Economical Equilibrium

by Ilya Kuntsevich

  An economy grows only when willing buyers and sellers produce and exchange more. Economic growth stops when all possible assets are already sold or exchanged, but it is not necessarily a bad thing because an economy can grow only at the expense of greater consumption of natural resources. I personally want the global economy to stop growing and people to start thinking at what expense it has been growing to date, and whether such a growth model is sustainable given the unaccounted footprint such growth is leaving behind.

  Economical distortions from profit, value add, inflation and interest cause frictions in all planes of economics, including social and political. The best measurement of such frictions is dissatisfaction. Dissatisfaction is impossible to avoid if something is wrong. It must be a natural internal control mechanism of all humans that brings things back to balance.

  Invention is a reaction to dissatisfaction with the current state of things. If someone is not happy with the reality, he or she makes something to compensate for it. Once something gets outside of equilibrium, something else will bring it back to balance.

  Any economic growth model will be balanced if the monetary volume (M*V) in the system increases in the same proportion as contribution of consumed natural resources, both renewable and non-renewable. As the contribution decreases due to inevitable market saturation and economic slowdown, the amount of money in circulation continues to exchange hands at its peak value, gradually causing monetary inflation:

  The profit motive, prevailing in the modern economy, creates excess money, which, in the end, gets allocated across very few individuals or corporations, as was presented in the Wealth Distribution diagram. In this scenario, excess money is transformed into “safe havens”, e.g. real estate, precious metals, art, scarce resources, etc. thus causing them to go up in price. Upon change of ownership, “safe havens” reach their peak value, but the new owners of money will keep it idle on the banks’ books for a while. When this happens, money “dries out” from the economic system and people in the bottom triangle of the Wealth Distribution diagram start to rebel, because they are forced to work more to sustain their standard of living due to profit pressures on businesses in which they are employed. This trend is unsustainable, and eventually causes such an economic system to fall apart, unless vigorously regulated by the government in the form of taxes in order to compensate the contributing community for the wages or jobs lost to profits.

  Use of debt allows boosting an economy (consumption) beyond its actual capacity (contribution), thus causing an unsustainable trend. Financial institutions, motivated to make money on money, introduced loan origination on commercial levels, spinning the same money multiple times thus creating unbearable leverage and values, which cannot be converted back to cash. We all know the end result of this frenzy – the U.S. government had to save these banks with taxpayers’ and international debt money in order to keep the banks afloat. How much cash value (not book value per GAAP) the U.S. banks have on their balance sheets is a big unknown.

  What Generates a Crisis?

  An economic crisis is an unexpected event of loss in GDP and general employment level. A financial crisis is an unexpected event of inability to honor financial obligations. Given economics and finance are closely related, both economic and financial crises often coincide.

  Living in the twenty-first century makes you wonder why, with all the technological advances we have at our disposal, including computing power and complex financial modeling tools, we still ended up with one of the most horrific financial and economic crises in 2008, still continuing through 2013.

  Karl Marx outlined the inherent tendency of capitalism towards overproduction in his prominent work Das Kapital. While it could be true in the time when Marx created his theory (nineteenth century), two centuries later overproduction cannot be the cause of a crisis, because manufacturers are “lean” and use sophisticated models and techniques that help identify correct production levels. So, what is it?

  Any economic or financial crisis occurs due to misalignment between contribution and demand, or the factors ultimately contributing to them. Decreasing contribution by economic participants due to outsourcing and / or technological innovations, on the one hand, and artificially increasing demand, fueled by debt of no real cash value, otherwise disguised with fair value accounting, on the other hand, are the main reasons behind modern era economic and financial crises.

  If we were to visualize supply (contribution) and demand with geometry, decreasing contribution results in angularity of the bottom triangle, while demand, represented by the top triangle, disproportionately increases:

  The angle of decreased contribution is due to less work provided by the economic participants, while the angle of yet increased demand is due to the increasing debt levels. Whenever a diagram starts getting an inverted triangle shape, a crisis will not be long in coming.

  Other reasons, such as greed, ignorance and incompetence, add to the distortion. While it is true that these qualities are present in humanity in general, I am full of hope that general good and intelligence will prevail and add transparency that would prevent further abuse of economics, accounting and finance.

  Best and Worst Storage of Value

  The best “storage” of value is what can be exchanged to cash or exchanged for another value, and at the same time has an inelastic supply due to shortage and/or technology dependence. So far, land, houses, precious metals, art, oil and natural gas are the best candidates – pretty much everything that is readily available, is in constant demand and has a limited supply is best fitted for value “storage”.

  Despite numerous attempts to call stocks and bonds markets the best “storage” of value, there are very strong arguments against such a position, as was discussed earlier. Back in the nineteenth century things were quite the same, as follows from Mark Twain’s famous quote: “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.”

  I was once approached by a start-up company that had an original idea of allowing family members to invest in their children’s education online, just like 529 Plan would do. When I asked them where the money would be invested, they said it would be one of the mutual funds. When I asked to see the performance of that fund, I was less than convinced that I would put my children savings into that fund, although the idea was great – no barriers to entry, and convenience was definitely there.

  When profit money is accumulated from previous transactions and no investment opportunities are created to make more money otherwise, IPO markets become “hot” and, therefore, equity bubbles are created. After money gets into the economy by people “cashing out” by selling their stocks, the stock markets fall into a trap of “financial models” valuation based on perpetuity and CAPM formulas with high P/E, but in fact are worth much less if sold immediately and/or converted to cash. Therefore, IPO and stocks are simply cash-transferring mechanisms, making business owners rich and individuals, investing their money in equities, less rich in cash, but more rich in stocks. The only problem with the latter is that stocks can be prone to loss of value at a much higher rate than cash. Don’t keep your value in stocks, unless you own a public business and know when to sell.

  Bonds and debt, in general, have the same characteristics as equities, but they just have better downside protection, because they are secured with real assets, which can be sold. But again, when a company acquires debt, it spends the money on equipment, inventory, employees, etc., so the money is gone. While debt is evaluated for “dangerous” levels as a percentage to equity or EBITDA, the residual value of assets, backing the debt, will always be insufficient in order to cover the obligations if something goes wrong. This is due to the accounting rules mismatch of how assets are recorded on the books versus their liquidation value if immediate sale is required.

  Something needs to change in the mentality of people who still th
ink that stocks and bonds markets are safe for their investments and retirement. The same holds true for other “investment products”, i.e. indexed funds, ETFs, mutual funds, hedge funds, all kinds of “securitized” products like MBS, CLO, CDO, private equity and venture capital, etc. These are very risky, very volatile instruments and / or investments.

  Risk and volatility are best measured with geometry, where the bottom triangle represents cash exchanged to maintain overall value of a given asset, and the top triangle is the value – quoted market price. In case of angularity, slopes should be studied in order to visualize critical levels.

  It should be noted that certain values, if increased with debt but not actual cash, will achieve disproportionately high magnitudes, but will be doomed to bust cycles after their peak levels.

  On the contrary, values that have high CVR and VRR ratios, will have circular-type shapes, because they can be easily interchanged into cash regardless of how much they are worth today:

  But even if someone decides to keep money in a bank, there’s still no guarantee that money is safe, because the banks are prone to losing their customers’ funds, as recently happened in Cyprus (and in many other countries before them). While inflation appears to be a necessary evil, there is a way to fix the banking system in order to prevent it from losing customers’ money. More on this in the last chapter of Part III.

  Ten Postulates of Economical Equilibrium

  1. Think geometry.

  This is the foundation of the Economical Equilibrium theory, a mirror effect of economic events. Visualization of any economical processes with geometry allows seeing the distribution dynamics, issuing warning signals when critical levels are achieved.

  Many economists stress the importance of economic growth, but what’s frequently left out is at what expense such growth is achieved. Economic growth (GDP) increase is possible either at the expense of more natural resource conversion to goods or more human labor converted to hours of productive work for services. It is not possible to sustain economic growth fueled with debt because the latter triggers demand not matched with actual contribution. Thus a real-time comparison between economic growth (one part of the equation) and at what expense it is achieved (another part) is required in order to analyze the dynamics and cause and effect relationship between the two.

  2. Fractals explain the economics.

  Global economic system processes have an identical pattern, i.e. wealth distribution, debt and economic growth, etc. The only difference is size and subformation. If one economic system is absorbed by another, the former takes the pattern of the latter. Patterns (diagrams) are best recorded with geometry; hence Economic Equilibrium tools become useful.

  Fractals are geometrical patterns that repeat themselves consistently at any level of scale we look at them. The wealth distribution pattern would be consistent between different countries if their economic system was the same.

  A certain pattern of economic activity can repeat itself both at a country, a company, or an individual level. An interesting hypothesis could be made: if economics is broken at an individual level, it would also be broken at a company and a country level, and vice versa.

  3. Perpetuity (linearity) and economics don’t match.

  John Keynes: “The long run is a misleading guide to current affairs. In the long run we are all dead.”

  Perpetuity is a concept of linear mathematics, while its practical application is non-existent in the real world. Nothing lasts forever. Any valuation technique using perpetuity formula (i.e. Terminal Value) creates valuations that will never be supported in the long run due to market saturation, competition and other economic factors.

  4. Economics has an ellipse shape when contribution is matched with demand.

  Economics, by its very definition, is represented by the exchange of goods and services between people. Economic transactions occur when people contribute what’s in demand.

  Any infusion of money not prompted by existing levels of contribution causes distortions in economics due to misalignment between contribution and demand. Inverted triangles, discussed in the Geometry of Economics chapter, explain the evolution of such distortions and the reasons why they occur.

  5. Circular growth is good for the economy, angularity is bad.

  Ellipse represents balanced contribution and demand, while angularity occurs when there is more consumption or purchasing power, on the one hand, and less contribution, on the other. Angularity reaches a critical point at specific slope levels for each type of economic activity.

  The profit-making motive, combined with a possibility to use excess liquidity, otherwise unwanted in the economy, creates pressure on profit makers to use money continuously in order to make more money. When this happens, certain value items, representing wealth, become overpriced yet required for the overall use of economic participants, thus causing an unbalanced economy.

  6. Wealth is distributed in inverse proportion to the number of people.

  Organic expansion of economics results in an ellipse shape of wealth distribution and exchange based on equality of contribution and demand. Due to scarcity of land, natural resources and intellectual property (technology), on the one hand, and human nature of ego, moneymaking and profit motive on the other, the initial ellipse shape of wealth distribution gradually transforms into inverted pyramids.

  Inverted pyramids reach dangerous levels when the top pyramid starts growing faster than the bottom pyramid due to exploitation of labor and underpayment of the latter for the benefit of the former, as the profit making motive dictates.

  7. Wealth is prone to increase or loss of monetary value.

  Technological progress, paradigm change and time tend to transform wealth, although certain wealth categories, like real estate, art, oil & gas and certain precious metals tend to retain value regardless of introduction of new values.

  When critical leverage levels are achieved by the financial institutions, artificially created values of certain assets crumble due to otherwise unsupported future contributions (future economic benefits), which have been taken into account as a basis for their valuation.

  Had contribution and demand been taken into account in valuation of assets, and had no money been allowed to turn around multiple times to instigate otherwise unwanted demand, we wouldn’t have seen the disturbing economic crisis patterns observed over the last decade.

  8. Profit = Value-add = Inflation (monetary) = Interest Income.

  When profit is recognized for a value-add (e.g. new technology), immediate monetary inflation follows to keep money circulation at the previous level. Interest income represents future growth implied by a debt-holder.

  Profit, value-add, inflation and interest income, all measured in monetary terms, are a reflection of the same thing – economic growth. Organic economic growth can be achieved by increased extraction and conversion of natural resources through more labor and / or technology contribution, met with respective demand of the economic participants.

  9. Debt = money spent today, but its value is derived from expected future economic benefits.

  Debt is a way to turn the same money multiple times in order to increase today’s consumption (demand) at the expense of the expected future contribution. Debt is the major cause of bubble creation throughout the global economy, because it depends on future performance while it boosts today’s economic activity. Overreliance on future performance occurs due to perpetuity formulas used in evaluation of businesses (e.g. Terminal Value), causing excessive debt levels not supported by the actual performance results or contribution.

  Economical Equilibrium theory explains why higher debt levels are required to sustain lower increase levels of the economic activity (GDP), as was presented in the Geometry of Economics chapter. Disproportionate debt level increase in the U.S. over the past decade, with very modest GDP increase at the same time, is indirect proof of this relationship.

  GAAP, which allows debt recognition at cost (loans) or f
air value (marketable securities), doesn’t take into account the fact that debt is non-monetary (cannot be immediately converted into cash). Accounting rules, using fair value and historical cost, but not cash basis, disguise the real cash value of the assets, including those acquired with debt and leverage. Quoted market prices, while nominated and presented in the financial books and records with currency, cannot be instantaneously converted into currency. The latter is due to the fact that the financial system, when turning the same money multiple times, creates non-monetary values.

  10. People work harder for their love of progress and increased standard of living.

  On the one hand, technology allows people to work less, thus they should have more free time. On the other hand, people tend to invent new things in their free time and thus produce more technology to enjoy life even more (telephones, cars, internet, etc.). More working people is good for the economy (it is growing) and for government (more tax revenue), making a given country more prosperous (e.g. the recent economic rise of China).