The Solid Gold Bath Towel

“C’mon, Sy, I heard weaseling there — ‘velocity‑based thinking‘ ain’t the same as velocity numbers.”

“Guilty as charged, Vinnie. The centuries-old ‘velocity of money‘ notion has been superceded for a half-century, but the theory’s still useful in the right circumstances. It’s like Newton’s Law of Gravity that way, except we’ve been drifting away from Newton for a full century.”

“What, gravity doesn’t work any more?”

“Sure it does, and most places the force is exactly what Newton said it should be — proportional to the mass divided by the distance. But it goes wrong when the mass‑to‑distance ratio gets huge, say close to a star or a black hole. That’s when we move up to Einstein’s theory. It includes Newton’s Law as a special case but it covers the high-ratio cases more exactly and accounts for more phenomena.”

“Just for grins, how about when the ratio is tiny?”

“We don’t know. Some cosmologists have suggested that’s what dark energy is about. Maybe when galaxies get really far apart, they’re not attracted to each other quite as much as Newton’s Law says.”

“I suppose the money theories have problems at high and low velocities?”

“That’s one pair of problems. Money velocity is proportional to nominal traffic divided by money supply. Suppose an average currency unit changes hands thousands of times a day. That says people don’t have confidence that money will buy as much tomorrow as it could today. They’ve got hyperinflation.”

“Ah, and at the low end it’d be like me putting Eddie’s autographed $20 in a frame on my wall. No spend, no traffic, zero velocity.”

“Right, but for the economy it’d be everyone putting all their money under their mattresses. Money that’s frozen in place doesn’t do anything except maybe make someone feel good. It’s like water in a stream, it has to be flowing to be useful in generating power.”

“Wait, you used a word back there, ‘nominal.’ What’s that about?”

“Good ears. It points up another important distinction between Physics and Economics. Suppose you’re engineering a mill at that stream and you measure water flow in cubic meters per second. Kinetic energy is mass times velocity squared and power is energy per unit time. If you know water’s density in kilograms per cubic meter you can calculate the stream’s available water power. Density is key to finding mass from volume when volume’s easy to measure, or volume from easily‑measured mass.”

“OK, so what’s that got to do with ‘nominal‘?”

“In economic situations, money is easy to measure — it’s just the price paid — but value is a puzzle. In fact, people say that understanding the linkage between price and value is the central problem of Economics. There’s a huge number of theories out there, with good counter-examples for every one of them. For example, consider the solid gold bath towel.”

“What a stupid idea. Thing like that couldn’t dry you off in the desert.”

“True, but it’s made out of a rare material and some people think rarity makes value. In the right setting it’d be beautiful and there are certainly people who think beauty makes value. A lot of person‑time would be required to create it and some people think labor input is what makes value. The people who think utility makes value would give that towel very low marks. Of course, if you’ve already got plenty of bath towels you’re not about to buy another one so you don’t care.”

“So how do they decide what its price should be?”

“Depends on where you are. Many countries use a supply‑demand auction system that measures value by what people are willing to pay. Planned‑economy countries set prices by government edict. Other countries use a mixed system where the government sets prices for certain commodities like bread and fuel but everything else is subject to haggling. Whatever system’s in use, ‘nominal‘ traffic is the total of all transaction prices and that’s supposed to measure value.”

“Velocity’s supposed to be money supply divided into value flow but we can’t use value so we fake it with money flow?”

“You got it. Then the government tries to manage the money supply so velocity’s in a sweet spot.”

“Sounds rickety.”

“Yup.”

~~ Rich Olcott

The Flight of George’s Dollar

<chirp, chirp> “Moire here.”

“Hi, Sy, it’s Vinnie. Eddie just dropped off my pizza order —”

“What did you get?”

“My usual, large with extra pepperoni. Anyhow, Eddie said you guys were talking about Money Physics which has me curious. I don’t suppose it’s about how young George Washington couldn’t have thrown that silver dollar across the Potomac.”

“It couldn’t have been a US dollar because they didn’t exist yet and it couldn’t have been the Potomac because it’s a mile wide and probably nothing of the sort happened anyway. You’re right, though. What I’m calling Money Physics is about the parallels and differences between Economics and Newtonian Physics. Remember that $20 bill your dice‑playing won from Eddie a while ago and he signed it?”

“Yeah, that was fun. I was hot that night.”

“Well, the other day I used that very same bill to pay Eddie for pizza.”

“How’d you get it?”

“We figured you used the bill to pay down your tab at Al’s —”

“That’s right.”

“And he used it to buy some old astronomy magazines from me. I paid it to Eddie to complete the circle. ‘Whoa,’ I thought. ‘The velocity of money, like in Economics.”

“There’s a word I know from flight school. Velocity’s a vector, combines speed and direction. Speed would be how quick money changes hands, of course, but how do you attach a direction to that and what do you figure from the vectors?”

“Their equivalent to speed isn’t what you think it is and there’s no notion of direction. The ghost that’s left is the concept that ‘velocity of money‘ should describe how often a unit of currency is reused. The problems start popping up when you try to measure that. Economists grew up thinking about first‑purchase productivity so their metrics exclude a lot of what we’d consider economic activity. That traveling $20, for instance. How many transactions would you say it went through?”

“Eddie to me to Al to you to Eddie. Four.”

“Sorry, the productivity right answer is one. Eddie didn’t buy anything from you when he lost those bets. Your debt to Al was already outstanding. Al bought used goods from me. The only transaction that counts in the productivity calculation was my paying for what came fresh from Eddie’s pizza oven.”

“Dice games don’t count? How about bank fees or talking to my lawyer, stuff like that?”

“Oh, there’s lots of controversial questions, especially in view of our economy turning from mostly farm and manufacturing to mostly services and now we’re paying attention to environmental costs. ‘Reuse, repurpose, recycle‘ doesn’t enter into the productivity equation, and neither does installing a pollution control system except for the initial purchase price. Do you own stock, maybe in a pension plan?”

“Not as much as I’d like, especially recently.”

“I know the feeling. When you bought your shares, the brokerage fee counted as services but economists argue about the cost of the shares themselves. There are loads of what-abouts like that. Bottom line is that trying to track money movement at the transaction level just doesn’t work.”

“So what did they do?”

“Fell back to country-level aggregate numbers which are very rough by Physics standards. Add up the total economic traffic in dollars, divide by the size of the money supply, that’s the number of times an average dollar must have changed hands, OK?”

“Gimme a sec … that sounds right.”

“So how do you evaluate each part of the fraction? Some people measure economic activity indirectly by summing up transactions, maybe by looking at sales tax revenue data. That’s the spend side. Or you could look at the income side using payroll or income tax data and supposing that people spend everything they pull in. It’s not a hard think to find holes in both of those, but suppose you come up with a number somehow. That gets divided by the money supply, which we understand a little better but not much. Do the arithmetic and you have a dollars-to-dollars ratio, not somethings-per-time. No physicist would call that a velocity, but what can you do?”

“You got me, but who cares?”

“The Fed cares, because velocity‑based thinking helps drive their policy decisions.”

~~ Rich Olcott

Supply, Demand And Friction

<chirp, chirp> “Moire here. Open for business on a reduced schedule.”

“Hiya, Sy. It’s Eddie, taking orders for tonight’s pizza deliveries. My 6:15 wave is full-up, can I schedule you for 6:45? Whaddaya like tonight?”

“Yeah, a little later’s OK, Eddie. Mmmm, I think a stromboli this time. Rolled up like that, it ought to stay hot longer.”

“Good idea. Hey, I been thinking about that ‘velocity of money‘ thing and the forces that change where it goes. Isn’t that just another name for ‘supply and demand’? Bad weather messes up the wheat crop, I gotta pay more for pizza flour, that kinda thing.”

“That’s one of the oldest theories in economics, the idea that low supply increases prices and conversely. Economists often use two hyperbolas to describe the trade-off. Unfortunately, the idea’s only sorta true and only for certain markets. Oh, and it’s only sorta related to how fast money flows through the economy.”

“C’mon, Sy, you’re talking to a professional here. I watch my costs pretty close. Supply-demand tells my story — a bad tomato harvest drives my red sauce price through the roof.”

“No question it works for some products where there’s many independent buyers, many independent sellers, everyone has the same information, and a few other technical only-ifs. It’s what they call a perfect market. How many different companies do you buy flour from?”

“Three or four in town here. I switch around. Keeps ’em on their toes and holds their price down.”

“Competition’s a good thing, right? No buyer pays more than they absolutely must and no seller takes less than their competition does. Negative feedback all over the place. If one vendor figures out an advantage and can make money selling the same stuff for a lower price, everyone else copies them and the market price settles into a new lower equilibrium and there’s no advantage any more.”

“Yeah, that’s the way it works for flour.”

“And a few other commodities like grains and metals and West Texas crude. Economic theorists love the perfect-market model because it sets prices so nicely. Physicists love ideal cases, too — frictionless pulleys on infinitely sharp pivots, that kind of thing, where you can ignore the practical details. Most markets have lots of practical considerations that gum up the works.”

“Devil’s in the details, huh?”

“Sure. I seem to recall you’ve got a favorite sausage supplier.”

“Yeah, my brother-in-law Joey. OK, he’s family, but he does good work — fresh meat ground exactly the way I want it, got a good nose for spices, dependable delivery, what’s not to like?”

“Is he more expensive?””

“A little, a little, but it’s worth it.”

“So hereabouts there’s an imperfect market for sausage. The economists might tally Joey’s extra profit from that premium price to an accounting column labeled ‘Goodwill.’ A physicist would have another name for it.”

“Goodwill. Joey’d like that. So what would the physicist call it?”

“Real mechanical systems are never perfectly energy‑efficient. Energy is always lost to friction. In my money‑physics framework money’s lost to friction. It’s the reason you pay a premium above what would be perfect‑market price for sausage. Nothing wrong with that so long as you know you’re doing it and why. Most real markets are loaded with friction of various sorts. Think of market regulators as mechanics, running around with oil cans as they reduce inefficiency and friction.”

“What other frictions … lemme think. Monopoly, for sure — some big chain takes over my market, drives me the rest of the way out of business and then they can charge whatever they want. Umm … collusion, either direction. Advertising, maybe, but that’s mostly legal.”

“You got the idea. So, how is business?”

“Are you kidding? Way off. I had to lay off people, now it’s just me baking and delivering.”

“Would you buy flour these days at the usual price?”

“Nah. At the rate things are going what I got will last me for a l‑o‑o‑n‑g time. I got no place to put any more.”

“Your customers aren’t buying, you’re not buying, money’s not changing hands. The velocity of money’s so low that supply-demand isn’t capable of setting price. That’s deflation, not market friction.”

“Either way, it hurts.”

~~ Rich Olcott