Wednesday, May 28, 2008

The Cash-Inventory Equivalency

The cash value equation I’ve been using rests on an assumption that the money supply of any economy is exactly equal to the inventory of all the goods that it can buy. Any difference reflects an error of pricing (or production). The principle resembles the quantity theory of money, where as money supply expands prices tend to increase, and when it contracts, there is a downward pressure on prices. Money supply is one of many factors that affect the price a merchant chooses to charge for an item or that the buyer chooses to pay for it.

Having discussed monetary velocity in the last post I can now defend this assumption a little better. If there were a difference between the supply of money and prices of goods in the inventory, velocity is the mechanism by which the two are reconciled. If availability of money greatly outweighs the prices charged of the inventory for sale, things would be bought up quickly. A lot of money would be spent and inventory would quickly contract. If a merchant easily sells items quickly at a given price, it would increase his or her profit margin to raise prices. So if goods are cheap (cash supply > inventory prices; in other words say there were $1,000,000 in the economy and an inventory of 100 tacos for sale at $2 each) inventory shrinks as people buy up supplies—to restore equilibrium prices have to increase.

Conversely, if prices charged for items are greatly in excess of the money supply, then at any given moment not everything could be bought. If an economy consisted of 100 tacos for $2 a piece, and there were only $100 in the economy, then only half the tacos could be bought from the taco shop owner. If all 50 tacos that could be bought were, then monetary velocity stops. In a real economy, if prices are in excess of the supply of cash then velocity would slow, and inventory of both supplies and unused production capacity would build. In order to clear the inventory, prices would have to drop to levels commensurate with the available money supply.

In this way, money velocity pushes prices to equilibrium where money supply equals inventory. Velocity is the mechanism that restores the cash-inventory equivalency.

Wednesday, May 21, 2008

Perfect Velocity

The income velocity of money is defined as the number of times an individual unit of currency turns over (i.e., is spent) in a specific period of time. According to Investopedia:
"Velocity is important for measuring the rate at which money in circulation is used for purchasing goods and services. This helps investors gauge how robust the economy is. It is usually measured as a ratio of GNP to a country's total supply of money."
To common sense, money velocity would be correlated with prices. If prices go down, desire for the item increases and more of it is purchased—so velocity increases. If prices rise, the opposite happens, and money velocity slows. Inventory shrinks as money velocity increases, and inventory grows as money velocity slows.

So velocity works to reconcile discrepancies of price and inventory. High velocity occurs when goods are priced low. This might be a good strategy when, say, one it starting a business, to become well known. Low velocity occurs when goods are overpriced.

So what is that “perfect velocity,” then, right in the middle of low and high? How is that determined?

Perfect velocity is no velocity, or no monetary exchange—an exact equilibrium at the given moment between money supply and inventory, where all goods are priced right at, or maybe slightly above, the total money supply, and nothing is bought. Perfect velocity is zero; viewing the economy at a freeze-frame moment. Now, say someone becomes hungry and wants a taco, there is a disruption in equilibrium. The onset of desire as driven by hunger drives the impulse for the taco over the price barrier, and the taco is bought and consumed.

Say instead of a couple dollars for a taco, the tacqueria owner charges $50 a piece. It is rare that desire for a taco ever goes that high, but surely there must be a few rich people who enjoy eating tacos in peace and quiet, so maybe a taco is sold every couple of weeks at that rate. Tacos are readily available and introduced into the economy as they are demanded, but if a manufactured item is regularly produced, and it is overpriced, then inventory starts to build. Prices must drop so the velocity is such that consumption equals production; if viewed over time, this is perfect velocity.

Perfect velocity is where the inventory remains constant and is consumed as fast as it is produced. If an item were hotly desired and flying off the shelves, it is under-priced. One might have to get on a waiting list to buy it. If inventory builds, an item is overpriced, which reflects an error of pricing. This concept of "perfect velocity" will be used to argue the equivalence of money supply and inventory.

Saturday, May 17, 2008

Currency Exchange

In conducting business internationally, if one possesses a foreign currency, and wants to spend business profits at home, the money will need to be exchanged.

Say one dollar buys .7 euros, then if you want 7 euros it will cost you 10 dollars, or if you have 1000 dollars it gets you 700 euros. One euro has more value than one dollar. You can buy more goods with one euro than one dollar, in America at least, after the exchange has taken place. The exchange coefficient (E) is .7 for the euro.

Mainly the currency exchange market serves international trade, but you can try to game it. If you expect the exchange rate to decrease to .5 the next day, and you buy 7 euros for 10 dollars today, and you are right, those 7 euros will get you 14 dollars tomorrow.

So the value of the dollar is the exchange rate multiplied by the value of the euro. V($) = .7*V(euro). If monetary value (V) is inventory (I) divided by money supply (M), then I(us)/M($) = E*[I(eu)/M(euro)]. Or E = [Ius*M(euro)]/[(M($)*I(eu)]. So if the inventory of the US increases, or the money supply in Europe increases, then the change in the exchange rate (delta-E) is positive, so stay away from the euro. If money supply in the US is growing, or inventory in Europe is growing, that’s a good time to consider moving money over to the euro—since the exchange coefficient is falling.

Likewise, if cash value is inventory divided by money supply, then one can estimate relative inventories of different economic systems—if one knows money supplies of both and the exchange rate. Of course, this assumes no errors of pricing and production, and real economies are fraught with them. However I’ll argue they all correct themselves, eventually.

Wednesday, May 14, 2008

Trade Deficits and the Dollar

For those who had a manufacturing job that has been off-shored to China, and are now cashiers at Wal-Mart, the trade deficit has worked against them—and to the degree they consume goods and services from fellow Americans, it has worked against the whole system. But if one’s job is stable, then it matters not whether your TV comes from China or America. If it came from China and it is just as good as an American one, or better, and cheaper, then you have more money for other things, and foreign trade has worked for you and the system.

The trade deficit means that dollars accumulate off-shore. Foreign factory owners cannot buy goods or pay expenses and salaries with dollars. They use their own currency for that, which they will have to exchange with dollars. If this continues at a high rate, dollars become plentiful and local money scarce. If the factory owner takes dollars to the money exchanger, and the exchanger gives back less and less of the local currency per dollar, then to maintain profits and pay expenses the price (in dollars) must be increased. So, say, as China accrues American currency, owners of Chinese factories would exchange dollars for local currency, which over time would rise in value against the dollar, and a new equilibrium is reached: Chinese TVs aren’t as cheap any more, Chinese workers would live better because their wages are more valuable, and manufacturing in America has a competitive chance. This is the easy way to resolve the trade deficit.

But problems happen when foreign currencies are pegged to the dollar. If Chinese currency is suppressed in value and does not float, then the prices of their TVs stay low indefinitely, and American plants close, and Chinese regulators are sitting on a massive pile of U.S. dollars. We have their goods, they have our money. Now what do they do? If they invest in U.S. T-Bills, then our government could initiate all manner of spending programs with little difficulty raising cash. Maybe—as the Fed dropped interest rates and treasuries followed suit—cash-laden foreign interests sought out mortgage-backed securities hoping for better returns. Maybe they just lent it right back to American consumers so we could continue to buy more and more.

I guess the idea would then have been you can extend credit forever. But you can’t. Americans have been lent more than they will be able to pay back, which will result in widespread defaults and foreclosures. We are left with a shell of an industrial base, and trading partners are left with unpaid debt. This is the hard way to resolve the trade deficit.

Saturday, May 10, 2008

What About the Euro?

What the dollar can fetch against the euro has been all over the news lately, indeed because it matters greatly. It matters if you eat euros, drive to work in euros, pay for your child’s college tuition in euros, are planning to travel to Europe, or you buy European goods.

As for European travel, I’m afraid that is a luxury good; sorry, but you can’t be taken seriously. How about a trip to the Grand Canyon instead? San Francisco is kind of like a European city in a more beautiful natural setting than most, and nothing beats New York for action and excitement. As far as buying European goods, probably something similar is made right here in the U. S. A. If we don’t make it, perhaps there is underutilized manufacturing capacity that might rise to the occasion. So long as trade deficits remain imbalanced and jobs are off-shored, a weak dollar against foreign currency is a corrective force necessary to restore the domestic economy.

So how can I defend holding cash then?

The dollar is a tool for buying American goods. The value of the dollar is measured by how well it accomplishes that task; its exchange against foreign currencies is incidental. If prices of goods in American were to drop (like say because they are overpriced) then the value of the dollar rises. So even if it is doing poorly against world currencies—even if it drops against world currencies—its value could still rise.

Since commodities, like oil, wood, and corn, are under foreign as well as domestic demand, these do become more expensive if dollar exchange rates fall; but domestically-produced commodities will yield higher profits for the national economy. So a weak dollar has a mixed but probably mostly beneficial effect if we suffer a high trade deficit.

Another way to look at it is, say to stave of deflation, the Fed inflates the dollar by a multiple of 8—and a few months later, facing the same problem, the European Central Bank hyperinflates the Euro by a multiple of 12. Does that mean the dollar is a good investment because it will rise against the Euro? Both would be horrible stores of wealth, the dollar a little less so, but horrible still. In the upcoming deflationary event; both dollars and euros are good investments, the dollar I think is slightly better since it is probably undervalued at this time.

I think the dollar will correct against foreign currencies eventually, but slowly, so the dollar would be a long-term investment if you are not planning to spend it here. Domestically, asset prices will fall from the upcoming contraction of credit, strengthening the value of the dollar as a purchasing tool.

The value of cash will rise in all countries that have a credit bubble about to pop—which means every country with a central bank, except for Japan where this has already happened. America is next on deck. Europe is a few months behind.

Thursday, May 8, 2008

The Desire Coefficient

This post will consider the role of desire on the inventory variable in the cash value equation, and its effect on the value of the dollar.

So far, it has been a given that all items of the inventory are equally desired. Now, take an economy whose available inventory consists of 3 houses, 100 barrels of oil, 395 bushels of wheat, and 2 gardeners who are paid by the month, with $10,000 to go around. So there are 500 items in the inventory. If everything is equally wanted, everything costs $20, or the value of the dollar is 1/20 of an item.

To address this error, the “desire coefficient” (D) is the proportion of the money supply (M)a fraction between 0 and 1that is spent in each economic sub-category. To start with, say the money supply is equally divided between houses (h), oil (o), wheat (w), and gardeners (g)—then desire coefficients for each is .25, since they all have to add up to 1. Dh, Do, Dw, and Dg are all .25. So, the money in this economy that goes to housing is Dh*M = .25*$10,000 = $2,500—and for now it is the same for all other subcategories. Since price ($) = money supply/inventory, $(houses)=Dh*M/Ih—and since there are 3 houses, the price for each is $2,500/3, or a little over $800. By the same math, oil is $25 a barrel, wheat is around $6 a bushel, and the gardeners work for $1250 a month.

This doesn’t sound quite right—houses should be worth a little more than the monthly salary of a gardener. Let’s push the desire coefficient for houses to .3, and for the gardener to .2. Wheat and oil stay the same. There is now $3000 for the housing budget, and $2000 that go to gardeners. Since there are 3 houses, and 2 gardeners, the cost of a house and the monthly salary of a gardener is the same: $1,000 all around. Let’s push it further: the desire coefficient of housing is .4 and gardener is .1. Now there is $4000 going to housing, so each of the 3 is worth $1333; and with $1000 going to gardeners, each one gets $500/month.

Here I’ve calculated the unit price as: $x=Dx*M/Ix. This equation can be shifted around to Dx=$x*Ix/M. This is the true, natural form of the equation. Desire is a psychological phenomenon that cannot be measured; however prices, inventory, and money supply can all be observed and tallied. In this example I was altering desire to set prices—in reality, desire can only be known from prices set by the market. Whatever prices happen to be, that reflects desire for the good. The desire per unit (Dx/Ix) is the desire coefficient divided by number of particular units, which equals $x/M once the Ix’s are cancelled—or individual desire is correlated with prices if money supply is constant. Now if increased desire causes prices to rise, it diminishes cash value for that item, simply because a given dollar would buy less of it.

So this is a way to give weight to preferred units within the inventory. Within each subcategory, additional desire coefficients can be used, to reflect subgroup preferences within each category. The desire coefficient for any individual unit is simply its market price divided by the money supply.

Monday, May 5, 2008

Errors of Pricing and Production

This post is a follow-up on the ongoing theory line where previously I defined cash value.

The cash value equation [V=I/(P+C)] assumes no "errors of production." If the entire economy consists of 100 bags of popcorn for sale, and there are 100 dollars, each bag is worth about a dollar, or the value of the dollar is a bag of popcorn. If money supply shrinks by half, then one dollar can buy two bags of popcorn, assuming everybody with money wants them. If nobody is hungry, than those 100 bags of popcorn are worth nothing; we have an error of production. If someone puts grains of sand for sale at the beach, no reasonable person would buy what can be had for free, and again we have an error of production—except that sand is free to produce, so the only error would be the time anyone spends trying to sell it.

The price equation [$=(P+C)/I] assumes no "errors of pricing." Prices are whatever the seller decides to charge. If charges are too high, units go unsold; this is an error of pricing. If charges are too low, units are bought and resold on the market at a higher price; such would be generous but not an error. Money supply limits the prices that can be charged for all goods. If the sum of prices charged for all things exceeds the money supply, unsold inventory will start to build.

An error of pricing is to overcharge so that some units go unsold. To correct, remaining units must drop in price. If prices have to drop below the cost to make and sell the item, that would be an error of production. Both diminish the desirability of the inventory.

The core assumption in either equation is the price of the inventory of all goods is equivalent to the money supply, in terms of printed currency plus credit. In other words, the entire money supply is able to purchase all goods for sale.

Sunday, May 4, 2008

Student Loan Cuts

I've seen ongoing reports of banks pulling out of student loans, but Businessweek summed it up as:
"distress in the credit markets has caused more than 60 lenders to stop making federally guaranteed student loans, either temporarily or permanently. The exiting lenders, which include college loan agencies in several states, account for an estimated 15 percent of the federally backed student loan market."
60 lenders is a fair number, and 15% is quite a chunk.

I remember my student loans deducting 10% right off the top as "administration fees," and no end to extraneous charges when I paid them off early. Still, the money was needed for rent and tuition and such. As mentioned in a recent post, the Fed has intervened by letting these lenders, as well as their subprime brethren, participate in ever expanding TAFs. This is one more indication of a credit environment increasingly on life support.

Friday, May 2, 2008

Countrywide Cut to Junk

When Bank of America announced plans in January to purchase Countrywide by the third quarter—given all the subprime mortgage debt held by Countrywide, bloggers wondered if BAC was (a) crazy, (b) stupid, or (c) had a trick up its sleeve. In rapidly evolving events, Countrywide’s bond rating was cut to junk today following disclosure from BAC that: “there is no assurance that any such debt would be redeemed, assumed or guaranteed.”

In other words, Bank of America would cherrypick Countrywide’s assets, while sending its debt over to a shell corporation called Red Oak Merger Corp., who may default as needed. If BAC gets away with this, who would buy corporate bonds anymore—if in the event of a takeover assets are accumulated by the new company and the bonds are defaulted?

Like Bear Stearns, everything was going just swell for Countrywide—until one news release later it wasn’t.

TAFs Rise to $75 Billion

Today, on the heels of the reduction in the Federal Funds Rate to 2%, the Fed raises TAF limits to $75 billion. They also expanded what they accept as collateral, from houses and commercial properties, to credit car debt, student loans, and car loans.

The term auction facility (TAF) was introduced by the Fed in December 2007 to address the credit freeze that happened late last year as a result of rampant subprime foreclosures, from teaser interest rate resets and a generally declining housing market. The TAF occurs every two weeks, and sells easy credit to banks, which they can lend out at higher rates. It began at $20 billion, then quickly rose to $50, and is now at $75 billion. It's a variant of their discount window, basically intended to allow cheaper access by lending institutions, with a broader range of collateral. This isn't necessarily a $75 billion increase in the money supply every two weeks, since what is given through TAFs is reduced at the discount window. But it does probably augment the money supply through expanding credit—still this is not necessarily an absolute increase if repayments and defaults exceed lending.

Now we face a credit freeze, for which the Fed had been engaging in aggressive maneuvering to undo, upping the ante precipitously since last September, both through decreasing the Federal Funds Rate and increasing TAF limits. Naturally, Wall Street will respond favorably. It really indictates, however, deep solvency problems that are not improving. I have more posts planned on the nature and cause of the credit freeze coming up shortly.

There is no evidence so far of increased printing. However, if the Fed trades sound treasuries for garbage assets as collateral which default, taxpayers are liable for the treasuries, and in essence this amounts to a veiled taxpayer bailout of bad bank loans.