Unwinding the global fiat money experiment

The Paper Empire. - 2012

I find John Exter’s upside down debt period to be an extremely useful model for developing a visual understanding of the monetary system and economic cycles.

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In order to make use of it though, we must first make the distinction between real wealth and claims on wealth. Real wealth is represented by actual items that people want or need. This can be food, land, natural resources, buildings, factories, etc. Financial assets, shown as layers in the pyramid, represent claims on real wealth. In a fully-developed financial system in good perceived standing, there is a high ratio of claims on wealth to actual underlying real wealth. In this environment, the average buying power of the financial assets is lower. This can best be observed by looking at the purchasing power at the bottom of the pyramid. Gold is at a minimum here. It is competing with all of the other claims on wealth for a relatively constant amount of underlying real assets.

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According to Exter’s theory of money, when economies get into trouble through the accumulation of too much debt, the levels of the pyramid disappear in order from highest to lowest. As the pyramid contracts downward, the remaining layers represent a proportionally higher claim on the real underlying wealth. In other words, their value increases. Using gold as our reference point, its relative purchasing power increases as the pyramid contracts. Gold finds itself in a secular bull market.

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In the extreme hypothetical case, where all other asset classes are destroyed, including the currency itself, only gold remains. In this case, the holders of gold compete with no other financial assets for claims on the underlying wealth. This scenario represents the ultimate clearing of the economy. All currency denominated debts have been wiped clean.

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If a market economy remains in place then the pyramid begins to expand and grow again. The wealth claims represented in gold will be deployed as investments and a new currency will emerge that garners the faith of those who use it. As this new economy grows and expands, the previous instruments of credit and financing will appear again. Layer upon layer are added back to the pyramid. From the perspective of gold, its relative purchasing power decreases as it competes with these new financial assets for claims on the underlying real wealth. Gold is in a secular bear market as the newest levels of the pyramid are in their growth phase.

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This model provides a useful intuitive understanding of the alternating secular bull and bear markets of commodities vs. equities. Bear in mind that normal cycles of expansion and contraction of the system involve only the outermost levels of the pyramid. Only in extreme historical examples does the contraction reach the lowest levels in which the currency itself is destroyed.

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Of course, a visualization this simplistic is only intended to give a very broad understanding of some of the root fundamentals that drive economic cycles. On top of this are many complications that arise from not only the extraordinary complexity of the global financial system but also of the massive non-market interventions of government and central banking.

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Bailouts and the propping up of assets represent distortions in the anticipated successive evaporation of layers from the pyramid. Layers may temporarily appear and disappear out of order as non-market forces hold temporary reign.

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Additional complexities arise when the currency itself is at risk as it usually serves are the numeraire or reference point by which the purchasing power of other asset classes is measured. During rapid currency debasement, an asset may appear to be rising in nominal terms but actually decreasing as a claim on the underlying wealth. A good example of this is the difference in the DOW since 2000 when priced in Dollars vs. ounces of gold.

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A note on equities

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I don’t believe the original version of Exter’s pyramid included stocks. It was simply layers of debt instruments and money. The more recent addition of stocks (and real estate) as part of the model does complicate the behavior in my mind. Stocks exhibit more of a hybrid behavior as both a financial asset and as well as a hard asset. At their core they do represent ownership of an actual company but, since the trading of that ownership involves no production, storage, delivery or rolling over of contracts, they behave under normal circumstance more as financial instruments. During a severe contraction of the pyramid in which the currency is severely damaged, stocks revert to their fundamental nature as a hard asset. So unlike a debt layer which disappears completely, the equities layer will at some point stabilize even as underlying layers start to disappear. A good example of this was the Zimbabwe stock exchange during their hyperinflation. Instead of stocks going to zero they became something of a hedge against inflation as the market experienced large percentage increases.