The Magical Jet Engine and Global Monetary Disconnect
When engineers were developing the jet engine they encountered a very strange phenomenon: while holding the fuel level, the input to their system, constant the engine at some point starts to turn faster, the output to their system; to avoid an explosion they would lower the fuel level, but the engine would keep on turning faster. At that point the engineers would stop the flow of fuel and still the engine would keep on going faster for a while and then power down.
This strange phenomenon was not only a violation of physical laws (conservation of energy, etc) but was in stark contrast to what engineers have been doing since the first steam engine: engineers usually work on getting output from their input and not the other way around. After much testing they had no other choice but to take the engine apart and see what was happening inside; tests, finally, showed the problem was in the flow of the fuel inside the fire chamber.
The fuel would enter the fire chamber in a turbulent flow that creates pools of unconsumed fuel on the side; these pools would slowly increase in size and when they reached a critical point they would start leaking back into the main flow and thus increasing the fuel being consumed, this increase would show as an increase in output while the input was constant. When the engineers shut down the fuel flow the fire, in an effort to stay alive, would start sucking the fuel from the side pools, when this fuel, finally, runs out the engine would stop. The problem was solved when they redesigned the chamber so that the flow was regular and all fuel was consumed.
Now let us look at the financial system of the world, the world has a system of fait currency, paper money printed by sovereign governments and functioning as legal tender. Looking closer we discover that the world is dominated by one currency: the US dollar, some call this situation Dollar Hegemony. The Fed (US Federal Reserve) prints the dollar and it also decides the level of interest rate (Funds Target Rate). In this system the Fed are the engineers and the dollar is the fuel (input), by increasing the rate the Fed cuts off the fuel supply and by decreasing the rate the opposite happens.
If the rate is the input then the output is both economic growth and inflation corresponding to mechanical movement of the engine and heat of the fire chamber-in the most efficient engines only thirty percent of the fuel would be converted into mechanical movement, while the rest dissipate as heat-these two are also the Fed’s mandated areas of responsibility: sustainable growth and price stability. The Fed’s job is to increase the input as much as possible, to get growth, without causing inflation, corresponding to an engineer who wants maximum power without overheating.
The world has, just like an engine, a kind of cooling system. After the second world war when the British empire was being dismembered the US took a prime cut off that empire-a payment in due for the all Sherman tanks that saved the British from Rommel-a cut that was marinated in naphtha: The Arabian oil region.
Holding the world’s oil reserve regions in its power-including Venezuela and Nigeria-means in reality that OPEC is a US cartel that functions for its benefit; proving this in practice OPEC only accepts dollars for its oil. Since the whole world needs oil to function, the whole world need dollars to buy oil; since only the Fed can print dollars, the whole world exports goods to the US while it export dollars to the world. At first glance the US had the best of both worlds: cheap goods and low inflation, the heat produced in the heart of the system was being transferred to the entire world instead. The end of the nineties proclaimed a new economy, an economy of sustainable growth and low inflation.
Of course an end came and the stock market crashed in 2001, and the Fed obligingly cut interest rates to get the system moving again. The now infamous too-low-for-too-long cut started an asset bubble in the US housing market and accelerated the accumulation of dollar reserves by the world; the resulting inflation started a trend in the prices of all tangible commodities from oil to gold, the dollar declined and everything else went up.
The Fed’s cut produced inflation in house prices in the US and local inflation in the exporting world; the US public welcomed the increase in house prices because that enabled them to borrow hundred of billions of dollars secured by their homes and also to engage in house speculation. The Fed however had to take charge of the situation and so it started to increase the rate regularly over two years expecting that the 10-year treasury rate, which determines mortgage rates, would also increase.
The flow in the fire chamber of the global monetary system is anything but regular, the flow by then was highly turbulent. The Fed discovered that there were a-to paraphrase Doug Noland-Global Monetary Disconnect. The Fed’s rate increase was ineffective in raising the 10-year treasury rate, as we can see in this graph:
Federal Funds Target Rate
vs. 10-Year Treasury Rate
Just like the disconnect between fuel and engine power in the thirties, now there was a disconnect between input and output in the monetary system. The rate could not be increased beyond a certain limit, after all the US was a debtor nation and a higher rate meant more debt servicing. The Fed held the rate at the level of 5,25% and it was kept there until 2007. In 2007 the delayed effect of the Fed’s 17 consecutive rate increases-between 2004 and 2006-suddenly kicked in all in one day in August and the world learnt a new catch phrase: The Credit Crunch.
So people in the US borrowed hundreds of billions of dollars thanks to the rising prices of their houses and they spent these dollars on cheap imported products, the countries that export cheap products accumulated dollars and the countries that export raw materials accumulated dollars. Oil exporting countries had already been accumulating dollars and now their dollar reserves was growing at a faster rate. The only thing to do with all these dollars was to hold it in the central bank to support the local fait currency, i.e. dollars in another colour, or invest these dollars in US assets:
The “recycling” of our “Bubble dollars” (in the process inflating local Credit systems, asset markets, commodities and economies across the globe) directly back into our securities markets rests at the epicenter of Global Monetary Dysfunction.
Doug Noland, Setting the Backdrop for Stage Two
So all these dollars functioned exactly as the fuel pools in the magical jet engine, they leaked back into the fire and when the input was lowered, by raising rates, they kept the fire (inflation) going, until the Credit Crunch that is. So how big are these pools? First there is a little pool of fuel, a small matter of a trillion and a half dollars, called China; followed by a smaller pool, a solitary trillion dollars, called Japan, another trillion is divided by the world: hundreds of billions in the oil-exporting countries of Arabia, seventy billions in Russia, thirty billions in Venezuela, even crumbling Iraq has stash of dollars in its central bank.
So the size of all these pools of dollars is substantial, the functioning of the system itself adds more input by the use of financial instruments like derivatives; using them banks and financial institutes can crate credit from thin air, bypassing the Fed, and so add more fuel to the fire even when the engine is overheating-this effect is being reversed, they suck money while the system is powering down.
If an engineer encounters something like the Credit Crunch he would power the engine down and take it apart to see what is going on inside it. The Fed does not have this luxury, furthermore the Fed is under pressure to prevent asset deflation, collapse of banks and brokers and at the same time deliver growth. The Fed in response to the Credit Crunch, despite knowing the result of the too-low-too-long cut, cut the rate all the way down to the too-low level: real return on US treasuries is now negative, saving in dollars or lending to the US government is a waste of money.
Now a war rage-in the realm of pure thought-between those who see deflation and those who see inflation, is the Fed’s cut causing the one or the other?
Those who see inflation have this to back their arguments: commodity prices are going up, the dollar’s value is going down, cost of labour in China is going up, the price of gold and oil has doubled, the rate cut according to economic theory is inflationary.
A historic inflation in dollar financial claims was the undoing of anything resembling a global monetary system, and now this anchorless “system” of wildcat finance is the bane of financial and economic stability. To be sure, massive and unrelenting U.S. Current Account Deficits and resulting dollar impairment have unleashed domestic Credit systems around the globe to expand uncontrollably. Today, virtually any major Credit system can and does inflate domestic Credit to create the purchasing power to procure inflating global food, energy, and commodities prices.
Doug Noland, Setting the Backdrop for Stage Two
Others see deflation and present this as evidence: house prices are going down, supply of money and credit is going down, debt is defaulting, the banks are not lending, the Fed’s cut is not effective, the (expected) recession according to economic theory is deflationary.
A Weak Dollar Is Masking Deflation!
Right now what we have is deflation with a weak dollar. That weak dollar, in conjunction with peak oil, has caught nearly everyone off guard to the point they are screaming about oil prices and bond bubbles, while missing the far more important deflationary forces of foreclosures, bankruptcies, and massive writedowns in credit.
Mike Shedlock, Deflation In A Fiat Regime?
Those who see deflation are looking at one side: decreasing credit and money supply; while those who see inflation are looking at another side: increasing prices and decline in the value of the dollar. The deflationist seeing the decrease in speed of the engine call a deflation, while the inflationist seeing the temperature going up call an inflation.
Both are correct in what they see, they observe correctly but the problem is that they analyse the system and assume a well functioning system, a system that obeys the laws of nature. Well functioning engines won’t overheat if it is powering down, but malfunctioning engines can power down while still overheating.
What they fail to realise is that there is a disconnect between input and output, between cause and effect, between action and reaction, the system now is beyond analysis or understanding, economic theory is no longer valid, chaos theory has taken over.
Hyperinflation would end the game and whatever power the Fed had. With that backdrop, there are huge constraints on the Fed. One of them is the US dollar. Another one is wages. It does no good to force home prices up if people are out of work and cannot pay the bills.
Mike Shedlock, Deflation In A Fiat Regime?
If the system keeps on heating then it will be in danger of exploding, already the monetary cooling system is unable to take all the heat out of the centre. A monetary explosion will come in the form of hyperinflation, while a severe deflation will cause a depression.
Depression powers the engine down, killing the fire; hyperinflation rips it apart and leaves it a total wreck. Depression is a problem; hyperinflation is a national calamity (The Germans who experienced it made sure that the only mandate of the ECB is price stability). Hyperinflation of the dollar will be a global calamity.
If the riots continue to spread, especially into some of the more developed countries, then we think it is only a matter of time until the Chinese, Japanese, European, and even American central bankers climb aboard the inflation-fighting train. A hawkish Fed may be difficult to fathom, but if gas price increases start to bankrupt the entire transportation sector and we see truckers striking like they do in France, the political winds will shift. For a preview of what this political environment may look like, we suggest that readers dig up Jimmy Carter’s speeches on YouTube or the Carter library web site.
Inflation is here and it is likely to continue for some time. But investors must watch for signs of the political winds shifting. The question to keep in mind over the coming months is whether it is more politically feasible to have severe inflation or severe deflation. We still believe rampant inflation and U.S. Dollar debasement is the most likely outcome in the short term. But, if riots and upheaval continue to spread, all out deflation may be the only antidote.
T. Stein & S. McIntyre, Riots May Kill Inflation
The Fed in trying to steer between deflation and inflation will come across another phenomenon encountered by engineers, this time trying to design the first wing-shaped aircraft in the forties: Pilot-Induced Oscillation, where a small oscillation of the airplane is magnified by the pilot’s reaction to it and instead of stabilising the airplane he ends up crashing it (a problem that was only solved by putting a computer between the two). Any measure that the Fed takes to prevent inflation will induce deflation and vice versa.
The time for theory is gone, the time for debate has finished, it is too late for analyses, going back to gold is no longer an option, the chance of repairing the system has passed, the Fed is impotent, the US is bankrupt, the world’s reserves are worthless paper. The time for total collapse of the world’s monetary system is upon us, the time of troubles on a global scale is nearing, famine has started, war is developing, expect disease and chaos to follow on their heels: The End is Nigh!
