Chapter One: An Overview of Instability

1) What was once considered “impossible” has been normalized to the point that truly unprecedented imbalances are now accepted as “normal.” But the normalcy is illusory.

For example, it is now considered “normal” that the Federal government borrows $1.6 trillion every year to prop up the Status Quo, fully 11% of America’s Gross Domestic Product (GDP) and 40% of all Federal expenditures. This stands in stark contrast to the traditional view that deficits in excess of 3% of GDP a year are inherently destabilizing. Now we borrow roughly four times that much (including the off-budget “supplemental appropriations” that run into the hundreds of billions of dollars every year) and the political and financial Elites evince a complacent faith that these extremes are benign and sustainable.

Those who believe unprecedented central bank and State interventions in global markets are not just necessary but positive point to Japan, a nation that thus far is untroubled by debts far in excess of 200% of its GDP. They also point to the rapid growth in developing countries as the engine which will grow the world’s financial pie so everyone’s slice gets bigger every year.

But the fundamental problems in the global economy have not been addressed--they’ve just been papered over with trillions of dollars in printed or borrowed money. Behind the paper-thin façade of “extend and pretend” normalcy, the foundations of the financial Status Quo in China, Japan, the European Union and the U.S. rest on shifting sand. By avoiding structural reform in favor of facsimiles of reform and by “fixing” over-indebtedness with more debt, the political and financial Elites have simply increased the height the world will have to fall to correct the imbalances.

In the forest fire analogy, fixing debt crises by adding more debt is like putting out a small fire: that suppression of a healthy cleansing of the system only guarantees a monstrous fire later.

2) The global economy is now based on a widespread trust that central banks and governments will never let assets fall in value. This insulation from risk is known as moral hazard, as those who are insulated from risk will have an insatiable appetite for risky bets because any gains will be theirs to keep but any losses will be covered by the central bank.

The financial authorities’ success in propping up assets like stocks in the U.S. and real estate in China over the past three years has strengthened this moral hazard into a dangerous quasi-religious faith that central banks and governments have essentially unlimited power to keep asset prices aloft via printing money and easy credit.

3) This isn’t just a failure to reform an opaque and broken financial system: conventional economics has failed. This Grand Failure of Conventional Economics has gone unnoticed, as all those wedded to the Status Quo keep applying “lessons learned” during The Great Depression of the 1930s. They are pursuing the magical-thinking hope that the old rules still apply, even though the fundamentals have changed dramatically.

The Grand Failure of Conventional Economics is more than failed policy: it is a profound blindness to the resource limitations of our planet. Not one of the many strands of conventional economics recognizes the limits on growth in production and consumption as measured by GDP (Gross Domestic Product).

When the planet's human population reached 500 million, there were sufficient resources to enable a doubling to 1 billion. Then 1 billion tripled to 3 billion, which has doubled to 6 billion. Now, as China, India and other nations are industrializing, the 600 million high-consumption "middle class" of the developed economies is expanding four-fold to 2.4 billion.

There simply isn't enough oil and other resources on the planet, in any remotely plausible scenario, for 600 million of China's 1.3 billion people to live on an American scale of consumption, not to mention 600 million of India's 1.2 billion, and another billion avid consumers in other developing economies.

4) Conventional economics is also incapable of grasping the profound consequences of disruptive technologies that are “creatively destroying” the old foundations of centralized economies and replacing them with decentralized models of much greater efficiency. These new technologies are resistant to controls imposed by concentrations of power such as central banks and governments. Centralization—what I call the “factory” model—reaped enormous gains in the industrialization era; now centralization is increasingly counter-productive, as coordinated monetary manipulations have destabilized the global economy.

Industries that were once mainstays of the economy have been destroyed by irresistibly efficient Internet, communications and digital technologies: long-distance telephony, travel agencies, musical recordings, print media and retailing, to name a few. Next to be disrupted: education, healthcare, finance and government, precisely those industries widely considered immune to creative destruction.

5) These forces are incomprehensible to conventional economics partly because they are triggering simultaneous effects such as deflation and inflation which have been understood as linear and sequential. Disruption of old industries is deflationary to price and employment even as massive government money printing and support of moral hazard is inflationary. As “hot money” flees old industries and seeks higher returns from speculation, asset bubbles expand and pop as capital is misallocated into overcapacity. As money is devalued by these monetary policies, bizarre analogs of money such as derivatives, mortgage-backed securities and tulip bulbs arise and then implode in what I term the speculative supernova model.

6) This dynamic intersection of disruptive new decentralizing technologies, resource depletion and the grand failure of conventional economics is unprecedented in human history; we would have to look back to the era that was transformed by the invention of the printing press, the explosive rise of Renaissance commerce and the discovery of the New World for historical precedents. The difference is the accelerated pace of transformation in our digital era: changes that took 200 years to unfold between 1500 and 1700 will likely be compressed into the next 20 years. The predictability of this process of creative destruction is low; nobody knows what will happen five years hence, much less 20 years hence.

Francis Bacon wrote in 1620 that the printing press "changed the whole face and state of things throughout the world." The same can be said of the Internet and other digital technologies, and the transformation of the global economy is far from complete.

7) From the long view, conventional economics developed in the era of ever-cheaper, ever-more abundant energy and the miraculous "low hanging fruit" productivity gains made possible by cheap energy and centralized mass production. Like a creature born in the morning that has only seen daylight, conventional economics has never experienced night and so it has no conception of darkness.

Thus the current failure of conventional economics is not the failure of individuals or policies--it is a profound conceptual failure. Conventional economics, based on limitless “growth,” globalized financialization, and ever-greater central bank-Central State intervention in markets, is incapable of understanding a world of resource limits and a financial system that is increasingly vulnerable to unpredictable cascades.

Behind the present rose-tinted façade, the only limitless resources are paper money and propaganda. Everything else is limited by real world constraints. An economy that consumes ever-greater quantities of real-world resources such as oil, and harvests renewable resources such as timber and wild fisheries at rates far in excess of their renew rates, will soon encounter shortages and higher prices as those with paper or electronic money bid for the remaining reserves.

8) The markets now depend on massive State and central bank intervention for their veneer of stability. The “ratchet effect” is in full force: every crisis requires ever greater State borrowing and ever larger interventions by central banks. If this vast machinery of intervention were withdrawn, the system’s fundamental instability would be revealed.

This intervention is not limited to monetary policy; official statistics have been gamed to support the Status Quo assertions of a return to prosperity. This legerdemain has two unintended consequences: it discredits the statistics and the government that issues them, and it undermines market correlations that had been valid for decades. Investors and speculators alike are rushing to the lifeboats to find they’re only paper mache stage props.

9) The human mind has a number of default settings which have proven advantageous as “short cuts” in most circumstances, one of which is called “the normalcy bias.” As events spiral out of control and dangers rise exponentially, our tendency is to underestimate the risks and potential losses. As long as a few shreds of normalcy remain intact, we view these as evidence that “it’s really not so bad.”

Most of the time, this trait pays off as most systems are self-correcting and catastrophe is avoided. But when self-reinforcing negative trends take hold, this complacency is ultimately self-destructive.

10) The financial Status Quo, already discredited in the eyes of most well-informed observers, will eventually lose all credibility, and global stock markets will languish as participants abandon them.

If this sounds farfetched, recall that 70% of all shares traded in the U.S. stock market are exchanged in opaque “dark pools” operated by Wall Street and “too big to fail” banks, and high-frequency trading executed by “black box” algorithms account for the majority of the remaining 30% of publicly traded shares. This means that some 90% of stock market activity is hidden from non-insider investors.

The idea that we can rely on opaque markets for our financial security will increasingly be discredited. As increasingly heavy-handed interventions fail to restore stability, public faith in these institutions will decline. This delegitimization will further destabilize global markets, and those who accepted the implicit guarantees of stability, transparency and liquidity may find instead that their financial security has vanished in a cloud of “impossible” disruptions and dislocations.

This loss of faith is already evident. As the U.S. stock market doubled from its March 2009 lows, U.S. households withdrew hundreds of billions of dollars from domestic equity mutual funds, and quadrupled their holdings of “safe” U.S. Treasury bonds. If you look at a 10-year chart of volume in U.S. stocks, you will see a steady erosion of participation in the stock market. These are the actions of people who have lost faith in the stock market, the nation’s financial and political institutions and the official “story” of permanently rising prosperity.

Once trust is lost, it cannot be won back easily or quickly.

As the financial authorities attempt to keep the system from crumbling beneath their feet, they will take increasingly drastic actions as markets destabilize: investment rules that were presumed to be eternal will be changed overnight, without warning, and then changed again. Decades of low volatility that encouraged people to buy long-term bonds, annuities and dividend-paying stocks will be upended by unprecedented financial and political volatility. Seemingly permanent low interest rates that lured investors to pile into high-risk gambles will suddenly leap up, wiping out gamblers who weren’t even aware they were playing a game rigged in favor of the “house.”

Such expectations are well-grounded in history. Most investors have forgotten that the U.S. stock market was summarily closed for months during World War I, and that in 1933, the Federal government seized all citizens’ privately held gold. These actions were, at the time, considered necessary and prudent by the authorities. More recently, in 2008 speculating that banking stocks would decline (that is, shorting banking stocks) was summarily banned. The rules governing the market were changed to defend the Status Quo, and speculation was only allowed if it flowed in one direction—the one favored by the financial authorities.

11) Stripped of mumbo-jumbo, central banks and States have only two buttons to push: Keynesian fiscal stimulus, i.e. governments borrowing and spending vast sums in an effort to stimulate demand and the “animal spirits” that drive private borrowing, and monetary easing, i.e. lowering interest rates to near-zero, and printing or creating credit electronically to flood the economy with “liquid,” easy-to-borrow money.

Central banks and States are hitting these two buttons like frenzied laboratory rats, but the machine is out of cocaine-laced pellets. In effect, central banks and Central States are both addicted to exponential expansion of credit, intervention and Central State borrowing and spending. Each is only exacerbating the system’s risks, and as the authorities ratchet up these interventions to ever-higher levels, they’re insuring an even greater collapse.

There is a pernicious agenda at work in setting interest rates near zero while boosting money supply and deficit spending to create inflation. By robbing savers of any return on their savings and sparking “sustainable, orderly” inflation of around 4%, central banks are in effect transferring 4% from the owners of cash to reduce the debt of the central bank/State by this same amount every year. In a decade of this monetary scheme, savers’ wealth will be reduced by roughly 50% while the debt created by the central bank/State will decline by 50%.

“Purchasing power” is a concept while helps us understand the results of low interest rates and “politically benign” inflation: the owner of cash will find their money buys only half of what it did ten years before, while the government debt has also fallen in half. The net result of this slight-of-hand is that government debt that was crushing becomes manageable again as savers’ wealth was invisibly transferred via carefully engineered inflation.

The key phrase in this sub rosa agenda of transferring private wealth to reduce government/central bank debt is “politically benign:” since the loss of wealth and the rise in consumer prices is “only” 4% a year, the consequences are not severe enough to trigger political resistance. Financial and political authorities know that people quickly habituate to an “orderly” reduction in wealth and an “orderly” inflation in prices; that is, this erosion of purchasing power soon becomes “the new normal” and people plan around it.

The purpose of this central bank/State agenda is to avoid the two end-games that would destabilize the Status Quo: outright default on the Status Quo’s staggering debts, and hyperinflation, or loss of faith in a paper (fiat) currency. Either of these events would destroy the credit markets that form the foundation of the global economy.

We can see how successful this strategy of engineering orderly, “normal” inflation has been: 30 years ago, a Federal debt of $15 trillion would have unimaginable. Today, it is accepted as “sustainable” because it will never be paid back in today’s dollars, and low interest rates insure that the carrying costs of that debt remains small enough that no other government spending need be sacrificed to pay the annual interest.

This agenda has worked like magic for the past 30 years, but beneath the apparent success, the foundations of the current system-- cheap energy, globalization, financialization, monetary expansion, fiscal stimulus, opaque markets and constant State/central bank intervention--are all eroding. As they dissolve then so too will the Status Quo’s implicit promises of permanent stability, low interest rates and limitless growth.

The point here that the levels of intervention required to create inflation in a deflationary, deleveraging-of-debt era are not just stupendous-- they must ratchet up to ever higher levels to maintain superficial stability as the system becomes increasingly precarious. Ironically, increasing the heavy-handed centralized interventions only increases the system’s precariousness—the exact opposite of the Central Planners’ intentions. This is the result of trying to manage non-linear systems with linear-system tools: all that manipulation can achieve is to extend surface stability at the cost of a more severe system crash later on.

This poses two challenges for us as investors: if the central banks/States succeed in triggering inflation, how can we maintain our purchasing power? And if they fail to engineer stable inflation, which is increasingly likely, then how do we survive the black hole of hyperinflation or systemic credit default?

12) The Status Quo advice of diversifying your money among global stocks, bonds and commodities may not offer the low risk and security that’s being promised, as interconnected global markets are destabilizing in unison.

As we enter this unprecedented era, we quite naturally ask: what can I do to preserve my capital? What can I do to prosper in a tumultuous and increasingly unpredictable world?

13) I am not an economist, money manager or financial advisor—I am an observer. Being an observer offers a number of strengths which I hope to bring to bear in this book. One is a keen awareness that I have no idea what will happen in the future, and neither does anyone else. Nobody knows the price of anything tomorrow, much less its price five years hence.

14) The investment world is keen on probabilities as reliable guides to the future. But low-probability events occur with remarkable regularity, so it’s prudent not to put too much faith in statistical or probabilistic reassurances. All such models are based on the idea that the recent past is a reliable guide to the future. But if the thesis that the next 20 years will necessarily be very different from the previous 60 years, then this faith that the recent past offers a roadmap of the future is dangerously misleading.

15) The uneven, unpredictable process of destabilization and devolution will play out over many years as periods of apparent stability are punctuated by the re-emergence of crises which were supposedly resolved in the previous cycle of central bank/government intervention. Every era of stability will be less enduring than the last, and come to rest at a lower level of security and prosperity than the last. Every intervention will be larger, more desperate and more intrusive than the last, and much less effective.

16) Periods of creative destruction are inherent to Capitalism, indeed, essential to its long-term success. Just as we cannot fool Mother Nature for long--for example, by reckoning we can eliminate forest fires--we cannot manipulate the global economy to eliminate creative destruction. All the unprecedented efforts of central financial authorities to eliminate risk and instability are simply piling up more deadwood in an already tinderbox forest.

Financial risk is like water in a closed system: it cannot be compressed. As pressure mounts, the risk builds up and eventually escapes, often through whatever part of the system was considered “safe.”

Periods of great transition in which existing systems are consumed by creative destruction and a new paradigm emerges offer great opportunities as well as great risks.

If I had to summarize this book in a single sentence, it would be this: Money is a tool; don’t invest your money in Wall Street’s promises, invest it with an unblinking eye on systemic risk; invest in your own life and in the lives of others. This book explores how to do just that.

(I am indebted to David Gobel, Gary Baker and C.N.F. for some of the ideas presented here.)

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