On Oct 17, 2008, at 4:50 AM, Stephen A. Lawrence wrote:
I don't disagree with most of what you say here, but the drop in money
supply is something which can be accounted for "conventionally". I
had
a couple comments, which I'll give out of order.
Horace Heffner wrote:
This theory seems to be working out to some degree. It appears M has
been driven strongly toward zero.
This may have nothing whatsoever to do with program trading.
Very roughly speaking, the money supply is determined by the amount of
"high powered money" in existence (direct loans and gifts from the
Fed)
times a multiplier. The multiplier is determined by the reserve
requirement in effect on banks.
If the reserve requirement is 5%, then of each dollar placed in the
banking system, 95 cents is lent out. The borrowers may stuff a
little
of the money they borrow into a mattress (and hence take it out of
circulation), but *nearly all* of it is going to be either spent or
invested. If it's spent, it goes to a company, and if it's
invested, it
also goes to a company, and ultimately it works its way back to the
banking system.
Once back in the banking system, it's subject to the same reserve
requirement, and once again 95% of it is lent out.... and around and
around and around we go.
The result is that the money supply can be viewed as, *very*
approximately,
high powered money * sum_{n=0,inf} (1 - a)^n
where "a" is the reserve requirement. The sum on the right can be
evaluated by subtracting from it the same sum taken from 1 to infinity
and dividing through by (1 - (1 - a)) to obtain
sum_{n=0,inf} (1-a)^n = (1-a)/a = 1/a - 1
With our "strawman" reserve requirement of 5%, that evaluates to a
factor of 19. Thus, with a 5% reserve requirement, the money supply
might be expected to be (*very* approximately!) 19 times the amount of
money deposited in the system by the Fed.
Now, suppose there's panic or breakdown in the financial system.
If the
bank lending rate drops because of fear among the bankers, *or* if
people panic and start removing their money from the banks (a "run"),
that factor of 19 can drop very quickly. And when the "lending
multiplier" drops the money supply drops just as fast.
Something like this happened at the beginning of the 30's depression,
and about 2/3 of the money supply simply vanished, virtually
overnight.
(Or maybe it wasn't 2/3 -- I've forgotten the actual fraction, as
calculated by Friedman in some essay or other.)
The question must be asked which is the tail and which the dog, or
more to the point whether the dog can be led by pulling the tail? A
fast collapsing market, especially derivative markets in which the
banks and brokerages are heavily entwined, drives the need for
capital to cover margin calls. The faster the market moves the
greater the run on on the money supply - and other reserves, like
gold. It is ironic we are possibly in the greatest worldwide
inflationary period ever, with gold coin products backordered,
difficult to find and flying off the shelves, while the price of gold
momentarily drops due to the need to cover margin calls.
The velocity of money is too high. This prevents orderly application
of economic principles with predictable results. Volatility can be
expected to go out of control unless damping factors can be engaged.
The problem with modern portfolio theory is its fundamental
assumption, that the market activity is actually based on stochastic
processes. It is assumed that all fundamentals are known by all the
participants and very quickly "priced into the market". All that is
left is due to random fluctuations.
This is indeed the common assumption, and it is patently false.
Stock prices continue to be set largely by emotional factors, and
stocks
which are "in style" are consistently overvalued while those which are
"out of style" are consistently undervalued. By "overvalued" I mean
over a long term (say, a year) the value of "stylish" stocks tends to
drop relative to the market, and by "undervalued" I mean that over a
long term (say, a year) the value of "out of style" stocks tends to
rise
relative to the market.
This has been true for as long as anyone's been studying the market
and
it continues to the true today, as far as I can tell.
Fear and greed are underlying factors driving the stock market, but
there is way more involved here than just a stock market, or even
human decision making. Computer trading is happening by rules
derived on false principles and for circumstances which have changed
beyond the scope of their design.
P/E ratios (and, more recently, PEG ratios) tend to tell the "style"
story pretty clearly. As one trivial example, back when Sun
Microsystems' PE hit ~ 90 it was clear that it was a "stylish"
stock and
its price was being supported not by perfect information, but by the
usual herd mentality among brokers. That was a few years back but I
don't see any evidence that much has changed since then, save for the
massive increase in volatility which results from program trading and
from the loss of some securities regulations which "damped" things
(and
which were removed under pressure from the program traders).
As far as I know there is no model which correctly predicts company
growth. Unlike option prices, stock prices have no firm theoretical
foundation.
Well, the above theory, assuming the underlying theory of money is
correct, brackets the world of possibilities, i.e. defines boundaries
on what can happen in reality if the velocity of money runs away. It
unfortunately doesn't provide any wisdom in any way regarding what
happens inside those boundaries. It seems to me the opening of the
flood gates through internationally dropping the bank margin
requirements and increasing money supply without bounds should
temporarily solve the M problem, but is a recipe for disaster if the
velocity of money is not damped. This is because in the end either P
-> inf or M-> 0, or both, as V -> inf.
Best regards,
Horace Heffner
http://www.mtaonline.net/~hheffner/
