Causal Loop Diagrams and Interventionist Policy

There's a room where the light won't find you
Holding hands while the walls come tumbling down
When they do
I'll be right behind you
--Tears for Fears

Previously we demonstrated how causal loop diagrams illuminate the workings of economic systems. In this post we'll extend the concept to pinpoint fatal errors in current interventionist policy.

Prior to that, we need to add another loop to the symbiotic economic system portrayed last time. We noted that saving drives interest rates lower which in turn drives borrowing higher. This borrowing promotes consumption and capital investment.

But borrowing also spurs the buying of financial assets such as stocks, real estate, and bonds. Particularly in the case of bonds, the more bonds that are bought with borrowed money, the lower interest rates go. This creates a feedback loop, let's call it the Speculation Loop, that locally takes on reinforcing character. Lower interest rates drive speculation in bonds, which pushes interest rates lower still.

In unhampered markets, however, the reinforcing capacity of the Speculation Loop is limited. As bond buying pushes interest rates lower, savings are depleted. At some point, lower savings push interest rates higher and send the reinforcing Speculation Loop in the opposite direction. Thus, the Speculation Loop is held in check by the amount of savings in the system. An overall balancing effect is present.

As we highlighted last time, causal loop analysis suggests saving as the critical variable in the system because it regulates the pace of the Existence Loop, the Debt Loop, the Investment Loop, and, now, the Speculation Loop.

Unfortunately, what we have right now is not a natural, symbiotic system. Policymakers are messing with Mother Nature in attempts to push economic progress beyond the capacity of natural law. Through their market interventions, policymakers are trying to circumvent the regulating effect of savings on the economic system.

Essentially, policymakers seek to do this by injecting 'fiat credit' into the system. Fiat credit, also known as bank credit, can be viewed as 'false savings' in that it is not grounded in production that has been set aside rather than consumed. In the natural economic system modeled above, production that is not consumed forms the basis for 'true savings' that can be loaned to borrowers. Because loans grounded in true savings represent real economic resources, this type of credit is sometimes called commodity credit.

The source of fiat credit is central banks. Only central banks can get away with creating credit out of thin air, because they are backed by the force of government which can print money or tax citizens to mend balance sheets and maintain solvency.

As shown in the diagram below in red, fiat credit is injected into the system as a substitute for real savings. Interest rates now depend on the supply of false savings which, in a fiat world, is virtually unlimited--meaning that interest rates are likely to be driven lower (at least for quite some time) by fiat credit. The previous relationship between real savings and interest rates is therefore broken. Real savings can still be borrowed, but real savings no longer has a governing influence on interest rates. 

Because interest rates no longer depend on the supply of savings, lower interest rates spur ever more borrowing which, in turn, consumes ever more savings in the Debt, Investment, and Speculation Loops. The critical long term consequence of this policy is to deplete savings.

At some point the system freezes when saving declines to the point where there are no longer enough real economic resources set aside to support the Debt, Capital Investment, and Speculation Loops.

Policymakers mistakenly believe that fiat credit created from thin air can elevate economic performance. Tragically, however, the ultimate effect of this intervention is impoverishment.