Score, part 2

In the mysterious realm of financial assets, cash is referred to as liquidity. It flows, presumably, better than a truck full of pigs and stays relatively level in value over time, whereas, for example, said truckload of pigs brings with it an implication of fluctuating costs, like the need for transport and specialized storage, the total costs of cleaning up after them and feeding for the rest of their expected lifespans, the costs of slaughter and processing and packaging and further storage and further shipping and distribution… The value of the pigs varies wildly depending on the portion of their lifespan during which you are responsible for them.

For some people a truckload of pigs has a negative value even. I personally would consider paying money to have a truckload of pigs removed from my inventory if I could not find a buyer fairly quickly. But, if you completely ignore what I said in the last couple of paragraphs of part one, you can presume $5 means just about the same thing to just about everybody.

As strange as money is, there’s another state of matter in financial physics, and that’s credit. If a truckload of pigs is solid and money is liquid, then credit is … not a gas, per se. It’s more like … foam. It’s constrained by (remember: intrinsically valueless) cash, but it’s largely empty in and of itself. It’s the promise of cash later, and the broken part is that it seems to have a higher value than cash now. Overall.

It doesn’t seem like that at first, but it’s true. Here’s the basics so you can decide for yourself.

Say you have a pound of bacon and I have $5 and we’re prepared to trade one for the other. But maybe I’d rather hold onto that $5 for now for whatever reason, and I offer to pay you $6 next month. If that deal looks attractive at all to both parties, it’s because to me a future $6 is worth less than $5 now, but to you it’s worth more.

It seems to even out, right? And it would if that’s where it all ended. But remember (again) from part one, cash has no intrinsic value. It’s only artificially scarce. Earners are given it in exchange for labor, manufacturers are given it in exchange for products, but products are consumable and degrade in value over time and labor is in continual supply. Like grass in the lawn, there will always be more to mow tomorrow. It’s amazing that we try to make cash represent both. But when we throw in hoarding, the fact that the government is forced to print more when too much is hoarded, and transactions on credit, it gets to be too much to bear.

But where it gets to be particularly unbelievable is the feedback loops that credit can cause. Back to our example.

You want that $6 next month instead of $5 now because at the end of the year, $5 is $5 and $6 is $6. Provided I actually pay up, anyway. And when you need to make expensive improvements to your bacon-production process, you can either wait until you have all the cash on hand, or you can borrow that money and pay a larger amount back later.

Here’s the feedback loop: You can borrow more money now, or at least pay back a smidge less money later, if you can show that you expect to have more money by the time the payment is due. A better chance of being able to make your payments means a lower interest rate. Or a slightly larger loan with larger payments.

But the bank you borrow from also borrows money from time to time, and they count the promise of your future payments as future income for paying back their own loans, so the more you operate on credit, the larger amounts they can borrow for gambling and investing….

…and it’s all based on me actually being able to pay you $6 next month for a pound of bacon I’ll have probably eaten in a single sitting by this afternoon.

All of this foam is an awesome substitute for actual wealth, but like the Ponzi/Madoff scam it actually is, it only works in a growing economy, and the overall success of it really is firmly linked to the rate of economic growth. If there’s ever any kind of crisis, like a crop failure, or a plague, or a war, or earthquakes or bad weather or what have you, that diverts away enough of those cash payments at the very bottom, then the whole thing collapses like the head on a beer when someone sticks a finger in it.

If you don’t drink beer, I’m not sure I can come up with a suitable metaphor for you. But you can believe me when I say that finally coming to understand stuff like this is one of the reasons I drink beer.

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December 6, 2010 · by xalieri · Posted in Everything Else  
    

Comments

2 Responses to “Score, part 2”

  1. SRF Heavy Industries » Score, part 3 on December 7th, 2010 5:17 pm

    […] But not really, as I stated in Part One. A $5 bill is a token that, by its motion, allows $5-worth of goods or services to change hands. It has no intrinsic worth. Tomorrow it will be used to move a sack of flour. The next day a gallon or two of gasoline. Until it evaporates back into government hands via taxes or falls into a hoard, where it will be used to gravitationally attract more money or sit around until it is stolen/confiscated/devalued/donated or put to whatever other non-purchasing use that is available to “rich-people money“. Probably loaned out at interest. […]

  2. SRF Heavy Industries » Score, part 4 on December 8th, 2010 3:12 pm

    […] once your account passes some magic minimum balance, you are allowed to request that you earn interest on your balance — because by now you’ve discovered that the bank takes the total amount […]

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