If a collection of people were to begin a conversation with the following, “we are going to make society wholly dependent on a collection of abstractions”; it is a certainty that it would draw a skeptical response. It is the case however, that our society is wholly dependent on a collection of abstractions – abstract representations of the human endeavor. The first tier of which is fiat currency, since Brentonwoods – a meeting of financiers – the entire world has been dependent on debased currency, with greatest dependence on the US$ as the world reserve currency.
If one contemplates trade absent currency of any kind, one arrives at a barter society – the exchange between individuals of goods and services; the public sentiment or the “castle of the mind” can wreak no havoc in the barter society because there is no opportunity for the migration of value, so the actions of people immediately proximal are the sole determinant of the volume of trade or the “Domestic Product”. There are no bubbles to burst, there is no means to create them. The barter society of course is very limiting, precisely because there is no opportunity for the migration or accumulation of value, nor is there any real means to remunerate an offering of greater value with greater reward. The barter society offers stability at the cost of stasis.
It becomes necessary to mobilize value and to accumulate value to facilitate the human endeavor, in the face of this realty people seek compact and readily transferable sources of value, gold for example. The most cogent example of currency is the clay tablets used in early society to represent a share of a collective grain holding, people would take the tablet to the central granary to retrieve a portion of their share of the stored grain. At times people would circumvent the granary and trade the tablet for a good or service – the tablet was a currency based to grain – an abstract representation of a given person’s grain holding or share. It is easy to see the effect of making more clay tablets, the tablets value relative to the grain and grain’s value in society at large would diminish. With gold based currency the only opportunity for a “devalued” currency is to find more gold, a phenomena that happened in the mid 1800s when there were large discoveries of gold and the resulting gold inflations.
The currencies we all rely on now have no base, money is created now at the swipe of a credit card, there is no limitation on the amount of money that can be created or the rate it can be created, fiat currency is only functional due to the belief of value – here the “castle of the mind” can wreak havoc. When a collective optimism exists – people begin to buy more, so more currency is created, as currency is created it spurs demand, it then takes more dollars to purchase a given good or service – both because people are demanding more and because there is no limit on the dollars to be had – this fuels an inflationary feedback loop where optimism reaffirms optimism in the collective “castle of the mind”. Of course optimism always runs its course, and when the collective “castle of the mind” contracts much of the money previously created is unsupported as values contract, as values contract pessimism grows and the feedback loop is now in the opposite direction. It is the mix of the first tier of abstraction – fiat currency – and the second tier of abstraction, the ability to readily contract credit, which fuels the currency cycle that often has a massive affect on the economy at large.
To put boundaries on this phenomenon one either has to limit money or its availability – we have in large measure choose to limit availability; this is achieved by central bankers exercising judgment on level of the interest rate on money lent from the central bank to banks and the interest rate of money lent between banks.
The challenge has been that the complexity of any given economy precludes the ability to intervene at a appropriate time to prevent damaging outcomes of the cycle and this reality is exacerbated by foreign exchange of money and other global influences. Regardless of any given domestic interest rate, money can be borrowed in another jurisdiction for an attractive rate.
Central banks look at the forest in assessing when to raise or lower interest rates; secular inflation has little play in the decision process. It was the housing sector in the US which was running an inflation rate in excess of 20% in some cases and all the resultant lending complex that started the crisis of confidence. The US Central back had a low rate of inflation indicated by a low percent growth in the Consumer Price Index (CPI), a CPI that was suppressed by a long and sustained influx of “cheap goods” provisioned by the escalation in the Chinese manufacturing capacity. This coupled with the Japanese government’s near zero interest rate in the face of a lagging economy and the resulting yen foreign exchange (yen carry trade) muffling the effect of any US rate increases resulted in ready stream of credit to fuel the housing sector. This was further exacerbated by tacit understanding the via Freddy Mac and Fanny May the US government was in effect underwriting the credit binge in the housing sector.
It is important to stop here to contemplate the key point of discourse, in observing the first tier of abstraction, fiat currency – one can see from the above discourse that just a single tier of abstraction fuels violent cyclicality, and one can see the complexity in managing and understanding the effects of actions taken in the realm of just currency. Our financial system is a complex of several tiers of abstraction, and with each tier of abstraction comes, to some degree, the same degree of instability. In the financial world the increasing tiers of abstraction are referred to as “financial deepening”. In 1985 the abstract representation of the economy had a value about on par with the “real economy”, by 2006 the abstract representations of the economy had increase dramatically – some estimated up to 365 times the “real economy”. Of course it was impossible to know due to opaque trading systems and the nature of the financial instruments themselves.
For Discourse on Specific Causal Elements