The Big Historical Cycle George Friedman Misses

A big problem with The Storm Before the Calm is that it ignores the most significant historical cycle driving the current crisis: The monetary cycle.

The monetary cycle consists of the transition from sound to unsound money, eventually resulting in a monetary crisis and a reset of the system. The transition is sometimes driven by external events like a war, other times by the seemingly irresistable temptation of governments to fund themselves through the printing press.

The current monetary cycle is unprecedented insofar as every currency in the world has been a pure fiat currency since 1971. Historically, monetary cycles end and begin when the market displaces a debased currency with a sound one. The two World Wars, for example, put a severe strain on the British Pound, which had been the world's reserve currency for more than one hundred years. The debt accumulated, and the fact that Britain had sent all its gold to the United States in payment for food and arms, made the Pound an unsound currency by the end of WW2. At the Bretton Woods Conference held in 1944, based on the fact that the United States at that point owned 70% of the world's gold, it was agreed that the U.S. Dollar would replace the Pound as the world's reserve currency. Furthermore, all other currencies would peg themselves to the dollar rather than be backed by gold. The Dollar remained the sole currency redeemable for gold.

This system persisted into the 1960s, by which time the U.S. could not resist printing more money than it could back with gold to fund the Vietnam War and the Great Society programs. Foreigners were trading in their dollars for gold, at the rate that the 20,000 tons of gold owned by the U.S. at the end of WW2 had been reduced to 8,000 tons. To prevent the rest of U.S. gold reserves from fleeing the country, Nixon "temporarily" suspended the redemption of dollars for gold on August 15, 1971, a suspension that persists to this day. 

This has resulted in the unprecedented fiat monetary system noted above. The dollar continues to be the world's reserve currency, if for no other reason than that there is no suitable alternative. Furthermore, since 1980 we have been in a debt bull market of falling interest rates. See below.

Federal Funds Rate since 1950

The falling interest rate regime is not an accident or a result of the free market, but has been a deliberate policy of the Federal Reserve. This isn't a conspiracy theory; it is part of the Fed's charter to manage interest rates. Falling interest rates support the dollar (and the accumulation of dollar debt) because it makes the purchase of debt more attractive. If I anticipate that the interest rate on the U.S. 10 year treasury bond will drop, then if I buy a 10 year treasury carrying a 5% interest, I will be able to sell it at a profit when the interest rate on new 10 year treasuries drops to 4%, since the higher interest rate on my bond represents greater value.

So the increased printing of dollars did not cause a crisis in the dollar as long as interest rates have had room to drop. The accumulation of debt in response to lowering interest rates happened accordingly.

U.S. Debt to GDP ratio

But notice that since 2008 interest rates have been close to 0. What happens when there is no more room for interest rates to drop? Then the debt cycle would naturally reverse, interest rates rise, and there is a major financial crisis, likely much worse than 2008 and on a global basis (since most other countries are running up debt and printing currency as fast as we are).

But that hasn't happened. Debt is still being bought despite tiny interest rates. Who is buying debt now that interest rates aren't going lower? The answer is the Federal Reserve:

Federal Reserve Balance Sheet in Millions

This has gone into hyperdrive since the COVID crisis hit. Since we were already running a deficit before the COVID pandemic, all the trillion dollar "stimulus packages" since then are financed purely through Federal Reserve money printing - that is the spike at the far right. Just in the last couple of months the Federal Reserve has bought up $3 trillion in government debt. This signals the end phase of the monetary cycle, which will result in the demise of the dollar and its replacement as the worlds reserve currency.

Friedman misses all this. He interprets the drop in interest rates over the last 30 years as an indication of capital accumulation. It would be in a regime of free market interest rates. But we don't have that: Interest rates are manipulated through Fed policy. As debt increased over the years, interest rates should have risen as well, incentivizing savings as a balance to debt accumulation. By forcing interest rates lower, the Fed has short-circuited these market forces and put us in a situation where a catastrophic financial crisis can only be put off by ever more furious money printing.

Comments on "The Storm Before the Calm" by George Friedman

In this book George Friedman argues that we are experiencing the convergence of two historical cycles: A socioeconomic cycle and an institutional cycle. The present time is unusual insofar as the two cycles are coming into crisis at the same time, and will result in an unusual period of upheaval, disorder and, in Friedman's optimistic view, the reinvention of the American experiment in an as yet unidentified form that will nonetheless be a positive development and represent civilizational advancement.

I broadly agree with Friedman's thesis on the cyclical nature of history, and that the present moment represents an unusual convergence of cycles. I don't agree with him completely on the nature of the cycles, and think that he doesn't appreciate a historical cycle that is more significant that the ones he identifies. I will say more about that in another post.

Here I would like to make a skeptical argument concerning Friedman's optimistic view of the future, and argue why the present crisis is different than prior American crises. I am not necessarily pessimistic, but I imagine the future very differently than Friedman does.

The basis of my skepticism is the role natural resources, and in particular energy, play in American history. It is only recently that the United States has come to fully exploit the natural resources of the continent it claimed in Manifest Destiny. The North American continent and the exploitation of its resources shaped the history of the United States.

Consider the Civil War. At the time of the Civil War, the Industrial Revolution was just getting underway. The Industrial Revolution embodied a transition from a civilization founded on wood based energy to a civilization founded on coal based energy. Coal is a more dense form of energy than wood; it is essentially wood energy compacted over thousands of years into a much smaller space. This makes the use of coal more cost effective to gather as energy and more efficient as an energy source: A coal-fired train can travel farther than a wood-fired train before it has to restock its coal car, and coal burns hotter. It also costs less energy to harvest energy, in terms of the "energy return on investment." The consequence is that a wood-based energy civilization can never achieve the complexity or technological sophistication of a coal-based civilization. Its low efficiency energy limits its development. This is precisely the reason why major civilizational transformations are accompanied by a change in the energy foundation of the civilization.

Also at the time of the Civil War, large-scale Western migration was just beginning. In fact it was stalled prior to the war as the North and the South squabbled about the legal status of slavery in the new territories.

With the secession of the Southern states, the political roadblocks to full-scale Western migration disappeared and the migration West accelerated even during the war. The demands of the war accelerated the already nascent industrial revolution, fueled by the new energy, cheap and abundant coal, to transform the nation into a continental and industrial power very different from the nation that existed just a few years before. By 1870 the United States was a major industrial world power and had steam locomotives running from coast to coast.

Now consider the Second World War. Like the Civil War, this crisis occurred as the world was transitioning from a less dense to a more dense source of energy: From coal to oil. The United States was just beginning to exploit its oil resources in the 1930s. Those were the days when a Jed Clampett, in Beverly Hillbillies style, could shoot his gun and up from the ground came a bubbling crude. The war accelerated this change, especially as the U.S. industrial base and energy sources were not subject to attack like the rest of the world's were. As the war went on, it became clear that access to oil was the crucial factor. We sank Japan's merchant fleet denying them oil, and destroyed Germany's oil refineries through bombing, grounding the Luftwaffe.

The crucial factor about the current crisis is that it does not occur during an ongoing transition from a less dense to a more dense energy source. So-called "green energy" may or not be feasible, and perhaps is even necessary, but one thing it definitely is not is a more dense source of energy than oil. If it were, the transition would occur on its own rather than being subsidized by governments and forced through regulation. Towards the end of the book, Friedman speculates about space-based solar power. If possible, such power will require a massive infrastructure development and it is hard to believe it would be a more dense source of energy than oil. Coal and oil fueled their respective civilization transformations because they were sitting there, ready to hand, waiting to be exploited. There is no such new energy source available.

This is a misunderstanding people sometimes have concerning technology and energy. They believe our technology will solve the energy crisis. This gets the causality backwards. It is the energy that fuels the technological revolution, not technology that drives the energy revolution. It's true that civilization must be advanced to a certain point before it can exploit coal and then oil usefully. We didn't jump directly from wood-based energy to oil-based energy; it took a period of coal-based energy to develop the technology to exploit oil usefully. The key point is that the technology necessary is the technology to exploit the energy, not to harvest the energy. Civilization was capable of mining coal for thousands of years; it just had no special use for it until industrial civilization advanced enough. Similarly, early oil exploitation involved no special technological breakthroughs as the oil was near the surface. Doing not much more than poking a hole in the ground was good enough.

The difference today is people are imagining technological breakthroughs to harvest the energy, not exploit it. The energy harvested - electricity in the case of space-based solar power - we already exploit. The energy it takes to develop and use additional technology to harvest energy is an energy cost, not a gain. This is the Achilles heel of shale oil; exploiting technology to harvest these heretofore unreachable reserves is an energy cost that makes shale oil more expensive than conventional oil.

In any case, shale oil is rapidly depleting, and conventional oil has also peaked. What's going to happen in the next crisis is something that hasn't happened before: The transition to a civilization based on a less dense form of energy than the last. Whether it is "green" or not, this energy will not have the density of oil.

The United States is fortunate that we still have unexploited natural resources, in particular massive coal reserves that can fuel our nation for many decades. I suspect that as things start to get truly difficult, all the "climate change" rhetoric and "green energy" initiatives will be rapidly forgotten as people see their civilization crumbling around them (as might even be starting now). We will be happy to turn back to coal.

But the result must be a simpler civilization than the one now, not a more complex civilization as after the Civil War and WW2. We will still have our iPhones and Netflix, but you won't be able to get fresh vegetables in the supermarket year round. The oil-based civilization that can grow vegetables in California's Central Valley, then truck them all over the country at any time, will be gone. Instead, food will be more locally grown. People will not take as many or as exotic vacations as they once did, maybe going camping instead of Disney World. People will get used to living in some heat rather than blasting air conditioning anytime it gets warm. We will miss some of the things that are gone, like always available air conditioning, but appreciate some things that are rediscovered, like playing board games with the family or playing outside if you are a kid. They hyper-scheduled childhood of the recent past of carting kids from soccer to piano lessons to boy scouts will be gone. Childhood will be simpler and, as far as that goes, more healthy.