Crazy Markets

In my post titled “Money Tree,” I explained in a general way how the addition of “non-market money[1]” distorts market prices, which in turn leads to a misallocation of resources.

In this post, I will build a hypothetical model to show how that process works in more specific conditions. I will follow two different market actors through two possible scenarios for that model. In the second of these scenarios, I will show how the addition of “non-market money” leads to several low-priced stocks’ market craziness, including Gamestop’s shares.

Ceterus Paribus

For the sake of this model, I have applied ceterus paribus limitations (to borrow a term from economists.) I have held constant several factors that might otherwise affect prices — the most notable I have held production, which plays a significant role in price determination, constant.

The Actors

This model will use two imaginary market actors (workers and buyers.)

We will call our first actor Marvin. He practices law and makes an above-average income. He spends his money on the same categories as Joe, but he can afford higher quality products, and his nights-out come far more frequently.

We call the second actor Joe. He works as an auto mechanic. Joe makes a good living under normal circumstances, but he usually cannot afford any extravagances. He mostly spends his money on food, clothing, and shelter. Occasionally he has enough to take the family out to dinner.

Scenario #1

In their infinite wisdom, government officials have placed restrictions on people’s activities; however, in this scenario, they have not succumbed to the pressure to distribute money to citizens (unlike our current reality). The market must operate on “market money” only. People must produce something to exchange for the money they have.

The coronavirus restrictions have had an adverse effect on Marvin’s income. He has not had to make significant sacrifices, but he has had to trim his spending around the edges.

The coronavirus panic has had a relatively similar effect on Joe’s income. People don’t have their cars repaired as much, and Joe now works fewer hours. He has eliminated the dinner outings, and he must skimp on the rest of his budget.

Prices- Scenario #1

Initially, the prices of the products that Joe and Marvin purchase did not change much. After the suppliers of these products saw their inventories start to grow, they lowered their offering prices to get products to move.

By offering products at lower prices, stores effectively increase the real wages of their customers — including Joe and Marvin.

Resource Allocations

Because the market continued to operate with only “market money,” both Joe and Marvin, although to differing degrees, adjusted their purchases to accommodate their reduced incomes. In response, sellers accepted lower prices, which benefited Marvin, Joe, and other shoppers. Even though production and consumption both declined, prices accurately reflected that new reality, leading to an effective allocation of resources.

By operating with only “market money,” market prices adjusted to reflect the real damage done by government intervention — closing businesses.

Scenario #2

In the second scenario, in addition to the restrictions placed on people’s activities, the government distributed “non-market money” to various people in the economy, including Joe and Marvin.

As with scenario #1, coronavirus restrictions have reduced Marvin’s income, but now he has an additional $1,000. Again Marvin has not had to reduce his spending. What should he do with the extra money?

Marvin decides to buy a pair of shoes he has eyed for some time. They cost him $100. Before he can decide what to do with the other $900, he gets a message from the Reddit investors. On their suggestion, he buys $900 worth of Gamestop stock.

I will discuss the result of the decision below.

In scenario #2, the restrictions have had the same adverse effect on Joe’s income. This time, however, Joe also gets the additional $1,000 (“non-market money”) from the government.

Joe continues to restrict his budget because he does not know how long his repair work will suffer. He feels that he can afford to spend some of the $1,000 he received from the government.

Joe spends $50 on a take out meal for the family and $150 for a new bike for his son. He plans to save the rest.

Then Joe hears about the success that the Reddit Investors have had with Gamestop, and he decides to buy $800 of stock.

Prices- Scenario #2

Although many people had lower incomes because of the COVID restrictions, many of them had the “stimulus” money, and they did not reduce their spending as much as they would have in scenario #1. Because demand seemed to remain strong, retailers did not reduce prices as much as in scenario #1. Thus, people did not get the same boost in real income.

But another phenomenon occurred.

Because Marvin and Joe and many like them spent part, or all, of their “stimulus” money on Gamestop, the stock price rose from about $10 a share to nearly $500 a share. Being able to buy low and sell high sounds like a good deal, but this price increase did not have a uniform impact.

As the price rose, not every investor made the same amount of money. Some got in early and held on to near the peak. Marvin bought at $50 and sold at $400 – he made $17,100. Others got in early and got out early, making a small profit. Still others got in late and got out only slightly later, also making a small profit. But, everyone did not make money due to this price rise. Hedge funds, because they had shorted the stock, lost billions during the price rise.

Then the price fell back to around $20 a share. As the price crashed, investors lost varying amounts of money. Joe bought at $100 and sold at $25. He lost $600, money he could not afford to lose.

Distortions in Resource Allocations

The extra “non-market money” really screwed things up. When “non-market money” enters the market, it turns the process into a zero-sum game — for every loser a winner, for every winner a loser.

Marvin managed to make a handsome profit, but that came at someone’s expense. Marvin could now buy things for which he would not sacrifice. Part of his gain could have come at Joe’s loss.

Joe, instead of spending money on his family, lost a bunch on a bet that he would not otherwise have made. Joe could not now buy things that he could have afforded, even with a reduced income. Did his loss finance the gains of others who invested money they really could afford to lose?

Hedge funds lost a lot of money. Don’t be too quick to judge. You don’t really know who had invested in these funds.

Conclusion

Because of the complexity of markets, financial and otherwise, no one has the capability to assess the impact of “non-market money” on the allocation of resources. We can say with certainty that the distribution of this money causes a misallocation of resources. People make market transactions with money for which they did not have to sacrifice and for which — in the case of “artificial money” — they did not exchange goods valued by anyone in the market.

I have used the trading of highly volatile stocks as an example because, although not typical, it shows an extreme example of the impact of the injection of “non-market money.”

Politicians have no clue of the damaging effects of their “generous” spending. The price will definitely come sometime in the future. When and how bad?

You guess.


  1. “Non-market money” & “market money” – I introduced these non-standard terms in a previous post. The terms refer to the sources of the money. “Non-market money” consists of money either taken by force (i.e. taxation) or created artificially (i.e. created out of nothing by the banking system)>

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