Money Supply and Energy: Is The Economy Inherently Unstable? : 13.7: Cosmos And Culture Stuart Kauffman attempts to apply Newton's three laws of motion to monetary policy.

Money Supply and Energy: Is The Economy Inherently Unstable?

I begin with the caveat that I am not an economist and what I shall say may well be known and, if correct, can only be part of a vast picture.

Martin Shubik, a very well known game theorist, as a graduate student at Princeton, asked the great John von Neumann what money “was.”  Von Neumann thought and replied that it must have something to do with energy.
It seems this idea is not part of economics.  We have not known how to find an analogy between money and energy.

Maybe one exists:

Last summer, a group of us, Mike Brown, former CFO of Microsoft and Chairman of Nasdaq, ZoeVonna Palmerose, an SEC advising professor of accounting at USC, Jim Herriot, a computer scientist, Bruce Sawhill and I, gathered at Mike’s home on Double Island in the San Juans to “have an economic think about it.” Could money somehow be energy, we wondered?

Let’s go back to Newton’s three laws of motion: 1) a body continues in straight line motion unless disturbed by an outside force. This is due to “inertia” 2) F = MA, i.e. acceleration, plus or minus, in a body’s motion, requires force, F, and is inversely proportional to mass, M. 3) Every action has an equal and opposite reaction.

We will focus on the first two laws.  Without the first law, the second law makes no sense. F = MA requires that without F, it be true that rectilinear motion would continue “on its own” due to inertia.

But the second law gives us the notion of force, F.  Now work is force acting through a distance, e.g. accelerating a hocky puck with a hocky stick.  But work is a form of energy along with heat.

Then without a first law, we cannot get to a second law, its derivative, positive or negative, and thence to work.

But, we wondered at Mike’s house, what is the analogue of economic inertia?
A surprising tentative answer lay to hand. The group had invented an economic model with inertia.  If 50,000 years ago during clan life, you come up the trail with a rabbit and I come up with medicinal herbs, we have advantages of trade. So we trade. Why, because none of us alone can do all the activities and make all produces we jointly need to survive. So: Trade Or Die.  That became our inertia.  In the absence of other processes, we will just continue to trade due advantages of trade that arise because none of us is self sufficient.

In our agent based model, agents must trade within a time window or perish. The model gives rise, in neat ways to money, diverse currencies whose ratios match the ratios of currency usage in the real world and other interesting things.

But it is all based on what I will now call the economic first, law, Trade or Die, so in the absence of other forces, steady trading will continue.

Somewhat hopefully, we wondered what a second law analogue of F = MA might be.

We realized that probably an increase in the money supply, with a lag in price increases, was a “force.”  Watch: If money supply goes up faster than prices go up, then during that increase, we all have more money, the prices of goods and services are lower than our money supply per person, so aggregate demand goes up; we trade more so the velocity of trade goes up; we are trading more. Further the velocity of money, flowing in the opposite direction also goes up. Then a growing money supply with a lag in prices is like a force acting on a mass, the increased wealth per person per good is a force acting on the inertial rate of constant trading to increase the rate of trading, in a crude analogy to the second law F = MA.  In this set of ideas, the “inertia” are our human habits of buying or not, given our budget and prices, which resist changing.

But then the integral of this increased trade over an increase in trade, driven by the “force” of our increased wealth per good, is the analogue of physical force acting through a distance to accelerate motion, hence the analogue of work or ENERGY.

If so, growing the money supply while prices lag is adding economic “energy” to the economic system.

What happens?  Economic growth of GDP.

Now try the reverse, let the money supply fall, but price fall lags. Then we all have less money compared to the still high prices, so we consume less. Trading rate falls. So the velocity of money falls. The integral yields the analogue of pulling economic energy out of the economic system.

If this is on the right track, as long as price changes lag money supply changes, the economic analogue of energy is being poured into the economic system driving growth, or being removed from the system driving deflation of economic activity and GDP shows negative growth.

The idea is very simple and the real world is more complex of course.
But what has happened in the past 40 years?  We have driven up the money supply not by simple fractional reserve banking, but by going out on debt at the level of individuals with credit card debt, states in the United States borrowing with municipal bonds, and governments with increasing deficits financed by bonds and debt.  So we have increased M3, the most general measure of money supply strongly for 40 years, driving growth based on debt growth.

It seems we are now more or less at the point where the first world has stretched this debt burden to the point where investors incrreasingly doubt the credit-worthiness of the bonds and other credit floated. Witness the Eurozone, Greek debt crisis, the Japanese Prime Minister saying publically that Japan could be the next Greece, the financial woes of many states in the United States where the insurance rates on municiple bonds are rising presumably to cover credit risk.

We may have expanded the M3 money supply about as far as it can expand before credit is no longer available at supportable interest rates, driving a 40 year bubble of growth based on debt.

Then what? If the Eurozone will try austerity, the M3 money supply will contract, presumably faster than prices drop, sucking economic energy out of the Eurozone.  Here is the scary part: Like the bubble going up, there could be the opposite, a bubble going down.  The system seems inherently unstable.

Europe, like much of the world now in debt coupled with IMF austerity programs that also must have sucked economic energy out of those economies, could fall not to “neutral” pre debt driven bubble levels, but much further in a downward spiral driven by the price drop lag instability and the human emotion of fear, a self fulfilling fear as F.D.R famously said, “The only thing we have to fear is fear itself.”

How much this fear contributes to such a downward bubble is totally unclear at this point in the absence of clear mathematical models of the above ideas, if they are relevant.

The US may try to print money.  If it prints money about as fast as M3 collapses, the total money supply might stay roughly constant and the downward spiral be averted. Overshoot and we get inflation.

I’m not an economist, the world is  more complex than this, but it seems these ideas may be worth factoring in as we attempt to negotiate our way through this large crisis.