Accounting For Time And Risk
Part VI of the Bitgenstein Serialization
In pondering the flow of money around the creation of capital, I think it is helpful to be rigorous in keeping track of accounting identities and thinking about how they evolve across time. Trading certainty for uncertainty in the form of experiments in capital creation results in a very particular accounting transformation. It pulls forward potential value from the future and crystallizes it as value in the present, while we create a separate financial asset to reflect the future value we hope will one day be realized. We might call this financialization. We pay for production capital with financial capital.
For example, say we take $100 of savings and make an entrepreneurial investment. That is to say, we buy some capital goods, some raw materials, and hire some workers, and put them all to work over time to try to churn out a product we will attempt to sell for a profit. This $100 which was originally intended for future consumption will now very likely lead to present consumption, as our workers and suppliers will be $100 better off and may very well decide to consume. This will happen first. It will take time for us to make a profit, but we will have to make our payments upfront as we are the ones willing to bear these risks, not our employees and not our suppliers.
This $100 has become a $100 liability of equity finance and probably less than $100 of assets with the remainder as an expense. If we succeed in making a profit above these expenses, we will earn cash as an asset, which we balance with retained earnings as a liability. But we can’t know that until it happens. At the very start, we have simply spent $100 in exchange for a collection of assets and promises. We have swapped certainty for uncertainty. Our workers and suppliers have crystallized $100 in present value in exchange for future value, the risk of which we have decided to bear over the period of its attempted realization.
This could all be more complicated still. Rather than owning a stake in the uncertain output of an entrepreneurial venture, a provider of capital may prefer to be entitled to an agreed upon return, provided it is received first amongst the venture’s profits. This may be efficient all-round as such a provider of capital may willing to embrace some uncertainty, but not quite the level she thinks this entrepreneurial venture entails in its entirety, and would prefer to trade potential upside for surety and priority of repayment. The entrepreneur may agree to this as she may be unable to reach the required $100 of financing otherwise, or may be confident enough of the relative certainty of the return on the project that accepting the need to divert the first profits is worth it to boost her own returns on equity.
Of course, I have just described debt — hardy a revelation. But once again, let us track the accounting identities: the debt provider started with $50 of savings and gave it all to the entrepreneur. Now the debt provider has a liability of $50 equity finance and $50 of credit assets. There is some uncertainty surrounding the true value of this credit, but it will only become clear as the venture is carried out. Hopefully, it will lead to a profit such that retained earnings top up assets as cash. Possibly, the venture will fail so badly that even the $50 provided cannot be recovered from the remaining assets. The debtor and creditor weighing up these possibilities in their own minds, and comparing them to their respective other opportunities, will determine the level of interest — the cost of this capital.
The entrepreneur is in a similar accounting position to previously: $100 of assets of entirely uncertain value, but now $50 of equity liability and $50 of debt, with an additional cost going forward of interest on this debt. Once again, this total of $100 of savings has been crystalized as present value, transferred, and very possibly spent currently, while the future value for which it was traded remains as-yet-unrealized and uncertain.
The final complexification possible is that financial capital and production capital are sufficiently decoupled such that it is possible to purely intermediate financial capital without ever directly investing. That is to say, to take savings from those seeking a debt-like return and to make credit investments — i.e., a bank. Once more, the accounting identities: that of the business will be the same, but now we introduce an intermediary with, let’s say $40 of debt financing, $10 of its own equity, and the $50 credit to the business, but now underlying savers who have $40 of equity and a $40 credit to the intermediary.
Again, this will hardly be a revelation. I run through these possibilities in such granular detail so as to make three points as clearly as possible. The first is to make plain the accounting balance: no matter how complex this gets, the same underlying uncertainty is still there. It cannot be escaped. It cannot be financialized away. We cannot use accounting to conjure up more time or energy. The capital structure financing the endeavor may be unboundedly complex, but there will always be $100 of expenditure of subsequently uncertain value that traces back to $100 of equity, somewhere.
The second is to make clear that while this underlying uncertainty cannot be removed by different financializations, the parceling up of risk can affect the experiment. This can be made clear in two ways: first of all, from the entrepreneur’s point of view, the more debt is used as finance, the more her potential equity returns are boosted, but the less room she allows for variability in the success of the venture. There are lower and closer bounds of the level of profitability that will be acceptable for the experiment to continue before her equity value is wiped out and the experiment ends with asset write-downs. Equivalently, at the macro level, we can see the proliferation of assets as we introduce more and more debt to the system. More and more (perceived) value is tied to the same underlying experiment. Debt gives greater perceived safety to the provider of financial capital by sucking safety from the rest of the system and making the real experiment more fragile. It is useful — but only to the extent this transfer of risk is what everybody really wants.
Financialization and Prices
The third, and most important, is what will happen to prices. Note that I am very deliberately not saying, what will happen to “inflation”, as this word has two distinct meanings that may be related to one another, but may not. We will shortly consider what happens if “the money supply” changes — call this “monetary inflation” — but in what follows, we assume it does not, and we face only “price inflation”.
It is instructive to think about why prices might increase as a result of decisions made by real people, rather than assuming this is a fact of life or some metaphysical constant (it is neither). Prices are set by sellers at the level they best judge will not be so high as to lead to customers going to competitors and leaving their own inventory unsold, but not so low that they can’t still make a desired profit and return. These decisions depend crucially on uncertainty and time. Profits, returns, and depletion of inventory cannot be known in advance and can only be judged and reacted to with respect to how they unfold over time.
Sellers will therefore decide to increase their prices for one of two reasons: i) their own costs have increased and they can no longer make the desired profit or return otherwise, or, ii) customers start to buy faster, such that inventory is depleted before it can be replaced, suggesting that more potential customers exist than can be serviced and unit profits can be risklessly increased. Likewise, sellers will decide to decrease prices if, i) costs have decreased and the increase in customers gained by lowering prices will more than offset the fall in unit profit, leading to an increase in aggregate profit and returns or, ii) customers start to buy slower, such that inventory is not being shipped as fast as it is being bought in.
The speed with which inventory can be moved is really a function of how much capital has been devoted to its production in the first place. Increasing or decreasing prices is the appropriate short-term response to positive or negative strains on inventory. But the appropriate long-term response may be more or less capital investment, such that real supply can be increased or decreased. The wisdom of such a decision will depend on whether the source of the faster or slower purchasing is fundamentally sustainable. Capital investment is essentially an experiment that must be financed and will take time, whereas prices can be changed on the spot.
This all raises a fascinating and more complex question: what will be the effect on prices of financialization to create capital? If we pull forward value from the future and crystallize it in the present, what will happen to prices? On the face of it, this turns savings that would not have been used to consume into income, some portion of which probably will. Therefore, goods will start to be bought faster.
But we must remember this $100 of present value only exists because it has been traded for an experiment of entirely uncertain value. What happens with this experiment is key. If the experiment fails: those who financed it will have $100 less than they had accounted for at the time of failure and therefore will be forced to consume less, meaning customers will buy slower. Recall, however, that capital naturally depletes, and so if it is not replaced, its ability to turn time and energy into a relatively increased output will diminish, meaning costs will steadily increase.
If the experiment succeeds: there will be no asset write-offs that destroy the ability to consume and so the $100 brought forward will not be perfectly balanced out. However, the financialization will have to be unwound, which will turn newly created income back into savings. Over the period this happens, consumption will once again be slower. But more importantly, the capital created by the experiment will then allow time and energy to produce more of some or other output, meaning goods and services can be created at relatively lower cost.
Of course, we must aggregate all such behavior as no single experiment will impact all prices (or probably even any prices), hence in the above three paragraphs I referred only to costs of production and speed of purchasing, not to prices. But it is straightforward enough to realize that the timing of all experiments is all that really matters in determining to what extent the impact of a single experiment can be generalized. Let us look in turn at the immediate effect of crystallizing future value, then the delayed effect of changing the capital stock.
Financialization will always lead to immediate faster consumption, but later slower consumption as the financialization is unwound. If the unwinding follows from a successful experiment, the slower later consumption will be somewhat transient as the capital will likely be recycled; if a failed experiment, the slower later consumption will be permanent as the capital allowing for this consumption has been destroyed. But there will be slower later consumption of some variety due to this financialization alone in either case.
We must then look across all financializations: if the experiments are conducted in perfect synchrony, we can be fairly certain prices will rise dramatically in the short term. If they are perfectly desynchronized, then the unwinding of completed financializations will tend to cancel out the setting up of new financializations. Hence it is fair to say that that the effect of financialization alone on price will reflect the rate at which aggregate financialization is increasing or decreasing.
Changing the capital stock will have a simpler and more fundamental effect: the capital stock naturally depletes, causing costs to rise and hence prices to rise. Hence the successful creation of new capital will cause costs to fall and prices to fall. We might summarise by observing that, in the short run, prices will respond to accelerating or decelerating financialization, but in the long run will respond to the inverse of the change in productive capital. In the medium run, it seems unlikely these processes will be perfectly synchronized or perfectly desynchronized, and hence prices may well be volatile as per accelerating and decelerating financialization, but following a trend as per net capital accumulation.
The desire to create capital at the level of individual such experiments will probably always follow, in one way or another, from the entrepreneur’s assessment of the sustainability of the movements in price she is seeing. There will never be a right answer — it will depend on knowledge, judgment, and appetite for risk. We must recognize that these decisions to create capital will affect prices in turn. If financial capital and production capital are adequately decoupled, the relationship in aggregate can quickly become complex and the feedback profound. A farmer may well be able to fashion a plow with time he consciously decides not to devote to tilling. But pledging some portion of a hoped-to-be-more-plentiful harvest against the tractor that will provide it — and which in no amount of time could he have possibly built himself — is another matter altogether. As is the possibility this pledge could then be traded on. Judgment pertaining to prices will affect decisions to experimentally create capital, but so too will decisions to experimentally create capital affect prices. We must bear all this in mind in charting the health of the capital stock.
The more we financialize, the more experiments we are able to run. The incremental experiment will probably be the next riskiest, and the more its financialization is steered towards debt, the greater the risk becomes still. As we need some level of experimentation to avoid the entropic decay of the capital stock and the collapse of civilization, there emerges an ever-important question of, how much risk do we want to take? and, derivatively, who is deciding to take these risks, and who is bearing them?
So far, the assumed answers to these questions have been something like, we take as many risks as individuals desire to and whoever decides to take the risks bears the risks. We haven’t assumed anybody is taking risks they don’t want to or that they aren’t bearing, and we certainly haven’t assumed that the aggregate magnitude of consumption features in anybody’s calculations. Unfortunately, to make the analysis more applicable to our sordid reality — to make clear why we might be incentivized not to create capital but to consume it; not to cultivate the land but to strip mine it — we will have to explore both.
continue to Part VII:
or go back to Part V:
n.b. This is a serialization of my previous trilogy on Bitcoin, economics, and capital markets: Wittgenstein’s Money, The Capital Strip Mine, and, Bitcoin is Venice.
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