Past Performance is no Guarantee of Future Performance

So far we have taken it for granted that the U.S. dollar has held its value and will continue to do so. We accept as natural the small daily fluctuations in its value, including a small, general trend towards inflation. In this economic regime the U.S. dollar has held its place as the global standard.

What if such assumption is false and the dollar does fall in value (say half of what it is now)? I believe this is now in the realm of possibilities, and we can’t dismiss it like most of us did the housing market crash before it happened. Let me summarize where we are now and where we may be heading.

First, let me establish the framework of this alarmist viewpoint. There is an obscure but influential group of economists, adherents of Ludwig von Mises, who have held all along that fiat money, along with necessary government interventions, is the cause of business cycles. (Practically all currencies today are fiat money, including the mighty U.S. dollar.) Fiat money is not subject to market forces but instead is the subject of constant manipulation by central banks, whose avowed purpose is to keep employment high without eroding the value of money (i.e., control inflation).

Control Feedback Loop

Like any economic good, the U.S. dollar’s value can be controlled by either increasing or decreasing its gross quantity in circulation (the law of supply and demand). The Fed increases the money supply (lowers the dollar value) in order to make it easy for business to obtain money and increase production and the consumers to buy products. In short, increasing the money supply fosters a boom. Just before the economy overheats and inflation sets in, the Fed decreases the money supply in order to slow things down. Politicians like it when the Fed eases (increases the money supply) because, with more money, everyone seems to be lifted: employees get more pay and companies can get more capital. Incumbents have a much better chance of winning elections when people are happy.

Misesians claim that this government manipulation of the value of money is unsustainable, that it’s causing the bust that is now expected to follow every boom. Moreover, the boom/bust cycle swings get bigger and bigger until it all ends in an apocalyptic total loss of value. This is very similar to a fundamental problem in control engineering: when flying a model helicopter, you have to be careful with the control sticks. There is a delay from the instant you send the control signal to the helicopter reaction, and another delay from the time of reaction to the time you decide to either push or pull the lever. Until you get the “feel” of it, you tend to over-control, causing the helicopter to oscillate up and down. This is a case of delays in both control and feedback (your eyes watching the helicopter) causing control overshoot and ever-increasing oscillation until the helicopter goes out of control and crashes.

The problem with government control of the money supply is not that there are delays, but rather that the feedback is not directly connected to the controlling mechanism. Imagine flying the helicopter blindfolded and your only feedback is a friend yelling at you to either push or pull the control lever. In the current financial system, it is the banks that ultimately determine the money supply (controlling mechanism), and the Fed is the indirect feedback mechanism.

Solutions being proposed by mainstream economists to the current crisis range from tightening control of the banks (your friend needs to yell louder at you) to nationalizing the banks altogether (your friend grabs the remote control away from you).

A Little Bit of Control Engineering Theory

In order to prevent oscillation, several control engineering algorithms have been invented. One is called the Proportional Integral Derivative Controller (PID controller in short), and a more elaborate one is called the Kalman filter. Basically you try to eliminate the bad effects of delay by predicting the state of things from one control loop cycle to the next. The Kalman filter is by far the best, and is now used in most control loop situations like missile flight control.

To get rid of the business cycles, Misesians propose the following:

• First of all get rid of central banks (get rid of the Fed to remove unnecessary delays in the control loop).
• Next, let the banks receive individual feedback and let them control their own destiny. Banks are much better able to predict each of their immediate future solvency than any one body (say the Fed) can predict what’s going to happen next in the macro economy.
• Finally, the Misesians propose that each bank be allowed to issue its own fiduciary media (money) backed by gold. The corollary is that no bank should be rescued if it gets in trouble. If any one individual bank issues too much fiduciary media, its clients can circulate among themselves such media without straining its (the bank’s) reserves. However, its clients can and do deal with non-clients, and when such fiduciary media is used with these non-clients, the other banks will have to clear any amount against the expanding bank’s gold reserves. The feedback is in the depletion of the expanding bank’s gold reserve: if it doesn’t stop expanding its fiduciary media, it runs the risk of becoming insolvent.

The only problem with the Misesian solution is that it is still politically impossible. Decades of Keynesian practice has lulled us into thinking that it is both natural and ethical for governments to control the money supply.

Where We are Now and Where We may be Heading

The latest business cycle bust so far looks deeper than any recession since the Great Depression; and, Fed pronouncements to the contrary, we may not have reached bottom. According to MarketWatch, "The U.S. government and the Federal Reserve have spent, lent or committed more than $10 trillion to stem the economic downturn since the financial crisis began.” However, George Soros has just recently declared that such actions of the U.S. government are still not having the intended effect, and that the banking system is now insolvent. A prominent analyst has backed Soros’ assertion. Gold has gone down in price a bit, but that is largely because the Internation Monetary Fund (IMF) is planning to sell about 400 tons of the yellow metal.

Are we now in the final, apocalyptic bust predicted by Ludwig von Mises? May be not, but at the very least, the uncertainty of the immediate future is palpable. I am watching the price of gold because its rise is a sign that traders around the world are losing confidence in fiat money. I should also watch how much gold is being sold by central banks and the IMF, because increased sales means that rampant inflation has started and that the governments are beginning to get desperate and are propping up fiat money. Central bank gold reserves, although very large, are still finite. In fact, the total value of all gold ever mined was valued at U.S. $4.39 trillion using the price of gold as of last February.