Too much thinking, too little observing

In the midst of the current economic crisis, the main cast which include politicians, the soon-to-be burned bankers, economists, newspaper columnists and talking heads, all well endowed with brain power, never tire of pontificating about the crisis. Each would come up with his/her own assessment of the situation together with the proposed nostrum. Unfortunately the diagnosis is invariably wide of the mark, what more the prognosis and remedy.

This woeful situation is the result of everybody using too much brain power, when in fact he/she should not be thinking at all. In pattern recognition, all you need to do is recognise the pattern to be able to portend the future state. Thinking, if any, should be kept to the absolute minimum. If you need to think, it should have been accomplished long ago, not when the crisis is brewing.

Alfred North Whitehead (1861-1947), the English mathematician and philosopher, years ago warned against thinking about something anew since it would invariably lead to ill-thought-out decisions: 'Civilisation advances by extending the number of important operations which we can perform without thinking of them.' In fact, the failure of the many personalities in coming up with a coherent diagnosis and prognosis of the current crisis can be attributed to the overuse of their grey matter and underuse of habituated responses.

By grey matter, we specifically mean the prefrontal cortex (PFC), the 20 percent of the brain that is involved in decision-making, empathising, higher-order thinking, directing attention and regulating emotions. Lying in the anterior (front) part, it is also the brain's working memory. In the animal kingdom, mankind not only has the greatest ratio of brain to body size but also the highest percentage of PFC, enabling it to dominate life on earth. However because the PFC holds only short-term memory, over-reliance on it can make us choke in our decision-making. If you've faced a panic before, such as stage fright, you would've experienced choking: your heart starts racing, your palm begins sweating, your muscles tense up and your mind seems blocked. That's because your PFC is bombarded by incessant messages that are too numerous to handle. So as the PFC jams shut, your mind goes blank and your body becomes stiff. To overcome this, we need to change our thinking process to become more automated.

As guides to transforming our thinking process from meditated to automatic, we have two acronyms to help us: OODA and FEED. Both amount to the same thing. OODA, short for Observe, Orient (or Orientate for Brits), Decide and Act, is a decision making loop developed by USAF Colonel John Boyd (1927-1997), a co-designer of the F16 fighter jet. The intent is to get inside the enemies' loop so that you think several cycles faster than your enemy, preventing him from discerning your thinking pattern. A simple example helps: in a crocodile infested river, you should never fetch water from the same location. The crocodile's thinking pattern is to sneak up on you the next time you come to the same spot. Your pattern is to keep changing the spot. It's easy to outwit a crocodile since it doesn't have PFC.

But with human adversaries, the difference is fine. For example, in air combat, a few seconds can mean the difference between registering a kill and being blown to smithereens. Similarly, the renowned undefeated samurai, Miyamoto Musashi, also the author of The Book of Five Rings that predated OODA by centuries, continually honed his swordplay through regular practice so that he could gain the few precious seconds needed to defeat his opponents in sword duels.

Let's see what OODA really is. On the top left diagram is the OODA loop. For comparison, below it is the PDCA loop typically used by Japanese companies; the PDCA is the reason why the Japanese are good at incremental but not radical progress. Immediately, without reading the boxes, you can spot the key difference between the two. The process flows from all the boxes in OODA not only proceed sequentially forward but also feed back to the Observe box (note that most of the OODA diagrams on the web are wrong except for Boyd's original) while that of the PDCA only advance sequentially. The flows in OODA imply that the Observe process is the most important part of the OODA loop.

That's the reason we are endowed with five sense organs and only one brain. If you look at the top predators in the animal kingdom, say, the sharks, their sense organs have been highly developed and seem almost perfect for the environment in which they roam. Their brains do not have PFC but they don't need to since they have vastly superior sense organs that can hear low frequency sound from a distant, detect electrical impulses generated by their prey, smell one part blood in a million parts seawater, and feel vibrations from pressure waves that bounce off objects.

The other acronym, FEED, comes from John B. Arden the author of Rewire Your Brain. It represents Focus, Effort, Effortlessness and Determination. Focus is akin to Observe. You then spend Effort, particularly practice, on your area of Focus in order to achieve Effortlessness in thinking as reflected in fast decisions and actions. Determination means to keep in practice so that Effortlessness is continuously maintained.

We can achieve the quick decisions by assigning to the PFC and the other cortices of the brain their true roles. The PFC should be used to process new information which should then be etched into other parts of the brain since the PFC's capacity is limited and temporary. To do so, the brain must be trained (or oriented) through repeated practices, much like what Miyamoto Musashi did, so that it rewires the other areas of the brain for long-term storage, thus enabling quick recall. The PFC is then left free for higher order thinking.

What about economics which is not amenable to being practised? Well, by continually deliberating and focusing on the issue, testing your own hypothesis against similar situations in different time periods and locations, you'll achieve the same effect. Extensive readings are also a must. You can start with economics topic but as you go along, digress into economic history, general history, military history, ecology, politics, demography, technology history, agricultural history and anthropology. Yes, anthropology, the study of humanity, because economics, which is the study of the material welfare of humankind, is actually a branch of anthropology.

Anthropologists possess several enviable traits that economists should emulate. They don't pass value judgement on the subject matter, i.e., the tribe or society, of their research. And they embed themselves within the subject matter in order to get first-hand information. Economists on the other are stuffed with preconceived notions of what's right and what's wrong. Free trade for example is sacrosanct. As long as sacred cows exist, progress in knowledge cannot proceed. The whole exercise can be purposeful as well as serendipitous, discovering things both intentionally and accidentally.

Without the help of OODA, our economic cast of characters can be likened to the six blind men and the elephant. The neo-Keynesian economists having touched the tail, proclaim that failing demand is the cause. At the front feeling the trunk are the monetarists. Unknowingly having been misled by Milton Friedman, they counter that falling money supply contributes to the mess. This flawed reasoning is the approach adopted by Bernanke, noted for his failed QEs. Next are the supply-siders who include the Republicans. They argue that fixing the supply side through a low tax regime will rejuvenate growth at a time when the problem is demand, not supply. Another are the ECB bankers and the EU bureaucrats who having forged an economic union that is not matched by a political one, thus ensuring its quick demise, are now hastening its death through a suicidal austerity measure. Japan is still lost as musical chair leaders still have no clue on what ails Japan. Then there is China still infatuated with superpower grandeur, not realising that the bigger threat is internal implosion. The coming depression itself is a tragedy but the nonsensical delusions of these blind men are turning the whole thing into a farce.

The orienting part needs to do one more step to complete the Orient process, that is, to develop the underlying pattern. It's not enough to have eyes to see the shape of the elephant since we must delve into its various functions, e.g., respiratory system, locomotion system, digestive system and so on. We need to know how changes in one aspect of the elephant's system affect the future state of the elephant. For economics, the 4C (see Reality in 4C) is a framework that sufficiently explains the mechanics of societies or nation-states. Why four, not seven or eight? Simply because the human mind cannot remember too many things. For example under Capacity, we could have enlarged it into energy, materials, agriculture and demography. But the framework would have been too unwieldy, slowing decision-making. To reduce many categories into a brain-manageable one, we use sub-grouping or nesting, one on top of the other. So under Capacity we have probably four more sub-groups. The longer the chain the more nesting levels needed but under normal situations, two would have been enough.

The key issue is not just grouping but how things are grouped. An expert group things by function whereas a novice does so by physical proximity. For example, the respiratory system is a grouping of body organs — nose, mouth, trachea, lungs, and diaphragm — that has the objective of supplying oxygen through the blood to all parts of the body. A novice groups things by physical proximity, for example, categorising eyes, ears, trunk and mouth together as they are physically located in the head. We know that the first grouping is more meaningful as it gives us a diagnosis and prognosis capability while the second one doesn't.

Once you have mastered these thinking skills, decisions and actions come naturally. You'll have a complete grasp of the overall landscape, having a helicopter view of your surroundings. You may not have an in-depth knowledge of any particular spot but that is the least of your worries. You can always drill deep down by hiring micro experts. On the other hand, with so much information that can be googled, you may not even need them.

And you'll never by caught off-guard by Nicholas Taleb's black swan. Using this approach you can even laugh him off. In fact with the current advanced knowledge in genes, we now know even if the black swan doesn't exist, we can tailor make one by changing the relevant genetic marker. Like science, economics and all other spheres governing human interactions are governed by the laws of nature. And anything that is subject to such laws can best be understood through the application of pattern recognition.

On and off the Marx

Marxism nowadays has been totally discredited and rejected by all save for a score of diehard revolutionaries who still believe in its view of how society and economy would eventually evolve. However, Marxism's real appeal to its staunch advocates doesn't lie in its economic or socio-political ideas since it's highly doubtful that they understand the complexity of Karl Marx's (1818-1883) Das Kapital. Instead Marxism's attraction to them is the class struggle that would lead to the triumph of the proletariat as idealised in a communist classless society. Such a society has hardly existed except in tribes living in unforgiving landscape, such as the Kalahari desert where equality is a necessary precondition for survival. As for the proletariat, once they gain power they take on the affectations of the bourgeoisie, dashing Marx's dream of his utopia.

However we cannot totally dismiss what Karl Marx wrote since he spent the better part of his life studying capitalism and its inherent weaknesses. He actually read the works of every economist. Also bear in mind that the background to Marx's economics thoughts was 19th century Europe, specifically England where he lived from 1849 till his death. In fact Marx's life straddled two Kondratieff wave periods, i.e., the first (1780-1840) and the second (1840-1900). So he was able to observe firsthand the winding down of the first Kondratieff wave and its succession by the next wave.

Thus it is Marx's economic ideas, not his revolutionary ones, which are more momentous since they could actually plug the missing gaps in the present repository of economic knowledge. Several of his predictions proved prescient. Among them, the growth of a few huge business firms that would come to dominate commerce and industry at a time when the prevailing business forms were small-scale. The most notable of course is his reckoning that the collapse of capitalism was the logical outcome of a constant class struggle between the bourgeois and the proletariat.

How that collapse would come about is an interesting piece that should have been required reading for all economists. Marx foresaw that to maintain profits, a business must constantly innovate. To him, the direction of innovation was in labour-saving machinery. Nowadays we know that innovation can take many forms—new processes, new materials, new machinery and so on—but the bottom line is the same: more output for less input. As the capitalist enterprises invest in more machinery, fewer workers will be needed resulting in a higher number of unemployed. If we examine the evidence in the later half of the past three Kondratieff waves Marx has actually been vindicated.

Even now in the fourth Kondratieff wave, a stream of unrest is plaguing most economies as the ranks of the unemployed begin to swell. The proletariat has risen in protest against the status quo. The cause is the imbalance of wealth distribution which cannot be solved by increasing productivity but by upending the manner in which wealth is presently distributed.

Having presciently pointed where capitalism would lead to, Marx miserably failed in recognising how capitalism overcame that weakness. He thought that capitalism would eventually destroy itself. He couldn't see that a succession of new Kondratieff waves would be ushered in to creatively destroy the wealth accumulated in the productive investments of the previous wave. The investments would be destroyed not physically but through obsolescence as the new wave's investments would produce better and cheaper products. The benefits of the new wave were not only enjoyed by the bourgeoisie but also spilled over to the proletariat. Marx was in despair when he witnessed his proletariat transformed into bourgeois proletariat. Having spent so much time and effort in formulating his theory, most of it in the reading room of the British Museum, he couldn't bring himself to rewriting it even though his observation was contradicting it.

For example, the second wave introduced cheap steel to replace wrought iron. This enabled boiler steam pressure to be increased making engine more efficient. Ships also could be made lighter and rails could bear heavier loads. New communication modes utilising rail, telegraph and telephone superseded canals. The impact was enormous. In the US the grain producing areas moved from New York and Pennsylvania to the Midwest. Rail also enabled France and Germany to industrialise by unlocking their landlocked coal fields.

Marx could only predict the demise of capitalism but he could not come up with an alternative beyond that of the proletariat rule. His Labour Theory of Value appears laughable now given that labour input forms a very small part of the production cost. In Marx's days the work week was around 80 hours. The communist countries took Marx's labour theory seriously. Instead of letting demand and supply set the price of goods, they were using labour input as the price determinant. Their central planning and mispricing produced the wrong goods for the wrong market. In the end, the lack of a profit motive reduced the incentive to produce. The USSR in its final days had to rely on oil to sustain itself because in all other areas, the workers were pretending to produce. Communism's failure thus was a failure of supply.

If communism failed because of supply, its anti-thesis, capitalism surely would meet its fate because of failure of demand. In fact, the depression that characterises the end of a Kondratieff wave is the result of demand not keeping pace with supply. Fixing demand is many times harder than fixing supply since those willing to spend must first be given the means to spend. Remember that during this stage of the Kondratieff wave, there are many unemployed people whose demand for economic goods has vanished. In the last few years, credit has been liberally dished out to continue stoking demand. The result is a world awash in toxic debts that cannot be solved other than writing them off. Because of the prominence of the toxic debts, it's commonly believed that the current crisis is a credit crisis where in fact it is a secondary cause. The root cause is the imbalance in wealth distribution the solution to which requires a major paradigm shift 0f the fifth Kondratieff wave.

The only remaining way to sustain demand in the current Kondratieff wave is continual deficit spending by the government or for the wealthy to donate part of their riches to the poor. You've probably heard suggestions to fix the crisis by resolving the supply side so that goods can be made cheaper and more affordable to the public. This is the wrong approach because cheaper goods usually entail more automation. The benefits eventually flow back to a narrower band of rich owners of capital. The poor still have no income no matter how cheap the goods are. Whatever means must be resurrected to reinstate income to the poor even to the extent of erecting the economically inefficient tariff barrier.

Only the government is capable of doing so but with the government heavily swayed by the benefits of free trade and its budget undermined by the planned spending cuts, the government has been hobbled. That makes 'giving' the only option left. However Adam Smith's individual self-interest working collectively for the public good no longer applies here. Instead as the rich wind down their spending and generosity because of fear of future uncertainties, the rest are consigned to the depths of despair and misery. But no, when humans are in such wretched conditions, they fight back and everyone will be the loser. Adam Smith's The Wealth of Nations should now be aptly retitled The Woes of Nations.

Another high speed crash on the way

The collision of two Chinese bullet trains on 23 July 2011 has elicited public outrage on its microblogging services. The crash caused by a lightning strike that stalled a train was not totally unexpected as China has been expanding its high speed rail network at breakneck speed. Still this is nothing compared to the disaster that will be visited upon China when another of its fast speeding contrivances, that is, its economy, starts to hit the skids.

China has been copying and modifying imported rail technology in order to breach the speed limit. Its meddling with its trains is akin to its tinkering with its economy writ small.

A picture tells a thousand words. The two charts from The Financial Times on the left demonstrate that China is dangerously breaking the economic speed limit.

The most revealing information from these charts is that China's net exports, much ballyhooed as the driver of China's GDP is not what it was made out to be. Instead it's its gross fixed asset investment or gross fixed capital formation, i.e., before depreciation, that's the real engine of growth.

Compared to Japan's fixed asset investment in its bubble years, which topped out at 35 percent of GDP, China's figure is now approaching 50 percent of GDP. Even the US registers only 20 percent.

China's investment, mostly debt financed, has gone past diminishing returns, swinging into negative territory. Its rail accident may be due to its failure to grasp the need for the rail signalling software to keep pace with advances in the hardware. Similarly, its breakneck economic growth would be incomplete without a corresponding growth in debt financing. Rushing headlong into capitalism just after ditching communism is hazardous for a nation that hasn't grasped the dark side of capitalism.

The final chart from The New York Times is more alarming. The difference between this chart and the above is that the fixed asset investment includes expenditure on land and inventories which the gross fixed capital formation excludes. This chart shows that China's GDP closely tracks its fixed asset investment. The investment, at a staggering 70% of GDP, is unprecedented in economic history.

One Chinese microblogger perfectly summed up the bleak situation that is dawning over China: "China today is a train travelling through a thunderstorm. None of us are spectators; we are all passengers." The two colliding high-speed trains with 1,400 passengers registered only 39 fatalities. Its economic train with 1.3 billion passengers however won't be so lucky.

Weak hypothesis on a great empire

History is an open subject; every historian has hisstory or herstory. In fact, you also can posit your own theory of the rise and fall of past societies. Now a new one has been made by a historian, Elin Whitney-Smith. Essentially, she hypothesises that great economic shifts have been precipitated by changes in the way information is managed. By her assertion, she has reduced the underlying pattern to a single cause, going too far in the direction of simplicity. This violates Einstein's dictum that "Everything should be made as simple as possible, but not simpler." Anyway, her information-revolutions.com website contains nuggets of interesting facts and her in-progress book would appeal to any history buff.

We can use her take on the collapse of Ancient Rome, specifically its western half, to test the tenability of her contention that information is key to understanding momentous changes in human history. She argues that the collapse of Ancient Rome was prompted by information overload. Rome was too big to be effectively governed, so it had to split into two: the Western and Eastern Roman empires. To reduce the overload, both Emperors Diocletian (reigned 284-305) and Constantinople (r. 313-324) turned to autocracy and mandated one state religion, the former promoting paganism and the latter Christianity.

As usual, Whitney-Smith has fallen into the single lever trap. The proponents of this approach try to discover one single overarching theme that can explain all monumental shifts in history. Then they tailor their findings to suit their hypothesis, ignoring all evidence that contradicts it. With enough materials assembled, voila, a new theory has been discovered. As history is subjective, everybody is entitled to his opinion. So their new theory is accepted as one of the many causes of great historical shifts. What history ends up is a mass of erroneous inferences which no one has taken the trouble to contradict, correct and reassemble. To do so, we need to bring up the big picture for which the various inferences can be fitted in so that the real story can emerge.

As a rule, history can never be reduced to a single lever theme. It takes several major causes, at its simplest not less than four, to explain great transformations. The four are encompassed in the 4C framework or model comprising Capacity, Communication, Consumption and Capacity. Whitney-Smith's information theme is only one aspect, i.e., the communication, of the 4C. That means she has missed out on more than three quarters of the causes. With the 4C as a reference, picking holes in any historian's arguments is a cinch.

Let's look back at the narrative on Ancient Rome so that we can fully understand why it collapsed. It will provide lessons on the coming collapse of nation-states. Ancient Rome reached its greatest territorial extent under Emperor Trajan (r. 98-117). Administering it was very costly because Trajan had overextended. However his successor, Emperor Hadrian (r. 117-138) undid his mistake by withdrawing from Mesopotamia and Armenia.

Land transport in those days was 60 times more expensive than water transport. As a result the Roman territories could not extend more than 75 miles from the coasts or navigable rivers. The map below, taken from the companion website of the Civilization in the West textbook, shows that the dominion of Ancient Rome was limited to accessible waterways, comprising maritime and riverine routes. Even now rail movement, the cheapest land transport, costs four times the cost of moving goods on a large ship.

The beginning of the split between West and East occurred around the time of Emperor Diocletian (r. AD 284-305). That's more than 165 years after Trajan's death. Mind you, the age of the US in its largely present form is less than that. California and New Mexico were annexed into the US only in 1848. Alaska was purchased in 1867 and Hawaii, the last state, added in 1898. Certainly information overload wouldn't have been an issue for the Romans. If it had been, the empire wouldn't have extended that far in the first place. In fact, communication between the two halves of the empire was cheap. Look at the map and immediately you'll notice the Mediterranean Sea, the main communication artery that fused the empire together. But extending beyond the 75-mile coastal and riverine limits was not possible as costs would have exceeded benefits.

In terms of capacity, the Roman empire's fortune moved downhill the moment it couldn't extend its land acquisition. In contrast to the modern-day superpower which must keep on acquiring new technologies to remain dominant, ancient Rome must keep on acquiring territories. New territories furnished Rome with new slaves and economic goods especially agricultural produce. Once Rome stopped expanding, economic growth stagnated though eventual downfall in those days took some time since events moved at a glacial pace.

Rome itself initially was a centre for the production of wine and olive oil. However other Italian regions began eroding Rome's competitive advantage. Eventually its colonies, Spain and Gaul (modern France), cornered this production leaving Rome a hollow core economically. Meanwhile, gold and silver flowed out to China and India to balance the trade deficits arising from silk and spice imports. The only economic activity left in Rome was building works as this could not be traded across borders. It also served to provide jobs for the unemployed. Sounds familiar?

The troubled times with chronic usurpations of power occurred around the 50 years after the death of Severus Alexander (r. 222-235). This chaotic period was characterised by rapid inflation, the combined result of decreased food production and coin debasement. Coin debasement took two forms: reduction of silver content and when this had reached its limit, changing the denominations to higher amounts.

As the western half of Ancient Rome was subjected to constant harassment by the barbarians on its borders, maintaining it cost more than the benefits it generated. It was therefore inevitable that for the empire to survive, it had to size itself down. This move began under the rule of Diocletian (r. 284-305) who divided the rule into two halves by nominating Maximian as the western co-emperor. He also appointed two junior caesars, in the process of which the two senior emperors were elevated to augusti. This Tetrarchy system secured his rule from the chronic usurpations of power as powerful army commanders now had more opportunities to be emperors. In actual fact, it solved the problem in his time but the problem reappeared later because more openings led to more contenders for power. The root cause had always been economics, not politics.

Diocletian managed to bring back some stability to the empire. But in an empire that had been on a natural decline, it was a temporary fix and the cost was immense. Inflation was rampant and this could be attributed to the fall in agricultural production as a result of his ruthless taxation. When the monetary system had broken down following hyperinflation, Diocletian instituted taxation-in-kind. As powerful landowners received exemptions from taxation, the burden of taxation fell on the small landowners. To avoid the oppressive tax, the small landowners left their farms deserted to become tenants or slaves to the big landowners. Notice that even now, the big corporations and the rich know how to find tax loopholes in order to avoid paying tax. This deceit would in turn hasten the breakdown of society.

The increased tax revenue allowed Diocletian to increase the hitherto declining Roman army by one third to 435,000 thus providing the needed stability. Bureaucracy was also expanded. He tried to reform the currency by issuing non-debased full-weight coins but his fixing of the new coin denominations at the same value as the debased ones resulted in the new coins being hoarded and taken out of circulation. Bad money drove out good money. Though politically astute, till his retirement economic issues proved elusive to him.

Emperor Constantine (r. 306-337) was able to consolidate the emperorship into one in 324 after spending the early part of his rule usurping power from fellow emperors and contenders. His rule was the last in which Rome regained its supremacy prior to its official split into east and west. Again the price was costly and it was just a short spurt in a secular decline. Constantine increased slightly the size of the Roman army to 450,000. Also like Diocletian, he used religion to strengthen the state but whereas Diocletian embraced paganism and turned against Christianity, Constantine was intensely sympathetic to the Christians. Turning to religion provides a ruler an alternative instrument of control when the economics crutch can no longer be relied upon.

Constantine initially ruled the western half of the Roman empire. However after uniting the two halves, he moved the capital to Byzantium, which he renamed Constantinople. It was a strategic location as it sat astride the east-west trade route. It could live off trade. This move marked the end of Rome. Sucked hollow economically and besieged by the barbarians militarily, Rome would permanently lose its preeminence. The official split between east and west took place in 395. Long before the western half collapsed in 476, its capital had moved from Rome to Ravenna in 402.

Constantine raised his funds in other ways aside from taxation. The pagan temples that he destroyed yielded a lot of gold and treasures. In addition he regularly received gifts, which were actually tributes, from Roman cities and provinces in the form of gold and silver on the many special occasions. With his new found sources of wealth, Constantine was able to issue a new type of gold coins known as the solidus. The solidus which eventually became the tribute objects, was to be produced over the next 700 years, the longest time any currency was ever used. Of course, Constantine relied on wealth transfer to mint his solidus but subsequent eastern Roman emperors assiduously cultivated its current account to ensure that it always generated surpluses.

After the split, Justinian (r. 527-565), the eastern emperor attempted to resurrect the old Roman empire by invading the Italian peninsula. He succeeded in 554 (see map below) but it was an expensive affair, costing him 300,000 pounds of gold with no significant economic returns. By 568, three years after his death, the new territories had to be relinquished. As usual the defining yardstick has always been the 4C, this time the conquest not yielding any new capacity that would have compensated for the cost of the expedition. Using information as the sole criterion does not do justice to the events surrounding the downfall of the Roman empire.

The economic and political evolution of the Roman Republic

The no-enigma trilemma

It is common nowadays to hear self-proclaimed pundits extolling the benefits of a strong currency, one that is tied to gold, commonly known as the gold standard, just so to prevent the erosion of its value by irresponsible politicians. Most people will be swayed by the seductiveness of this assertion without realising the misfortune that it will wreak on the many in order to benefit the few.

Still, can we resurrect the gold standard? It's easy to decide if you're Joe Public. The thought that your savings won't be stealthily diminished by the government's money printing shenanigans is good enough reason to revert to the gold standard. But how sure are you that you're going to have savings in the first place? That's the issue that should've been addressed. Those pundits manage funds in the billions of dollars and their advice surely has a self serving agenda. Instead the best counsel to understanding the appropriateness of a monetary or currency system is of course economic history especially the evolution of our modern-day currencies over the last 100 years.

The theoretical underpinning that superbly explains the currency evolution is none other than the Mundell-Fleming trilemma (see diagram from The Telegraph below). This economic model was formulated independently by economists Robert Mundell and Marcus Fleming.

Under this monetary policy trilemma, you can only pick two out of three choices. Actually, the word 'can' is misleading as you'll soon realise that you can't decide; the choices have been predetermined. If you choose all three, the trilemma will penalise you for this transgression and put you in a worse off position than before. A political leader's role thus is to move with the ebb and flow of economic waves.

This trilemma won't be explained here in detail since you can google its many articles on the web. Instead this post will demonstrate that the trilemma doesn't justify its name because picking up which two of the three options is a no-brainer.

The three choices available in the trilemma are fixed exchange rates, capital mobility and independent monetary policy. In chronological order, our modern-day currencies, that is, over the last 100 years, began with the gold standard which lasted until 1914, the start of World War I when it was suspended. In any crisis or panic such as war, everybody wants to switch to gold which can lead to a severe run on a country's gold reserves. To preempt that, you have to suspend gold convertibility.

During the heyday of the pre-1914 gold standard, capital was mobile and exchange rates were fixed but no country had control over its monetary policy, i.e., it could not set its interest rates nor money supply. But the world then had minimal borrowings. Government deficits were unknown except in times of war; in the first half of 1910s the US government debt was less than 4.0 percent of its GDP. Governments derived their incomes from import tariffs. The US government only reestablished its income tax in 1913 after the earlier one, necessitated by the Civil War, had been abolished in 1872. Consumer credit was small and only used for the purchase of furniture and sewing machines; credit for consumer durables was introduced only after World War I.

In those days, the population was largely rural, so money was not crucial for the low-volume economic transactions which in most cases were carried out through barter. The farmers upon harvesting would deliver enough supply of flour, after it had been ground by the miller, to the grocer in exchange for one year's supply of groceries. Sometimes, it entailed a system of credit to be settled upon harvesting. In rural areas such a system worked because everybody knew one another; running away from your obligation wasn't an option. In present-day cities where everyone is a stranger, barter is impracticable. Without money, life in cities would collapse. But in the beginning of the last century, there was little need for financial savings. You could rely on your next of kin and neighbours should any misfortune befall you. If all else failed, death was just around the corner. Life expectancy in the 1910s was in the early 50s, that is, you worked until you fell dead. So you didn't have to save for old age.

The problem with the gold standard was that the money supply was restricted to the amount of gold held as reserves. With the annual global gold supply increasing at only 1.5 percent, there was always the risk that money supply would be outpaced by goods and services production, which was increasing at 2.6 percent annually from 1900 to 1925. A situation of falling prices or deflation would soon follow. Of course, policymakers could issue bank notes not supported by gold reserves but they'd be courting the serious danger of inadequate reserves should there be a run on gold.

As long as credit was minimal, the gold standard could persist because the likelihood of a financial panic was small. Under the gold standard, the policymakers couldn't pump up the money supply to replace money withdrawn from the system unless they could come up with enough gold reserves. And money could only disappear if a substantial part of it was in the form of credit (if you've been following my earlier posts, by now, you should know how money vanishes). World War I upended this calm scenario. To finance the war, the countries resorted to deficit spending by printing money. The US on the other hand benefited from the overseas demand for war materials. From being the largest debtor in 1914, it transformed into the largest creditor in 1918. Its capital surplus was then invested in Europe.

The Europeans however were suffering from high inflation as a result of money printing to finance their deficits; Germany especially suffered terribly from hyperinflation from 1921 to 1923. To dampen the inflation, Germany revived the gold standard in 1924 followed by Britain the next year. Because of the high value originally set for the pound, Britain suffered an economic contraction that by 1931 it had to dump the gold standard following which it enjoyed a five-year mini boom. Japan which had gone on gold standard in 1930 went off it within one year. Only the US and France were happily sequestering gold reserves because they had set their currencies at values lower than their real worth.

Germany's stable currency had attracted funds from the US but the US stock market boom in 1928-1929 reversed the flow. Germany found itself short of money made worse by its uncompetitive economy because of the high value originally fixed for the German mark. Soon after getting out of hyperinflation, Germany was facing hyperdeflation. The resulting banking crisis and depression forced it to junk the gold standard in 1932 but it was too late to prevent Hitler from becoming chancellor in 1933. As they say, the rest is history. In fact, if you go back to the root cause, it could be argued that it was the US who sowed the seeds of World War II. By moving huge amount of funds in and out of Germany, it destabilised Germany's economic and financial conditions, facilitating Hitler's rise.

Actually there's a way to cope with the shrinking money under the gold standard. It's by reducing prices, including wages, across the board. However powerful unions prevented such a move. Even now, nobody would tolerate having his pay cut. The only available alternative thus was to drop the gold standard and devalue the currency. That was how the gold standard met its fate. Moreover you can never have fixed exchange rates if you allow unrestricted international trade while maintaining inflexible prices and wages since some countries will always try to benefit at the expense of the others. Free trade is never fair.

After Word War II, the US economy was at its greatest relative to that of the world: its share of world economic output was about 30 percent in 1945. It also had strong trade surplus and held two thirds of the world gold stock. As a result the US dollar was chosen as the reserve currency under the 1944 Bretton Woods agreement, a new currency arrangement to replace the gold standard. The British pound was also selected as another reserve currency but this was more to placate the British than for any other economic reason since Britain was no longer the superpower that it once had been.

Under Bretton Woods, the politicians adopted a system that swapped capital mobility for independent monetary policy in order to escape the misery under the gold standard. This boded well for politicians since they now controlled the money supply. Thus it appeared that they could regulate the economy though the reality has always been the other way round. Under Bretton Woods, the dollar was pegged to gold and the other currencies in turn anchored to the dollar. Although the dollar was no longer convertible to gold, sovereign nations could still exchange with the Federal Reserve their dollar holdings for gold bullion. It was a gold standard of sorts.

The key flaw with this arrangement is that with the dollar being the anchor currency, it restricted the US from adjusting its currency whenever it suffered current account deficits whereas the others could do so. As expected, what actually unfolded was that uncompetitive countries would adjust their currencies downwards while competitive ones, like Japan and Germany, would prevent any upward revision or did so at less than what should have been their appropriate values. The US bore the brunt of Bretton Woods. As long as the US was enjoying current account surpluses, this arrangement would last.

Beginning in the mid 1950s, Germany and Japan were having persistent balance of payments (BOP) surpluses financed by the US BOP deficits. Actually the US current account was in surplus for most of the 1950s and 1960s. Its capital account on the other hand was in deficit because of foreign direct investments (FDI) by the US multinationals in Europe. The net impact overall however was still deficit because the negative balance of the capital account outweighed the current account's positive balance. The growth of the US multinationals can be traced to this propitious period. The industrialised economies of the West benefited greatly from the US FDIs. As the dollar flowed into Europe, by the late 1950s the European countries were confident enough to relax their exchange controls, flouting a fundamental rule of the trilemma. This capital mobility was to eventually kill Bretton Woods.

The original exchange control restriction was in respect of both the capital and current account convertibility, terms which you hardly hear nowadays. Capital account convertibility refers to the conversion of one currency into another for the purpose of investments or loans while current account pertains to trade related currency movement, for example, payment for imports and receipts for exports. The current account convertibility was liberalised first at the end of the 1950s followed by the capital account in the 1960s. Actually in those days, aside from the US, only Canada and Switzerland, countries spared the ravages of World War II, were countries that had no exchange controls,

As for the Bretton Woods reserve currencies, the British pound, being the weaker of the two was the first to lose the status. It had to devalue by 14 percent in 1967 after suffering a string of large current account deficits. In those days, a billion pound was a huge sum. Like oil wealth, possession of a reserve currency was a curse. Because other countries were accumulating dollar and pound reserves, the US and Britain would eventually suffer current account deficits which could not be redressed except through a devaluation.

The gradual decline of the US current account began in 1968 with higher government spending following President Lyndon Johnson's Great Society programmes and increasing involvement in the Vietnam war. However, Nixon drastically reduced the deficits in his first two years as President but by 1971 the Vietnam spending took its toll. By August 1971, the dollar convertibility to gold was halted after it could no longer be defended against sustained withdrawals by other nations. That signaled the end of Bretton Woods. The US and Europe attempted to resurrect Bretton Woods in December 1971 through the Smithsonian Agreement but it was stillborn as the price of gold kept moving upwards. The trilemma could not entertain fixed exchange rates with free movement of capital.

In the same year the US suffered its first current account deficit, of $1.4 billion followed by $5.8 billion the next year. Meanwhile the oil embargo following the October 1973 Arab Israeli war pushed the oil price from $3 to $12. The Arab states began accumulating petrodollars which they parked with the US banks which in turn relent them to the Latin Americans and the US private sector. Once the banks realised how easy it was to make profits from other people's money, they never looked back, forgetting their fiduciary duty to prudently manage the nation's money supply. The chart above (from The Economist) shows that the growth of the US financial sector began around this time. The high inflation, beginning in 1973, was initially caused by these recycled petrodollars, not money printing by the government though later the government also fanned it through its increasing budget deficits. Had the US crimped the money supply by increasing the banks' reserve requirement, the inflation wouldn't have ensued although a severe contraction would have been the outcome.

As a result of these actions, from 1973 to 1981, the US money supply was boosted on average 6.5 percent annually. In consequence, the other major currencies appreciated against the dollar and the US current account turned positive from 1973 to 1976. But the other nations soon learned the trick, which was to tag their currencies after the dollar. They lowered their currency values through money creation. The US current account surpluses switched to deficits from 1977 to 1980. However, this concerted money creation effort unleashed inflation on a global scale.

To suppress inflation, President Carter appointed Paul Volcker as the Fed chairman in August 1979. His solution was simply to increase the federal funds rate to 20 percent by mid 1981. The dollar became a stable currency, better in fact than gold because aside from credibility, it now had liquidity. Rarely in economic history would a currency possess both qualities.

President Reagan capitalised on the strength of the dollar to unleash deficit spending on a scale unheard of before. The resultant massive current account deficits transformed the US from a creditor to a debtor by the mid 1980s (see left chart from The Economist). This time around, inflation didn't rear its ugly head as the global capacity was ready to unleash the supply to match the demand let loose by the monetary flood. The trilemma seemed to have been vanquished. But not quite. Just as the Europeans had been the beneficiaries in the 1960s and the petro states and the Latin Americans in the 1970s, the 1980s belonged to the Japanese.

Intoxicated with dollar reserves, the Japanese kept suppressing the yen exchange rate by creating massive amount of yen through increased bank loans. The money ended up inflating stock and real estate prices. The spectacular collapse of these prices at the end of 1989 marked the twilight of Japan. Soon the 1990s was the turn of the Asian tigers. Again the same Japanese scheme was hatched and the same ruinous fate met in 1997. The Chinese latched onto similar machinations in the 2000s but this time on a much grander scale. This time is different, they gloat. A new global power is staking its rightful claim. Indeed, it is. Highways, bridges, tunnels and railroads, all to nowhere; buildings and factories, all for no one. Going by the reckoning of the past, China's chapter should have closed by the late 2000s. Trying to delay destiny into the 2010s is certainly a heavy price to pay just to prove that the trilemma can be subdued.