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Conservation Law of Money

December 12, 2011

Being a mathematician, I’ve always been on the lookout for quantitative statements about the financial system as a whole that explain large economic phenomena. Just for the satisfaction of it all.

For example, I think it’s possible that many bubbles (dot com, Japanese stocks) can be explained simply by saying that, when normal people, rather than professional investors, are putting their money in the market, then the market is gonna go up. And moreover, when that happens, we can throw away any silly ideas we may have been harboring about price as indicator of true value; the prices are going up because the public is inflating the market with more cash money.

In other words, the opportunities for good investing doesn’t keep up with the cash flow in those moments. We could go further and say that there’s a kind of seasonality of money flow, which is dominating the market signal at times like these, just like you see in housing markets (when the housing market is functional) in the springtime when humans come out of their hibernation and feel like nesting and mating.

There are other ways for seasonality of money flow to affect the market without introducing newcomers to the market, such as inflation or deflation, where the value of the existing money itself changes. or when there’s an outside force either extracting or adding to the money supply, like the Saudi Arabia or China, although that’s more of a continual drag than a sudden jolt.

I think we may be encountering a very real “Conservation Law of Money” situation with the European debt crisis. Namely, there are all these banks that are on the prowl for cash, since they’re worried about being undercapitalized, with good reason: they are still hanging on to many toxic assets from the credit crisis, and in the meantime their enormous government bond holdings are going to pot. In the meantime Basel III, a new regulatory regime, will be in effect in 2015 and requires much more liquid, high quality assets than they currently own.

But here’s the thing, and it’s not a new observation but it’s an important one: not all of those banks can recover, unless something dramatic happens. From BusinessWeek:

“There aren’t enough assets in the world that are genuinely liquid and of high enough quality to allow all the banks to meet this ratio,” said Barbara Ridpath, chief executive officer of the International Centre for Financial Regulation, a London research group funded by banks and the U.K. government. “And that’s only likely to get worse because of the changing credit quality of some of the sovereigns.”

Mathematically speaking we have an impossibility: way more required stuff than existing stuff inside the current European system. What’s gonna give? Here’s a list of the things I can think of:

  1. Basel III will be scrapped and Europe will live with an enormous zombie system,
  2. the ECB will start printing money and eventually inflate the system out of insolvency,
  3. the banking system will fight to the death over the scarce resources and thereby be massively shrinked (but probably the few surviving banks will be politically well-places too-big-to-fail behemoths),
  4. European citizens will foot the bill through bailouts and then taxes, possibly leading to widespread civil unrest or even war, or
  5. outsiders will step in when the price is right (China and/or the Middle East) and end up owning the European banks.

There may be others options as well (please tell me). Of the above though I guess I prefer 3, where Europe ends up with a few huge banks that are highly regulated and well-capitalized. This is the Australian model and I posted about it here. Maybe then the financial system can be allowed to be utility-bank oriented and boring and smart young people will apply their energy outside of financial engineering.

Categories: finance
  1. Evan
    December 12, 2011 at 3:48 pm

    Aside from the problem of getting the ECB to actually do this, what is the problem with #2?


  2. December 13, 2011 at 11:41 am


    You said “…when normal people, rather than professional investors, are putting their money in the market, then the market is gonna go up.” But can the measly sums such normal people invest really overwhelm the vast quantities the MOTU-bots shift around?


  1. December 21, 2011 at 4:59 pm
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