Friday, December 18, 2009

Measures of the availability of money

It remains important for the development of the money cycle framework for the relative scarcity of money from the perspective of individual actors to be described. The meaning of various measures relating to this scarcity and the relationship between individual perspectives must be flushed out. In turn, this will allow, among other things, the use of empirical tools to establish the position of a given economy and to assess the relative effectiveness of various policy tools in practice.

It is tempting to immediately equate money with the objects that would be acquired through it, to value a currency only on the basis of what it can be exchanged for. However, a functioning currency that has value as an object of exchange acquires additional value as the desired object of others. In other words, individuals will acquire a currency even without having a clear set of objects that they desire to acquire through the spending of that currency. In fact, currency can take value as a collector's object, just as any trinket might, that fluctuates as a cultural object independent of its value in exchange for the typical goods bundles purchased by consumers. Therefore, the value of money is as much a cultural object as it is an economic one, and it is dangerous to make adjustments to 'real' currency value in the formulation of economic theories.

As described previously, money moves through the economy along many paths and capillaries connected together in a complex lattice that has no single central gateway of exchange. The availability of money to any point within the economy can be described as the flow at that point. While it is possible that an individual may horde cash received, the great bulk of received income is placed in accounts, that is transferred to the financial services sector. Typically, the bulk of this income is then paid out again in the form of payments for various goods and services through the period between paychecks, with little or no surplus and even deficits from time to time. Income constrains spending; it is the natural constraint in this formula. Velocity of money is a misleading term, as this essay will show that it is not the number of linkages so much as the quantity of movement that determines the amount of flow.

Assume an economy had a single, central bank. All the accounts in the economy are administered by this bank. All accumulations of money in accounts at this bank will be the result of business profits and individual savings.

If the availability of money is limited to positive account values, such that a person who has no money available is unable to take any loans for the purpose of further withdrawals, a shortage can only occur if the total cash withdrawals comes to exceed what is deposited into the bank. This is impossible if printed cash is kept on hand for every supposed dollar in existence. Note that this situation only makes sense when bank overhead costs are considered zero. Furthermore, under such a limitation, increasingly large quantities of currency will come to remain within the bank as individual savings and business profits. The dollars available will need to be stretched further and further, leading to deflation. It is not the fact that this currency takes any particular form, but that a greater portion of economic activity, when measured in goods production and exchange, must make do with a smaller portion of the actual dollars within the economy. I'll call this phenomenon the currency shortage.

When loans are allowed with a given reserve level, a bank's total obligation in demand accounts (those that can be withdrawn as cash) comes to exceed the actual quantity of cash held by that bank. Assuming that the loans are made without interest, the total amount in loans will be repaid over their course, with each term payment being a reassociation of dollars loaned with dollars pledged to accounts. Though the reserve requirement generally allows a series of progressively smaller loans to spawn from each initial loan, the repayment of these loans ultimately follow the same rule, since there is still an initial actual deposit serving as the seed for all later activity. An individual repaying a loan will typically have a lower level of consumption than one free of debt. The economic effect of the loan is therefore the creation of an initial jump in demand for goods, followed by a suppressed demand as repayment occurs. If economic activity is to remain at the same levels, it must therefore occur at lower prices over time or with a constantly increasing level of average debt.

Now, assume that bank overhead costs are not zero, the bank will secure an income stream from the collections taken on loan interest. Assuming that interest rates merely cover operating costs, total interest collected in each term will therefore be offset by the total paid, with any savings by bank employees being the expression of "profits". This generally represents a steepening of the effect described above.

In other words, the rate of accumulation of wealth must be offset by the government creation of additional currency. If this currency is given to banks in one form or another, it will manifest through the creation of loans, which can only function to extend the amount of consumer debt that the economy can sustain.

The above is written under the assumption that bankruptcies and defaults do not occur. In situations where debt is not repayed by borrower, the bank has a proportional diminishment in profits, meaning a certain level of default will only serve to limit the rate of accumulation and therefore delay instability in currency supply. In the long run, the bank will adjust down their level of borrowing either through increases in interest rates or avoiding of lending to risky buyers, accelerating the rate of accumulation again and leading to monetary shortages faster. A sudden spike in default rates can also bring about a rapid money shortage as the bank becomes unable to cover these losses except through tapping into reserve funds, forcing the bank to suddenly curtail lending. If such an event has a large enough impact, the bank could be unable to meet demand deposit obligations. As this type of crisis is not the topic of this essay, I'll leave the details of such a situation to another time, and probably a different model.

The existence of several banks rather than a single central bank complicates matters in certain ways. It becomes possible for one bank to loan to another bank. This allows for patterns of default to spread from one bank to another. Generally speaking, the risk of local shortages becomes greater as the number of banks proliferate. The network of banks means that money is constantly bouncing from one bank's accounts to another's. However, the specter of poor managment at a central bank leads me to believe that a network of properly regulated small banks is a superior method of organizing a banking industry. Having many banks does not impact the smooth flow of electronic transactions except when one or another bank behaves with deliberate belligerence.

In any event, this model of money availability indicates that the essential relationship is not between total money and prices but between the concentration of wealth and prices. Therefore, the equation that MV = PQ could probably best be reimagined to replace the quantity V with something else. On the basis of this and my previous blog posts, I would recommend V be a value between 0 and 1, expressing the portion of money "positioned to be spent".

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