The author - Paul Tustain - has been widely published on the failures of ancient monetary systems.
This article looks at how the abandonment of a naturally competitive market leads to an economically unfit population, and great dangers for savers. The contradictions in the modern social market economy are examined, and persuasive evidence from the markets presented. The article is for those who like their arguments quietly rational, rather than hot-blooded.
The pendulum and the thermostat
The father of the free market system - Adam Smith - disapproved of meddling governments, which he viewed as possibly well intentioned but invariably counter-productive. He viewed the economist's role as dispassionate philosopher rather than meddling mechanic.
Smith's model economy worked like a pendulum which swings under the action of natural forces yet is always accelerating toward its equilibrium. Today's economies are much more like central heating systems. A target temperature is chosen, away from the natural one, and then lots of energy is consumed in trying to hold things steady. A heating system is regulated by its thermostat, unlike a pendulum which is self-regulating under natural laws. When heating systems break the temperature slides all the way down to the one outside, a long way from the target.
This is the important point which shows the difference between a regulated and a self-regulating mechanism. As far as we know in the whole of history no pendulum has ever failed to seek its point of equilibrium. But in that same period no central heating system we know about has survived and continued to operate for more than a few decades.
Indeed all systems which achieve their ends through clever devices and imposed regulators are 100% unreliable over the long term.
Modern democracies like thermostats
Before 1930 governments recognised their impotence in the face of the natural forces which swing the economic pendulum. But in the final 80 years of that period - from about 1850 - the western world adopted the principle of one person one vote.
During those 80 years financial crises kept occurring as the economic pendulum oscillated. They culminated in 1930 with the Great Depression.
Everyone recognised a particularly severe oscillation of the business cycle. But some of our grandfathers believed with great conviction (for which economists widely ridicule them now) that the correct economic policy was to avoid intervention and let the swing of the pendulum run its course. Their deeply held view was that once they started meddling there would be no end until, much later, the corrections which would be required to regain economic equilibrium would be cataclysmic.
Evolutionary change
Many of our grandfathers had learnt from Charles Darwin, who himself acknowledged the economic ancestry - founded on Smith - of his Theory of Evolution.
Theirs was the first adult generation able to see clearly the elegant natural relationship between birth, competition, inheritance, death and gradual change; it understood that the giraffe's long neck came about through the loss of those with shorter ones. Since the giraffe had not changed the length of its neck by strenuous stretching, and following Darwinian reasoning, they figured their institutions would turn out better suited to their economic environments if their antecedents were subjected to the regular test of fierce competition and mortality which comes with a natural downswing in the business cycle.
So those grandfathers believed their obstinate refusal to support government protection of the economically weak was a commitment to the long term competitive strength of their society. But this did not make them at all popular with their contemporaries.
Politics and survival of the fittest
Social attitudes were rapidly changing. Political parties had to adopt the idea that letting things follow a commercially mortal course - with the unemployment and hardship which resulted - was too cruel for a public on whose widespread support these parties depended for their existence.
Politics too turned out to be subject to Darwin's process. In their democratic countries it was no use proposing things which disadvantaged the current electorate, in favour of a future one, because such policies consigned parties to extinction. Meanwhile government interference which protected jobs and prosperity, and promoted change through managed effort (giraffe-like neck stretching), were those which offered the longest life of greatest comfort to their electorates.
These political parties were the ones best adapted to their democratic environment, and they thrived.
So in 1932 the USA applied the brakes on the rate of evolution of its economic system. It chose to protect its electorate with economic central heating. After 70 more years we find all the major economies of the world are centrally heated by their governments. Politicians decide where they want economies to go, and they pull levers to try to engineer the desired result, rather than let the harsh judgement of free market competition subject them to rejection on voting day. The economic thermostat is now routinely turned up in the quest for growth and re-election, resulting in institutions which have become immortal and do not change. On the face of it we have all benefited because we live longer and more economically comfortable lives. Certainly we have not seen a repeat of a depression on anything like the same scale.
This may mean our economic guardians have designed the first thermostat which never fails; but our observation of the unreliability of machines, and the observed extinction of all organisms which tend to individual longevity, both suggest that the odds are heavily against it.
The broken thermostat
So what would happen to a modern centrally heated economy if its mechanism failed?
In the Great Depression years - from 1930 to 1932 - the US economy lost about half of its economic output as people cut back on avoidable spending where they could. During the depression they didn't go to restaurants, or take luxury holidays, or generally swan about spending money; all of which seems a normal response to bad economic times.
Yet they continued to buy food, and other basic goods. The business sectors which were most damaged in the Great Depression were the ones which supplied life's 'un-necessaries', many of which had only recently built up, during the roaring twenties.
So as the pendulum swung back during the depression the world economy was propped by essential goods and services, and this ultimately arrested the inevitable over-swing, stopping unemployment in the US at a ceiling of around 25%, and productive output at a floor of about 50% down from the output high of 1929. It was only when this production floor was reached that people looked round and realised that it actually couldn't get much worse, and from then on confidence started to rebuild as available resources were re-applied in new configurations into the gaps that economic mortality had created.
If the same pattern were to apply to the world's next great depression then we have a problem. The result of prolonged economic central heating is that demand for progressively more extravagant products has been ratcheted up year after year, so that food, fuel and basic goods and services are now a far smaller constituent of expenditure than they have ever previously been.
In 1913 food production represented 70% of world trade, now it represents 17%. Food consumption over 35 years has doubled in the USA, while leisure and recreation have grown by around 10 times.
The accretion of this luxury productive output is exactly what could set the scene for economic catastrophe. A slump to the fundamental support level now could eliminate 80% of economic output.
Command economy deficits
This is beyond even the scale of contraction which befell the 'command economies' of the East after 1988.
That term 'command economy' should provoke careful thought. At the peak of enmity between West and East during the Cold War our certainty was that our free economies were operating far more efficiently than the directed economies of the East. Their command economies were inefficient and unresponsive to changing circumstances and they lagged the West, and it was this more than anything else which brought the West its victory.
But since then virtually the entire regulatory apparatus which held back Eastern productivity growth has been removed, and an extraordinarily harsh blast of competition has blown upon Russia, Eastern Europe and China, wiping out their old institutions and making their resources available to billions of relatively unconstrained producers. Like-for-like they are already out-producing us by an order of magnitude.
So, ironically, the command economy is alive and well, but no longer in the shadow of a red flag. Nowadays it is western monetary stimulus which commands the factories to produce, and people to buy.
It could so easily be called 'protectionism' too, for the protection of jobs and industries from natural forces of competition is exactly what is intended and achieved. But protectionism, like the command economy, is a discredited philosophy, so commentators do not support the use of economic stimulation policies under that name.
How about some hard evidence?
This greatly increased command, or protectionist, effect has been quantified in America. In the last 55 years the bureaucratic share of the American economy, incorporating federal taxation, local taxation, and regulatory compliance, has increased from 26% to 53%. Western Europe is much worse.
Under the influence of protected individual longevity the powerhouse economies of democracy are failing. Confirmation is found in trade figures. Unable to sell the output of bureaucrats and regulators the US has become a very large net importer of foreign goods.
Per capita deficits
The effect on an average family of the famous twin deficits - trade and budget - is simpler to express than the strings of zeros in government statistics.
The US government borrows $5,000 a year on behalf of each US family (which it dares not tax). It spends it keeping itself popular, and Americans in work, and that $5,000 buys foreign goods, giving the foreign supplier $5,000. So the foreign supplier lends it back to the government by buying $5,000 in bonds, which the US government promises will eventually be paid back by taxing that American family at some time in the future.
The current four year period will end having increased the average family's future tax debt by about $18,000. The family's total accumulated tax debt is approaching $70,000, most of which has been built up since 1990. That $70,000 is the visible tip of a much larger iceberg of debt, because that same family believes itself entitled to future welfare provided by government. This is the "generational debt" - so called because it's what the next generation owes to us in welfare we've financed for the previous one through our taxes. It has been calculated by the widely respected Economist magazine at $44,000,000,000,000 - or about $440,000 per family, and unlike the requirements of US law for corporations this government liability is currently not provided for in public accounts.
All this debt has been the fuel which has consistently heated the US economy and kept us voting for the retention of a social market economy system.
Debt - the fuel of economic central heating
Debt causes most financial disasters.
"Prosperity was assisted, too, by ... stimulants to purchasing, each of which mortgaged the future but kept the factories roaring while it was being injected ... People were getting to consider it old-fashioned to limit their purchases to the amount of their cash balance; the thing to do was to 'exercise their credit' ... 15% of all retail sales were on an instalment basis ...It was fun while it lasted." - Only Yesterday, an informal history of the 1920's, F.L.Allen (published 1931).
These 1920 'stimulants to purchasing' were modest by comparison with ours.
Nowadays, in addition to a public policy of borrow-and-spend, private credit is available through re-mortgaging, personal loans and credit cards. Its mail-based advertising single-handedly sustains the postal services.
Our democratic system cannot now continue without it. We simply will not vote for people who tell us that we must tighten our belts now or pay a heavy future price, and so our governments compete to turn up the heat on our economic thermostat. They reward the most financially reckless in our society as they do so.
This is exactly what Adam Smith would have predicted. He believed even benevolent government meddling creates weaknesses in the economic continuum.
Rewarding the reckless
At any hint of a tailing off in economic activity we now all know our governments will inject more demand.
Our smartest company executives have adjusted their policy to account for this. If it is known that potentially severe economic downturns will be cushioned by government policy to increase demand then at any given level of indebtedness their company is less likely to fail.
So companies issue their own debt - to the maximum of their ability - and consume more cautious businesses in a flurry of debt-laden deals. Executives and business schools long since got the message that a state sponsored safety net will protect them, and they adjust by moving their businesses closer to the flames of destruction by debt, to places they would never have approached without the confidence that government would intervene on their behalf.
They have no choice. They have to do this or they fall into the hands of another company which had the necessary courage.
Eventually credit rating agencies draw attention to the huge debts of these businesses and the risk of economic shocks. But it is not the end of the cycle. Although some managements quieten down, jealous of their investment grade credit rating, others - from the smarter business schools - extend themselves 'off balance-sheet' into the derivatives markets.
Here - under the disguise of clever financial management - they underwrite financial contracts for fantastic amounts of money and generate small profits on large but improbable risks. It's very similar to insurance, only the risk that is being insured is not a fire, or a flood, but the financial equivalent - something like "the yield on 10 year US Treasury bonds, less the yield on 5 year Japanese government bonds, divided by the change in the yen/dollar exchange rate will not exceed 5% before the end of 2005".
Procter and Gamble famously found out what can happen when their £200m borrowings were 'insured' by derivatives to 'save' $7.5m over 5 years. When the impossible happened their small saving turned into a loss of $157m.
But for every Proctor and Gamble there are 50 smaller winners, for whom the risk pays off, resulting in what amounts to financial insurance profits being generated apparently out of nowhere - because, remember, these risks are 'off' the balance sheet. So profits rise, shares follow, and the brilliance of their management leads them to take over those companies more circumspect than themselves.
Steadily the corporate credit habit is perpetuated and reinforced, and companies start to rely for their profits on being lucky in financial insurance markets rather than being good at doing something commercial. That they can do this at all is because government is fuelling a central heating system for the economy, and preventing reckless risk-taking from being found out by the swing of the economic pendulum.
So, just as Adam Smith predicted, government meddling creates over-indebtedness, and allows maximal exposure to risk to pay handsomely. Being sensibly cautious in this business environment spells certain doom.
More evidence - this time from the markets
Hard evidence can be found in financial figures. The world bond market, i.e. debt which has been issued in the form of traded bonds, grew from $800bn in 1970 to over $35,000bn in 2001. This is 43 times.
But even this newly colossal bond market is a runt next to derivatives, which caught the prevailing wind of off-balance-sheet accounting and exploded out of control.
The BIS estimated the main financial derivatives markets at $1,100bn in 1986. The figure for 2001 for the exchange traded contracts monitored by the BIS was $150,000bn. A further $98,800bn in Over The Counter (OTC) derivatives have to be added as well. In 15 years the notional sum of derivatives outstanding has grown by nearly 250 times.
Yet in the minds of investment bankers every cent of these derivative exposures is secure.
"One of the paradoxes of speculation in securities is that the loans that underwrite it are among the safest of all investments. They are protected by stocks which under all ordinary circumstances are instantly saleable, and by a cash margin as well....A few firms made this decision: instead of trying to produce goods with its manifold headaches and inconveniences, they confined themselves to financing speculation...This was, possibly, the most profitable arbitrage operation of all time." The Great Crash 1929 - J.K.Galbraith describing in 1954 how the brokers' loans which ultimately brought disaster looked so attractive and safe before the event.
Conclusion
What we now have - in Darwinian terms - is long lived individual corporations superbly adapted for the consumption of debt. In an animal analogy extinction beckons as soon as the available supply of debt dries up. Surely that circumstance is unavoidable when the world's savers consider whether an organisation of 100 million individual families, each with unsecured debts of $70,000, genuinely deserves its AAA credit rating.
It's depressing in its way, yet it's also exciting to be able to see through the economic contradictions of the society to which we owe our current financial comfort - especially while it still allows us sufficient freedom to act.
It must be likely that investing for capital growth will soon become a memory; that pension savings will become worthless for the majority; that houses will become homes again; and that goods which provide a pleasant standard of life will become expensive. Capital preservation between now and then is a serious challenge with a valuable prize, but it remains a possibility for every one of us who has a critical look at history.
Enjoy learning about historical monetary systems and their failures from Galmarley's History of Money series, including:-
