Metrics: Cash, Credit, and Prices

The "cash-inventory equivalency," proposed before, states: money supply (MS)—or the sum of printed cash (P) and outstanding credit (C)—exactly equals the value of the inventory (I) of all things for sale (e.g. MS = I; or P + C = I).

Where there are discrepancies in this equation, where things for sale are overpriced or underpriced, it reflects an error of pricing, relative to the desire society has for a given item. Since errors of pricing reflect inefficiencies for the seller, prices will tend to self-adjust over time to conform to this equivalency. From the cash-inventory equivalency, one can derive a value for cash that reflects its purchasing power at home, independent of how it sizes up against foreign currencies. Also, equilibrium and disequilibrium prices can be conceptualized.

But this equation is an assumption. I have argued that if the sum of all prices is greatly lower than money supply, then sales velocity increases and sellers adjust by increasing prices; or if prices greatly exceed money supply, then sales will slow, and sellers have to cut prices such that sales keep up with productive capacity. In either of these extreme cases the direction of price correction goes toward the cash-inventory equivalency, but does it exactly equal it? That I cannot say for sure.

Even if money supply and inventory were not exactly equal but exactly proportional and related by a constant, then cash value and price disequilibrium would still hold valid, but with the constant factored in. But if money supply and prices are generally proportional and not exactly proportional, then no headway has been made since the quantity theory of money, which has been around for centuries.

Now, the cash-inventory equivalency (P + C = I) could be demonstrated if each variable were measurable and could be followed over time; and especially opportune would be a setting where the relative proportion of credit to printed currency is in flux as it is now. This post will offer some initial thoughts on the measurement of these variables.

1. Cash (P) is the easiest to measure. There are two approaches I have, both of which yield around the same answer: you have M1-currency which is the amount of cash that was run off at the presses; either that you can subtract bank reserves from base money supply—all of these numbers are published regularly by the Fed. Interestingly, while base money and bank reserves have been skyrocketing, M1 has risen slightly. The Fed isn’t really “printing” all that much. Base money expansion is just ineffable eMoney which gives the banks some leeway for making loans in the current credit environment; or more importantly, it will allow them to withstand the implosion of Alt-A (stated income) loans, commercial real estate, and credit cards, particularly as the effect of recent job losses snowballs through the economy. Currently, there is about $800B cash in circulation.

2. As for measuring credit (C), to the degree that the money originated by fractional reserve lending is redeposited by sellers back in to banks, and I think that is a pretty reliable assumption, then deposits are a reasonably good estimate of credit. Until March 2006, we used to have that information when M3 was published by the Fed. Subtract M1-currency from M3 and you have outstanding credit in dollars. So now there is M2 and MZM which do not factor in large CDs or deposits with a maturity date. M3 was becoming increasingly disproportionate to M2 right before the Fed stopped publishing it, so it’s essential data in measuring credit.

So all we have are M2 and MZM, which are around $8-9 trillion dollars. Subtract cash and we have close to $7 trillion outstanding credit in the system (I am using broad approximations with wide error margins for now and will refine over time). While the financial industry is crashing and burning, we don’t see declines in M2. Part of this may be due to bailout efforts delaying the pain, particularly in protecting the balance sheets of the banks. Defaulted credit does not hit personal deposits; it hits the reserves of banks, and that is where the bailout money and base money expansion has been going.

3. As far as prices (I) go, thus far I’ve been following trends. I watch several indices: DJIA for the health of businesses; Case Shiller for house prices; Reuters-CBH commodities index; spot oil; the CPI for everyday expenses; GDP; and gold. Trends in these indices can be eyeballed as indications of general price trends.

So far, I have a decent measurement of cash, a broad and inaccurate underestimation of credit, and broad indices of general price movements, but nothing that could be considered “the sum of all things for sale.” The first step in demonstrating the cash inventory equivalency would be to refine measurements of credit and pricing trends to determine whether money supply and inventory could be regarded as exactly proportionate or not.