'Gary North's REALITY CHECK
Issue 35
February 3, 1999
SIMULTANEOUS FORECASTING ERRORS
To understand why the capital markets are not reacting
to the threat of Y2K, we must understand Ludwig von Mises'
theory of simultaneous forecasting failures. It applies to
the fractional reserve banking system's expansion of
credit.
In 1912, Mises's classic book appeared, THE THEORY OF
MONEY AND CREDIT. In it, he argued for a theory of the
business cycle -- booms and busts -- based on the effect of
fiat money -- credit money or fiduciary media -- on the
interest rate. He offered a short version of his trade
cycle theory in 1949 in Chapter 20 of HUMAN ACTION. (You
can order a reprint of this book from mises.org)
His theory was presented to a wider academic audience in
the 1930's by his disciple, F. A. Hayek. Almost no
economist has ever believed it.
Mises asked this: How is it that, in a free market, so
many businessmen make the same mistake of expanding
business in a boom, which leads to a contraction (bust)?
Why shouldn't the errors of groups of entrepreneurs offset
each other? In short, why the simultaneous forecasting
errors?
To answer this, he argued, we must look at the common
element in the market: money. Fractional reserve banks
increase the money supply by lending it into circulation.
With a 10% reserve ratio, a $100 initial deposit becomes
$900 of money.
The increased supply of money initially lowers
interest rates: more money + stable demand = lower price.
The price of money drops. But if the process of money
expansion continues, the new money will be used by buyers
to bid up prices. This will raise long-term rates, for
lenders will tack on an inflation premium to their loans,
to compensate them for the expected loss of purchasing
power.
The boom is created by the low initial interest rates,
which lead entrepreneurs to conclude that the savings rate
has increased. It hasn't. Instead, it was the fiat money
has lowered the price of loans. There has been no increase
in thrift. So, when consumers get their hands on the new
money, they will bid up prices of consumer goods, and even
go into debt to buy them. Interest rates climb. The
public did not want to save more. So, those businessmen
who started projects find that they cannot complete them
when the interest rate rises. The bust phase replaces the
boom phase.
NO OFFSETTING PLANS
Today, investors do not recognize the threat of Y2K.
Neither do consumers. Everyone is enjoying low price
inflation. The FED has lowered interest rates by
increasing the money supply mildly. But foreign
competition keeps prices low. It's the best of worlds in
1999.
We do not see entrepreneurs selling off stocks and
bonds and moving into CD's or other short-term instruments.
They are expanding their businesses. They are running full
steam ahead. Why? Don't they see the threat?
No, they don't. Men want to believe that good times
are normal and bad times are the exception. They think the
world owes them good times. They are not amazed by years
of prosperity. They expect more of the same.
This computerized economy has rewarded the innovative
entrepreneurs who cut costs by moving their information
systems to digital form. It has led to the destruction of
old ways of managing, production, and distribution. The
old ways persist in some peripheral industries, but these
are not significant in the economy any longer. I call them
the cottage industries. They are the ones that will find
it impossible to respond to large increases in demand.
The survivors of the computer wars believe in
computers. After all, computers gave them their
competitive edge. Those who built fortunes with computers
cannot accept the fact that these computers were programmed
wrong from the beginning. The computers giveth, and
computers taketh away.
It is too late to revert to pen-and-paper management
systems in any but the smallest production units. But if
computers start spewing out inaccurate data, the existing
systems will shut down, either through digital command -- a
modern paper mill, for example -- or through bankruptcy.
We are dealing with religious faith. Men do not
abandon the religions that they held when they became
successful. The religion of just-in-time production rests
on digital coordination. To lose faith in computers is to
lose faith in men's ability to structure complex systems
through digital simulations and record-keeping.
Our production systems are too complex for mere
mortals to manage apart from computers. Yet we must learn
how to manage them. So, there must be a great
simplification of production and distribution in 2000.
This is what I mean when I speak of the collapse of the
division of labor. Men who have achieved success in niche
markets will find that these markets no longer have any
demand in 2000. They will see their lifestyles fall as
never before in recent memory -- and possibly in recorded
history.
Think of those beggars' signs: "Will Work for Food."
Think of the businessmen in the 1930's who sold apples on
sidewalk stands. That's what is coming. But almost no one
sees this. They all admit that ours is a knowledge
economy, but they do not admit that Alzheimer's threatens
the world's electronic brains.
This is why we do not see entrepreneurs selling off
assets that depend on computers. The stock market has not
collapsed. We do not see urban streets filled with For
Sale signs. We see commercial construction. We are still
adding to our stock of capital, which means capital that is
dependent on future consumer demand. But future consumer
demand rests on future productivity by consumers. That is
what y2k calls into question.
INVENTORIES
The production revolution created by computers is a
revolution in inventories. They have been cut to the bone.
Just-in-time production and distribution have reduced them,
thereby cutting carrying costs for sellers. But this has
been accomplished at a tremendous cost: capital costs of
these new systems of production. Free market entrepreneurs
have invested trillions of dollars in these new systems of
production. If these systems go blind, these investments
will fall to close to zero value. The stock markets of the
world will collapse.
To cut the size of inventories, entrepreneurs have
place us all in great peril: the possibility of a break in
the supply chain. If the supply chain breaks, then we as
individuals are without reserves. A break in the means of
payment is one such break. So is a break in electrical
circuits. If the grid goes down, this civilization goes
down.
It is not possible to add to an inventory of
electricity. You can buy a battery, but not to run a
chemical plant. The inventory of power stored in fuels
must be transported and converted into electricity. If
that supply chain breaks, we're dead. Millions of us will
die. Hundreds of millions of us if the grid stays down.
Why? Because we have no inventories. We are not
farmers who refused to sell their crops until they had a
year's supply in storage. They saved food and simple
tools, not money. They let the city slickers save money.
We save electronic digits. If the computers that give
these digits value -- i.e., a future stream of real income
-- should die, then all our paper print-outs will mean
nothing. They will mean less than a bank passbook meant to
a depositors in an uninsured rural bank in 1932.
Digits are promises. They are electronic testaments
to our faith in unbroken supply lines. They may become
last words and testaments in 2000.
People refuse to admit to themselves that this threat
exists. It exists nonetheless. The code is objectively
broken.
Inventories of basic goods are not that expensive to
assemble. They may not be cheap to store. If you don't
have a basement or underground storage area, it will cost
you a lot of money to store a year's supply of food, liquid
soap, detergent, toilet paper, etc. Here is my point: you
have only a few months to assemble the inventories you need
for basic survival. The entrepreneurs have substituted
sophisticated supply lines for inventories.
Last weekend, I was involved in a church project. Ten
men came to a warehouse and poured sacks of pinto beans and
rice into buckets. It took some coordination. What made
it possible was one member of the congregation who had a
lot of spare space in a warehouse.
On each pallet, there are 36 buckets of grain, each
weighing 35 lbs. The average adult will consume a bucket
of grain a month, plus some vegetables, which he had better
get planted. Each pallet can feed three adults for a year.
I think there were five pallets. That will not feed many
people.
You don't know how much you eat until you see it in
pallets. That's what going to the supermarket week after
week adds up to.
To store enough food to feed a family for a year takes
a lot of space. It cannot be stored in warehouses. Only
families can afford to devote the space, such as in a hot
garage. But few families will do this. So, we are at
great risk. If the supply line for food breaks, millions
of people will starve. They will not starve quietly and
peacefully. If you are known to have food, you will be a
target. Count on it. Prepare for it.
Can your local church store enough food to feed its
members for a year? Obviously not. The deacons wouldn't
if there were enough space. Their priorities are affected
by their faith in the supply lines. They babble on and on
about how God will protect them, but they really mean that
the computerized distribution systems will protect them.
I met a pastor at a community meeting called by a
local mayor. I spoke at the meeting. He came up afterward
and told me that his deacons had forbidden him to preach on
y2k. They would not hear it. I told him I would preach on
nothing else, morning and evening, until (1) they fired me;
(2) they changed their minds; or (3) they quit.
His deacons believe in God the buttercup. They
believe in computers. They will tolerate no other god.
In a year, they will probably be dead. At least, they
will be unemployed, bankrupt, and living in terror. They
will not know where their next meal is coming from. They
will have a lesson on practical theology that they will not
soon forget.
SOLVING A PROBLEM WITH FEW RESERVES
If the banks close their doors, how will you eat? How
will you pay for what you need to sustain you?
If you have no answer, buy what you think you will
need in 2000 in the way of reserves. Buy the things you
will need in 2000 to rebuild in 2001.
The free market assigns the task of making these
estimates to entrepreneurs. They look at large markets and
decide what the mass of consumers will buy. Consumers
defer to these specialists. Consumers trust these
forecasters with their lives.
The problem is, these entrepreneurs are blind to y2k.
They will not consider it in their forecasts except as a
blip: a reduction of 0.1 or 0.2 in economic growth. "We're
an information society," they love to say, but they refuse
to consider what universally erroneous information will do
to this information society.
There is no institution that has reserves sufficient
to sustain a society for several months. In the past, one
institution did this: the family. But families have
deferred their decisions to entrepreneurs, who have in turn
deferred their decisions to digital idiot savants that have
been programmed incorrectly.
This is why we are at risk as a society. Surely, we
are at risk of a huge economic setback. The capital
markets do not discount this risk because this risk calls
into question the wisdom of the free market, which
voluntarily paid for the computerization of the supply
lines. So, those to whom we have deferred the
responsibility of planning for the future are blind to the
risk of blind computers.
Their blindness is what gives you a bit more time to
maneuver. But you have dawdled. Already, you have missed
the chance to buy U.S. silver coins at anything like
bullion value. The premium is 50%, and there are almost no
coins to buy. Coin companies are rationing them to their
best customers, one or two bags per client. Too many of my
readers failed to listen to me when I told them that time
is running out. But they will listen when it has run out.
I have just told you that you can no longer buy bags of
silver coins. You're interested now, aren't you?
That's human nature. You must learn to deal with it.
You don't have much time to learn.
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email letter from Gary North
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