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January 12th, 2009
The global monetary system is at a critical juncture. It is fast approaching a breakpoint. We take a philosophical worldview based on chaos theory that considers the evolution of seemingly stable complex systems reaching a bifurcation point, where the whole system rather unpredictably either "explodes" or "implodes" with a lightning speed. The transition is perceived as "chaotic" - the old order collapses and a new order is established. We think that the global monetary system approaches bifurcation - the breakpoint.
The Limits of Knowledge
Little schoolchildren are always impressed with the knowledge of their teachers. So were we - we thought highly of them as very smart and very knowledgeable. The physics teacher knew the meaning of gravity and the composition of the universe; the biology teacher knew the evolution of life and the formation of DNA molecules; the psychology teacher knew consciousness and human psychology. Only much later we realize that we are only given this impression. In reality, teachers struggle intellectually with these problems. The reality is that even scientists that are smarter than them also face sometimes insurmountable problems with these issues.
Today, we are left with the impression that economists understand how the economy works. They continuously forecast next year's rate of inflation, the fulfilment of EMU accession criteria, the depth and length of the real estate crisis, the probability of a currency crisis, and so on. But for some reason, we now feel about them just like we now feel about our teachers - their confidence is only an impression, while the reality is infinitely more complicated; and they often fail miserably with their economic forecasts.
From a big-picture point of view, their ultimate analytical sin is their attempt to analyze and predict only individual economic processes: inflation, productivity, growth, unemployment, etc. Instead, the whole economy should be viewed more broadly, more holistically, and more philosophically. A more dialectic approach is necessary to account for the driving forces behind economic development and growth, behind financial and economic crises, and behind the cataclysmic financial and economic metamorphosis caused by various crises.
Complex Systems & Chaos Theory
A broader view through chaos theory can provide a keen insight into the economy. This is the type of theory that observes the whole process, not its individual elements. For example, when we look at a waterfall, there is no point in trying to track every drop of water; instead, the waterfall should be viewed as a complete structure whose elements are changing. New drops of water are passing over the waterfall each moment - the behaviour of water drops is quite chaotic, yet the waterfall itself is stable. The economy should be similarly viewed: we should not attempt to understand a particular financial number in the short term, but should focus instead on the general long-term economic processes. Forecasting short-term economic numbers is just as impossible as forecasting the motion of chaotic water drops. On the other hand, forecasting the whole economic system is a lot more realistic and manageable.
Chaos theory deals with this type of processes. In order to understand the relationship between order and chaos, between economic development and the current financial crisis, we offer both basic principles and complicated terminology related to the evolution of complex systems. We hope the reader will forgive us for this more advanced treatment and will appreciate the depth of our more philosophical approach towards the economy.
The Second Law of Thermodynamics undeniably exists in nature. Its international version states that the world is itself heading in the direction of increasingly greater chaos and disarray. Simple examples would be a brand-new car that leaves the factory in order, but will be later rusting in a junkyard; or powerful civilisations and influential cultures that have in the long term all been destroyed; or a tidy room at home that for some reason repeatedly gets messy. Wherever we look in the universe -- from the stars that will someday go dark to molecules that are travelling around the universe ever more chaotically -- it is clear that this law is universal.
The entire universe is subject to and moves in the direction of increasing chaos, or more scientifically, entropy. The term entropy measures the disorder of a system, the randomness within a system, its lack of order. The larger the entropy, the lower the orderliness of the system, and thus the more random and more chaotic it is. For example, a new car has very little entropy, while an old, rusting car has very high entropy; a recently built and beautifully furnished residence has low entropy, but an abandoned and rundown house has high entropy. These examples are static, even somewhat illogical, because they do not show a forward development, but just the opposite - a devolution, a backward movement, a movement towards a lower state.
Thus, an increase in entropy means the devolution of a system. When viewing the universe, it becomes clear that all processes, objects, and systems are moving in the direction of rising entropy and increasing chaos. It is a universal law, known as the Second Law of Thermodynamics, that the total entropy in a system tends to increase over time.
All of this was already known in the 19th century, when in 1865, during the course of the investigation of thermodynamics, the corresponding concept was formulated and developed. Scientists were then faced with the so-called million-dollar question: How is it possible that in a Universe that continually moves towards increasing chaos, we constantly witness the creation and the development of increasingly complex systems?
We know that the initial Big Bang did not result in the formation of an amorphous mass of elementary particles; they were instead gathered in stars and galaxies. We know the fact that atoms have formed complex molecules; in turn, molecules have formed even more complex macromolecules; macromolecules in turn have joined to form amino acids, which are the cornerstone of life; they in turn have formed simple single-celled organisms, which in turn have formed complex life organisms.
The development of life from simple to complex, from multi-cellular organisms to human beings, testifies against this universal constant. However, the development of humans has not brought an end to development in biological creatures. Humans have become self-aware; humans have joined together to form a complex system called society; societies interact to form complex geopolitical systems. Everything is increasingly complex, with increasing levels of higher-order systems created from lower-order systems. How is all this possible? Our everyday experience does not confirm in the least the operation of the Second Law of Thermodynamics.
This problem troubled scientists for over a century until Ilya Prigogine (aka Ilya Prigozhin) discovered its solution. He received the 1977 Nobel Prize in Chemistry for his discovery.
Scientists had been previously examining only closed systems. A closed system is a system that is isolated from its environment, a system that does not exchange energy, information, or matter with its environment. Examples of closed systems are a brick and a newspaper. There is no development in each case; they correspond completely to the second law of thermodynamics: they are subject to a continuous increase in entropy until one succumbs to decay and the other to rot.
Instead, Prigogine studied open systems, those that interact or counteract with the environment, that exchange matter, energy, and/or information with the environment. It became clear that development occurs in the open system through the process of disorder. The creation of order requires chaos. However, one more unexpected matter arose - in the case of an open system, the level of disorder within the system itself increased, but each open system increased the entropy outside of itself. Or in other words: during the development of the system, the level of chaos outside of the system increased. A classic example of this would be a refrigerator that lowers the entropy (heat) inside it, but increases the entropy (heat) of the surrounding environment by more than it lowers it in the refrigerator.
At the level of society, when we look at our increasingly disorganised material world, with its mobile telephones, i-Pods, and skyscrapers, and compare it with 16th century Europe or with an Amazonian jungle tribe, we see that modern society is accompanied by giant garbage dumps and complex sewage systems. When looking at a factory and its large smoke stack, it is clear that some type of product is created in the factory and that entropy exits via the smoke stack, not the other way around. This is similar to air conditioning - it keeps cool at home, but blows the heat in the atmosphere.
In simple terms - an unavoidable condition of each open system is that it must send entropy into its surrounding environment. Growth inside the system must necessarily increase the entropy outside the system.
Further investigation of open systems concluded that each system has its own capacity to emit entropy into the environment. When the system reaches this threshold, where it is no longer able to emit all received matter, energy, and information and expel the residue, a critical point is reached - the breakpoint, the crisis. In science this point is known as the bifurcation point - the point of dividing into two braches or two parts, the point where a turn must be made. This is the moment where the entire system becomes increasingly chaotic and a choice must be made between two directions: whether the system continues developing, while coping with its previously-unbearable stress, or the system reaches its breakpoint and collapses. The bifurcation point is the moment of truth where the system suddenly takes a turn towards one direction or the other - towards a rapid explosion or a rapid implosion, towards hyperinflationary collapse or deflationary depression.
The bifurcation point is thus the moment where events must begin to develop in either one direction or the other, with radically different outcome in either case. At this moment, one small push is enough to trigger the unravelling process with either one or another sequence of events, the end results as different from each other as heaven from hell.
A simple example would be a ball that is perched exactly on the top of a mountain. A small push is enough to start the ball rolling downhill, either North or South, along the north slope or the south slope of the mountain. The result is radically different in each case, but was caused by the tiniest of nudges. And it is only this particular moment of nudging during a period of instability in the system that is the bifurcation point. This is just like a perfect, frictionless pendulum that is set motionless in its top position, so a little wind to the right or a tiny nudge to the left would set it in motion rotating clockwise or counterclockwise.
Bifurcation Points for Society
Let's take a look at history. The Roman Empire was in steadily in decline for a couple of centuries - it was a nation of consumers, ran significant fiscal and trade deficits, a corrupt senate taxed and looted the people, and the imperial military was overstreched - just like modern-day America. Its economic decline and weakness was challenged by various barbarian tribes eager for a big slice of the Roman pie. The empire had to either restructure its economy and military or face defeat. It ended defeated and destroyed.
Much later, the feudal age collapsed from its own internal contradictions, but humanity did not return to the Stone Age; instead its collapse gave birth to a qualitatively different economic system known today as capitalism, gave birth of modern banking in Italy, and revived science, culture, and art during the Renaissance.
More recently, at the beginning of World War II, Japan was at peace, but nevertheless prepared for war. The Japanese economy was choking under the ever dwindling supplies of oil that were vital for the development of its military. The critical point was reached when the Americans cur off a vital source of oil supply in 1941. Without oil, Japan had literally two options - either suffer economically and abandon militarization or strike back and declare war. The fateful decision was to strike Pearl Harbour and the rest is history.
We can similarly view the development of the economic and political system. As complexity rises and the current institutional and regulatory framework cannot cope with internal disorder, the breakpoint is typically reached with the eruption of an economic crisis; this usually leads to social chaos, revolution, social and economic re-engineering, and qualitative jumps in development. The crisis causes either the system to collapse or brings about progress. Crisis should bring hope, like the crisis in Zimbabwe today, but unfortunately the reality is not that simple - crises cause an uncountable suffering and death, yet the outcome is far from clear.
With rising social confusion and system entropy, the system becomes increasingly uncertain and unpredictable. It is quite unclear which way it will swing. For example, both Belarus and Estonia arose from the same obscurant socialistic heritage, yet the results were radically different - the first has a dictator, the second - democracy. The Dominican Republic and Haiti are neighbouring countries on the same island, yet different from each other like night and day.
With rising chaos and uncertainty, social systems become resistant to change. The leaders of North Korea may well understand that their system is a mess, but little will change until the system reaches total chaos. Similarly, it would have been quite unrealistic to expect Brezhnev to initiate transition from a socialist economy to a free market one during the 1980 Olympic Games - there simply was not enough systemic instability and chaos at the time.
While the above examples are primarily political, the same principle nevertheless applies on all levels of complexity - from the formation of simple molecules and organisms to the formation of galaxies. Prigogine actually received his Nobel Prize for his research on the so-called Zabolotsky chemical reactions, where he demonstrated how mixing four substances together formed increasingly more complex colours, patterns, and relationships.
Another good example of the development of a system is the road network in a country, for example the United States. If the number of automobiles keeps rising, traffic jams become inevitable. At first, the early morning traffic jams will dissipate by late morning and the afternoon jams -- by early evening, while most of the time the traffic flow is relatively stable. However, with the subsequent addition of automobiles, the moment arrives when the roads are no longer able to support the desired automobile flow (Los Angeles?), and then the system either grinds to a halt or reorganises at a higher level. In this case, designers and builders help re-organisation at a higher level by adding extra lanes and exits to the road system, so that the system is capable of handling a much higher number of automobiles than before.
The American example is adaptive in nature. Closer to home, the city centre of Tallinn and the roads leading there are no longer able to cope with the flow of automobiles; for some reason, additional lanes are not being added in Tallinn, while in some places, there are actually fewer lanes. On the other hand, authorities in Sofia have delivered a highly "innovative" solution to traffic jams in a key downtown boulevard - ban traffic altogether and declare it a pedestrian zone; a simple municipal order with the signature of the mayor "solved" the problem literally in one day and at no cost.
The Global Monetary Crisis
Taking a look at the economic, and especially the financial world, it is clear that the system today is no longer able to cope with the situation. Futures transactions are being performed at previously unimaginable levels. A couple of billion shares change hands every day on the NYSE. All parties to a transaction are convinced that the system operates smoothly and without interruptions; if a problem occurs, they expect it resolved judicially by properly settling with payment of monies and transfer of assets.
Today the system operates effectively, so far. However, if one is to remember his history, there was a period in the 17th century during Holland's Tulipomania when previously unheard of futures transactions were being concluded for the purchase and sale of tulip bulbs. However, when their prices dropped dramatically and the sellers demanded the agreed-upon huge amounts of money from the buyers, the buyers interestingly enough refused to pay. Naturally the matter was taken to court, and the judicial power began to honourably resolve case after the case. Soon enough, the number of cases overwhelmed the working capacity of the court. The processing of all nonperforming contracts would have taken the courts hundreds of years. Therefore, the court turned the problem to the parliament; the parliament could not decide, so pushed back the problem to the court system. Soon the problem reached crisis proportions that forced upon the courts a Solomonic decision: all futures transactions were declared null and void.
Since that time, the financial system has evolved significantly. Currently, thousands of transactions can be performed every second, all of which are precisely filled. A similar mess will hopefully not repeat. However, in the case of a more serious problem, it is difficult to believe that the current legal system would be capable of sorting out all financial obligations and ensuring their fulfilment. Just think about it! How long would it take to clean up the Lehman mess? What if there were ten Lehman's? What if there were thousands of bankrupt banks, just like in the 1980s. What will happen with all derivatives whose notional value exceeds a quadrillion?
The world's monetary system is subject, like all other open systems, to chaos theory. Thus, a jump in development requires chaos, from which a new order arises. It seems that chaos is fast approaching, since inputs into the system are beginning to push it to the brink, where it is no longer be able to emit sufficient entropy into the environment.
Entropy has two interrelated economic interpretations. The first interpretation is that of inefficiencies and losses within the U.S. financial system; the second is that of transferring those inefficiencies and losses to the rest of the world by supplying them with more worthless dollars.
Internal entropy--financial losses--are currently rising exponentially. Excessive transactions and excessive accumulation of financial risks in the financial system have not been counterbalanced with adequate provision of capital, and timely write-offs of assets, and proper recognition of losses. It is very difficult to hide poor quality for too long in the real economy. When poor decisions are made and low-quality goods are produced, the low quality is visible almost immediately and requires proper fixing. This is not the case in the financial economy.
In banking, it is possible to creatively hide poor decisions and long-running losses in a number of ways, including outright fraud. Enron is the poster boy of accounting fraud. Losses reflect the difference between acquisition cost and current mark-to-market value, the latter using convenient arcane formulae or quite often completely unknown due to lack of a market and liquidity for the asset. Skeletons have been piling in banks' closets; no one wants them and no one wants to admit their existence. Instead of cleaning the closets up, the current patchwork of band-aid solutions is akin to a paintjob.
The U.S. is also emitting entropy to the rest of the world in the form of excessive amounts of dollars accumulated as foreign reserves in central banks around the globe. The world is rapidly approaching the point of unwillingness to accumulate more dollars with the realization that Obama is intent on creating trillion-dollar stimuli to keep the current financial disorder going, force-feeding the bulk of those dollars onto the world. This is inherently unsustainable. As long as the world is willing to absorb U.S. entropy, the system holds together; as son as the world balks at absorbing those dollars, its value would collapse and the global monetary system would reach a bifurcation point as dollar reserves depreciate rapidly and inflict losses on foreign dollar holders.
So far the system holds together, but there is no escape from chaos in the global monetary and banking system. Initially, the chaos will wipe out most of the value of foreign dollar reserves; later, it will wipe out most financial assets and electronic money. The resulting chaos will wipe the slate clean for a new and better financial system.
The current electronic monetary experiment is, after all, only the first. The history of money is replete with failed attempts to make money out of nothing. This group includes alchemists, who tried to turn lead into gold, and governments that melted and debased coins in circulation, believing they were twice as rich, because they had twice as many coins.
All paper currencies, without a single exception, have in the long-term approached their intrinsic value - zero. The Euro, the Yuan, and the Kroon will not likely prove an exception. Soon, no one will doubt the collapse of the dollar. The crash of an electronic money market has never been experienced before; most likely it will be global in scope and more destructive than any previous monetary crisis. At the moment, an estimated 96% of banks' money is in electronic form, without an actual carrier of its value and without any backing.
The current system is based on trust. It would be impossible even for 10% of bank depositors to withdraw their paper money simultaneously. The system is designed so that all people never come at the same time to demand their money. This is the nature of the modern fractional-reserve banking system. However, this assumption is incorrect. The coordinated action of only 5% of the people would be enough to stir the masses to follow suit.
Leaving aside pictures of millions of Europeans and Americans from the 1930s demanding their money back from the banks, one could think of Britain's modern-day Northern Rock besieged by savers eager to get their money back despite full guarantees by the British government. Just look at the people on the picture lining up the street.
While the financial crisis spread globally like wildfire, fortunately the bank run of Northern Rock was an isolated case, so far. However, the next time we might not be so lucky; it could start in an obscure country like Iceland, or our own Estonia or Bulgaria and jump like lightning through the border respectively into Britain, Sweden, or Greece, and so the global run is on. The police would need to restore order on the streets and banks would need to close in the interest of society, but this would not give people's money back - it just ain't there!
The main mistake that people make is that they fail to differentiate between real wealth and financial wealth. Real wealth represents objects that you can touch and feel - cars, houses, food, etc.--those that we can consume. Then there is financial wealth - cash, debit cards, stocks, bonds, bank deposits, etc. The nature of financial wealth is that during extended periods of time, it can be converted into real wealth. You pay with cash, a debit card, or a credit card for the purchase of food or cars.
Financial wealth has one other very important characteristic - it seems to appear out of nowhere. The owner of shares can sell them for cash and then use the proceeds to buy more real goods. This property entices people to believe that financial wealth is greater than real wealth. It fools them into believing that financial wealth can grow faster than real wealth! How could this be, when this is obviously impossible!
Of course, this is impossible, but creates the illusion that it is. If stock prices double, a million-dollar stockholder can buy two million dollars worth of goods from the store. Unfortunately, in reality this comes from a decrease in the purchasing power of other cash-holders and stockholders. It remains unnoticed that the reduced real wealth is now divided between millions of people. The current system benefits the astute and sophisticated in the short run, but hurts everyone in the long run. Even those who gain initially must eventually suffer a lower standard of living.
This is easy to notice in a developing country with fluctuating exchange rates. When someone sells a foreign currency that has appreciated in value, he generates a capital gain. So, if the currency holder gains, then who loses? It is impossible to create something from nothing, to create wealth spontaneously. Thus, if someone gains, then someone else must necessarily lose. Then it becomes easy to see that in rising euro against the dollar, the winners are all the holders of Euros, and the losers are all the holders of dollars, because dollar-holders have lost purchasing power.
Currently billions of dollars are injected daily into the financial system. As a result, the dollar continuously loses value. Now it has become increasingly clear to everyone that this process cannot be sustained; but it cannot be stopped or reversed either. The dollar must inevitably collapse and cause total chaos throughout the global financial system. This will destroy the value of dollar savings and dollar-denominated assets and will most likely destroy the bulk of global financial system. In the best case, a new and improved monetary order will emerge from the chaos.
One of the properties of chaos and organisation theory is that we can't possibly know what the new system might be. It is frequently the opposite of the previous one. In Hegelian terms, this is the dialectic nature of growth and development, where the current stage in the spiral of development is replaced at a higher stage with its dialectically opposite. The next stage completely negates the previous one, while completely resolving all of its problems. Later, the new system reaches a crisis once again, and it seemingly reverts to its previous stage of development, however at a new, higher level.
In this sense, it is very likely that the collapse of the dollar will be most likely replaced by a new and better system. However, according to the Hegelian dialectic approach, gold--the antithesis of paper money--may once again return as global money, since gold has been sufficiently displaced as money since 1971. It may well be that gold is the money of our future.
ABOUT THE AUTHORS
Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and I encourage you to complete your own due diligence when making an investment decision.
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