Demystifying the inflation conundrum

Some economists worry that uncontrolled inflation will soon surface following the money printing antics of the central bankers. Still others believe that deflation will arise instead. So what to make of this contentious issue? If economists themselves can't agree on how a major situation will unfold, can we dummies, with no formal learning in economics, be more prescient than them? Worry not, you only need to know a little bit about money to trump them. Once you understand money, you can easily grasp the cause of inflation, hyperinflation and deflation. For this post, we'll deal with inflation to be followed by deflation in the next post. As we are dealing with the real world, our lodestar to understanding money is economic history, not economic theory which is good only for the surreal world.

To know what money is, you don't need to rely on the economists' M measures, i.e., M0 to M3 or sometimes M4. Same goes for the velocity of money, a crackpot idea that should have never seen the light of day. Those are red herring measures which serve more to distract than illuminate. The only measure that should be used is total credit. Credit is money. In fact between 95% and 98% of money is credit except in a hyperinflationary environment wherein physical money will drown credit. So under normal conditions the physical bills in your pocket don't make a dent to the money supply.

Economists who fear unconstrained money printing by central bankers are exposing their money ignorance (See "Money 101 for the Fed"). How much cash do you carry on your body or stash under your pillow? Compare that with the amount you keep in the bank and invest in bonds. If the cash that you keep in its physical form is more that 5% of your total cash holdings, you belong to the 1%, at the bottom, that is. Your cash in the bank is not sitting there idle. The bank will lend it to someone. So instead of tallying the cash, you can get the same effect by looking from the opposite angle, that is, the amount of credit drawn by the various borrowers. However credit from the bank is only one element of the total credit in the system. Credit also arises from bonds issued by corporations, municipalities and the government.

What about the newfangled financial instruments, such as the alphabet soup of derivatives? No need to feel overwhelmed. Their only impact is to make credit widely available. They don't reduce the risk though they may lower the price, i.e., the interest rate, of credit because more money now gets to the market and the cost of the intermediary, that is, the bank has been eliminated.

However money is only one of the causes of inflation. Recall the 4C framework of currency, capacity, consumption and communication. In simple terms, if the goods or services production lags the supply of currency, the result is inflation (see left panel of left picture). In rare circumstances, goods or services production may decline at a faster rate than that of money supply; that also leads to inflation (see right panel of the same picture). Another combination which only Robert Mugabe can magically conjure is a fast climbing money supply accompanied by a declining goods or services production. This is hyperinflation.  Note that hyperinflation is a state in which price increases are experienced daily while inflation monthly. Hyperinflation disastrously disrupts an economy that only insane politicians would allow it to proceed indefinitely.

What drives the movement of each component of the 4C? The supply of goods or services is dependent on advances in capacity and communication. Every Kondratieff Wave has witnessed a significant leap in both capacity and communication, resulting in lesser input for greater output. Even now a disruption in either capacity or communication could drive costs or prices up. The recent Pakistani blockade of the border crossings along the Afghan-Pakistan border has driven the cost of delivering fuel to NATO's remote outposts to US$400 a gallon.

The supply of money on the other hand depends on the increase in credit unless we talk of hyperinflation which requires the government to print money and spend it. However in most true representative democracies, it's not possible for governments to create hyperinflation because there are enough checks and balances to constrain their budgets. Only autocratic government can foster hyperinflation. Weimar Germany, the post WWI German government, although democratically elected, was different because of its unique circumstances which will be explained later.

Direct borrowings by businesses that bypass the bank usually through corporate bonds cannot be blamed for contributing to inflation. A non-financial business is restricted in the level of debt that it can raise relative to its capital, this proportion being termed the gearing or leverage. A gearing of 3 to 4 would have been the maximum tolerable for a non-financial business. Financial corporations however have a tremendous ability to create credit or money. Usually, they could push the ratio to 15 although the excessive risk takers among them have stretched this ratio to the extreme limits, with disastrous consequences. The gearing of Long-Term Capital Management which succumbed in 1998 skyrocketed to 292 (including total derivatives) or 62.5 (based on assumed risk only), while in the 2008 failures of Bear Stearns and Lehman Brothers, they were having ratios of around 35 and 31. The financial corporation thus are the obvious culprits for any inflation fostered by excess money supply.

So the rule for inflation in most modern democracies is this: for normal inflation, it is always caused by increased financial institution lending, not government printing unless it is hyperinflation in which case, the culprit will always be the government. But excessive lending need not necessarily lead to inflation if the goods and services production capacity can match the increased money supply. As is typical of any 60-year Kondratieff Wave cycle (see left chart from The Economist for the fourth wave which began in 1960), the first half of the wave is always plagued with capacity constraint but the second half is blessed with capacity surplus. So even though there may be pockets of inflation during the second half, they are mainly due to short-term inelastic supply of certain goods, such as houses and oil. Their prices are doomed to fall when the capacity bottleneck is broken. A similar portrayal of the inflation chart of the third Kondratieff Wave for the period 1900-1960 however would not appear so clear cut as the two world wars distorted the inflation numbers.

As for consumption, since the start of the Industrial Revolution, it has been benign because population growth has always been growing or at least hasn't faltered. But that's about to change with the fourth Kondratieff wave. The entry of women into the labour force has escalated the opportunity cost of raising kids. Women's total fertility rate (TFR) is falling all over the world, in some places, such as Japan, even below replacement rates. Population declines mean that consumption would now count far more towards contributing to deflation (less goods consumed means more goods available at a given money supply).

Although consumption now struggles, capacity flourishes. It is obvious now that we need less manpower to achieve a given level of production. What happens to the unneeded manpower? In the past, they could move from agriculture to industry or migrate to the new world of the Americas. Even up to the third Kondratieff Wave, manufacturing was still employing many workers. That enabled many to move up to middle class status. That has now changed as technology has automated many tasks while globalisation, aided by containerisation, has offshored tasks requiring many workers to foreign countries with cheap labour. Those in middle class  now are being demoted to lower class, worsening the wealth and income gap between the upper and the lower class.

One more issue that has been confusing us is whether inflation is cost-push or demand-pull. Generally, since the Industrial Revolution it's been demand-pull as mankind's ingenuity has enabled it to break the supply constraints. On occasions, when cost-push arose, the situation wouldn't last long, meaning round about 10 years. Take the 1973 oil crisis. The oil prices jumped then because the producers hadn't been exploring for new oil fields as prices had remained low despite the increasing demand. We've been fed the story of how Paul Volcker tamed the inflation in 1981 by hiking the interest rates to more than 19%. That's a half-truth. If Volcker had been Fed Chairman in 1974, his action would have needlessly put a great number of people out of work for a prolonged period. Luckily it was the early 1980s because by then the oil producers' spare capacity was reaching record highs, so the convulsions wrought on the economy by the sky high interest rates didn't last long. Compare this with the oil price hike that pushed oil to more US$140 per barrel in July 2008. That didn't have much ripple effect on the inflation numbers simply because of excess capacity in goods and services production. The goods and services producers had to absorb the higher energy costs and soldier on with wafer thin margins.

Let's get to the hyperinflationary world of Weimar Germany to see why it happened and why it wasn't a disaster it had been made out to be. In reality it was a relatively short-lived episode lasting from July 1922 to November 1923 but has been given too much bad press and wrongly accused of fostering the rise of Hitler. The cause of the hyperinflation was money printing by the German government during World War I. To finance war spending, the German government issued bonds which were subscribed fully by the Reichsbank through the issuance of new notes. These notes then circulated through the economy. However rationing and price controls during the war postponed the consumption of goods and price inflation. After the war the new socialist government increased spending to pay for higher wages and compensate displaced war victims at a time when capacity was still constrained. Prices rose but then stabilised after February 1920. The government however continued printing money. Prices held steady until May 1921 before continuing their rise, finally erupting into hyperinflation in July 1922.

Wasn't it easy to kill off hyperinflation and if so, why did the German government continued with its money printing madness? It actually was but the German economy then was burdened by war reparations which amounted to US$64 billion in gold. Had Germany paid the war reparations, its currency would have depreciated and the economy would in time regain its competitiveness, given the industriousness of the German people. But after a string of defaults by Germany in its war reparation payments, France and Belgium occupied the Ruhr in January 1923. In response, Germany printed more money to pay the companies, that suffered from the occupation, and their evicted workers. This was the trigger that unleashed the hyperinflation. However by November 1923, the hyperinflation was subdued through the replacement of the much devalued Papiermark by the Rentenmark at the rate of 1 trillion Papiermark for 1 Rentenmark, which was in turn replaced by the Reichsmark the following year. The reparation payments were rescheduled to more manageable terms. The sum was eventually reduced to US$29 billion in 1929. Money from abroad to invest in the stabilised German economy especially from the US provided support for the Reichsmark.

How bad the impact of the hyperinflation, it didn't lead to the rise of Hitler. Hitler attempted a coup d'état only in November 1923, about the time the hyperinflation was tamed. If hyperinflation was the villain, Hitler's popularity would have plummeted right after his failed coup d'état. To be sure, the conditions in Germany during the inflationary years were chaotic with lots of violence but that was to be expected of a losing combatant which had lost territories and had war reparations to settle.

However such conditions paled in comparison with the economic depression that afflicted Germany beginning in late 1929. This time the German economy instead of being flushed with money as in the hyperinflationary years was now short of funds as the Americans had pulled out their money for more profitable stock market speculation on Wall Street. Export markets dried up and banks were hit with closures. In 1932, the year before Hitler's ascent, Germany's unemployment rate was 25%. These negative conditions smoothened Hitler's rise and his eventual consolidation of power.

So which is worse, hyperinflation or deflation? Surely it's deflation. The conditions we're in now are ideal for a deflationary environment. The economists who have been warning us about the danger of money printing and hyperinflation very soon have to eat humble pie as prices data all over the world are pointing towards lower inflation. It won't be long before deflation rear its ugly head and these very same economists will be warning of deflationary dangers instead.

Great in debt

It is said that Margaret Thatcher and Ronald Reagan were the two great leaders of the western world in the 1980s, instrumental in ending the Cold War and ushering in a new era of small government, low taxes, free trade, weak union, prosperity and freedom. With the current palpable lack of leadership in the major economies, the public is yearning for the good old days of Reagan and Thatcher.

We don't want to revisit the legacy of both leaders; that would be the job of historians. Indeed they were truly admirable. But were there to be a leader of similar ability, could he or she reach the great heights of global stature especially in these trying times? Or was there something else about Reagan and Thatcher that has yet to be made known to us, the gullible public?

With the benefit of hindsight and a vast treasure trove of information on the web, we can now reexamine the reasons behind their prominence from the perspective of the 4C (see "Reality in 4C"). You should have been aware by now that Reagan secured his second term by paying homage to the credit market. But let's get into the details to debunk the conventional wisdom surrounding Reagan first, to be followed by Thatcher in a future post.

We begin with the tax and spending cuts, two issues frequently cited by the Republicans to justify their calls for similar action by Obama. When Reagan came into office in 1981, he reduced the top marginal tax rate from 70% to 50%, and federal spending by almost 5% of the federal budget. However this step could only last one year as coupled with Volcker's high fed funds rate that topped 19%, the economy was plunged into a recession (see left chart from The New York Times). The fall in inflation rate following Volcker's tight money policy accentuated the fall in the tax intake. So Reagan had to reinstate the tax revenue in 1982 not by reversing course but by transferring the burden onto businesses. Still, his tax cuts were much more than the increases; by the end of his administration the top marginal rate was further reduced to 28%.

The result of the tax cuts was reflected in the ballooning federal deficit, tripling from US$900 billion to $2.7 trillion by the end of his administration (blue column on the left chart). However this deficit actually boosted the economy. It supplied the spending and liquidity that uplifted the incomes of households, businesses and foreign nations. In turn the businesses and households took on higher borrowings of their own, resulting in a spike of total US debt that started from the end of Reagan's first term.

Now, two questions remain a puzzle to most observers of the Reagan administration. First, can't we continue the borrowing binge by all sectors that brought prosperity not only to the US but also to the whole world? Second, why was the inflation subdued when in fact the money supply as reflected in the debt increase during his second term was skyrocketing? Nobody has satisfactorily addressed these issues. Our attempt will demonstrate that Reagan came into office at the most propitious time. Because of that, his mistakes, which would have been calamitous to any other president, were glossed over.

He gained much from the cautious policies of his predecessors. Not only were they conservative with deficit spending but the inflationary conditions that had characterised their presidencies reduced the relative level of the federal debt. For example, Carter increased the federal debt by about 30% but because of the inflationary condition, the debt/GDP ratio actually decreased by 3.3%. Reagan's two terms however marked a new era of debt financing, not only by the government but also by the other sectors: businesses and households. Reagan took advantage of the depressed borrowings of the earlier years to let rip the borrowing and spending spree.

Also, unlike Nixon, Ford and Carter, Reagan didn't have to endure periods of high inflation, commonly known as stagflation because of the stagnating GDP. Milton Friedman used to remark, erroneously in fact, "Inflation is always and everywhere a monetary phenomenon." It should have been a 4C phenomenon instead of only a monetary phenomenon. The other important factor is capacity in which oil plays a very significant role as the driver of virtually all economic activities.

Remember that oil prices started to experience wild swings following the 1973 OPEC oil embargo. In fact, the sudden jump in prices wasn't totally unexpected had the buyers observed the declining spare capacity leading to the embargo (see "Oiled for Turmoil"). But as new oil fields took at least 7 to 10 years from initial exploration to production, it wasn't until the early 1980s that these fields managed to boost the spare capacity. However the 1979 Iranian Revolution followed by the Iran-Iraq War in the following year further scuttled oil production leaving the Carter administration wondering why his increased spending didn't translate into higher economic growth instead of higher inflation.

Only in 1985 did the prices drop to US$26 per barrel and by the following year to as low as US$11. Until the end of Reagan's second term the prices remained favourable, hovering around US$20. So Reagan could have the cake and eat it too, his spending going straight into the consumers' pockets instead of the oil producers'. Production capacity could increase to take care of the spending when previously any increase was constrained by higher input costs.

These two factors explain why no one else can repeat Reagan's feat and why there is so much yearning for Reagan's leadership. Although oil prices will likely go down as vast new fields in North Dakota, Colorado, North Sea, Colombia and Brazil's coastal waters come onstream in the next couple of years, the debt could no longer be increased. It has reached the peak of the S-curve and the only way forward is down. Those who want to spend no longer have the income to afford the debt while those who have the means have no use of further borrowings.

Poor Obama, intelligence alone is not enough to guarantee good leadership. More important is the external environment which in these troubled times can do far more to make or break a leader.

The errors of the neo-Keynesians

The importance of observing events cannot be emphasized enough as demonstrated by the erroneous diagnoses and prognoses of the global economy by the self-proclaimed experts. So let's tease out the reasons behind their errors which typically stem from incorrect observations.

For this post, we'll deal with the neo-Keynesians since they have quite an influence on the economic thinking of most governments, especially those bent to the left. The neo-Keynesians seek to fuse the thoughts of John M. Keynes (1883-1946) with those of classical economists. They have introduced mathematical models, something which Keynes never used, to provide a semblance of rigorous veracity. As always the case, the legitimacy of models depend on the assumptions and in this the neo-Keynesians fall far short of reality.

The neo-Keynesians  argue that government intervention is needed for continual economic growth as capitalism, left to its own devices, can dislocate itself by going unnecessarily to extremes. Therefore the guiding hand of the state is needed to ensure full employment and price stability. Whereas Keynes counselled intervention during a crisis, the neo-Keynesians support intervention on a continuing basis. Keynes also stated that an economy's output in the short run was determined by the aggregate demand, that is, the total spending of households, businesses and government. So Keynes's advice for the government to spend heavily during the Great Depression of the 1930s was right but it was only right for that time and under the conditions prevailing then.

It's easy to see where the neo-Keynesians have misunderstood Keynes. They have placed demand as the solution to recessions and economic slowdowns for all times. Now if we weigh this against the 4C framework, it is obvious that the neo-Keynesians have ignored both Capacity and Communication, and placed little importance on Currency. Their obsession has always been with Consumption. Till today, Paul Krugman, the popular public face of the neo-Keynesians, stubbornly insists on major government deficit spending to stave off the depression, not realising that such a move only buys time. It's a counter-measure, not a solution since there is no solution.

Now let's tackle their theoretical underpinning, that is, the IS-LM (Investment Saving - Liquidity Preference Money Supply) model (see left charts from The Economist). This model works only in a closed economy and as low cost producers started to compete with American goods in the 1970s, the model began to give way.

The model has two curves, the IS and the LM. The IS charts the different combinations of output and  interest rates at which demand equals supply (or saving equals investment). It marks the real (goods and services production) part of the economy and therefore used as the basis for fiscal policy. It is negatively sloped because as interest rate goes down, output (synonymous with income or demand) increases. The neo-Keynesians believe government can shift this curve to the left (by reducing spending) or the right (by increasing spending), thus reducing or increasing income. With an open economy, a shift to the right may not result in increased income if the income is siphoned off by the foreigners. The other failing is that with increasing technology use, the income is not shared by all as a few producers become very efficient leaving many others without jobs and income.

The LM curve on the other hand charts the different combinations of output and interest rates at which the demand for non-interest bearing money equals its supply. It is positively sloped because as output increases, the demand for holding money increases thus pushing up interest rate. It forms the basis for monetary policy. The government, it is thought by the neo-Keynesians, can shift this curve to the right (by printing money) or the left (by issuing bonds to mop up the money). The intersection between the IS and LM curves represent the equilibrium point for goods production and money holding. In reality, it's doubtful whether there is such a state.

The events post 1973 rendered the IS-LM  irrelevant. As oil prices began to rise after 1973, the recycled petrodollars from the inflating oil prices pushed money supply up through bank lending. The Fed had to jack up the fed funds rate to almost 13 percent in 1974 to suppress inflation. Although inflation did indeed fall briefly to 4.9 percent in 1976, it was achieved at the cost of high unemployment. Energy had become a constraint on capacity as new oil fields, now explored as a result of the high prices, took some time to enter production. Only by the mid 1980s, did oil prices fall. Consequently much of the late 1970s and early 1980s was characterised by high inflation and high unemployment, a phenomenon known as stagflation.

As the neo-Keynesians were baffled by this turn of events, Milton Friedman of the monetarist school came up with his NAIRU (non-accelerating inflation rate of unemployment) which posits that there's a natural rate of unemployment below which inflation will rise.

We can now prove that both schools are wrong. The neo-Keynesians and the monetarists have been using the unemployment rate as the yardstick for measuring capacity utilisation. High unemployment, in the neo-Keynesians' views, reflect high slack capacity and therefore the economy could do with some monetary expansion to increase output with no impact on inflation. However had they studied the 4C's Capacity, they would have realised that capacity is much more than unemployment; energy, materials and technology play a much bigger role. With so much automation in the factory even as far back as the 1970s, labour was no longer a key factor in determining the economy's capacity utilisation. Actually unemployment now has no relations to capacity utilisation as we now have surplus capacity but high unemployment. As for Milton Friedman, his views were always naive but the fact that he could influence so many policymakers to this day is a reflection of the low acumen of those to whom we surrender our fate.

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.

Reality in 4C

Why have economists been mostly wrong not only in prognosticating future economic outlook but also in rationalising past events? The root cause is the university and college economics curriculum. All over the world we are churning out armies of economists who've been wrongly taught and who in turn are preaching deviant thoughts. To stop accepting their economic nostrums, we must have ready a credible alternative.

To be sure, not all economists are clueless. Some really understood the workings of the economy; among them John Maynard Keynes, Hyman Minsky, Wynne Godley and Charles Kindleberger. Sadly they are all deceased. Outside the mainstream, the Austrian school of economists provides a good alternative viewpoint but in this case restrict yourself to just their view of the business cycle. Nikolai Kondratieff, a Russian economist executed by Stalin in 1938, was another proponent of the business cycle but he did not come out with a persuasive explanation to support his theory. Had he lived longer, he might have come out with one. As a result many successive 'experts' have come out with their own ideas which have no strong theoretical basis either.

What should we resort to? Nikolai Kondratieff's long waves are actually a good starting point. What we need is a sound underpinning in the form of a framework. It can only come after an exhaustive study of ancient as well as the modern post-Industrial Revolution societies. Only if the framework can successfully explain the rise and fall of all these societies, can we accept it as a valid theoretical basis.

No, this framework is not going to contain any mathematical symbol nor algebraic equation. Economics is about people, not numbers which should be restricted to the physical sciences and mathematics. With people, emotion generally trumps reason. The melancholic state of economics nowadays is a result of the field being taken over by the quants who have so much blind faith in mathematics. In finance and banking, they have wreaked havoc. Unknown to many, they also are doing much more serious damage to economics but till today such harm has yet to be exposed. The father of this movement is Paul Samuelson who happened to be the author of the widely used college economics text. Not surprisingly, Ben Bernanke was a student of Samuelson. So now you know why the Federal Reserve still can't get a handle on the US economy.

The framework which is meant to undo this damage has been tested against the economic waxing and waning of the societies of Ancient Greece, Ancient Rome, Charlemagne's pre-medieval Europe, the Dutch Republic, the British Empire and the US Republic. In addition the framework must also be able to prognosticate the future economic outlook. The framework, consisting of four components - Capacity, Communication, Consumption and Currency - abbreviated as the 4C, is depicted below. In reality, the structure is a dense network with many-to-many relationship instead of the circular one-to-one relationship. However, understanding comes through simplification as long as the simplification doesn't change the substance of the subject matter.

Don't be deceived by the simplicity of the 4C. Remember Albert Einstein's dictum: "Everything should be made as simple as possible, but no simpler." In the 4C's simplicity lies a powerful tool enabling us to understand the past and foresee the future.

Let's walk through the framework. We know that an economy revolves around the exchange of goods or services. This implies that you must first produce goods or services surplus to your own needs. A self-subsistence existence on the other hand has no need for any economic exchange or trade. Capacity to produce surplus is thus the precondition for trade. But having capacity is useless unless the surplus production can be transported to those who want to consume it. Hence the communication and consumption legs. Finally a common measure, i.e., currency is needed to enable the exchange. Barter doesn't cut it because a plethora of prices will emerge to overwhelm the exchange. For example, under a barter system, 10 items will result in 45 prices, that is (10 x 9)/2, the formula being n(n-1)/2, whereas a common currency produces only 10 prices.

Currency doesn't have to be physical. In fact, most of our economic transactions are conducted using credit, the virtual currency that forms more than 90 percent of our money. Those who disparage fiat paper currency should have redirected their denunciation towards credit instead. Ancient and traditional societies with surplus economic goods also resorted to credit simply because there was not enough physical money, be they shells, beads or precious metals, to meet the needs of trade. And the main reason for the collapse of the discredited gold standard was its failure to meet the shortage of money.

In our modern day, the capacity and communication legs of the framework are primarily powered by technological advances. Hence to really understand them you need to have a full grasp of the history of technology. Historically, capacity has come in the form of cheaper and more plentiful energy and materials. Those are two out of the three hallmarks of the Industrial Revolution, the other being the setting of the work pace by machines.

Communication which can be either physical or virtual is the leg that drives stock market booms. The consumption leg on the other hand is tied up with demographic growth. Consequently a history of demography is a must. As population growth used to be highly dependent on food, a history of food is also in order. However in modern times, food and population no longer move in sync as fertility rates rapidly decline in the developed world though in the poor developing nations, high fertility rates and declining food production are storing up future troubles.

Only the currency aspect is within the purview of economists. Guess what do you need to know to master this? A history of economics for sure. Not the theoretical stuff peddled in universities. In effect, economists know only probably 20 percent of the knowledge needed to explain monumental shifts in economic conditions. No wonder their predictions go haywire and their rationalisations of the past fail scrutiny.

In the 4C framework, the circle or cell can represent an individual, a corporation or a state. A cell must be a producer (capacity) as well as a consumer (consumption). The purpose of an economy is to keep the network moving so that everybody produces and consumes; if he stops producing, he also cannot consume. If this happens to be a business enterprise, it can be made bankrupt. But you can't do that to humans or nations. That explains why good CEOs make poor politicians.

To support the flow of goods and services, the communication lines must keep the flow moving and there must be enough currency to lubricate the economic exchanges. Like a production planner on the factory floor, the aim is to balance the load along the network. There's no point in making some cells highly efficient in producing goods that the idled others cannot consume. The resources should have been diverted to the slow producing cells so that they can start producing and thus accumulate the wherewithal to pay for their consumption.

Among the four components of the framework, only the currency leg can be manipulated by policymakers. During the first half of any Kondratieff Wave, they would hike the interest rate in order to reduce credit growth. Because the interest rate is the price of money, the higher it is, the less money is borrowed. Through this means, they control consumption so as to be in line with capacity which is still trying to meet demand. A runaway inflation would be subdued in this manner.

Conversely, during the second half, they would reduce the price of money so as to stimulate demand for money. It works, but in the form of a borrowing and spending binge on real estate, and only for a very short duration. To understand why, you must drag in the capacity and the consumption legs. During this stage, the capacity has become lopsided with a few extremely efficient producers cornering the market. As a result the consumption also fails since many cells have been knocked out of the economic game because of their inefficient productive capacity. If this were a factory, you'd see harried economists confusedly scurrying around trying to fix a production flow that heaped superfluous parts at the wrong work cells while starving others of needed parts. So even at zero price or interest, there are no takers for the money. Nobody can borrow if they have no income to repay the loan. Borrowings plummet and money supply drops. Deflation ensues morphing eventually into a depression. A new beginning takes place only when a new 4C replaces the outmoded 4C.

The real life stories are more interesting and will be posted over time. In fact, with this framework as a guide, history will appear to you as a jigsaw puzzle capable of being solved. You'll spot gaps in the narratives of even noted historians. History will no longer be the boring stuff but a fascinating subject offering many lessons and patterns for the future. But one thing is certain, once you've viewed reality in 4C, you'll never want to go back to 3D.