Friday, December 19, 2014

Speculative markets are not black holes


Marc Faber is a very knowledgeable guy, but thumbing through a copy of his most recent Gloom, Boom, & Doom Report, I stumbled on a pretty big error. Here is Faber:
"All the liquidity that central banks have created isn't flowing into the real economy but remains in asset markets (mostly financial markets) buying and selling currencies, bonds, stocks, real estate, art, entire companies, etc. For example, most corporations find it advantageous to buy back their own shares (in order to boost their share prices) instead of investing in new plant and equipment... Or take wealthy individuals as another example. Most of them invest in stocks, bonds, funds or real estate; very few of them go out and build businesses. Private equity funds do the same: instead of building new businesses, they tend to buy existing assets." 
and later on:
"I believe that as long as savings and newly created fiat money flow into booming and speculative asset markets, real economic activity will remain depressed."
Faber is repeating a very old fallacy that goes something like this: new money and credit can stay tied up in financial markets indefinitely. This unproductive absorption of capital by speculators in turn prevents the real economy from benefiting. New buildings and factories go unbuilt, consumer goods go unsold, and cutting- edge technology goes undeveloped because the stock market 'sucks up' all the money.

Marc Faber styles himself as an Austrian economist, so he should know that Fritz Machlup, an Austrian 'fellow-traveller', dealt with this particular fallacy in his 1940 book The Stock Market, Credit and Capital Formation (pdf).

In a nutshell, newly-created money (or already existing money) that flows into stock and bond markets does not enter a financial black hole. For every buyer there is a seller. By definition, money will flow away from the market on which it is spent just as quickly as it enters it.

Here is the argument in more depth. Say that Frank (for lack of a better name) invests fresh money in a new issue of corporate shares. These funds don't fall into an abyss. Rather, the issuing company now owns them and uses them to build a factory. Faber would approve since machinery is being created from scratch.

But even if Frank uses the new money to buy already-issued shares rather than newly-issued shares, these funds don't get sucked into a vortex. They are now held by the seller of the used shares, Tom. And the moment Tom uses these funds to buy a car or invest in his home business, they are released into the real economy.

Of course, Tom might simply reinvest the funds earned on the sale in another stock or bond. But this changes nothing since an entirely new seller, Sally, comes into ownership of the funds. Like Tom, Sally might choose to invest it in real capital or on consumption, the real economy enjoying the benefits. Or she might choose to reinvest in the stock market, selling to Harry, and so on and so on. But even if the next ten or twenty recipients of Frank's newly-created money all choose to reinvest those funds in equities, the stock market is nothing akin to a black hole. At some point along the chain the money will inevitably arrive in the account of an investor who chooses to dispatch it to the so-called real economy by either purchasing consumption goods, services, or some sort of industrial good. Though the chain along which this money might travel can include many people along the way, when it finally exits only a few financial heartbeats will have passed.

So in sum, contra Faber money and credit cannot be held up inside speculative markets. It doesn't take long for it to be spent into the real economy.

For those who like to keep track of these things, the 'financial black hole' myth is related to the 'idle cash on the sidelines' myth, dealt with ably by John Hussman many years ago. In the 'sidelines' story, money sniffs its nose at the market and stays at the edge of the dance floor only to have a sudden change of heart, subsequently flooding the stock market. But as Hussman points out, when you put your cash on the sidelines to work in the stock market, it becomes someone else's cash on the sidelines. Both the black hole and sidelines stories are wrong because money doesn't disappear when it is spent. Rather, there is a seller who is left holding the stuff.

15 comments:

  1. Aha! This is related to what Machlup called "The Junker fallacy". All the Prussian saving went into land, rather than investment.

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    1. Interesting. Here Tyler Cowen says that the Junker fallacy was first critiqued in Machlup's Stock market book (linked to in my post), which is where I got the inspiration.

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  2. Interesting.

    Makes sense - and definitely worthy of the physics analogy in this case.

    Maybe jazz it up a bit with "escape velocity" - from the financial economy to the real economy.

    This must be important in understanding QE.

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  3. I certainly agree with your main point, but not with: "At some point along the chain the money will inevitably arrive in the account of an investor who chooses to dispatch it to the so-called real economy by either purchasing consumption goods, services, or some sort of industrial good."

    Spending in the real economy does not mean the money "finally exits" any more than acquisition in financial markets does. If new money is created, it only exits by repayment of bank debt or passing into the hands of entities outside the defined class of money holder. Otherwise money balances just go up. So what happens depends on what it takes to get people to accept higher money balances.

    It is quite possible that those people that sell their bond holdings when QE takes place simply decide to hold more money and therefore do nothing else. They might not, but they might. There's no inevitability about it going to someone who spends it on goods and services.

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    1. Nick:
      You've hit on a big deficiency of the "idle cash" idea. Money is just a veil. Underneath, it's goods being traded for goods. It's not a question of "This guy spends the money, then that guy gets it and spends it". If the goods are there to be traded, then money can be created to facilitate the trade, then retired right after. The trade would have happened (less efficiently) without the money.

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    2. Nick, fair enough. Assuming the new money is a hot potato, ie. it is in excess of the demand to hold money, it can't get stuck in speculative markets.

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  5. Yes, black holes slowly fade by "Hawking Radiation" but it can be a very slow process.

    It seems to me that the rate of money use is related to the velocity of money. The velocity of money seems to be going lower as time passes. Of course, if we are to use velocity-of-money as a measure, we need to decide which measure of money supply will be serve our discussion goal.

    For your post, I would suggest using the entire government debt (measured as Federal Reserve holdings and debt held by private investors) for the money supply term in finding velocity.You could find this used in a chart in my post

    http://mechanicalmoney.blogspot.com/2014/11/finding-exponent-in-fiat-decay-model.html

    as an example of two ways to find velocity.

    In my view, the observation that newly created money may only turn over about 1.4 times per year would support the Faber comments.

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  6. David Glasner had this to say in his recent "Traffic Jams ans Multipliers" post:

    Mike, If you look at my first post about Barro, you will see that I interpreted the multiplier as a shift of cash from people with a perfectly elastic demand for money in a liquidity trap to people who were cash constrained and would therefore spend any additional cash as soon as they got it.

    Certainly sounds like the "idle cash on the sidelines" fallacy.

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  7. I've been thinking about this myself. Perhaps the distribution of newly created money matters because of how it affects the velocity of money.

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  8. JP, it seems to me that you may be making a mistake.

    You write: “In a nutshell, newly-created money (or already existing money) that flows into stock and bond markets does not enter a financial black hole. For every buyer there is a seller. By definition, money will flow away from the market on which it is spent just as quickly as it enters it.” And you write “So in sum, contra Faber money and credit cannot be held up inside speculative markets.

    I directly believe this is all true. But then you write “It doesn't take long for it to be spent into the real economy.”

    But why would this be the case? The money that is received by the sellers is just an asset that has been traded for another asset. There is no income earned. And thus, why would this money be spent in the real economy? Can you give me a plausible explanation?

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    1. "And thus, why would this money be spent in the real economy? Can you give me a plausible explanation?"

      Do you mean, why isn't it just held, or hoarded?

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    2. Ok, I see. If newly created money was hoarded, that would imply that there was never an excess supply of the stuff, since people stepped forward to hold it. If so, the newly create money can't generate an increase in asset prices (or any other price for that matter) since there is no monetary hot potato that everyone simultaneously tries to rid themselves of.

      The above post implicitly assumed that the newly created money resulted in an excess supply of cash, which everyone tried to simultaneously rid themselves of. If so, those money balances can't get stuck in speculative markets... they will quickly make their way into the real economy.

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    3. JP, I am afraid that doesn't answer my question. I fully understand that money balances can't get stuck in speculative markets. They will always end up on someone's bank account.

      What I mean to say is the following: assume that someone (a central bank or whoever) buys up assets (bonds or shares or whatever). The people who sell these assets will do that (I assume) because this buyer is willing to pay a price for which these people are willing to sell.

      But that doesn't mean, in my opinion, that these people are going to spend the money they just received as some kind of hot potatoe in the real economy. It seems more likely to me that they will look for some other investment to buy.

      On the other hand, they may be willing to spend a small part of it in the real economy, because they will probably have made a profit (or a smaller loss than previously expected) on the assets the just sold.

      Anton

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