The West’s Addiction to Economic Disequilibrium
One of the largest and most problematic instances of economic disequilibrium arises from a disconnect between ‘claims on wealth’ and wealth itself (to quote Carroll Quigley). When these two magnitudes diverge, a great proportion of the population can stray from economic prudence. In the West (at least), periods consisting of these divergences have become the norm – moreover, it would seem that anything else is quite unacceptable to the masses. Here, I consider the nature of such divergences and explore the investment implications of their resolutions.
The Obsession with Expansion:
In Tragedy & Hope: A History of the World in Our Time (available at the greshams-law.com book store):, Carroll Quigley outlined the mentality that has gripped the West for — perhaps — hundreds of years:
An economic system does not have to be expansive — that is, constantly increasing its production of wealth — and it might well be possible for people to be completely happy in a nonexpansive economic system if they were accustomed to it. In the twentieth century, however, people of our culture have been living under expansive conditions for generations. Their minds are psychologically adjusted to expansion, and they feel deeply frustrated unless they are better off each year than they were the preceding year. The economic system itself has become organized for expansion, and if it does not expand it tends to collapse.
I should clarify that what really matters (to people) is that they think that they are better off each year compared to the preceding year. Unsurprisingly then, most economists of our day pay a lot of attention to Gross Domestic Product. By ‘engineering’ an environment with increasing GDP, people can be fooled into thinking that they’re progressing. Hugh Hendry has often addressed this issue when talking about China. He points out that resources are scarce, and that when these scarce resources are put into arbitrary projects (decreed by governments), the results are still worth something. However, they are not necessarily worth more than what it took to make them or what could have been made. In this way, GDP growth can be created at the expense of wealth creation. He alludes to this in the following video (you can start the video at around 0:50).
‘Claims on Wealth’ Vs Wealth Itself:
Carroll Quigley wrote lucidly about the monetary system, and so – naturally – he made the distinction between ‘claims on wealth’ and wealth itself (in the same way that Robert Prechter makes a distinction between ‘IOU money’ and money proper). The following quote is from Tragedy & Hope: A History of the World in Our Time:
In each country the supply of money took the form of an inverted pyramid or cone balanced on its point. In the point was a supply of gold and its equivalent certificates; on the intermediate levels was a much larger supply of notes; and at the top, with an open and expandable upper surface, was an even greater supply of deposits. Each level used the levels below it as its reserves, and, since these lower levels had smaller quantities of money, they were “sounder.” A holder of claims on the middle or upper level could increase his confidence in his claims on wealth by reducing them to a lower level, although, of course, if everyone, or any considerable number of persons, tried to do this at the same time the volume of reserves would be totally inadequate.
Since the collapse of the Bretton Woods system in the early 1970s, the cone’s ‘point’ is no longer the supply of gold reserves, but the supply of central bank notes (& reserve balances) themselves. This means that the stock of ‘claims on wealth’ – which most people refer to as ‘money’ – are pyramided on top of central banking liabilities (central bank notes & reserve balances). To make the matter even more confusing, people often refer to central bank notes as ‘money’ also. The key difference is that central banking liabilities can be created out of thin air, hence the cone’s ‘point’ is expandable. The catch is that expansions in the ‘point’ of the pyramid dilutes each individual unit. Nevertheless, at any given time, if everyone, or any considerable number of persons, tried to express their claims upon central bank notes, the volume of reserves to back those claims would be totally inadequate.
Illusions Created by the Disconnect between ‘Claims on Wealth’ & Wealth:
It is by strong divergences between ‘claims on wealth’ and wealth that we can experience periods of mass delusion. If a strong disconnect between these two magnitudes arises, then people may act on premises that are suitable for a richer and/or more abstinent parallel universe. It is by these diverging flows that great asset-price bubbles can arise.
This unique character in the American economy rests on the fact that the utilization of resources follows flow lines in the economy that are not everywhere reflected by corresponding flow lines of claims on wealth (that is, money). In general, in our economy the lines of flow of claims on wealth are such that they provide a very large volume of savings and a rather large volume of investment, even when no one really wants new productive capacity; they also provide an inadequate flow of consumer purchasing power, in terms of the flows, or potential flows, of consumers’ goods; but they provide very limited, sharply scrutinized, and often misdirected flows of funds for the use of resources to fulfill the needs of the governmental sector of our trisectored economy. As a result, we have our economy of distorted resource-utilization patterns, with overinvestment in many areas, overstuffed consumers in one place and impoverished consumers in another place, a drastic undersupply of social services, and widespread social needs for which public funds are lacking.
Resolutions of these Disequilibria:
Now that we’ve passed a decade of popping bubbles, it should be clear that the resolutions to these disequilibria are of utmost importance to the investor. Since a great number of people were engaged in activities that were premised on fictitious quantities of resources (and/or fictitious willingness to invest those resources), the revelations of these follies have a capacity to produce large (and swift) moves in asset prices.
Traditionally, this has occurred via deflation. That is, a drastic rush to acquire wealth with ‘claims on wealth’. As it comes to be realized that not all of the ‘claims on wealth’ are good for anything, the price level plunges and a great number of (unsustainable) businesses are forced to cease operation. This is the necessary cleansing process that is advocated by the Austrian School of Economics.
Generally speaking, people have been hostile to these periods of deflation. Unsurprisingly, people don’t like to take wage cuts or be unemployed. An example of this can be inferred from the period in which Great Britain abandoned the gold standard. In the preceding years, the major governments of the world (bar the US) had ‘gone off the gold standard’ to finance WW1. They had created ever increasing quantities of ‘claims on wealth’ without increasing the underlying stock of wealth. However, after the war, they wished to return to the gold standard. They did this by restoring the peg at the old rate, which had the effect of deflating prices. This was just unacceptable to the people (in particular to the British fleet at Invergordon):
The decisive event which caused the end of financial capitalism in Britain was the revolt of the British fleet at Invergordon on September 15, 1931, and not the abandonment of gold six days later. The mutiny made it clear that the policy of deflation must be ended. As a result, no real effort was made to defend the gold standard.
Incidentally, Hugh Hendry alludes to the Invergordon mutiny and the distaste for deflation that seems to have gripped certain Euro Area countries (he mentions this at 3:30).
Modern-Day Methods of Resolution:
As the West abandoned sound money, the means by which these disequilibria could be resolved changed. As mentioned above, the modern-day monetary system has the supply of central bank notes (& reserve balances) as its base. This supply can be manipulated by central banks, and so the modern-day methods of resolution are quite different.
When it comes to be understood that the quantity of wealth backing the stock of ‘claims on wealth’ is wholly insufficient, the modern-day method is to debauch the underlying (upon which there are claims). In this way, the stock of ‘claims on wealth’ has a greater propensity to stay in existence. Moreover, the utilization of resources remains directed towards a fictitious level of wealth and/or abstinence from consumption.
Investment Implications of the Above:
The above has significant implications for the macroeconomic investor. It implies that investing in the prospect of a major realignment in ‘claims on wealth’ and wealth should be considered as a relatively temporary endeavor. One can count on the monetary authorities to debauch the underlying wealth in order to preserve the stock of ‘claims on wealth’. As such, it only really pays to hold central bank notes for relatively brief periods of time.
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012