Friday, October 10, 2008

Price Disequilibrium Theory

Classically, prices are driven by supply and demand. The Austrian School of economics adds the influence of money supply, as defined by the sum of printed currency and credit. This post will consider the influence of all these factors on price stability and instability.

The present theory of pricing begins with the assumption that the sum of all prices for all goods, services, investments, and anything for sale in an economic system is exactly equal to the money supply. This assumption does not require that all sellers conspire to price their wares such that the sum total equals the supply of printed currency and credit. Rather, the system resolves itself spontaneously: if prices are set above the relative demand for the item, then velocity of sales will slow such that inventory builds and prices are forced downward to clear the excess supply.

Explaining it in mathematical terms, we start with the identity that money supply (M) equals inventory (I). This position was defended earlier in the post "The Cash-Inventory Equivalency." Inventory then can be broken down to the sum of all classes things for sale, with a desire coefficent (d), and numerical supply for each category of goods. The fraction of money supply that goes for each subcategory (x) is d(x)*M. This would be divided by the number of goods in each subcategory to calculate the price per item: or d(x)*M/I(x). This is the equilibrium price for the item so long as demand, money supply, and inventory remain constant.

Now sellers are free to set prices at whatever they choose, but if they price it above this equilibrium point then unsold inventory will start to accumulate.

If money supply were only printed currency, then if money supply were inflated by printing bills, then equilibrium prices will adjust upward to reflect the increased money supply. A printing campaign could wreak havoc on bonds, deposits, and other kinds of savings, but the active elements of the economy simply adjust to the inflationary pressures by raising wages and prices.

Now, let us examine how prices may be pulled from an equilibrium state through the injection of credit. Consider the truism that money supply is the sum of printed currency plus credit. If banks start lending out their deposits, but those deposits are still fully available for withdrawal, then by definition there is a fractional reserve banking system. If regulators or legislation dictate that fractional reserves must be kept at 10%, then if $1000 is deposited in a bank, then money supply is increased by 9 times the deposit. The bank, who must keep in reserves 10%, or $100 of the deposit, can still lend $900. After the $900 is borrowed and spent and redeposited in another account, then 90% of that, or $810, can be lent again, and so on, until that $1000 expands the money supply by $9000.

So in a 10% fractional reserve system, assuming banks hold on to all deposits, the money supply is expanded 10-fold through lending, and price equilibrium adjusts to the reality of fractional reserves.

The problem with fractional reserve lending is that it leverages money, and any kind of leverage increases sensitivity to economic downturns. What might otherwise be a small downturn becomes a financial catastrophe if one is over-leveraged. Economic stability in a fractional reserve system requires a government willing to bail out banks in these sorts of events. However, when things are going smoothly, fractional reserve banking does not cause price disequilibrium. It merely expands the money supply by the reciprocal of the fractional reserve.

However, when cranks are pulled and buttons pushed on the financial machine such that credit is piled in to the system in an unsustainable manner, beyond the level of the deposit base plus fractional reserve credit, to the point where the system cannot borrow any more regardless of how available the credit is or how favorable the interest rates are, we have the essence of price disequilibrium. Here, money supply is inflated by unsustainable levels of credit, where prices break from equilibrium to readjust to the expanded availability of credit. Predictably, this increase in the money supply is only temporary, and as the credit expansion is paid back or defaulted on, and the burden of paying back loans is such that now credit cannot be lent to match the peak rate or even the baseline fractional reserve rate, then prices of goods, services, and asset investments must fall to a new equilibrium that reflects the contracted money supply.

This post defines price disequilibrium and its general underlying mechanism. Further posts will consider the limits and timing of price shifts and the related phenomenon of speculative runs on commodity and asset investments.

No comments: