October 2013 - Richard 'Jerry' Haworth: Apparent Paradox - the secret cause

Felix qui potuit rerum cognoscere causas


Happy the man, who, studying nature’s laws,

Thro’ known effects can trace the secret cause

Dryden’s translation

One of finance’s greatest apparent paradoxes (which could be a law) is that since time immemorial wealth, seemingly, is being created in ever increasing quantities yet is being continually destroyed over time.

Why? Something this secret cause creates is the illusion that permanent or increasing wealth rather than wealth entropy is the natural state of affairs. What is this secret cause?  In a word: inflation. The expansion of the money supply created by either credit expansion or money supply growth.

For the last 35 years we have had credit expansion fuelled by deregulation and lower interest rates. 2008 turned the lights off on credit expansion so central bankers fired up the back-up generator, money supply growth, to keep the house lights burning. The amazing consequence of this apparent paradox is that very few people can sense this creeping inflation. We are getting poorer. We should and could act yet we don’t move…we don’t adjust…we don’t panic.  We just sit like frogs in boiling water deluding ourselves that the day of reckoning will not come.

Why? I feel it is the lollapalooza effect of a number of irrational biases all acting in concert to foster the delusion that nothing is out of place.

•              Firstly the government has an incentive bias to keep the consumer price index (CPI) low even in the prima facie evidence of much higher inflation. It pays pensioners social security payments based on CPI, the higher CPI, the higher payments they have to make. Central bankers also have a mandate to keep inflation in check (as measured by a CPI basket which keeps changing!). They tend to manage the CPI rather than inflation even though the two should be synonymous with each other.

•              If the government says there is no inflation, they are the authority figures hence due to our authority bias we believe there is no inflation.

•              Herding instinct – nobody else is panicking or even moving, therefore we won’t.

•              We feel wealthier. Nominal growth in wealth deludes us as to the state of our real wealth until hyperinflation shatters that delusion.

•              The averages lie. Nominal GDP might be going up but not in real terms. Even if it was, the averages are still lying because of the dispersion of wealth is getting greater (a side effect of inflation), the rich are getting richer, the poor are getting poorer and the middle are getting squeezed.  It is the equivalent of Bill Gates and robbers walking into a restaurant, Bill sits by the bar, the robbers relieve the patrons of all their money and also sit by the bar. An economist in the corner notes however that the GDP in the room has gone up $1m per person on average so nobody should be complaining!

Furthermore, generalising a bit, it is only older people that suffer the ravages of inflation. They have already earned their money in $1 units and saved it. Young people just starting out don’t care what denomination their salary is in going forward. Society, relatively speaking, is geared to the young. When old people bleat about the cost of living, we assume it is THEM just getting old. We (being the people) actively encourage government to debase our currency and to grow money supply. They happily oblige. The more they can borrow, the more they can spend, the more votes they can get. We don’t like the reality of deflation or depression. We want the illusion of prosperity.

Is it a bad thing? Like everything, not in moderation.

Is today’s credit and money supply creation moderate?  If you believe that then you may be interested in buying a bridge from me.


Footnote: The latter half of the phrase, "rerum cognoscere causas", is the motto of the London School of Economics.