December 31, 2011

Hotel Proprietors, Prostitutes and Monetary Velocity

The following story is often told to explain monetary velocity and how government money printing helps us all:
In a small town in the United States, the place looks almost totally deserted. It is tough times, everybody is in debt, and everybody lives on credit.
Suddenly, a rich tourist comes to town.
He enters the towns only hotel, lays a 100 Dollar Bill on the reception counter as a deposit, and goes to inspect the rooms upstairs in order to pick one.
The hotel proprietor takes the 100 Dollar Bill and runs to pay his debt to the butcher.
The Butcher takes the 100 Dollar Bill, and runs to pay his debt to the pig farmer.
The pig farmer runs to pay his debt to the supplier of his feed and fuel.
The supplier of feed and fuel takes the 100 Dollar Bill and runs to pay his debt to the town's prostitute that in these hard times, gave her "services" on credit.
The hooker runs to the hotel, and pays off her debt with the 100 Dollar Bill to the hotel proprietor to pay for the rooms that she rented when she brought her clients there.
The hotel proprietor then lays the 100 Dollar Bill back on the counter so that the rich tourist will not suspect anything.
At that moment, the tourist comes down after inspecting the rooms, and takes back his 100 Dollar Bill, saying that he did not like any of the rooms, and leaves town.
No one earned anything ... However, the whole town is now without debt, and looks to the future with a lot of optimism.
Sounds like we have discovered a perpetual motion machine, right?  Let's deconstruct.

Nobody in the town is actually in debt.  Each party has a receivable account of $100 and a payable of $100.  These net out to zero.  That's the setup for the magic trick.  What the story describes is a process for settlement of mutual A/R and A/P, in which the "tourist" unwittingly plays the role of short-term credit provider.  This is one of the fundamental purposes of banks and financial institutions, but even they are not strictly necessary for settlement.  There are multiple ways this could happen without a "tourist" or government printer:

If the parties sold their A/R to each other or to a third party, the third party could net out the accounts with no money exchanged.  For example, if the chain went in the opposite direction you wouldn't need the tourist at all.  The prostitute could sell her A/R with the fuel supplier to the hotelier to settle her account, the fuel supplier could do the same with his A/R, and so on.  The hotelier would wind up settling his debt with the butcher by tearing up the butcher's A/P with the pig farmer that he now owns.  We didn't need the tourist, and yes this type of transaction goes on all the time in the real world.

If any party (e.g. the pig farmer) factors their invoice or otherwise gets a short-term line of credit, the entire chain can be settled in cash.  This type of trade credit is self-liquidating and is indeed the lifeblood of commerce.  The town didn't need the tourist.

It is important to note that no economic activity occurred--this is simply moving money around to settle accounts, with the tourist providing self-liquidating short-term credit (for free, bless his soul).

Therefore this story, which simply illustrates how offsetting A/R and A/P can be settled, cannot be expanded to a larger analogy with monetary velocity or government stimulus.  In the current environment, profitable businesses have no problem getting credit to pay A/P while floating A/R--i.e. managing cash flow.  We are awash in liquidity.  Government stimulus money is never used for such short-term problems.

The kind of monetary velocity increase that is beneficial is demand-driven: the hotelier buys more meat and prostitution services because he has more paying guests.  Faster settlement of A/R doesn't reflect increased economic activity.

The real problem is that the hotel proprietor, the butcher, the pig farmer, the fuel supplier, and the prostitute all owe the bank hundreds of thousands of dollars in debt they aren't servicing, funded by leveraged credit against their own pension funds, while government spends against their children's account.  You're going to need the tourist to actually stay in the hotel to solve that problem and hope he spends a lot of time in the restaurant.

Edit: Other writers have the same idea: View from the Wilds: How a Bailout DOESN"T work

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