Economic Stability

To paraphrase F. A. Hayek; an economic system based on central planning cannot possibly work, because any central planner would need to have information about all transactions going on in the economy… as well as ‘intelligence’ to use this torrent of information to make economic decisions… and such knowledge and such ‘intelligence’ is impossible.

Unfortunately, the connotation here is that if only a central planner did have sufficient (all!) information, and endless ‘intelligence’ (computing power) then perhaps central planning could work… at least in principle. This leads to ever more ‘information mining’ in the (utopian) belief that central planning could work if only…

Ludwig von Mises went beyond this in his thinking. Mises believed that central planning is impossible, even in principle; because no matter how perfect the planner’s information or intelligence may be, no planner can account for human action based in free will. Or, to put it simply, no one can predict how humans will react… therefore no central plan can possibly work.

I must agree with Mises on this; even I do not know what I will do tomorrow… never mind a central planner trying to figure this out for all Earth inhabitants! But I suggest that the reality we live in today goes beyond Mises; that is, even if a central planner could know everything about all transactions, and even predict with 100% accuracy what each and every one of the ~7 Billion economic ‘actors’ on this planet will do, central planning would still not work.

The reason is simple; there is no mechanism in existence to transmit the central planner’s intent to the markets in a timely manner. Suppose Bernanke and Draghi were truly honest, and had the best interest of all Earthly inhabitants at heart, and knew exactly what policy is best for all… (OK, I know am asking for a lot… but just assume this for arguments sake) they still could not implement any such policy.

In the last articles on Real Bills and Interest vs. discount, we saw how the discount rate differs from the interest rate, and how fundamentally different forces determine interest rates and discount rates. We saw how shortages can be resolved through the mechanism of the discount rate, without involving the price structure. This understanding is of fundamental importance.

The key is that the discount rate responds virtually instantly to any disturbance of the dynamics of the economy… while interest rates respond much more slowly. Furthermore, a change in interest rates will only take effect in about 18 months.

This makes sense; interest rates are tied to mostly long term debt, like mortgages, bonds, etc… and these markets do not, indeed cannot respond quickly. Debt contracted at previously existing rates has to be retired, and this takes time. By contrast, the discount rate can change on the proverbial dime. Indeed, all Real Bills will be retired in not more than 91 days; the half-life of the bill markets as it were is only 45 days. The half-life of the bond markets is measured in years.

So, why is this a problem? Why can’t control of interest rates be used to control the economy? Quite simply, the economy is a dynamic system… this is true without any doubt. To control a dynamic system of any description, the control mechanism or feedback loop must respond significantly faster than the natural response time of the system being controlled. This is servo engineering 101.

To see how this works, consider a simple, familiar servo system… a house thermostat connected to a furnace and an AC unit. The system being controlled… the temperature of the house… has a response time measured in hours. The house tends to cool off at night, and to warm up with the rising sun.

The thermostat and the heating/cooling unit responds in a matter of minutes; at night, as the house starts to cool off, and before much change of temperature takes place, the furnace starts to produce heat and restores the temperature to the set point… whereupon the furnace shuts off, and the input of heat tapers off in a few minutes… stability is achieved.

Same thing during the day; if the temperature starts to rise, the AC kicks in, and again stability is achieved. The key is that the furnace and AC respond quickly… much faster than the speed with which the house temperature changes.

Now, suppose we have a much slower responding heat source or sink; say this source takes hours to respond. Now the situation is much different; the house starts to cool off, the thermostat kicks the heat source in… but nothing happens for hours. The house keeps getting colder and colder.

Finally, just before sunrise, the heat source finally starts to deliver heat. The house starts to warm up… just as the sun also starts to heat the house up. Soon the thermostat shuts off the heat source… but the delay of several hours means that heat keeps being added… the house gets hotter and hotter…

No need to talk about the cooling effect, the same problem arises; heat is added when it is no longer needed, and cooling comes on when heat is needed… the system is out of phase, and unstable. Not a good way to try to manage the house temperature.

What applies to the heating system also applies to all dynamic servo systems, say like the power steering in your car… What if there was a several second delay from the moment you started to turn the wheel, to when the servo ‘kicked in’… and another several second delay before it would ‘kick out’? A crash about to happen, no?

Same principle applies to robotic arms, or any other servo system… the control circuit must respond fast enough, or the system will be unstable… basically out of control. Well, guess what? Our economy is out of control!

The interest rate mechanism simply cannot respond fast enough to control the dynamics of the economy. It responds slowly, leading to out of phase response, and consequent instability. In contrast, the discount rate does respond quickly… fast enough to avoid causing instability in the economy.

Furthermore, the discount rate is set by market participants… not by a central planner, whose plan is certainly not in the best interest of the world population… but is in the best interest of the planner and his bosses.

So, does this mean the Hayek was wrong? Does it mean the von Mises was wrong? Not at all… just that their thinking did not go far enough. It should be clear that central planning cannot work… and that only a system that incorporates the discount rate mechanism can work. In order for the discount mechanism to exist, Real Bills must be in free, unhampered circulation… and for that to happen, Gold money must also be in free circulation. Real Bills will not, can not circulate without Gold money.

To restore dynamic stability to the world economy, Gold must be in circulation… and Real Bills must also be in circulation, as the vital clearing mechanism of the Unadulterated Gold Standard.

Rudy J. Fritsch

Editor in Chief

The Gold Standard Institute

About Rudy Fritsch

I was born in Hungary in 1947, and fled Socialist tyranny during the Hungarian Revolution of 1956. My family had lived through WWII and the consequent Hungarian hyperinflation, thus I have intimate experience with financial destruction. My Dad used Gold to buy our way out of Hungary. Paper money was as good as toilet paper. Later in life, during my studies of Austrian economics, I came to realize that only Gold could solve the Global Financial Crisis (which should be called the Global Monetary Crisis), just as Gold solved our otherwise insoluble problem of getting out of Communist Hungary.
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