Tuesday, January 25, 2011

Where Economics Goes Horribly Wrong- The Psychology of Depressions.

We are in a Depression.

Forget about the statistical term “recession” because that term is completely meaningless. The Powers that be are rallying around the published data that says Nominal GDP is rising, yet no one is considering that nominal GDP MUST RISE when the currency creation machine is cranking along at full output.

In August 2010, I wrote an essay for rickackerman.com that challenged the use of the terms “inflation” and “deflation” in the context of a macro-economic cause and affect analysis:

In today’s essay, I’m going to go one further. Today I’m travelling way out onto the thinnest of limbs as I try to convince readers that there is no reason for the inflation versus deflation debate at all; because inflation and deflation are the by-products of the EXACT SAME phenomenon when you strip away all the statistics, and look at the bare psychological core that forms the basis of human economics.

Anyone who watched Ben Bernanke’s “60 Minutes” interview on Dec 5th knows that The Fed is more concerned publicly  about deflation (the Fed’s preferred term for generally falling price levels) than they are about inflation (rising price levels), but it is my studied opinion that the Fed (and most other people for that matter) have it all wrong.  Almost everyone believes that market activity, and therefore inflation and deflation, all pivot on price levels; a very dangerous premise, as I hope you’ll see as we move forward through this analysis.

Everyone sees the inflation/deflation dynamic as a big teeter-totter, with prices acting as a fulcrum, while “more money and lower interest rates” sits on one seat, and “less money and higher rates” sits on the other seat. As the price pivot point shifts toward one end, the Fed shifts its policies to favor the other end, and this is supposedly how the Fed maintains “balance” in the system.

I contend that the Fed’s Teeter Totter model has a major, and potentially catastrophic design flaw, and I’m going to cite some very specific examples (both historical and current) that should demonstrate that the teeter-totter’s back and forth action is dependent on something far more delicate (and far less understood) than general price levels.

Teeter Totters do not shift directions without the force of gravity, and for the purpose of this discussion, we can assume that gravity is a universal physical constant (as mass increases, the force of the gravity by that mass upon other massive objects also increases).

To their credit, the Fed’s “money supply to price” balancing model is a little bit more complex than that. The Fed does not use a constant for the gravity proxy. The Fed’s model allows the downward force applied to their Teeter Totter’s seats (economic sentiment indicators) to vary over time, but they temper this variability by mandating that the rate of change be constant (they use monthly sentiment metrics). This is where their model has the potential to break down. The reason I say this is that rising prices do not necessarily inspire less spending, and falling prices do not necessarily inspire more spending; and neither of these actions can be used to forecast or correlate shifting sentiments at all; therefore the force applied to the alternate sides of the Teeter-Totter is never a constant to the mass of the money supply factor(s) sitting in either seat.

Ok, we should pause for a moment here, because the statement “that rising prices do not necessarily inspire less spending, and falling prices do not necessarily inspire more spending” probably needs more elaboration, because I’m sure it failed to pass through the common sense filter of most readers.

Naturally, everyone is more inspired to purchase when prices are lower, right? Well, it’s not really that easy. True, people are more inspired to spend when prices are low and liquidity (available capital/money) is high, but there is a relatively unknown (yet well documented by history) breakdown point where monetary saturation fails to inspire further spending, at which point supplies start to rise, and prices start to fall; and yet somehow these factors are unsuccessful in re-starting the spending engine.

Sounds kind of like the real estate crunch that kicked off in 2007, right? Well, it also correlates to the sentiment breakdown that occurred as the roaring 20’s came to a screeching halt and the economic declines of the 1930’s took charge of the common psyche . To use the current housing collapse as an example- we have reached a point where people are simply not inspired to move into another house, regardless of how cheap the process of buying houses has become.

Likewise, there are economic conditions where prices are rising,spending is falling, and thus money supply and interest rates are loosened up via policy, and yet the spending party still never gets back in gear- until suddenly, items begin leaving store shelves again, and policy makers, confusing this activity with economic growth, fail to shut down the money spigot, until eventually items begin leaving shelves at alarming rates. Then panic ensues, and spending goes parabolic (as if the gravity on the “less money, higher rates” side of the Teeter Totter suddenly develops into a black hole, forcing more and more “policy” to be thrown on the “more money, lower rates” seat. History is replete with examples of such events (Weimar, Zimbabwe, etc)- and for those who insist “it could never happen in the US”, I’ll remind you of the Continental currency of the Revolutionary War, and of the Lincoln Greenback during the Civil War- both of which died horrific hyper-inflated deaths.

So, using this inflation/deflation Teeter-Totter and the nebulous, unquantifiable gravity-proxy that is economic sentiment, we can address the central premise of my thesis that inflation and deflation are simply mirror image definitions of the same dynamic:

That premise is simply that money does not really buy things. Everything you think you know about using currency to purchase items in trade is an illusion. I use the term illusion because, once again, sentiment (the desire to purchase) is unquantifiable in absolute terms.

Simply put, people do not work for money. When you peel off all the statistical layers of the economic onion, you are left with a very simple, and rather elegant concept: People work for only two reasons:

1)      To appropriate those things they need to ensure survival and longevity.
2)      To appropriate those things which they desire to own.

Simple, right?  Number 1 relates to living (something we all must, and want to do), and number 2 relates to “standard of living”; That is, the level of arbitrary societal convention that seemingly elevates the importance of one person’s existence above others.

Standard of living is only a manifest of reason number 2 above.  Therefore, the desire for money (whether it be for capital gain, or the extinguishment of debt), falls exclusively and 100% into category number 2. While there is no question or argument that monetary currency, serving as a medium of exchange, definitely “lubricates” the process described in number 1, it certainly does not mandate it.

You might have to think through my reasoning a couple of times before this concept sinks in, but remember that I do not distinguish between “ownership for purpose of use” (like cars and wrist watches) versus “ownership for purpose of embellishment” (like Ferrari’s and Rolex’s); nor do I distinguish “ownership for purpose of non-essential consumption” (like tobacco or alcohol) or “ownership for purpose of enhanced efficiency” (like tractors and conveyor belts): all these things fall into category number 2 when you reduce them to their lowest common denominator- the desire to “own”.

Try to keep your focus on the simple fact that labor can nearly always be traded directly for food, shelter, and clothing, and that even during periods when one of these three are in scarce supply, there is nearly always the probability that more work will successfully secure the requirement. In the context of number 1 above, money is always and forever a proxy for work (a store of value, or a vehicle to secure future access to required supplies, to employ a couple commonly used definitions). Just as many of you may have learned in Econ101, money is not a mandatory component of the most basic trade based economic system.

So, it’s time to zero back in on the controversial premise of this discussion: Inflation and Deflation are mirror images of the same dynamic. Simply put, both phenomena are triggered at the moment in time that the unquantifiable factor (sentiment) begins to shift from being relatively stable (exerting equal force on both seats of the teeter totter) to being horrifically unstable (wildly shifting from side to side, with highly variable intensity).

Whether this shifting sentiment finally manifests itself as a reduced willingness to use currency as a proxy for work in exchange for real goods (deflation), or a decreased willingness to accept currency as a proxy for real goods in exchange for work (inflation), the basis of either outcome is still rooted in the underlying common psychology moreso than in statistical economics…

We all spend too much time debating about how the event will manifest itself, instead of focusing our collective energies on how to stabilize the rapidly shifting collective force that has lost its sense of harmony and balance, because when this force decides which side of the teeter totter it’s going to zero in on, the result isn’t going to be good for anyone sitting in either seat.

Gravity (sentiment) is shifting wildly, frequently, and seemingly uncontrollably. When the psychological aspects of an economy become destabilized, the more accurate term for the sensation is Depression (a psychological term) as opposed to Recession (a statistical term)…

We are in a Depression.

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