Economical Equilibrium

by Ilya Kuntsevich

  As a conclusion from this hypothesis, little cash is required to boost market capitalization of the world’s indexes, which inevitably collapse either due to a systematic risk (when confidence in future performance is decreasing, or cash is needed to pay salaries, taxes, debts or cover margin calls, etc.). Trading on margin (when stocks are purchased with debt) requires no cash to be involved to begin with, but the stock market would still go up. It’s like one bubble (debt, leverage) creates another (stocks). In this situation the top triangle gets disproportionately larger than the bottom triangle and, when this happens, a collapse is inevitable. Additional analysis should be performed as to the slope of the lines of each triangle in order to see whether there’s a critical angle at which the structure becomes unstable and falls apart, thus causing the bust cycle in the stock markets.

  While this hypothesis can and should be challenged in terms of individual stocks (because there is competition and, as such, capital can move from one company to another as a winning bid) it should stand for the overall stock market. This situation is referred to as a “systematic risk” of the stock market, but to me it sounds more logical to call it “liquidity risk” due to the mechanism of purchasing stocks, as described above. This hypothesis is validated by the events in the stock market after Quantitative Easing II was discontinued on June 30, 2011, when global stock indexes plummeted over the remaining third and fourth quarters of 2011.

  Unfortunately, financial reporting requirements by FASB and U.S. Securities and Exchange Commission rules do not require a transparent view of how much market capitalization is achieved and what component of it is based on speculation, leverage, number of shares traded, etc. In order to partially solve this problem, I suggest conducting a comparison between M0, M1 and M2[11], on the one hand, and U.S. equities market capitalization and in dynamics over time, on another. A simple fact that difference between M1 and M2 is at least four-fold[12] tells me that money market funds are heading towards a pyramid structure. Market capitalization of U.S. equities only for 2011 was $15.6 trillion[13] versus M2 of $9.6 trillion[14], adding more questions regarding real value behind market capitalization and whether much of it will be left if converted back into cash.

  Debt and Economic Growth

  Global debt shows horrific statistics over the past two decades. United States’ government net debt percent of GDP increased from 46% in 1990 to 84% in 2012 and is projected to reach 89% by 2017[15]. Many advanced economies show similar trends in terms of debt / GDP relationship due to the same fractal pattern taken by other governments to stimulate their own economies. Going back to the Fractals In Economics chapter in Part II, these patterns do not seem to change.

  U.S. Corporate annual bond Issuance shows an increase from $344 billion in 1996 to $1,360 billion in 2012[16], adding to $6,463 billion[17] of total issues traded only, without taking into account the private bonds market.

  At the same time, United States’ GDP percent change was 1.9% in 1990 and, while 4–5% growth was achieved in the mid-1990s, on average there was only 2% growth in the 2000s with 2.17% in 2012[18].

  If debt money is spent on equipment, inventory, construction contracts and salaries, and ultimately all of these items contribute to GDP, does the U.S. have real GDP growth as the statistics show above, or is it only debt money we spend to keep the economy going? Unfortunately it appears to be the latter, because GDP is a measure of economic activity, rather than wealth.

  If we were to build a geometric figure of U.S. debt vs. GDP, we would get inverted triangles, similar to the ones in the previous example, where debt overhang (upper triangle) over GDP (lower triangle) shows that it takes more debt to generate more GDP, but at increasingly disproportionate levels:

  While this is only a diagram and doesn’t reflect the actual proportions, it is clear from this image that such a “business model” cannot be sustained for long and when asymmetry becomes greater (more data is needed to calculate the slopes when a critical moment occurs) the debt could be defaulted due to an inability to honor the obligations. Such scenario occurred in some European countries in 2011–2012 and continued in 2013 in Cyprus, resulting in external financial aid and restructuring of the local banks.

  No debt means that an economy and GDP would most likely grow in ellipse or circular shape, when GDP is increasing gradually and in consistent proportion of contribution and demand growth, thus expanding in volume around the long axis. Such growth is organic and it doesn’t depend on debt in any form, adding equivalent value based on contribution. Debt is the primary cause of an overheated economy and has a disruptive, rather than organic, pattern for economic growth:

  Wealth Distribution and Number of People

  Take the distribution of wealth model, which was initially presented in Part II. The bottom triangle shows number of people based on the amount of wealth they possess, while the top triangle shows respective wealth distribution. This representation makes a lot more sense than showing a graph skewed towards the right on just 2 axes:

  The slope of the line adjacent to the base will get a steeper angle as wealth distribution gets more uneven and, on the contrary, as the distribution evens out, it will disappear into an ellipse form, as show below.

  An ellipse distribution is natural for space and time, but not for the wealth distribution of human society (unfortunately). Ellipse distribution is centered on the long axis, making growth or decline more or less evenly distributed. Nevertheless I could make a hypothesis that a society, where the middle class possesses the majority of wealth (e.g. U.S. in 1960s), would show an ellipse type wealth distribution, making such a society stable and generally happy with the state of its economics.

  Geometric presentation of data distribution is in line with Economical Equilibrium theory regardless of the ultimate shape, because economics change due to a cause and effect relationship. What shape will it take is a different question.

  Let me step back and take a philosophical view of the business type environments. Had we lived in a different world, without leaders, managers, CEOs, etc. who we wouldn’t have to remunerate in accordance with a pyramid or “food chain” type of approach, we would see more circle-type shapes in economics, where everything would be distributed based on contribution and demand equality (take the village example from Part I where only $100 was in the system – such economics and respective distribution of wealth would be recorded with a circular shape). The fact of the matter is that in our world there are those who lead and those who follow, where the majority of people are the followers, and, for some reason, agree to work for less money than their superiors, thus leaving the majority of profits to the few at the top.

  An economy can take one shape or another, as Economical Equilibrium theory shows, but its balance and thus sustainability can become unstable, as could be visualized with geometric figures. A balanced economy would exist only if there was an equal contribution by all participants involved in the economic process – someone creates something and gets something else in exchange within a reasonably short period of time. In that case, circular-type symmetry would be maintained. Should there be shortage or excess of either contribution or demand, including artificially induced with debt, Economical Equilibrium will immediately reflect the distortion, which we will be able to see through respective change of geometric shapes.

  Ideally, economists, accounting and finance professionals should start working on a combined project to portray a full scale 4D Economical Equilibrium picture for both developed and developing countries, which would allow smoothing of sharp angles and disproportions presented by respective shapes. The following two chapters make a suggestion to use specific ratios that should help in this exercise.

  Cash Value Ratio

  Liquidity is an ability to convert an asset into cash quickly. Therefore, money is the most liquid asset and has a spot Cash Value Ratio (CVR) of 1:

  CVR = Spot Cash Value / Quoted Market Price

  CVR is a new ratio that I suggest the econo
mists, accountants and finance experts start using, in order to arrive at the cash value of items. The idea is not a novelty. Redemption/liquidity (how quickly an asset can be converted into cash) has recently become a widely used measure of portfolio managers’ performance evaluation – how quickly can a hedge fund convert its assets (stocks, bonds, etc.) into cash without losing any value. Stocks and debt can achieve lower than currently quoted prices if sold, so the question is how much cash value does an asset hold if sold immediately? For that reason CVR could be a universal measure to allow managers to evaluate their assets as a new liquidity benchmark.

  CVR statistics should also serve as an indicator of the current status of economics in order to see when things start getting “out of shape”. Most likely, in the growing economy, CVR will be close to 1 for the majority of financial instruments due to increased pressure on buying assets to increase wealth. In a neutral or declining economy it will be trending to less than 1 for any asset, other than cash, due to the fact that investors will try to receive profit upon acquisition of any asset and offer a discount to the quoted price.

  In addition, CVR is a good indicator of why fair value accounting does not hold true.

  Value Retention Ratio

  Value Retention Ratio (VRR) allows identification of a particular asset best fitted to preserve wealth at existing economic conditions. By asset I mean any asset, or a combination thereof, that would allow protection and accumulation of the principal balance:

  VRR = Spot Cash Value / Initial Cash Value

  In the growing economy, assets will have a higher VRR, than in the declining economy. While VRR has certain resemblance with CVR, its sole purpose is to identify the best value preservation assets that maintain the highest ratio both in growing and declining economic cycles.

  The only drawback in both CVR and VRR use is the fact that cash can be increased in volume through the printing mechanism of central banks worldwide and, as such, cannot be taken as an absolute measure. Such a drawback could be fixed through analysis of comparable world currencies with lowest volatility to their respective exchange rates.

  Based on my research, the same asset classes can show a wide range of CVR and VRR depending on timing of entry and exit points, as well as the state of economics. Nevertheless the following asset classes showed the best value over the entire analyzed period: gold, platinum, real estate, oil & gas versus others, showing lower ratios – stocks, bonds, derivatives (CMO, CDO, options, futures), silver, Indexed funds, ETFs, private equity and venture capital. I invite researchers and analysts to share their thoughts on this topic and identify the best value preservation assets of all time – this will be an interesting exercise[19].

  Balanced Growth Model

  After finishing this chapter I realized that it would be impossible to achieve balanced economic growth without some radical measures. This has nothing to do with economics as a science – we cannot blame the mirror. It has to do with corrupt human nature, laws of capitalism and accounting / finance misconceptions.

  Nevertheless, if a surgical procedure is required, at least we know what to remove before our “patient” could recover. The reason why this book came to mind in the first place was because I lived through three financial crises over the last fifteen years (including the one in Russia in 1998), and I wanted to understand the root causes of each one. More importantly, I wanted to contribute towards avoiding the next one, or at least make it less devastating for all parties involved.

  As was determined in Part I, U.S. Dollars are represented by paper or electronic form, but they still keep an implied value that one can buy goods and services with, thus keeping the exchange going. As an economic system grows, more money is introduced through P*Q = M*V formula (Price times Quantity of goods and services = Money times Velocity of circulation).

  Money is a valuable commodity, which derives its value from business activity of the economic system. Profit / Capital means Return On Capital (ROC), which implies that money, as a means of exchange, should also earn a profit. As was determined in Part I, an economic system can only receive profit through net growth or distribution of wealth between its participants. Therefore, if corporations are using profit as a key measurement of success in a closed-end economic system, they are either cannibalizing other participants by underpaying them, or cause monetary inflation (or both).

  If we want the Economical Equilibrium shape to be an ellipse, consumption of goods and services should be proportional to the contributed labor and/or technology. Additional value creation, which can be exchanged for cash without debt money, would allow a circular-type growth as long as its contribution is matched with demand, not fueled with debt. While this does sound idealistic to a certain extent (in this case, debt financing, interest rates, profits / value-add would not exist), this scenario would avoid the economic distortions we see repeating over and over again due to angularity caused by formation of the inverted pyramids.

  Economical Equilibrium theory suggests that balanced economic growth is possible only when more contribution and matching demand is created (horizontal growth of ellipse) by all of the participants. Given that key drivers of economics are natural resources and labor / technology, extensive growth is possible only when more natural resources are consumed through more labor / technology contribution and demand. As the technology advances it frees intensive labor, and technologically advanced economies tend to become more service-based and research and development focused, leaving developing countries in a position of natural resources and cheap labor suppliers.

  Another aspect I would like to bring up is that it makes sense that a single global currency should be prevailing in the global economy. I understand that human society is not ready to take this step yet, but otherwise distortions in economical equilibrium are inevitable. A temporary solution to this problem could be the one that the central bank of Switzerland implemented by pegging its currency to the Euro in 2011 in order to allow local products to stay competitively priced in other countries, but such activity puts a lot of pressure on local central banks that should protect a given country’s economy from unjustified buys and sells of their local currency.

  In addition, money should be independent from a given country and be in sync with production and consumption thereof. Instead of Dollars, Euros and Rubles there could be just Money – a convenient way to equally measure commodities, labor, goods and services all over the world. When everything is measured with Money and Money issuance or withdrawals are based on Economical Equilibrium, the global economy will become unified and will not suffer crises due to currency interventions, debt circulation, etc.

  Europe learned a good lesson over the last decade: while the Euro is a great new currency, it is only great if it is backed by valuable goods and services, both for internal and external markets.

  Going back to the Time Bomb chapter in Part II, it is vitally important to perform an analysis to identify economic distortions early using Economical Equilibrium theory methods, in order to calculate how much growth is still sustainable with the existing models and technology, and what steps should be taken while the inertia lasts. Upon completion of such analysis, global society should consider steps towards reduction of angularity.

  For example, one country has natural resources and another one has technology to convert it into something useful. One cannot live without another – the technology depends on the natural resources. Therefore, an exchange between countries should take place to allow an equal amount of natural resources for the respective technology’s benefit. As technology advances, its price should come down in comparison with natural resources’ prices, because otherwise overconsumption of limited resources decreases its deposits to extinction unless new technology emerges to stop its exploitation entirely.

  Let’s assume such analysis is not performed and people don’t invent an alternative energy source before oil and gas reserves dry out. Upon occurrence of this otherwise inevitable event, many people will return
to medieval conditions without oil and gas and live off the land as they did over 200 years ago.

  Geometrically, such a dilemma looks exactly like the inverted triangles’ diagram:

  The bottom triangle represents decreasing deposits of non-renewable natural resources, while the top triangle shows the respective consumption increase using existing technology.

  It should be noted that price limitation of an in-demand natural resource rarely helps if such a resource is required to sustain the needs of the human population. Therefore, the use of older technology to satisfy demand, which has grown in geometric progression over the last 20 years, should be evaluated with the Economical Equilibrium geometry in terms of when a given natural resource will become extinct.

  In conclusion, the Economical Equilibrium balanced growth model is possible if two things happen. First, we should use products and services which in turn use only renewable natural resources (i.e. solar energy, organic food, etc.) and don’t contaminate our planet, because FASB doesn’t know how to account for externalities. Second, we space out use of products that we absolutely must have, but which use non-renewable natural resources and/or contaminate our planet, in accordance with strict and smart regulations.

  Is a Country In Good “Shape”?

  By country I mean its economy. Use of geometry helps immensely in identification of the best shape a given economy should take in order to maintain a quality lifestyle for its citizens. It would be nice to have a study on hand that portrays the shape of every single country’s economy, using market capitalization distribution, debt and economic growth distribution, and wealth distribution examples presented earlier in Part III. For example, the geometrical “shape” of a country would be an ellipse if its wealth distribution is centered on horizontal mean – there is a strong middle class exchanging goods and services with matching contribution and demand.