Why Suppressing Feedback Leads to Financial Crashes

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Central-planning manipulation "works" by closing all the safety valves of market feedback, creating a dangerous but politically appealing illusion of stability and "growth."

If we see the economy as a system, we understand why removing or suppressing feedback inevitably leads to financial crashes. The essential feature of stable, robust systems (for example, healthy ecosystems) is their wealth of feedback loops and the low-intensity background volatility that complex feedback generates.

The essential feature of unstable, crash-prone systems is monoculture, an artificial structure imposed by a central authority that eliminates or suppresses feedback in service of a simplistic goal--for example, increasing the yield on a single crop, or pushing everyone with cash into risk assets.

Resistance seems futile, but the very act of suppressing feedback dooms the system to collapse.

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Removing or suppressing feedback seems to work wonders because the systemic risks generated by this suppression are pushed out of sight. The euro is an excellent example of this dynamic.

The system of national currencies is in essence a gigantic feedback mechanism, as the relative value of a nation's currency reflects its cost structure, trade deficits or surpluses, fiscal deficits, interest rates, central bank policies and a host of other inputs.

A currency that is allowed to fluctuate acts as a "safety valve" feedback when an economy becomes imbalanced. If the costs of production in one nation are relatively high, its exports will decline and its imports will rise. This leads to large trade deficits, which (except in the case of the reserve currency, the U.S. dollar) lead to lower currency valuations, which feeds back into imports and exports: imports become relatively more expensive as the currency loses buying power internationally, and exports rise as the nation's goods and services become relatively less expensive to other nations.

The net result of this currency feedback loop is to lower imports and increase exports, bringing the trade deficit back into relative balance.

The euro effectively removed this complex feedback from all the economies that accepted the euro. This is the root cause of the European debt crisis: credit was allowed to reach insane levels of fragility and excess because the feedback that was once provided by national currencies and central bank/fiscal policies was removed from the system.

This is why claims that the European Central Bank (ECB) will "do whatever it takes" to maintain the euro's suppression of feedback are doomed to failure.Removing or suppressing feedback allows risk and structural imbalances to pile up to the point they threaten the entire system. This is the case in Europe, Japan, China and the U.S.

In Japan and the U.S., the central banks and fiscal authorities in the central state have suppressed market feedback by pushing interest rates to near-zero and then using the central banks' unlimited ability to create money to buy government bonds. This suppresses feedback from the bond market and from the political sphere, as cheap money and unlimited issuance of government debt (bonds) enables politicos to avoid painful restructuring and choices.

If you eliminate feedback from the markets, you get asset bubbles and huge deficits.

Those extremes goose "growth" for the short-term, but the suppression of feedback only dams up risks and imbalances: out of sight, out of mind. But the imbalances haven't vanished; they're piling up unseen in the system, where they eventually break out at the system's weakest point.

Central-planning manipulation "works" by closing all the safety valves of market feedback, creating a dangerous but politically appealing illusion of stability and "growth." But the consequences of removing or suppressing feedback are catastrophic longer term, as the imbalances and risks pile up unseen until they bring down the entire system.

Source: Of Two Minds

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About Charles Hugh Smith