Induced Economic Effects Part 2 - Template Entities and "Buck Rot"

So last week we introduced the concept of money flowing into, through, and out of an economy based on an initial investment and subsequent transactions.

We also promised to update, and failed to deliver.

Of course I'm using the royal "we", in both senses, but that's neither here nor there.

Today, I want to introduce the concept of iterated transactions, because when we talk about how much money remains in an economy after a given period of time based off of an initial investment, what we're really trying to capture is a sequence of iterated transactions.

One of the fundamental truths of economics is that money itself has no value, and only its use gives it utility in the traditional economic/utilitarian sense. This is true whether we're talking about USD, BTC, or CNY. It's the ability to spend money that gives it its value, and consequently, the velocity of money is a core concept in economic analysis.

What is "the velocity of money"? It's very similar to the physical concept of velocity, in that it is the number of hands a unit of currency moves through in a given period of time. So in the case of economics, it is helpful to think of money (or value) as "mass", people (or entities) as "distance", and time as ... well time.

One of the derivations of this, and I won't go into too much detail in this post on it is the "stickiness" of prices in the New Neoclassical Synthesis, which is that prices are not perfectly fluid, because it takes a shock of sufficient "force" (similar to Newtonian F=ma) to move prices, and that they have a proportional rate of change equal to their momentum (big transactions that have been happening frequently for a long time change more slowly than little transactions that have been happening infrequently for a relatively short period of time).

When we talk about induced economic effects, and attempt to quantify the size of the residual impact after a given time, we need to talk about how much of each dollar stays in the economy after each transaction. To do that its useful to discuss template entities. The reason we have template entities, is that in practical terms, it's very difficult to quantify each individual transaction, but in aggregate, we can take averages, and develop a theorem with strong statistical validity as long as there's a solid average.

Last week I used a 7-11 as our example entity, and discussed the purchase of a candy bar. If we assume that every entity has a similar structure in terms of money that stays in the economy vs money that leaves the defined region, we can come up with a formula.

So again, for simple discussion, let's assume in each transaction, roughly 50% stays in the geographic region. That number is of course a placeholder, and there's a substantial body of work to calculate the actual value, primarily by the US Bureau of Economic Analysis through their Regional Input/Output Multiplier System, known colloquially as RIMS II.

What our simplified assumption tells us, is that for every dollar spent in the region under analysis, fifty cents stays in the region. Combining that with a velocity of money, which we'll assume to be at 1.5 per quarter, or 6 per year (which is close enough to the actual value for this simplified analysis) we can see that within a year, each dollar is spent 6 times, each time, half of it leaves the economy, or that our residual is equal to:

or the initial investment times the one minus the amount left after each transaction raised to the number of transactions we expect to have occurred in the time period. In our simplified example, this is effectively a half-life.

Barring outside reinvestment, the money in an economy decays at a predictable rate, hence the term of art I like to use, "buck rot".

In this example world, every year ~98.5% of our initial investment decays out of the economy, which is why reinvestment and exports play a crucial economic role.

Which we'll talk about soon. Before that though, there's a few posts I've been meaning to publish on the emerging Bitcoin phenomenon. 

Induced Economic Effects

A lot of people ask me what I do for a living.

Well, mostly the people paying me, but they ask it a lot, so I figured I'd take a blog post to talk about something relevant to my interests.

These days I spend a lot of time studying and quantifying the economic impacts of investments in different communities based on a concept called "Induced Economic Effects".

What it boils down to, is that for every dollar invested into an economy, a certain number of cents can be expected to stay circulating in that economy.

So, for example, if you were to buy a candy bar from your local 7-11, and for some strange reason, it were to cost exactly $1.00, my job is to figure out where all one hundred pennies wind up, and how quickly they get there.

I didn't say it was a good job.

Econometric Analysis has not led to nearly the debauchery I was promised, as both the booze and the bitches have been mysteriously over-represented in the brochure.

That being said, tracking a dollar is hard work. Tracking millions of them is even harder, but because this is a blog, and you free-loading readers aren't actually paying for this, we'll stick to the example of the dollar at the 7-11.

So let's follow the money.

Assuming you live in a civilized state like New Jersey (and not some communist VAT utopia like the EU), your state has a sales tax. Sales tax can range anywhere from 0 to 25%, but in this example, we'll assume it's going to be 6% because you're not the kind of person to shop in one of those sketchy low sales tax HUD areas.

That means that six pennies have disappeared to the coffers of the state, so we need only follow ninety four more. (Actually, that's a bald faced lie that we'll return to in a bit, but for now pretend to believe it.)

Of our remaining ninety-four cents, let's assume that the retailer marked the product up 100%, as is their custom. This means that forty-seven pennies disappear out of our economy back to the manufacturer. If you're keeping track at home, we've now accounted for nearly half of the first generation of pennies in just two short hops.

And this is where things get hairy. Of the forty-seven remaining pennies, some percentage went to overhead. Traditionally in retail we anticipate approximately 30 percent of Net Revenue to be consumed by overhead. In this simplified example, we'll assume that ~30% of the net revenue from every sale covers the SG&A expenses of the store since 7-11 generally runs a pretty tight ship. that takes fourteen more pennies out of the equation to the bank, the power company, and whatever other expenses the shopkeep has. This leaves thirty-three pennies for labor.

Not bad.

Or, if you're one of my clients, "What the hell are we paying you for, any idiot could have told us that?!"

True, and the difference is, this is where an idiot leaves the discussion. Because in reality, this is where things are just starting to get interesting.

If we assume that the region or economy under analysis is the state, how much money is left in the economy?

The correct answer is: None.

"Wait... what? I know I'm bad at math, but if we start with a dollar, how'd you get to none?" I can hear you asking now, because I, like the FBI, can turn your computer microphone on at will in direct contravention of any perceived rights or liberties you may have.

It's a gift.

What's actually going on is that after the first generation of transactions, a portion of each of these expenses stays in the state. At this point, to make things easier we'll have to create a template entity and assume that all of the recipients of our pennies behave the same way. While we know this is not true, we can make the assumption that on average they'll all even out to something.

What is that? Well stayed tuned, as tomorrow's post will detail template entities and the time-decay of microeconomies, or as I like to call it, "buck rot".