Created Tuesday 27 March 2018
The Actual Concept & Reality
After the analogy of the Coach and the Runner, we come to the Actual Concept and Reality that this book is about.
This time the Concept is Money.
And Reality is all known Resources on our planet.
This time the Mind is the Financial System and the Body is that of Mother Earth.
This time we let the Mind of the Financial System come up with a Concept and we will take everything from the Body of Mother Earth to fulfill it.
That Concept is money and money must grow.
Let us compare the the Concept and Reality and see what iimplications it reveals for the prospects of future Economic Growth.
Real World Versions of Concept and Reality
The left graph above shows actual figures of the Global Money Supply by year. You can see it has shaped as an exponential curve, just like we said our Money Curve should behave.
The right graph above is the Global Oil Production by year. It has followed a bell curve, or the theoretical Reality Curve, while trying to fulfill the top curve of exponential economic expectation. I remind the reader that I have chosen Global Oil Production as the Reality Curve because Oil is the defining factor for Industrial Growth and therefore Money Growth.
To see how they interact, let’s put them together (as shown below). We can clearly see that we are getting the same 3 phases in time as had happened with the Runner and Coach. Let us examine them one by one.
Phase 1 – Paradise Times
Starting Phase 1, we can see that in the beginning, the Earth’s Body, just like the Runner’s body, was able to keep pace with exponential demands. We were able to draw Oil (and other fossil fuels) from the Earth in an exponential pattern. It is possible, as we mentioned earlier, because this is the only part where the Reality Curve increases more or less exponentially and is able to keep pace with the Concept Curve, which is always exponential. Notice how the Money and Oil curve in the graph above are running fairly parallel in this phase.
Because the Earth was able to give us the resources and energy as per our exponential demands, we could fulfill any Concept and so were justified in feeling that anything is possible. We could cut as many forests as we wished, get as much metal to make as many tractors and draw as much oil to run them to get unlimited food from the Earth. We could get ourselves cars, planes, satellites, rockets – no limits to our imagination, concepts, dreams and desires. Yes, Reality was able to fulfill the requirement of the Money Curve.
Importantly, like the Runner, the Earth’s body was able to deliver, so there appeared to be no damaging effects on the body of the Earth yet. These were Paradise Times and the sky was the limit. No wonder we felt we were destined to reach there.
Phase 2 – Eco Collapse (Body Collapse)
Starting Phase 2 (early ‘70s) the 2 curves of Concept and Reality started moving apart. Money, by exponential definition wants to go steeply up, but Oil and all Natural resources follow the bell curve of the Earth which starts slowing down.
We now were in the same situation as the Runner whose body was not able to keep up with the exponential expectations of his coach. And just as his body started breaking down, so did the organic fabric of our Earth’s body.
That was the Beginning of the ECO-COLLAPSE.
This breakdown was manifested in the first signs of species becoming extinct, forests disappearing, fisheries declining, rivers drying, aquifers depleting, etc.
Yet, intoxicated with our flurry of material success, we raced to a yet unknown point of departure at the top of the curve. We intensified our assault on the body of the Earth to feed the ever hungry and steeply rising Money Curve.
So we cut half the world's forests...
Strip mined the Earth...
Blocked the Earth's arteries with 48,000 dams...
Diverted 1/4 of the fresh water supplies for industries...
Deprived other species of their rightful place in the web of life...
Pushed them to extinction...
Polluted our soil...
Fabricated complex and unsustainable habitats like mega cities...
Forged them to become financial centres of symbolic wealth....
And because everything that looked like a likely resource to come up with an edifice that we proudly called.........
This explains the ecological collapse that we are seeing all around today.But how much of this can happen before the fabric of life starts unravelling visibly?
In Earth terms, this is called “exceeding the ‘carrying capacity’ of the Earth’s ecosystems”. Another way of saying we have crossed the limit beyond which the body of the Earth cannot repair itself and starts showing signs of stress and breakdown.
We will examine this ecological collapse separately in the next section. Because for now we are concerned mainly with the mismatch of energy and money from the point of growth.
As growth was the most Sacred belief of the modern industrial worldWe did not careand we continued with our economic plans, thinking that their success was unconnected to the Earth’s body matters.
Moreover, because in this phase the Concept Curve and Reality Curve drift apart, there is an unseen differential between projected gains and actual ones. So, invisible to all, the hollowness of growth was building up under the surface of financial systems (see diagram above).
Actually there were signs, fine cracks of failure, that showed up several times in this phase. Events that the world labelled as “bubbles” and were pretty much forgotten: the 1980 Japan asset price bubble, the 1997 Asian Crisis, the 2000 dot-com bubble… Despite these warnings we were not willing to see the emerging failure of the growth concept.
Every effort was made to deny reality and to perpetuate growth. This naturally made more demands on the body of the Earth and steadily accentuated the eco-collapse. But ironically, the more you damaged the body of the Earth, the more difficult it became to live up to the Money Curve and to the first principle of economics: the Time-Value of Money.
In 1981, E. F. Schumacher stated in his seminal book, Small is Beautiful: “Modern man does not experience himself as a part of nature but as an outside force destined to dominate and conquer it. He even talks of a battle with nature, forgetting that, if he won the battle, he would find himself on the losing side”.
And that was exactly what we were to discover at the end of this phase.
Because, as time passed, and the two curves drifted exponentially apart, we found that besides certain life-systems fraying, so was our economic fabric weakening. We were finding it harder to match the Money Curve with real growth and, to match the deficit, the financial world had to float newer Concepts which would make the Money Curve appear true.
Remember that we had already defined money as a layer of Concepts with the intention of making it grow exponentially forever.
The prime mode of money growth is, therefore, through the mode of lending and charging a compounding interest. This is however restricted by how much money you can borrow. It is called Liquidity.
So instead of being limited to borrowing from individual people, we floated a new concept that would make it easy for us to borrow from thousands or even lakhs of investors to increase our Liquidity. This was done by selling shares in the enterprise that could be traded through an institutionalized system called the Stock Market. This marked the grand new entry of Concept 5 in our layers of Money Concepts.
Concept 5: Stock Market
Reason: It makes it easier to collect much larger capital from many more investors and therefore facilitates money growth even more.
But shares have 2 components – The Dividend, which is a real measure of productivity, and the Share Price, which is a perceived value. So that was the trick. With the deficit building up between the 2 curves, we needed to move onto perceived value because real growth was not keeping pace with the formula of exponential growth that we had imposed on our money system. In other words, we had become desperate enough to sanctify and institutionalise gambling.
Shares and Stock Markets of course existed before we reached phase 2 of the Money Curve, but the difference was that now they were being more broadly institutionalised as a mode of money growth.
However as time passed and the demands of the Money Curve rose ever steeper we needed to get more money into the system to keep it growing.
So we introduced Concept 6 to increase Liquidity.
Concept 6: Fractional Reserve Banking: Allow the banks to lend a greater ratio of the capital they hold.
Reason: It increased the amount of money that can be made available for loans which demand interest, of course. And interest is the prime mode of money expansion.
But this too reached a limit as eventually money was pegged to physical gold. So it was time for another Concept that would allow money to grow.
Concept 7: Remove the Gold Standard
Reason: There is only so much gold. Therefore, if we only print money based on gold, we cannot increase the money base. This again hinders liquidity and therefore growth of money. Get rid of it for progress and development.
So the limiting ceiling to money, the Gold Standard, was unceremoniously removed in the U.S. by President Nixon in 1971. The dollar was reborn as a fiat currency that had no physical value to back it. More and more countries followed by adopting various diluted versions of the original full-reserve gold standard. The end of gold convertibility represented a fundamental change. From that point forward, the creation of U.S. dollars and, by extension, all of the world’s currencies, was restrained by nothing more than political choice.
In short, we were shaping what I call the Money Onion. It consists of layers and layers of Concepts that can be extended outward at will by delving deeper into the mind and conjuring any number of symbolic ideas to add to the rules of money growth. Any real limits proving to be a hindrance to the exponential growth of money were being callously removed by the formulation of newer Concepts.
Yet there is a shadow side of the universe that counterbalances growth and profits – and that is Risk! With each added Concept, we were inadvertently underwriting a new level of risk. We would have to deal with this later.
For now, let us say that just like the Coach who did not tell the truth to his sponsors about the deficit building up between the projected and the actual speed of his trainee, we were shaping a financial system that was being less true to reflect actual growth or productivity and was getting more and more unstable and risky.
With each Concept added to remove a new limit to money growth, a new disconnect was accomplished between real production and value. We were truly shaping a casino model propped more and more on the perception and greed of investors and their speculation rather than representing any real growth of value. Yet we perceived growth of the value of money in just about everything from shares to services.
But remember the Money Curve is an exponential – starts slow then rises ever faster. By late ’90s, the hunger of the Money Curve had so exploded that Fractional Reserve Banking and removing the Gold Standard were not enough, as they only remove the money ceiling. We still had to show ways in which it was growing – real or not. This was getting increasingly difficult.
Once more, what was needed was a new Concept which this time would not just raise the ceiling but could also act as a capital and asset multiplier. This was the concept of Leverage.
In physics, a lever is a device that allows you to lift a heavier weight with a smaller weight.
In finance, this was to be achieved by defining new instruments of investment that magnified profits with lesser investments. Imagine putting down only 10,000 dollars that give you a stake on a million dollars. What about putting 1 million and getting leverage to 100 million?
And so, the world was gifted this new Concept of Leverage that promised a lot for a little.
Concept 8: Leverage: allows schemes where an investor or institution can use much more than the capital he owns.
Reason: Well, why restrict enterprise? Money had proved to be a facilitator of growth so far and therefore we must have as much of it as possible in the system. That is the true path to progress and development.
But the well-known aspect of financial leverage is that, while it magnifies returns, it can also magnify risks disproportionately. The financial world did not fret as it felt secure that it already had an antidote for risks in the form of another Concept called Options Trading.
Options trading was a very old practice in the history of trading, used to minimize risk. Basically, options mean that a trader, who certainly does not know the future, could place an option to buy a stock at a later date at a predetermined, flat, up-front sum called a premium. If the stock went up, he had the option to buy at the agreed price BUT if the price dropped he only suffered the loss of the premium.
And so Concept 9 of Options was added as a new layer to the Money Onion.
Concept 9: Options: provide an opportunity to leverage your capital for a bigger bet in the future against a minimal upfront commitment, called a premium.
Who wants risk? So if there is some way to minimize risk then this rule must be allowed.
This appeared to be a magic way to tame risk. The problem was no one knew how to price options – namely to set a fair premium amount to buy the option at.
Reason: This is where the math wizards came in. Fischer Black and Myron Scholes at MIT, Boston came up with a formula in 1973 that was to be known as the Black-Scholes Options Pricing Formula for minimizing risks in options.
Above are a sample of the mind-numbing, complex equations, in terms of the Black-Scholes Options Pricing Formula that are used in financial models for an instrument called Derivatives.
Balancing the double-edge of Growth vs. Risk was getting treacherous. And yet, Derivatives, though immensely risky, were an insanely powerful multiplier of money. Only they could cope with this super steep part of the Money Curve. So again, helplessly, Derivatives joined the ranks of concepts in the Money Onion.
Concept 10: Derivatives: use all kinds of complex mathematical models to outwit reality.
Reason: Well what is wrong with using mathematics to get an upper hand on reality? Only complex math promises to reduce risk. And the stakes are getting frighteningly high.
The very architects of derivatives were to discover what can go wrong with derivatives. Robert C. Merton and Myron Scholes won the 1997 Nobel prize for economics. They tested their model, by applying the Black-Scholes formula, in a financial investment firm called Long-Term Capital Management L. P. (LTCM) and raked billions. And then lost billions. Conveniently, the financial world forgave them their error. No one questioned the falseness of their mathematical model of perpetuating growth. It was put down to simply using their own formulae unwisely. The world concluded that since derivatives had worked like magic for a while, they could be made to do so again – as long as certain precautions were taken to deal with risk.
The truth was that Wall Street simply needed derivatives to keep the game of Growth going despite being well aware of the bloating Risk Factor. But their choice was to outwit it. They turned increasingly to MBAs, mathematicians and financial wizards from elite business schools to further use the power of mathematics to conquer risk.
But before Concept 10 of derivatives could be applied on a grand scale, there was another road-block for banks. This was the Glass-Steagall Act of 1933 instilled by the U.S. Government which came into existence because of the risky practices of banks before the financial crash of 1929.
The crash was considered to be largely due to overzealous commercial bank involvement in stock market investment, which took on too much risk with depositors’ money. In order to control this, the Glass-Steagall Act was setup as a regulatory firewall between commercial and investment bank activities. Banks were given a year to decide whether they would specialize in commercial or in investment banking. There was constant opposition to this act at all levels of the banking and financial community and some sections of the U.S. government. Yet, the Act remained firmly in place till 1995 for financial security reasons.
But nothing could hold back the demands of the Money Curve. Eventually, the Glass-Steagall Act was repealed in 1995. It was argued that it was seriously inhibiting growth. The repeal opened all stops and allowed big financial institutions to gamble with bank deposits and insurance funds at a colossal, institutionalized scale. Growth sky-rocketed but so did the Risk. This repeal was to be later acknowledged as the single largest factor in the 2008 financial crash.
Concept 11: Repeal the Glass-Steagall Act, and thereby remove control measures on banks.
Reason: Allowing speculative instruments of investment with depositor funds was supposed to help banks generate unimaginable profits and therefore maintain exponential growth.
The combination of Concept 10 (Derivatives) and Concept 11 (Repealing the Glass Steagal Act) allowed the rampant creation of a plethora of Concepts. These were Hedge Funds, Credit Default Swaps, Collateralized Debt Obligation (CDO), Slice and Dice Mortgage, Structured Investment Vehicle (SIV) and many more Concepts collectively called Complex Financial Instruments. And layers and layers were added to the Money Onion.
Concept 12: Complex Financial Instruments use derivatives to define risky paper financial instruments in such a manner that loans, mortgages and other financial transactions can be re-packaged and certified AAA, by colluding rating agencies and therefore can be sold as super-safe investments promising huge growth returns.
Reason: Well, let me think… I can’t really think why we should have allowed such a blatant fraud. But then again, it was like injecting steroids into the growth machine. And, besides, it also gave homes to the uncredit-worthy all over the U.S. and investment options for the rest of the world, did it not? For a while at least.
Yes, these Complex Financial Instruments were behind the largest bubble in the history of the U.S. housing mortgages. And we all now know what happened to that in the year 2008. But while it worked it was a runaway success. All mortgaged houses were ATMs and any jobless citizen was a multiple house owner.
The Money Onion was flourishing. The diagram above, which I call The Growth Trap, shows the connection between the layers of the Money Onion and roughly the point in time on the Concept/Money Curve when we needed to institutionalize various concepts to sustain exponential growth of money.
Each layer added was stretching the Concept further into the mathematical realm of growth and each layer was adding another degree of risk from the unknown and the untested.
The profits were soaring, floating high above the Reality Curve. But the world was sweetly unaware of the dark forms that were morphing beneath these apparent gains.
Ironic that nobody questioned that derivatives are financial instruments that have no intrinsic value but “derive” their value from something else. Maybe it required a child to remind us that basically they are just bets. The funny thing about these bets is that you can bet both ways. You could bet that the price of something will go up and then (hedge your bet) by placing a side bet that it may go down. That is how “Hedge funds” hedge bets in the derivatives market. Even more, you can bet on just about anything from the price of commodities to currency values. And above all, there are no limits on the number of bets you can place.
Now that is serious dabbling with real value. According to an article by Ellen Brown (Global Research, September 18, 2008):
“‘The point everyone misses,’ wrote economist Robert Chapman a decade ago, ‘is that buying derivatives is not investing. It is gambling, insurance and high stakes bookmaking. Derivatives create nothing.’ They not only create nothing, but they serve to enrich non-producers at the expense of the people who do create real goods and services.”
This glaring discrepancy was amply illustrated in an article by Ian Stewart (Guardian News and Media Ltd. 2012):
“Black-Scholes underpinned massive economic growth. By 2007, the international financial system was trading derivatives valued at one quadrillion dollars per year. This is 10 times the total worth, adjusted for inflation, of all products made by the world’s manufacturing industries over the last century”.
These mind boggling volumes of derivatives need to be put in perspective. Examine the bar graphs for some other well-known quantities in the year 2007:
- US Annual GDP 2007 was $14.48 trillion (World Bank,2008) [LINK]
- World GDP 2007 of all nations was $ 57.85 trillion (World Bank, 2008) [LINK]
- Gross Global Industrial Production over the last 100 years (adjusted for inflation) is about $100 trillion [LINK] (“Courtesy of Guardian News & Media Ltd”)
- 2007 valuation of world derivatives was roughly $ 1000 trillion [LINK] (“Courtesy of Guardian News & Media Ltd”)
But right now, from the point of view of this book, I am not concerned with the ethics of the matter. My prime objective is to point out that this madness and illusive strategy was inevitable. This is an old pattern. We have done it at all previous stages of monetary growth – from the Concept of interest, to the compounding of interest, to shares, to mortgages, to options, to derivatives, to hedging, to complex financial instruments. Each new Concept adds another level of intensity to money growth. And an accompanying undertow of risk.
Therefore, in this case too, the creators of these crazy formulae and instruments were simply trying their best to live up to the exponential expectation of the Money Curve. That, after all, is the Holy Grail of our Modern Economic paradigm.
The only difference was that they were trying to achieve it by increasingly symbolic and dangerous means. In a sense, there was no way out for them but to perpetuate growth falsely, given that real production of real goods requires real resources and real energy from the body of the Earth. And we had long gone past that point.
U.S. Treasury Secretary at the time, Henry Paulson, spoke about liquidity issues at Bear Stearns on television, saying “the binding threads that run throughout these vast financial galaxies are derivatives, and the brightest minds on Wall Street worry about how they work – especially as stock markets around the world become more unpredictable and complex”.
Warren Buffett, one of the world’s richest business magnates, later called these risky, mathematical devices “financial weapons of mass destruction”.
Yes, these financial instruments were so complex that the very creators would later be unable to unravel them to figure out who was holding the can after the whole crazy scheme collapsed.
And collapse it certainly did!
In 2005, we reached POINT 2: the top of the Reality Curve.
This is the maximum amount of Oil that we can extract from the Earth. This point is called Peak Oil.
Oil is the ultimate key driver of industrial growth and reaching the Peak of Oil production was proving to be a death knell to the religion of Perpetual Exponential Quantitative Growth (PEQG).
The Peak of the Resource Curve marks the end of Phase 2 which I have called Body Collapse. But as you can see, so far no one was seriously concerned about what was happening to the body of the Earth as long as our concept worked. But now the very Concept was in danger.
Because from Point 2 onwards, the Concept Curve and the Reality Curve start moving in opposite directions. One wants to go up but the other simply goes down. The very concept of growth fails. This ensures the beginning of Financial Collapse, as a huge false value in the economy is waiting to be corrected permanently.
Civilization at large, and the financial pundits in particular, had made two fundamental but impossible assumptions:
- That the Concept was true: That growth was a God-given right and could be perpetuated with mere mental, financial and mathematical ingenuity.
- That Reality would support it: That energy and resources could be obtained at ever increasing speeds to maintain this growth.
The scary truth remained that their model was like a ball of wool with one loose end tucked inside. No matter how deep inside the loose end is hidden, it will unravel one day.
And that loose end started unravelling unnoticed around 2005, when the world reached the Peak of Oil production.
From 2005 onwards, with each passing moment, the lie between Concept and Reality became harder to contain. Oil prices shot to $146 per barrel and the Financial System, predicated on cheap energy, collapsed in 2008. In a short period of a few months, 50 trillion dollars of perceived money got wiped off the world balance sheets.
This was Reality correcting the record.
We had reached the end of Phase 2, which marks the Beginning of FINANCIAL COLLAPSE. This is the iron-clad proof of Peak Oil and just a preview of what is to follow. A lot more imaginary money is lurking in pseudo assets below the surface waiting to get corrected in Phase 3 on the downside of the Reality Curve of Energy Descent!
“Anyone who believes that exponential growth can go on forever in a finite world is either a madman or an economist”.
Kenneth Ewart Boulding - economist, educator, and interdisciplinary philosopher.
Phase 3 – Financial Collapse (Concept Collapse)
STOP AND REFLECT:
We are today perched at the top of the Reality Curve – the Peak of Oil production that drives our concept of financial growth. Modern Industrial Civilization has therefore reached the limits of its Concept.
The future path in Phase 3 seems steeply downhill with our current economic paradigm. This is a good time to reflect.
Remember that we were in a similar situation with the Super Coach and the Runner. A crazy concept of the Super Coach to ever exponentially increase the speed of the Runner leads to the burning of all aspects of his health capital: body fitness, mental stability, social relationships and spiritual integrity. The cumulative effect is the collapse of his Body followed by the collapse of the Coach’s Concept.
Similarly the the economic concept of interest based money which compounds forever has resulted in us as a society to systematically loot all possible resources from the body of the Earth to maintain our model of perpetual exponential quantitative growth.
Over the last 200 years there seem to be no apparent effect on our environment but since 1960 it has become evident and we call it the ecological collapse of our planet.
The next section examines the nature of our Ecological Collapse.