Chapter 03 · Why does the system fail?

Economy's rigged compass

5 min

You are joining a course midway

This chapter builds on the ones before it. You can read it now, but it will not count towards your progress until the earlier chapters are done.

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Why do economic crises keep coming back, no matter how many lessons we draw from the past? The answer isn't market psychology. It's the money we use.

In the previous chapter, in an honest world, the interest rate reflected real savings: the compass told the truth.

Now, the same movie - rigged.

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The rigged compass

This time, nobody saved. But the banks (commercial ones through money creation, central ones through their policies) pin rates to the floor anyway. Steel, bricks, time - none of it is sitting in reserve.
Yet the low rate sends the very same message as before: "Go launch your projects." Except it's lying. The compass says "plenty of resources," reality says "the vaults are empty."
Fooled, entrepreneurs pile into projects that nothing supports: deserted airports, empty towers, startups burning cash without producing a thing. This is malinvestment⁠(opens in a new tab). And the gap widens between what we actually make and the numbers shooting up on screens.

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Physical reality always catches up with the monetary lie. At some point, we realize that resources are missing to finish all the projects. The bubble bursts: material prices skyrocket, banks panic and stop lending.

Then comes the purge: what we call a "crisis" is really a process of liquidating past errors. It's the moment when the economy clears out the bad projects to try to salvage what can be saved. The recession is a mandatory belt-tightening period to rebuild the savings we pretended to have during the boom.

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Robinson Crusoe's final test 🏝️

To check whether you've really grasped the previous concepts (which are a bit dense, I'll admit), let's run a little test with our friend Robinson Crusoe, alone on his island.

Robinson fishes by hand eight hours a day. That gets him four fish - exactly what he eats every day to feel full. His situation is stable, but his life is a bit limited. Then he gets a brilliant idea: build a fishing net so he only has to work four hours a day.

However, making this net will take whole days. Robinson knows that if he stops fishing to weave his net, he'll have nothing to eat.

Quiz

In your opinion, what should Robinson do?

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Robinson teaches us two fundamental things here.

Savings always precede real investment. You can't build a net (the capital good) without first setting aside the fish (the savings) needed to feed the worker during construction. Keynesians dispute this principle - but Robinson doesn't have a central bank!
Reality is unforgiving. You can't create time or food out of thin air.

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The cause of economic cycles isn't external. They aren't problems of investor "psychology." On the contrary - they're an endogenous phenomenon, caused by the structure of the system itself.

Because our money isn't "hard," we let banks sabotage our compass (the interest rate). We force the economy to live in a permanent lie that inevitably ends in a crash.

What if the problem runs deeper still? The lack of hardness might be just a symptom. The real cause: trying to steer the economy from a central office, without having the information to do so.

Ready to understand why can't see what they're trying to steer?