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Posts Tagged ‘market bubble’

Adjusting for Apparent Money – Part 1

Posted by publius2point0 on 2010/06/20


Continuing on the idea from the previous entry, we will track through what should theoretically happen when exchange system is used when money appears to deflate due to a decreased velocity of money. To make life easy, we will use the below model of the macro economy, rather than the rather complex (and still incomplete) image included in the previous blog:

We’ll say that we have three citizens of our economy, Jack, Alan, and Tina. Each month they spend $800 on food, clothes, gas, electricity, etc. which they purchase from Fnord Inc. They are also all in debt to the central bank, owing $50 each month to pay back a $500 loan. Their salary is $1000 per month working for Fnord Inc.

Balance Sheet
Month Apparent Money (per month) Debt Fnord Inc. Jack Alan Tina
Initial $3000 -$1500 $3000 $0 $0 $0

Unlike the modern world where the salary is pegged to a particular value, in the new system of doing things the salary is based on the value of the Apparent Money (AM) as it has tracked from month to month. We calculate the AM by adding all purchases. The initial value is set to $3000 as we assume that if Fnord Inc. is able to hire 3 people for $1000 each, they must have received $3000 in the previous month. Besides adjusting salary, we also adjust the amount of our loan payments — and in fact the total amount of debt as well.

In the first month, Jack, Alan, and Tina are each paid $1000. They purchase $800 worth of supplies, pay $50 in loan payments, and save the remaining $150. The total of all purchases in the economy for this month was only $2400, so we update the Apparent Money to that.

Balance Sheet
Month Apparent Money (per month) Debt Fnord Inc. Jack Alan Tina
Initial $3000 -$1500 $3000 $0 $0 $0
1 $2400 -$1350 $2400 $150 $150 $150

With an AM that is 80% of the previous month, Fnord adjusts the amount of salaries to match and pays its three employees $800, which is the same as their $1000 salary at current apparent inflationary/deflationary rates. At the current AM, the amount that is owed in debt is reduced to $1080 ($360 per person) and the amount owed is lowered to $40. Knowing that the amount of money in the economy has decreased, Fnord Inc. also lowers the price of all of its products by 80% and so our three citizens end up buying their usual goods for only $640 each, paying the $40 in loan payments, and save the remaining $120.

Balance Sheet
Month Apparent Money (per month) Debt Fnord Inc. Jack Alan Tina
Initial $3000 -$1500 $3000 $0 $0 $0
1 $2400 -$1350 $2400 $150 $150 $150
2 $1920 -$960 $1920 $270 $270 $270

Heading into the 3rd month, it’s worth pointing out that the $270 in our citizens’ savings is worth $421.88 at the value of money at Initial. They have made only two deposits, having expected to have saved $150 each month for a total of $300. Because the Apparent Money deflated, they have gained over a month’s extra savings compared the price at which Fnord Inc. is selling products during month 3. Subsequently, they each decide to splurge a bit and not save any money.

Balance Sheet
Month Apparent Money (per month) Debt Fnord Inc. Jack Alan Tina
Initial $3000 -$1500 $3000 $0 $0 $0
1 $2400 -$1350 $2400 $150 $150 $150
2 $1920 -$960 $1920 $270 $270 $270
3 $1824 -$736 $1824 $270 $270 $270

While this might seem mighty odd, in Classical Economics this is how the economy is meant to behave. A business is only able to pay as much as it has made, so if all revenue is less than all expenses, expenses need to be cut. Of course, in the real world, the amount of money being passed around doesn’t change by 80% from month to month and of course generally it inflates rather than deflates. When we save our money, in general day, instead of giving us greater power it becomes worth less and less as the money supply inflates. This encourages us to invest our money rather than save it. But as the money supply inflates, our salary itself drops in purchasing power. We need to get a bump in our salary periodically just to stay even. Using the AM measurement to adjust salary, your salary would grow slightly from month to month in a normal, growth economy.

But of course, sometimes the total quantity of purchases through the economy does drop, and at that point businesses have to cut expenses. In Classical Economics, this is handled by lowering wages, but in the real world it’s often handled by cutting employees as has been pointed out in previous blogs.

Increased Savings Equals People Laid Off

After the recession hit, there was a lot of call for banks and other large institutions to be more spendthrifty. One bank, I remember, had a tradition of throwing a big picnic for all of its employees once a year. The average citizen as well as the government all gave evil glares at this bank because of how wasteful they were being in a recession.

In the terms of Classical Economics, this makes some sort of sense. The true state of the economy has become clouded by various people and organizations doing a poor job of managing money, and so money needs to be withdrawn from those so that money can once again be safely spent on things which are financially sound. But in the terms of the real world, this is simply stupid. When the bank doesn’t throw its picnic, the catering company that was depending on the hundreds of thousands of dollars that it had gotten reliably each year for the last decade suddenly can’t pay any of its employees. They have to lay many or all of them off. Unemployment increases, which means that revenue to banks and all other businesses falls further. With decreasing revenue, but wages stuck at high levels by contracts, minimum wage legislation, etc. there’s no way that a business is going to hire on more workers.

Under the AM price adjustment method, however, as the call to save spreads across the nation and revenue starts to be cut across the market place, the cost of maintaining your employees stays consistent with revenue. Everyone is able to continue working and living, holding their money in savings and even having it gain in value the worse things get. When they are certain that measures have been taken to correct what was wrong with the economy to make customer confidence go down, the carrot of the increased purchasing power of their savings kicks in. They can buy a lot at cheap values, so the instant it seems like the air has cleared, people will want to get back into the market.

Of course, there will be some layoffs. The enterprises that were truly wasteful will be cut. But since corporations are saving their money as well, with those savings increasing in value, these laid off people are comparatively cheap to hire back for fiscally sound ventures.

The one interesting point of the AM adjustment is the treatment of loans. In the model laid out in Tying it all Together (Classical Economics), the amount of money paid back in loans is always equivalent to the amount that was loaned. If we continued to track the scenario of Jack, Alan, and Tina, however, the total amount of money paid to the central bank would not equate to the total loaned. To demonstrate, let’s presume that like month 1 and 2 that the AM deflated by 80% each month:

Balance Sheet
Month Apparent Money Original Debt (adjusted for AM) Owed (adjusted for AM) Remaining Debt (adjusted for AM) Before Payment Remaining Debt (adjusted for AM) After Payment
1 100% -$200 $50 $200 $150
2 80% -$160 $40 $120 $80
3 64% -$128 $32 $64 $32
4 51.2% -$102.40 $25.60 $25.60 $0

Adding the Owed column, the total paid was only $147.60. The AM adjustment scheme creates what I term fundamental money, inflating the economy. Given that all other recession-breaking schemes also create inflation of one sort or the other, this isn’t any particular travesty.

Revisiting Market Bubbles

To revisit the case of Jeff, Tanya, and Berkley that was laid in in Market Bubbles, we’ll show how AM adjustment’s creation of fundamental money solves the standoff created by a collapsing bubble.

1) Tanya borrows $50 from Jeff (the central bank). AM = 100%
2) Tanya buys comic books at above their true value from Berkley for $50. AM = 100%
3) Jeff confiscates comic books and sells them to Berkley for $10. AM = 20%

Since the market has adjusted to the amount that is being spent, down from $50 to $10, the AM has adjusted as well becoming 20%. At 20%, the amount that Tanya owed to Jeff ($50) becomes $10. Tanya has successfully paid off her debt and Jeff considers himself to be fully paid off. He doesn’t have to agonize over tracking down more money. At the same time, the $40 that Berkley has is now worth the equivalent of $200. The bicycle that he wanted to buy cost $120 at old prices. At prices adjusted for the poor economy, it only costs $24. With the $40, he can buy the bicycle that he wanted and go to work at the company that was too far away before.

4) Berkley buys bicycle for $24. AM = 48%

The salary being offered by the time he bicycles over will only be 48% of what it was, but since prices are also 48% of before, that’s perfectly okay. He owes nothing, and since neither Tanya nor Jeff are employed by the business, all of the money that he spent goes back to himself.

5) Berkley receives salary of $24. He spends all of it back on purchases. AM = 48%

If he takes all of his money out of savings and starts spending it, the value of the apparent economy will rise to $40 (80% of the original AM). Until someone goes into debt, it can’t grow any higher than that, so we can say that the market has fully corrected for the bubble. In Classic Economics, it should have corrected all of the way down to $0, but there’s no particular reason that it needs to do that. Ultimately, we left Berkley — who made wise economic decisions — in a pretty position compared to Tanya, who now has nothing. And we did so without stalling the economy.

On the other hand, we let Jeff off easy. He doesn’t have any outstanding debts, so he’s feeling fine to loan again. Of course, he had expected to be able to profit by $20 from Tanya, so in a sense he did lose out. But more importantly, he’s probably not going to loan to anyone trading in comics any more, and really that’s what we want. Ultimately, bubbles will always form and there’s no way to know where they’re going to happen. Plenty of very smart and respected economists thought everything was going fine right up to the moment that the housing crisis broke. You’re better off to fail around it gracefully than to live and breath by “Punish the evildoers!” Figuring out how the bubble happened and making sure it doesn’t happen again is where your attention needs to go. If someone was actually acting nefariously, criminal prosecution is the answer, not trying to milk a stone.

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Market Bubbles

Posted by publius2point0 on 2010/06/05


For the purpose of explaining a market bubble, I’m going to use the example of comic books. I do this because bubbles can form around any economic activity. It’s not just the stock market which can form a bubble — as the housing crisis demonstrated.

Let’s say that we have a world with 10,000 people in it. 1,000 of those people like to read comics and each would like to collect the complete set of each of their favorite comics. Unfortunately, early issues of comics are scarce because they were unknown titles with no audience following. Printing off a lot of them, at the time, would have been silly. But with a growing audience and ever growing number of issues being published, the total number of people who want the full series from the start is more than is physically possible (assuming that new copies of old issues can’t or won’t be made, which we will assume).

Within our smaller market of 1,000 people, it will be fairly well understood that if you want the first issue of Superman you’ll probably not be able to get it unless you’re quite wealthy. If you happen to be someone fairly poor who collected Superman when you were young and still have it today, it’s very likely that one of the wealthy comic collectors will offer you a value that you simply can’t refuse, and subsequently he most likely won’t let it go for any price. But, as soon as our poor comic fan gets this money, he will almost certainly instantly turn around and buy old issues of some of his personal favorite series that aren’t so popular as Superman. In end result, the market for comic books isn’t profitable for anyone. The use of money allows the series to be distributed around according to wealth and fandom. All money gained is immediately spent. The amount of money that is in the comic market is limited to how much the actual fans of the comics have and are willing to spend on their hobby.

Now, let’s say that a non-comic book fan inherits his fathers old comic books. He discovers that there’s a market for these books, so he goes and sells them. While doing so, he discovers that some of them are worth fairly significant amounts of money and that due to the growth of audiences, one can buy comics, sit on them for 10-30 years, and sell them for up to thousands of times the cover price. If he was to embark on this bit of financial speculation, he wouldn’t be doing so to get his favorite comics, but rather for the purpose of making money based on his observation of how the market works.

A person can, essentially, make money like this. He’ll profit off of the comic book fans, leaching money from their contained economy, which money he’ll spend in the general market, and which eventually makes it back to the comic book fans so that things are more or less even.

The problem comes when a significant number of people come in to try and profit from the comic book market. Instead of buying and selling from fans, they’re liable to purchase from each other and that is a problem.

Let’s say that 80% of our comic book fans have $1 per day that they are willing to spend on their hobby. A further 20% have $10 per day that they are willing to spend. The total market is $2800 per day and that doesn’t change with time. Now a speculator comes in and buys up a significant number of comics that he thinks will be big sellers. He is willing to pay however much he thinks he can pay and still make a profit, not based on his personal budget compared to his level of fan-love for those titles. Now he waits 10 years and goes to sell them. If there he finds someone else who thinks he can make a profit if he takes those and waits another 10 years, he might sell to that person. Ultimately, the total amount of money in the comic book market might be double or triple the natural value of $2800 per day. Eventually, the prices become so high that the fans can’t afford to buy the comics anymore and all of the market action is between people who have no interest in the product. And at that point, it becomes only a matter of time before everyone realizes that there isn’t a guaranteed end-purchaser. Their only hope for selling the comic books that they have stored up is by finding someone else who isn’t aware that there’s no guaranteed market for the item and selling it to him, and of course as the panic hits and news spreads, that becomes impossible.

In the end, there was only $2800 per day to be made and the only way to guarantee that there would be someone who would want to buy the comic books you had was by maintaining the market at something near its natural equilibrium.

Overall, this seems to imply that speculation is inherently a broken process. Many markets can be grown by speculation as pointed out in several blogs (1, 2, and 3). But even in such a market, there is a true level of more-or-less guaranteed returns above which you’re just playing find-the-greater-sucker so far as fiscal realities go.

The people within the comic book market may have acted like the speculators all along, but their gambles were based upon an inherent knowledge of realistic returns gained by being part of the actual market and seeing how it moved from day-to-day. They don’t bank on being able to make more than is realistic because they actually know what is and isn’t realistic. The problem with the outsiders isn’t so much that they entered the market, but that their valuation of the products wasn’t based on much knowledge of the fundamentals of the size of the market or its capability for growth. They just knew that other people were speculating, and this they should buy in too. They didn’t know how much was reasonable to put in to the market, they just threw in however much they had lying about that they felt alright to gamble with — which is an essentially arbitrary value. If the total quantity of money invested is significantly larger than the market is worth, then everything comes crumbling down.

But then the question becomes, where did all the money go?

The only way for money to “disappear” is for it to be paid back against debt. When you over-speculate in a market, for instance by buying up comic books, that money is going to other people who (mostly) spend it on perfectly rational endeavors. Essentially, everyone who was wiser is richer for it.

The problem is that money is only spent with the expectation of more money coming back in at a later time. There is the expectation of future growth.

Say that a small money lender, Jeff, loans Tanya $50 to buy comic books. Another man, Berkley, comes to Jeff and asks for a loan to buy a bicycle so that he can travel all the way to a better job making more money. Jeff is expecting to be able to make something like $70 from Tanya. Berkley came in at this point to buy the bicycle because he’d already made $50 selling a few comics at insane prices to some crazy lady and with that $50 and a loan of $70, he’ll be able to buy the bicycle and get the job making enough money to pay off his bicycle.

Jeff checks with Tanya and finds out that she can’t find a buyer and she has to default on the loan, and subsequently he declines to give Berkley the loan for the bicycle. Jeff takes all of the comic books away from Tanya and sells them to Berkley for $10 (their true value), but Berkley still holds most of the money that Jeff needs to get out of debt — currently at a total of -$40. Berkley could still afford to pay Jeff something like $85 in exchange for a loan of $70, which would get Jeff up to only -$25 of debt, but he’s worried about worsening his debt when he doesn’t have any money sources at the moment and is already in debt himself. Berkley has enough extra money — $40 with no useful purpose since he can’t afford the bike — that he could lend or even give to Jeff to get him out of the hole, but he’s not a money lender. He doesn’t feel safe in knowing where to speculate with his money that he could likely recuperate it, nor is he set up to do so.

Now, theoretically, the government can step in and either loan Jeff money or simply clear his debt. If they loan him money, over a long enough time period, eventually Berkley’s excess $40 will trickle its way back to Jeff so that he can catch up. If they clear his debt, they are effectively printing money and devaluing the money base — which might be looked down upon by other people as if Jeff lent money to bad investments once before, he might do so again and continuing to devalue the money base leads to a loss in market confidence as well. Though as this is expanding the fundamental money supply (as I termed it), no actual debt is taken on by the government in doing this.

Essentially, the more popularly accepted answer among economists has been for the government to loan the money as this solution makes everything balance out alright in the end. Of course, it ignores the fact that you’re loaning money to someone who has lent money to bad investments once before. It’s not terribly clear why humanity seems to think that this somehow makes it better, but so it seems to do.

In truth, neither solution is particularly better or worse than the other so far as the economics go. The only question is whether Jeff istruly  safe to prop up, and whether either solution will get Berkley to get back into the game instead of holding on to his excess $40, waiting for things to clear.

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