Culture, Complexity & Capital Markets in the 21st Century
A Race to the Bottom?
During the Panic of 2008 and the recession that followed it, fundamental problems within the United States’ economy were exposed, but unfortunately, ultimately ignored. Today, the idea exists among prominent economists and other elites throughout the world that the American economy – and by extension, the global economy – will continue on an infinite path. Yes, there will be boom and bust cycles, but they argue that the average person has nothing to worry about; the economy will self-adjust to any problems and if things get too bad then central banks can step in to prevent any major economic crisis from developing. Most people are happy with these explanations and few ask such pressing questions as: is another severe economic downturn inevitable and if so, what impact will it have and can it be avoided? These are questions that few economists are willing to tackle, but as more inherent problems within the economy manifest themselves, more and more economists are issuing warnings.
At the vanguard of the prominent figures who have sounded the calls for fundamental financial reforms is James Rickards, who has brought his warnings personally to top government officials and economists and detailed his ideas in his book Currency Wars: The Making of the Next Global Crisis. Rickards has utilized a fairly new social science philosophy known as “complexity theory” to examine the current, volatile state of the economy and to predict where it may end. One of the primary tenants of complexity theory asserts that the more complex something becomes – an organism, a nation-state, a civilization, or in this case, an economy – the less value it will produce. Complexity theory has been primarily used by historians to explain the collapse of kingdoms, nation-states, and civilizations, but it is utilized by Rickards to explain where the economy is headed – and the future does not look good. With the large volume of dollars that the Fed injected into the economy during the last recession, few economists will argue that some devaluation of the dollar is around the corner, although the extent of the devaluation and its long-term impact are major points of contention. Following the complexity theory, Rickards argues that the dollar’s devaluation is just the inevitable outcome of an economy that has grown too complex and has devolved into a race to the bottom. Despite Rickards’ gloomy prognosis, he offers a number of solutions that, with the proper political will, can be employed to stop the collapse of fiat currency and possibly the entire global economy.
A Paradigm Shift
Rickards argues that before economists and law makers can do anything to resuscitate America’s anemic economy and fiat currency system, a paradigm shift must take place. A paradigm shift is simply a radical shift in thinking or philosophy and can be applied to nearly anything including science, language, politics, and economics. Paradigm shifts can happen quickly, but acceptance by the greater population may take generations. For instance, Copernicus’ heliocentric idea of the solar system is taken for granted today, but in the sixteenth century the idea represented a real paradigm shift from the accepted Aristotelian view of the world that was consequently upheld by the Church. Although Copernicus never lived to see it, the heliocentric view of the solar system was gradually accepted about 100 years later. Rickards argues that an economic paradigm shift is required today.
Current world leaders and economists are generally hampered by an outdated economic paradigm that holds that gold is outdated and essentially useless as an anchor for currency in the twenty-first century. The acolytes of the current economic paradigm also believe in a template of inflation versus deflation. They generally believe that inflation is the lesser of the two evils and so will manipulate money supplies in order to create inflation, which in turn has led to costly currency wars. If the United States’ economy is to survive, argues Rickards, then a new paradigm must be created that will effectively replace the old one. Understanding the origins of the current economic paradigm is important in the current state of the global economy.
Milton Friedman and the Current Economic Paradigm
The current economic paradigm can be traced back to the 1950s and ‘60s with the Chicago School of economics, in particular Milton Friedman. Friedman was an important American economic scholar who published numerous articles and books and taught at the University of Chicago and also known to have the ear of different presidents, most notably Ronald Reagan during the 1980s. Because of his vast experience and academic expertise on economics, Friedman’s ideas have come to dominate not just current American economic philosophies, but also those of economists throughout the world. Current fiscal and monetary policies are largely the result of Friedman’s ideas concerning how to reach optimal economic growth.
Central to Friedman’s economic philosophies was the idea that a healthy economy should have an annual growth of 3-4%. He arrived at the number by noting that the annual population growth of the nation is 1-1 ½%, while the growth in productivity should be around 1 ½-2%, which when added equals 3-4%. The formula may seem simple enough, but it contains many moving parts, the most important of which is the money supply and its velocity.
Velocity in currency refers to how money is used once it enters circulation. A dollar that is used for goods and services and then continually used again for more goods and services exhibits a fair amount of velocity, while a dollar that is simply put into a savings account or used to pay off debt has little to no velocity. Obviously, currency velocity can be very unpredictable as it depends solely on the capricious nature of the consumer and has little to do with the Fed or other central banks, which is what Rickards argues is one of the fundamental problems of the current economic paradigm. Friedman argued that the money supply should be increased by 3-4% per year to keep pace with economic growth. He summed it all up in a neat little equation: MV=Py, which is money supply times velocity equals price levels times real gross domestic product. The equation is logical and has been taught for decades in economics courses at nearly every university and college but raises some questions that could throw the entire paradigm into disarray, such as the following: what happens when the money supply increases or decreases rapidly, or the people just quit spending?
From 1980 until 2008 the formula seemed to work well as the money supply increased by 3-4% even during the inflationary cycle of the late 1970s and early 1980s. It should be noted that the inflationary cycle of that period came years after President Nixon took the United States off the Bretton Woods monetary regime, which was essentially a modified gold standard, and then proceeded to print money at a rate that exceeded 4%. The economic situation may be even more precarious today because the Panic of 2008 resulted in policy moves by the Fed and the Obama administration that have yet to be felt including: three rounds of quantitative easing, printing of more dollars, and government stimulus plans that raised taxes. The most apparent results of these initiatives has been an increased money supply of 400% in four years with little currency velocity because people are saving their money and paying down debts. The government and the Federal Reserve Bank know that all of the excess currency they printed has the potential to lead to severe inflation if the consumers do not start spending. The Fed and the government need to entice people somehow to spend.
Perhaps the biggest reason why the Fed needs people to spend is because the gargantuan national debt of the federal government requires nominal GDP growth to make payments. Following Friedman’s standard of 4% annual nominal growth, the Fed reaches that target an equation that adds inflation and real growth. They prefer to have inflation at 1% and real growth at 3%, but will accept the reverse formula if it arrives at Friedman’s magic number of 4%. History has shown that keeping that 4% has been extremely difficult, even when the Fed has resorted to numerous methods of manipulation.
Since the Fed cannot influence velocity directly through new laws, it is forced to do so through some methods that Rickards has described as propaganda. One of the primary ways that the Fed has done this is by creating negative real interest rates with the idea that the lower interest rates are, the more people will borrow and ultimately spend, thereby adding much needed velocity back into the economy. If inflation is 3% and the nominal interest rate is 2%, then the real interest rate will actually be -1% based on ten year treasury notes. An actual inflation rate of 3% will also cause what is known as inflation expectation shock if the expected rate is 2%. Essentially, the Fed uses inflation as a tool to battle deflation, which it considers the worse of the two evils. If nominal growth is too low and there is a lack of currency in circulation then the government cannot pay its debts because there is a reduced tax base. In order to reduce interest rates, increase currency, battle deflation, and ultimately keep economic growth between 3 and 4%, the Fed has embarked on a number of different programs and methods over the last several years, all of which have had minimal success.
Quantitative easing and cutting interest rates have already been discussed above as Fed methods, but the Fed has also employed a number of other strategies. Rickards points out that one of the Fed’s most interesting methods is its communications program, or as he terms it, propaganda, which continually trumpets the idea through various news outlets that the economy is fine as long as the citizens spend. Another technique the Fed uses is what is called “helicopter money” because it is money that is essentially dropped into the public by releasing reserves held in banks. The problem with that procedure is that the banks have been hoarding their cash and so the government has had to respond with tax cuts, which further takes from the tax base. Perhaps the most destructive method that the Fed has at its disposal to reach its growth targets is currency wars. Currency wars are when a country devalues its currency in an effort to battle deflation and boost exports. Rickards clearly demonstrated in detail in Currency Wars that there is rarely a winner in a currency war because it creates a domino effect where several nations devalue their currencies, which eventually leads to severe inflationary cycles and recession. So if the Fed has been applying the wrong paradigm to handling the economy, what is the proper paradigm?
Changing the Paradigm
Rickards and other like-minded economists argue that the current paradigm is too linear and needs to be replaced by one that acknowledges the complex and dynamic nature of the global economy. He uses the metaphor of a thermostat versus a nuclear reactor: economists have viewed the economy as a thermostat for the last several decades when in reality it is more like a nuclear reactor – extremely volatile with many moving parts. The current paradigm views economic events as random, while Rickards argues that events in a complex system, which capital markets are, are causal. Because events in the markets are causal, then price movements are not random, risk is not evenly distributed, and essentially the markets themselves are not efficient. Risk prediction in particular, Rickards charges, is one of the primary reasons for the Panic of 2008 as many of the prognostications made by economists and money managers in the years leading up to the recession proved to be false, irresponsible, and sometimes criminal. So Rickards advocates that we must begin to view capital markets and the global economy with a new perspective, a new paradigm, if we are to avoid a catastrophic collapse.
Capital Markets and Complex Systems
Rickards takes a less myopic view of capital markets and the global economy by viewing them as complex systems through an approach known as “complexity theory.” Complexity theory was first articulated in the 1960s and has been used primarily by historians and anthropologists, most notably Joseph Tainter, to explain the collapse of nation-states and civilizations; but the theory can be applied to understand any organism or organization that reaches a certain level of sophistication. Complexity theory holds that complex systems design themselves through evolution or interaction of autonomous parts. For example, a small group of people may organize themselves into a tribe but as time goes on they acquire more members and eventually evolve into a federation, then a kingdom or nation-state, and finally coalesce with other like-minded kingdoms or nation-states to form a civilization. Essentially, in complexity theory, the whole is greater than the sum of its parts, which is why its proponents view the “big picture” first: they examine the entire civilization before studying the course of a constituent nation-state or they analyze the entire global economy as a whole instead of one single aspect. Complexity theory also holds that the more complex something becomes, more and more energy is needed to sustain the system.
Most people know that energy and resources are finite; one cannot just make oil, water, or even solar energy out of the thin air. According to complexity theory, no organization can become complex without increasing its energy consumption, which leads to the fundamental problem that most civilizations face – the law of diminishing returns. The law of diminishing returns essentially states that the more labor intensive something becomes, the less benefits will be gained. Joseph Tainter uses the example of scientific research to elucidate this point. He points out that once big discoveries have been made, such as the computer, then subsequent research in the field becomes more specialized and expensive because more scientists are needed. The increasingly complex system’s diminishing returns then ultimately threaten and destabilize it to the point of collapse. The complexity that was the hallmark of the system also is its ruination. Complexity theory may seem a bit complex to those not familiar with it, but it is surprisingly simple when applied to capital markets and the global economy.
Applying Complexity Theory to the Global Economy
James Rickards is currently one of the world’s foremost proponents of using complexity theory to analyze the global economy, which he has clearly and succinctly done in a number of lectures and publications. Rickards points out that the global economy possesses four traits that make it a complex system and therefore capable of being understood through complexity theory. Firstly, the global economy is extremely diverse and the result of several autonomous agents coalescing to form a larger whole. Secondly, the economy exhibits connectedness through media and other organizations, which work to keep the once autonomous agents united. Thirdly, there is interaction and interdependence through stock and commodity markets that are located on every corner of the globe. Finally, the global economy is adaptable and capable of learning through behavior. Along with the traits that Rickards identifies that make the global economy a complex system, he has also introduced two unique ideas in order to better understand complexity in economies.
Rickards argues that for economists and the public to grasp how complexity will affect the future of the economy, knowledge of “emergent properties” and “phase transitions” is imperative. Emergent properties is defined as the process by which elements come together to form a complex system. As described above, in the case of humans, it can be when a number of tribes fuse to create a kingdom, or in the case of economics, it can be the creation of a central bank and a stock market. As with civilizations, the constituent parts are important and play a role in the economy’s functionality, but they are not more important than the whole system. Phase transitions are the processes that Rickards uses to describe what happens when a complex system changes its state. Since complex systems are dynamic and ever evolving, phase transitions are a normal part of the evolution. Phase transitions are also often unpredictable much like a single snowflake causing an avalanche on the side of a mountain. In terms of the economy, the snowflake can be a policy decision by the Fed, such as quantitative easing, which could at some future point create an avalanche of hyperinflation.
The Law of Diminishing Returns and the Global Economy
Perhaps the most sober aspect of complexity theory is how the law of diminishing returns precipitates a collapse. Rickards points out that it does not take long for one see this process at work in the economy. In 2010, more Americans worked for the government than in construction, farming, fishing, forestry, manufacturing, mining, and utilities combined. This statistic points towards an economy that is less dependent on the production of resources by the perspective of the average working person; but a growing parasitic nature can be detected among the elites as well. In the midst of the last recession, as millions of people were struggling to find work and cutting corners to pay bills, the average CEO pay increased by 27% in 2010. Even more telling, the ratio of the average yearly earnings by the top 20% compared to the rest of the country went from 7.7 to 1 in 1968 to 14.5 to 1 in 2010. Any economist will tell you that it is virtually impossible to keep an economy afloat where the majority of the population work in government and retail and the financial gap between them and the elites keeps growing. It appears that the global economy may have reached critical mass with the law of diminishing returns. History shows that once a complex system reaches this point that there are only three possible solutions: a return to simplification, conquest by outside forces, or a total collapse.
A Paradigm Shift or the Collapse of the Dollar?
Rickards argues that without a significant paradigm shift, one that will simplify and decentralize the economy, the American and inevitably the entire global economy will collapse. He believes that the critical phase transition, the snowflake landing on the mountain, will take place when various global economic powers move to replace the dollar as the world’s reserve currency, which will be aggravated when private citizens divest in the dollar. Although all of the signs for the phase transition will be apparent, the process will happen slowly at first before turning into a full- fledged avalanche. Rickards further adds that it is not a question of if the dollar will collapse, but rather how it will happen and what the long-term ramifications will be.
The first possibility is that countries such as China and some of the other BRICS members will make a push to replace the dollar as the world’s reserve currency. When one considers the growing economic importance of those nations this seems like a plausible scenario, but Rickards points out that with no gold or any one single currency to act as an anchor, the system will originate with many inherent problems. A multiple reserve currency system will be even more complex than what is being used now and would therefore not be able to solve the problem of the law of diminishing returns. A multi-reserve currency system may end up leading to the creation of regional trading blocs, which would be a simplification of the global economy and a possible solution to its growing complexity. For several years now, some of the smaller, developing nations have favored the use of “special drawing rights” through the International Monetary Fund (IMF) to act as a sort of global currency between governments. Special drawing rights are a type of “pseudo-currency” that private citizens cannot use and similar to the use of multiple reserve currencies, would not be anchored to gold or any one currency. The third option is a return to some type of modified gold standard. Opponents of gold say that it is outdated and not flexible enough to compensate for a modern economy. An examination of gold’s use as a currency backing in modern times reveals that this is simply not true. The Bretton Woods monetary regime, which ended in 1971, was a flexible gold standard that set a minimum amount of gold that was needed to be held in reserve in order to back the currency. Historically, the Fed maintained a target of about 40% gold to currency so gold would not need to account for all of the currency; but all of this will most likely be a moot point because most world leaders show no interest in returning to any type of gold standard. The final scenario, and the one that Rickards believes is the most plausible, is a total collapse, not just of the dollar, but of the entire global economy. Historically speaking, if one were to follow complexity theory, the collapse of the global economy is just a matter of time unless leaders decide to simplify the system, which does not seem likely.
Rickard, James. Currency Wars: The Making of the Next Global Crisis. New York: Portfolio/Penguin, 2012.
Tainter, Joseph. “Problem Solving: Complexity, History, Sustainability.” Population and Environment 22 (2000): 3-41.
———. The Collapse of Complex Societies. Cambridge, U.K.: Cambridge University Press, 1990.
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