The tipping point

A recent article by David Jensen (Jensen Strategic) digs below the surface and analyses perceptively the reality of economic and financial developments over quite a long period. In particular, he looks more closely at the causes of those developments.

The essence of his analysis accords with what I put forward as long ago as 1971 in The Indigent Rich: A Theory of General Equilibrium in a Keynesian System, as well as in Inflation: A Study in Stability in 1974.

Much more recently, I have expressed similar views in America's Suicidal Statecraft: The Self-destruction of a Superpower (November 2006).

Jensen is one of very few analysts to remind us of Keynes’ reference to what he called "Gibson's Paradox" on the relationship between the price of gold and interest rates. The latter translates more widely into the relationship between interest rates and the rate of inflation, whether consumer-price or asset-price inflation.

In The Indigent Rich (1971), I pointed out that the restrictive policies of 1969 to 1971, including interest-rate hikes by the Fed, would increase, not reduce inflation; and, indeed, that was precisely what happened. We experienced what we then began to call stagflation. I reiterated my views in Inflation: A Study in Stability (1974) but the view of central banks and major governments persisted that the way to "fight inflation" was to raise interest rates.

Indeed, that view still prevails. The Fed and other central banks are seen to be "responsible" and to be "carrying out their fundamental mandate" when they raise interest rates in the face of inflation or the threat of inflation. That inflation is usually tacitly defined as consumer-price inflation.

Since 1969, Gibson's Paradox has proved to be correct. The purchasing-power value of the major currencies has declined precipitously - by many calculations, to about 5 per cent or less of their real value in 1971.

The value of gold has risen from about $30 an ounce to (in January 2008) about $900 an ounce. In other words, it now takes about 30 times the number of US dollars to buy an ounce of gold as it did in 1971.

As Jensen shows, the price of gold has been subject to intense financial-authority - central bank and other - manipulation. Its price was held down for long periods and, even now, its free-market value is almost certainly significantly suppressed.

That Consumer-Price Inflation (CPI) has seemed to be contained derives from this handling of gold, together with other deceits and manipulations. One device was the Greenspan-Boskin substitution and "hedonic" manipulation of the CPI. Meantime, however, the high nominal and/or real costs of production which the restrictive - "fight inflation with interest-rate hikes" - policies produced transferred real production from the United States and like economies to low-cost producers especially in Asia.

Over time, this led not only to a reduction - or lesser increase - in "inflation" in the United States but also to an enormous transfer of real fixed-capital investment, real production of goods and services and, with it, large increases in productivity, to the Asian Tigers and, most conspicuously in recent years, to China and India.

In the United States and like countries, manufacturing was gutted, jobs in the production of real goods and services was "off-shored" and "ownership" - especially speculative - investment took the place of real fixed-capital investment - both public and private.

Underlying inflation did not decline. On the contrary, it increased at a rapid pace and especially in those economic and financial sectors - infrastructure, education, health services and the rest - which could not be "off-shored".

Debt increased. This debt was partly from balance-of-trade deficits which in the United States have recently been running at between $700 and $800 billion a year. Debt was part official - it is now at a staggering total of trillions of US dollars and still rising; and household debt increased to unprecedented proportions; largely because real incomes of middle and working classes lost touch with consumer costs, especially where these were not modified by low-cost imports from emerging economies, especially in Asia - and, of course, those imports stole the jobs and the fixed-capital investment which would have benefited the lower-income earners.

At the same time, central-bank policies based on fundamentally flawed assumptions, were allied with political and ideological obsession with the free market, free trade, deregulation, privatisation, and other devices aimed at letting the market - and the bright, mostly young and highly creative “marketeers” of whatever kind - have as free rein as possible.

The result was, especially since the 1980s and more especially in the new century, an explosion of credit and credit derivatives of a range and volume that is completely unprecedented.

This was an explosion of CREDIT - repeat, CREDIT - the nature of which the global economy or national economies had never seen before. The rate of interest, as determined or fixed or whatever by central banks was of less significance because of the unregulated flow of funds from the non-banking as well as the banking sector, nationally and, again to an unprecedented extent, globally.

There was in this unregulated flow of credit or funds or “liquidity”, a large element of "Ponzi" finance and especially "Ponzi" speculation. “Ponzi” schemes could promise high returns, and keep their promises, so long as the blind faith of “investors” kept funds pouring into the schemes in sufficient quantity to enable the promises to be kept.

That meant that the boom in debt, credit, assets and the rest would go on spectacularly until some tipping point was reached. When something caused the avalanche of credit into the "Ponzi" schemes to slow, then the whole "system" would be quickly called into question and, at some point quite soon afterwards, it would be paralysed and, ultimately, destroyed.

That denouement was inevitable. It was inherent in the nature of the “system”. It was never a question of if there would be a bust, only a question of when and what form the bust would take in detailed terms.

This must have been known to some at least of the professionals in the financial markets. They must have known where it would end.

Their motives in not taking earlier action - earlier than when events forced it on them in the summer of 2007, for example - may have been in some sense honourable: they shrank from precipitating the acute crisis that would result from collapse of the "system" at whatever time it might take place. By postponing the inevitable, perhaps they hoped to ameliorate the pain in the short term. However, that pain might be even greater - and more enduring - down the track.

There may be less honourable motives - and these may still be operative. Those in the wobbly box-seats of the economic and financial “system” might have wanted, and might still want, to prop up a terribly flawed and inevitably doomed "system", come hell or high water. They will help those who have recklessly and selfishly exploited the "system", help them despite, at least in some cases, the dubious morality of their gains, even at the further expense of those who have already suffered severely from their policies and practices in recent years.

What this all comes down to is:

1. we must seek to minimise the suffering of the most vulnerable and innocent in our societies and economies;
2. we must gird ourselves to clear from the Augean stables of our economic and financial “system” the mess which has built up over the years since 1969 and, more especially, during the buccaneering years of the new century; and
3. we must be prepared for fundamental reforms in our national economies and the global economy, of at least the magnitude of those we instituted after the Great Depression and World War Two. These reforms call for new attention to such issues as the validity of “Gibson’s Paradox”; the role of credit as distinct from interest rates; a return to relatively stable exchange rates of the pre-1971 period instead of the speculation-prone, trade-distorting, “free-floating” exchange rates we have now; and sufficient regulation of the flow of funds within both the domestic and the global economy to ensure at least an amelioration of the cycle of boom and bust inherent in the present arrangements.

If only because of the intellectual inertia caused by long conditioning, these reforms will be difficult to achieve and they will take time.

However, if we do not adopt them, the consequences not only in economic and financial terms, but especially in political and strategic terms will be grave.

The United States is already well on the way to political and strategic self-destruction as a superpower. It is in the interests of global stability that this decline should be arrested - or at least moderated - as quickly and effectively as practicable.