Wednesday, December 16, 2009

Money Cycle

Among the many "laws" of Economics, the one standard that transcends all others in its unshakable nature is the law relating levels of market exchange to the flow of money: MV=PQ; this constraint relates two rates of flow to each other - one is the quantity of money (M) and total velocity (V, the number of times it changes hands), while the other is the average price of goods (P) and the quantity of goods exchanged (Q). The equation holds true, in part, because it requires a commitment of good faith from those who test it: That they will dutifully take into account advance deliveries and payments and count the supply of money in a certain way. The equation also holds true in part because it is directly derived from a simpler assumption: The collection of data related to this equation requires first that the total dollar value of all goods sold within a given period be estimated, which I'll label Y. Y then becomes both the products MV and PQ, with any advance or late payments considered minimal, and the various types of credit and currency treated as equivalent. Being nothing more than two parallel decompositions of the same equation Y = Y, the equation MV = PQ becomes nothing more than a truism.

The four variables, M, V, P, and Q bear a nominal connotation that can betray the casual observer of the economic discipline. If one imagines that the prices and quantity of goods exchanged are restricted to services of value and material goods, the equation becomes an object that relates monetary policy to economic output. Unfortunately, this cannot be the case, as financial objects, when exchanged on the market, no doubt increase the flow of money but contribute to P and Q only by being treated as an element of Q. Similarly, increases in GDP come as a result of the inclusion of traded financial assets.

It is possible to visualize the flow of money within the economy by tracking a uniformly distributed sample of dollars (from real cash, accounts, and credit). Though I am not aware of such a study, it is likely to reveal that many paths of various length and velocity are followed. Unlike a real river, the paths of these dollars will require a third dimension, as some cross above or below each other, splitting off and joining up in complex patterns.

Individual incomes will each be a small trickle from the large revenue stream of the employer firm. Each paycheck will be split into several streams, but only over the course of the time period from one paycheck to the next. Paychecks will first have taxes and union dues siphoned off. Next, rents, mortgage payments, and car payments take a huge draft that will vary from most of what remains down to about 1/6th. All the rest will go out in tiny disbursements for various consumer products, services, and financial products.

The stream of taxes will be paid out by Government to Government employees and contractors, but will first be placed into a receiving account. The stream of rental and mortgage incomes will be processed by property management firms and banks before being returned to investors. The stream of other goods and services will largely be paid out to employees and other businesses, with investors taking a cut from some profitable firms but not others. In the case of large businesses, the upper-level management will often receive very large compensation packages. These packages will be wage-type streams but are worth noting because they have atypical size and compositions.

Though much money swirls about in the wage cycle, moving from one wage earner's hands to the next, some dollars from this cycle are pulled into a different area, the financial products sector. This sector is similar in composition to the wage cycle sector but has invert composition - a small amount of the money exchanged is channeled into wage streams, while the remainder is moved from one financial product to the next. Presumably, these financial products represent investments in the non-financial service sector - investments in capital equipment and advance wage payments. However, the financial products can also be composed of other financial products and real estate, both objects which do not channel the dollars back into the wage cycle. Thus, the degree to which dollars are channeled back to the wage cycle depends on the distribution of financial-services dollar flow between the two channels of either production (capital equipment and wages) and finance (financial services and real estate).

There seems to be a relationship, of sorts, between the production level of the society and the interplay between the wage and financial service cycles. Let G be the net increase (or decrease) in dollars flowing into the wage cycle. Then if R is the part of rent and mortgage payments flowing into the financial services sector, S is the part of consumer spending entering the financial services sector (e.g. through the purchase of financial products), C is the part of financial services dollar flow that goes toward capital equipment purchases, and W is is the part of financial services dollar flow that goes toward wages, we have:

R + S + G = C + W

Broadly speaking, there are five sources of G:

1. The increase in worker spending on things other than R or S, as a result of either increases in wages or the extension of credit.

2. The decrease in R (lowered rents and mortgage payments).

3. The decrease in S (less investment in financial services).

4. The increase in C (more capital equipment, which is generally built and produced by wage workers).

5. The increase in W (direct conversion of financial service dollars to paychecks).

This G is not a representation of economic growth. It is merely an expression of nominal dollar balance. Growth is more intimately related to investment levels in C and W, which are dependent on the existence of consumer demand that can only exist while consumers have the necessary surpluses in their budgets. G expresses the change in these surpluses. In the absence of regulatory response, too much flow toward financial services pushes consumer budgets down too far, disincentivizing the financial services sector to invest in C or W (disincentive). Conversely, too much flow toward wages deprives the financial services sector of the capital it needs to make effective investments in new machinery and skilled workers (shortage). Thus, there is a difficult balance between the financial services cycles and the wage cycles that tends to fall farther out of balance rather than move toward an equilibrium - it is a repulsive fixed point.

The initial or casual regulatory response would depend on the proper reading of the indicators of whether disincentive or shortage is occuring. The disincentive condition is indicated by a high degree of concentration of wealth. The shortage condition is indicated by a highly equal distribution of wealth. However, if faith was placed in the theory, it could be used to track the accumulations through the measurement of G over time to constantly preserve the balance even when outward symptoms had not started to manifest.

Policies that regulate this relationship can take many forms.

Most straightforward would be a tax that simply redistributed earnings from the wealthy to the poor. Such a system, however, would necessitate that the economy remain on the disincentive side of the distribution. A fixed point would be reached in this zone, so long as the tax is not too severe. If such a policy were implemented when the economy was in shortage, it would simply make matters worse.

A tax used to purchase real estate and invest in financial services would allow an economy that is in the range of shortage to reach a fixed point in that range. However, such a policy would be ineffective when the economy is in disincentive.

A minimum wage, depending on what portion of workers are affected and how high the wage is, pushes the economy toward the shortage direction. The minimum wage is not neutral from the investor perspective because it makes wage and capital investments less attractive relative to real estate and financial investments. However, it is beneficial in the disincentive range so long as the increases in worker pay give a sufficient increase in demand for products to counteract that decrease.

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