which wishes to perpetuate itself. So the TBTF Banks will offload sovereign bonds on Da Fed, which serves as the “Bad Bank” upon which to dump all your losing bets. The large Banking Houses will consolidate down to just holding and trading about anything perceived as an asset holding real value, commodities for the most part. Regardless of the numerical denomination, with respect to each other these commodities will more or less move in tandem in perceive value, though it is likely in this scenario that PMs will crash with margin calls across other commodities Put it this way, if you are a Sovereign Nation holding a few tons of Gold and you need to buy Rice to feed the population, you are going to put that Gold up for sale at whatever the market will bear, elsewise your people are likely to Riot and string you up by the Gonads.
At this point, you have major banking houses owning large quantities of “stuff” everybody needs at a relatively high dollar denominated value. There are two roads possible, one is to issue money on the retail level to J6P to be able to buy the stuff at these high prices. In a country where most of the population is employed through Goobermint Trade Unions, you could just start indexing and raising the salaries to meet the rising costs of the commodities, but that isn’t the model the FSofA is working under. Rather what you see at the moment here is wage depression, more unemployment and further loss of purchasing power amongst the people who would buy the commodities for end use.
The most sensitive commodity here in the FSofA would be refined gasoline for private automobiles. As the price continues to rise here, it has to force people to start conserving and cutting back on usage. This would force inventories to rise as long as the supply chain is still producing the same amounts, but it may not be doing that. Libya for instance is not contributing its share to the supply chain at the moment. However, what is produced will move in the direction where the most people still have money to pay for it, and that would be toward the western nations with some percentage of the population still solvent. Less wealthy countries will begin to see shortages.
It is unclear how high a price the remaining solvent people in the FSofA can tolerate for gas before it forces too many people out of the market to maintain the distribution chain. I’m going to make a WAG it could go to $10/gallon at some stage before there is a complete collapse of distribution, but even a perpetuated period at the $5 range will have a devastating effect on commerce and GDP.
Similar effect here with Food, which as a percentage of the budget of even the lowest paid of the still employed here is relatively low, compared to countries where people subsist on $2/day. I think most Amerikans could withstand a doubling of food prices as long as they are still employed, simply by buying cheaper foods. As long as the SNAP card program keeps the unemployed fed, again we can see a steady rise in these prices that is compensated for by a forced economic rationing.
The problem is much larger and more immediate in the poorer countries of the world, and this is the most destabilizing aspect of the spin down. Again unclear is exactly how many places we can try to police to keep the Oil moving out of the M.E., so this can force a breaking point to occur much faster than just the economics.
In no scenario I can imagine would it behoove our Goobermint or Da Fed to keep issuing essentially free money to the States and Municipal Goobermints. So like Meredith Whitney, I see a period coming of Defaults through these entities, with less and less money circulating through their economies, which means ever falling tax receipts to fund their local Goobermints. This doesn’t mean an overnight failure of the monetary system, but it will put many places in a grinding down phase of increasing poverty which will be very difficult, complete with the kind of social dislocation you see now in places like Greece and Portugal, getting worse as time goes by.
Is this Inflation or Deflation? You could look at it either way, since core commodities will be increasing in price but real wages and purchasing power will be decreasing. Far as Hyperinflation goes, that is another phenomenon altogether, more Political in nature than economic. A given currency has to be more or less abandoned by the BIS and the country cut off from the international trade system to get a hyperinflation rolling. It does not seem likely that the BIS will abandon the Dollar as a currency unless and until there is a workable alternative to it, and there isn’t one on the Horizon at the moment. There will thus be political pressure both internally here and internationally to withdraw credit issuance by Da Fed, which Da Fed is looking for ways to do ever so gently so as not to rock the boat too much, but at this point it is a very unstable boat and very sensitive to perturbation of any kind. The effect remains possible of a virtually instant Lock Up in the financial markets if too much liquidity is withdrawn from the market, because without that liquidity a few margin calls can cause a cascade selling event on the markets with no bottom in sight. The Doomer in me waits impatiently for that day, because it would be a sight to behold indeed. It would make the Flash Crashes we have seen as Coming Attractions look like Chump Change. Credit where credit is due however, Helicopter Ben and the other Geniuses running the Super Computers for the PPT have demonstrated they have the ability to freeze, re-capitalize and manipulate these markets at will, so such an instantaneous crash may never happen. I have been regularly wrong in looking at the collapse at the gross market level because I underestimated just how smart these folks really are and how much control they actually do have over the markets. They cannot stop the eventual recognition though that the system is globally bankrupt, several times over actually.
To conclude this portion of the argument, I don’t think that examining the prices ex-post facto is the best way to understand how the collapse will proceed. In essence what we are looking at is a failure of the Credit-Debit model of the Bond Market at the Sovereign level. Because of the simultaneous geometric growth in population size and the tandem consumption of resources upon which to build those large populations, the ability of Sovereigns to tax out their populations to pay off on Bonds predicated on growth has for all intents and purposes disappeared. Without that ability, what gives money any value at all? Fiat money is a debt instrument, a Note of Zero Duration based on future production that isn’t coming down the pipe. So the fiat system will collapse as a result, though it can be a long grinding collapse because all production does not cease instantly everywhere.
Far as utilizing PMs as money, they do not represent Debt on future production but rather are the result of past production, the effort to dig up and smelt the relatively rare metal and then coin it. What value they actually hold depends upon exactly what there is available to buy with them, and whether it is in surplus or not. Anything still in surplus you will be able to buy with very little Gold; anything not in surplus you may not be able to buy with all the Gold in your basement safe. What you are dependent on here is the overall ability of your society to produce a surplus of food to feed the population, at its most basic level. Here in the FSofA, as long as some portion of the Oil Conduit keeps moving and we can as a society produce a surplus of food, the PMs will hold some value, but trading with them will likely become difficult and dangerous, and the Goobermint confiscation of such things becomes ever more likely if they gain any traction as a trading mechanism. I do not think they will gain such traction in most places, so I think the value of these metals will fall with respect to more necessary items.
In the medium term as a result, I see fewer Dollars being available to J6P to buy STUFF, which thus will continue to keep the Dollar valuable to J6P through its scarcity. I just do not see it likely that Helicopter Ben and TPTB will start sprinkling down higher wages and free money to J6P. In this environment, prices can rise as commodities become more scarce and Profit margins disappear on production, but as long as the Dollars are scarce to the consumer of the end products, you cannot support a Hyperinflationary event. The abandonment of the Dollar on the international level of trade by the BIS would cause a Hyperinflation, but there isn’t a readily available alternative to it right now so such an abandonment does not seem immediately likely.
However it does play itself out on the monetary level, inflation or deflation, the primary problem you are going to have is decreasing availability of the products of industrialized society. No matter how much Gold you have, if you want to buy a Plasma TV you won’t be able to do so, because the Plasma TV factories will shut down. Not ENOUGH people will have Gold to buy Plasma TVs to make running such a factory model profitable. You probably won’t miss a Plasma TV all that much, but when the profit margins in producing food along the industrial model disappear, this you will miss VERY much. It is as we approach that stage of the Spin Down that how you position yourself will become very important, because no group of people anywhere ever goes Quietly into the Good Night of Starvation. The industrial model of food production will be replaced on the local level in areas that can produce food for their populations. Farmland that is dependent on water pumped up from deep aquifers utilizing the thermodynamic energy of Oil will no longer produce, so these are not good long term areas for survival.
You cannot know how the climate might change in the future, but where you settle yourself must most certainly right NOW have enough Water dropping down as rainfall or sluicing down from mountains during the spring thaw. Water is NUMERO UNO in picking your hole. After the water, the condition of the local soil for supporting agriculture is the next bet you make, unless you are near a Coast where there is still good fisherie not contaminated by Radioactive Cesium and Iodine effluent from Fuk-U-Shima Nukes or Spilled Oil from BP’s Macondo Well in the GOM. After the water and food are covered, the next one to consider is Energy resources. The best places have all of these things, but of course in the future they will be popular places every last Zombie out there wants to migrate to. No guarantees you or your progeny will be able to keep or “own” the land you live on because you bought it with 10 pieces of Silver from the last Goobermint to run the show in that neighborhood. Your only Property Rights are what you can Protect and Defend, and nobody can do that effectively alone. So pick a place somewhere on the face of the earth with the Water and the Food resources and Good People you affiliate with well, and make yourself ready to defend that little patch of land. Because when this monetary system crashes and when the industrial model goes the way of the Dinosaur which they both inevitably MUST, that is all you will have left. If it is not enough to support you and your Tribe, you too will go the way of the Dinosaur.
See You on the Other Side.