## Thursday, November 27, 2008 ... //

### Dow Jones money: a stable future economy

I began to write this text in October when Ben Bernanke and his friends followed the laws of string theory (a Reuters blog) and cut the rates to fight against the self-feeding global panic. Note that to "push the strings" means to try to lower the rates in a situation where no one wants to lend or borrow, anyway. Economists agree with the physicists that such "pushing" is futile and unphysical due to the coordinate reparametrization invariance of the string.

To repay Bernanke's debt, I will look at the situation from an economist's viewpoint.

Unfortunately, I missed the 2008 Memorial Nobel Prize for Economics but this proposal should be early enough for the next one. :-) The goal of the text below is nothing less than to design a financial system for the future that will avoid the troubling cycles of bubbles and downturns and that will optimize the economies, leading the people to do things that are as useful as possible.

Useful and harmful degrees of freedom

If you quantize general relativity in the background of a Kaluza-Klein toroidal compactification, you will find out that different parameters describing the shape of the torus become scalar fields in four dimensions.

In every natural enough basis, virtually all of these scalars will have a normal kinetic term. But one scalar - the overall volume of the torus - will have a kinetic term with the opposite, ghostly sign.

I would like to present this simple physics exercise as an analogy to economics. It deals with a lot of time-dependent variables - various prices, interest rates, and indices. These degrees of freedom will be divided to two parts:

• useful degrees of freedom
• harmful degrees of freedom.
Most of the degrees of freedom are useful. This adjective means that the markets are naturally led to find the right equilibrium at which the creative power of the economy and the well-being of its participants is optimized. These degrees of freedom should be left to the invisible hand of the free markets who are most capable to find the right values.

This category includes the prices of various products etc. Investors need to understand the reality well in order to determine which of these prices are undervalued and which of them are overpriced. And the right price leads the producers to produce as much stuff of various types as they can sell, to the satisfaction of the consumers.

However, a small number of the degrees of freedom - especially one overall volume-like variable - are harmful. They are analogous to the conformal factor in the case of gravity. What do I mean? Well, these degrees of freedom tend to be repelled from any equilibrium value: they generate unstable directions in the moduli space. People often behave irrationally and think that these price ratios should go to zero or infinity. Expertise is not needed to determine the "right" sign of the trend. Moreover, the governments and central banks tend to play with these degrees of freedom, too. These game increase the unpredictability and usually end as in the overshot territory.

When the unstable, harmful degrees of freedom start to behave badly, many market participants start to buy something or sell something which leads to more buying or selling. Instead of oscillating around the equilibrium value, prices start to expand or drop exponentially; our present epoch (and hopefully, especially a few most recent months) is unfortunately described by the second description. The mood was (or is) getting bad which is why people sell which is why the mood gets even worse, and so on, until we approach a sufficiently strong cutoff effect that will stop the exponentially dropping insanity.

See also Dow Jones 1900-2003. Most of the wild wiggles in the graph are psychologically induced, objectively unjustified mood swings. Nevertheless, these oscillations have negatively influenced actual economies and real people.

In the periods of bubbles, everything works in the opposite way. The mood is getting good which is why people buy which is why their mood is getting even better, and so on, until the bubble bursts i.e. a stronger effect terminates the instability. These degrees of freedom harm the economy. It is clear that they're bad. They bring the depressions; unjustified profits to some people; undeserved losses for others; a degree of inevitable lottery to the system. They're based on emotions, herd mentality, and the work of speculators who focus on them brings nothing good to the mankind. Nations couldn't thrive if everyone were gambling in Las Vegas all the time.

When I am talking about useful and harmful degrees of freedom, it is obviously a matter of conventions which combinations of the degrees of freedom we pick. So what is the mathematical framework behind the choice of the "combinations" here? We take prices of all possible things and choose the symbol "p_i" for the (natural, by convention) logarithms of these prices in certain units: I chose the symbol to agree with our paper with Tom and Willy, Dualities vs Singularities, that discusses the same questions in the general relativistic context. ;-)

Now, the space of "p_i", the logarithms, is a linear vector space. The economy is described by a trajectory in this space. In the tangential space of this space, which is pretty similar to the original space spanned by "p_i", you may finely choose very specific directions that are considered "most harmful" and that tend to create instabilities. Because I am free market champion, I won't defend regulation of these harmful, "ghost" directions. I will advocate the opinion that these directions should be completely absent in the fully physical, functioning theory.

You might think that I am going to defend the gold standard or something of this sort. Well, you are not infinitely far from the truth. But gold is obsolete, arbitrary, and dangerous. Someone can find a lot of gold in the future and we don't want the world's economy die at that moment. Gold doesn't represent the overall economy - what people actually want to pay for - well. And if you think that all the commodities have fixed price ratios and only the "money" is fluctuating, note that the gold/silver price ratio has been oscillating frantically, by orders of magnitude in both directions. Pretty much everything can oscillate and does oscillate.

The gold standard brings some advantages but now we have a more comprehensive framework to adjust the advantages: we want to suppress the most unstable and harmful degrees of freedom by redefining the money. There is one more general advantage of the gold: you know what you own. With money, you own pieces of paper whose value can be manipulated by arbitrary decisions of the government. And an uncertainty about the value of things - their ill-definedness - is creating havoc. The only reason why prices expressed in the fiat money don't fluctuate wildly is that the other sellers don't know any definition of the money, either. ;-) So we want to peg the money to something more well-defined: to redefine them. What is it? It's the stocks.

Defining money: a fixed Dow Jones index

Fine. So what is the most harmful direction of the vector space? The prices of milk and millions of other things behave rationally, according to the rules of supply and demand. People have to buy and sell milk quickly which is why they know what the price should be: the buyers won't be able to get the milk for too cheap a price and sellers won't be able to sell it for too high a price. Consequently, the average inflation behaves in a predictable fashion. Because of the qualitatively stable milk production and milk consumption, the price never tends to go to zero or infinity.

However, more complex things to buy or sell, such as stocks or even derivatives, don't have such a well-defined price. No one really needs to drink them today. When people decide about the right price, they speculate about a distant future. Because such speculations are more or less physically unjustifiable, these speculations often switch to the mode of pure emotions and extrapolations of trends. That's a typical source of an unstable behavior.

While the average price of milk and similar products changes by a number close to 0.2% a month - which is moreover pretty constant - the price of the (weighted) average stock - such as the Dow Jones Industrial Index - easily changes by 7% a day, for reasons that are arguably irrational (fear and panic). Such irrational changes support themselves and negatively influence all sectors of the economy.

Everyone is inevitably a player in a gigantic lottery where he loses or profits, depending on his exposure to stocks and related objects - exposure that is largely a matter of coincidences. These random losses and profits cripple the otherwise tight and pretty accurate relationship between wealth and useful work which is why they reduce the efficiency of the whole economy. And the depressions can lead to even worse outcomes.

Moreover, the investors' bets on the "stocks" in general or "cash" in general are not opinions about the objective conditions in the markets: they are rather bets on the future government policies. For example, if the Fed prefer to fight inflation (and raise the interest rates whenever it will be remotely needed), it is better to hold cash. If the Fed prefers to fight any future slowdown (and to reduce the interest rates to stimulate growth), it is better to own stocks. It means that it is largely up to the government to decide which of these two main groups of investors will profit more than the other. The winning group should be grateful to the authorities while the losing group may blame them for the losses. This is not a part of an authentic free market. It is a so far inevitable lottery created by the government that the government forces everyone to play.

Fine. So what can be done about that? The rough answer is clear. Something should be done so that the price of the average stocks - let's say, the Dow Jones Industrial Index - becomes essentially constant in time. The harmful degree of freedom would be eliminated. Now, the identity of the index is not too important here and is open to a more detailed analysis. Maybe, another index - S&P 500 or one that also includes some commodities - would be better. Instead, the goal is to eliminate some of the wildest fluctuations in "all" equity/commodity prices.

Today, wealthy people - even those in the U.S. - tend to hold (at least) two types of local "currency": the dollars and the U.S. stocks. And they're massively migrating from one to the other depending on the overall mood. This degree of freedom is only backed by mass hysteria and is harmful. The average price of stocks in the U.S. dollar is pretty much close to the most harmful directions in the logarithmic price space and the "double currency" should be eliminated.

How the stock prices are kept to have the right average

Now you hopefully agree that it looks like an excellent idea. Dow Jones Industrial Index could be 10,000 forever - which would be, by the way, an improvement from the current state. Dow returned to levels seen as early as in 1998 which is very painful.

It is also very obvious that you must essentially peg the currency to the Dow. Your currency will be the Dow. In the case of the U.S. that I chose to be my experimental country ;-), the U.S. dollar (USD) has to be replaced by the U.S. Dow Jones currency (USJ). All your payments and savings will be expressed as a multiple of the (weighted) average Dow Jones company.

What does it change about the system? It should be clear that if USJ banknotes are printed and coins are minted, nothing changes about the way you buy the Big Mac. USJ are money, after all. However, what must change is the way how stocks are bought and sold. It must be guaranteed that the weighted average of the stock prices expressed in USJ will give you 10,000.

How do you achieve that? Well, you might think that the easiest solution would be for the government to buy or sell the Dow Jones mixture of stocks whenever the index jumps out of the 9,950 - 10,050 territory. If the index drops below 9,950, the government may cheaply buy these stocks. If it jumps above 10,050, it can sell them. If the price stays in this interval, the government would always profit. However, this is no good for several reasons:
• the government is not ready (and not talented) to control the company if it buys too much
• when the prices jump at the beginning, the government actually doesn't have enough stock to sell.
Another solution would be to force all traders to short a corresponding negative number of other stocks so that they keep the trajectory on the surface perpendicular to the harmful direction of the configuration space.

However, the previous sentence may sound too contrived. So let us choose a comprehensible alternative: taxes. There are servers that know who owns a stock every day or every hour. Taxes for holding stocks (or taxes for even shorter time intervals) can be redefined every hour - they can be positive or negative - to stimulate buyers or sellers and to keep the Dow Jones index near 10,000. These taxes (of either sign) would be a small percentage of the spot value of the stocks multiplied by the immediate deviation of the Dow Jones index from 10,000, with the coefficient determined by a (computerized) government "trader" whose task would be to play with the number in such a way that the Dow Jones index stays constant.

I would like to argue that the extra tax collected or returned for this stabilization of the Dow Jones index wouldn't have to be a subject of balanced budgets: the government could just print (or burn) this money instead of emitting bonds and borrowing because the stability of the money would be guaranteed by the peg with the stocks, not by the government's promise not to print the money.

For example, in the recent months when there was a pressure to sell stocks, the government would be paying the stockholders in the USJ system. These extra payments would play a similar role as the trillions that the U.S. government is pouring to the system in the USD system by other means. On the other hand, the remaining government budget deficits would have to be paid by the money that the government borrows; the government can't print companies, after all.

You may think of other alternatives how to keep the index constant. Some readers might object: but this is just another kind of inverventionism whose effect can be emulated by many policies that the government is doing these days, anyway. Yes, except that in my setup, it is a universal, eternal, and predictable rule: a part of the definition of the money. When the government is pouring trillions of loans into the economy, it is probably igniting new waves of instability (and overheated economy and inflation) in the future. With a fixed Dow Jones index, these mood swings would never repeat again.

Do you actually own the companies?

At this moment, it should be clear that by owning USJ, you don't actually own the companies. You don't get any dividends for owning USJ. You can't vote. In fact, you may have noticed that the USJ setup presented above can be realized with the normal USD banknotes so I can omit the section about "transition from USD to USJ". ;-)

If you throw away all the auxiliary stuff from my thought experiment above, you can see what the U.S. government could actually do in the time of a downturn: it should pay you money (tax credit for your 2008 tax return) for every day of owning stocks. Enough money so that the Dow Jones index will be essentially constant. People will simply forget about the need to watch the stock markets in order to buy or sell. This useless part of their life will disappear.

Isn't it a contradiction that the price ratio of consumer products and companies is kept fixed?

Average P/E ratio may indeed be changing in the USJ economy. But is it a problem? Not really: there is no other P/E in the economy to "easily" compare with. Note that the relative prices of stocks in different industries may change with time and this degree of freedom is pretty much "useful". The price ratios are changing in such a way that the ratios of the P/E ratios in different industries remain pretty much constant. Note that different industries tend to have different P/E ratios because the companies are believed to have different "durability".

However, the P/E ratios are also different because of different profit margins that are expected in the different industries. Aren't these differences harmful degrees of freedom, too? Well, to some extent, they are: you might imagine that the prices should be such that the profit margins in different industries will be aligned which sounds "fair". However, there are reasons why it's normal for the ratios to be higher in certain industries: if the companies in the industry would easily risk to go bankrupt, because of the inherent fluctuations etc., they (and their competitors) will typically evolve into demanding a higher profit margin.

More generally, I think it is a good idea to adopt the classification of the degrees of freedom and to think which price ratios or their combinations are useful and which of them are harmful.

In my system, you might be afraid that if the P/E ratios of all stocks become very small, people will tend to sell the real stocks, anyway. And my system will collapse. Well, assuming the tax system, you may see this not to be the case. The regulator that keeps Dow Jones at 10,000 is actually giving more money (tax breaks, negative taxes, see above) to all the stock holders whenever they tend to sell. These become a part of the stockholders' profits which increases the net profit per stock and reduces the P/E ratio. This procedure would become a routine law, an obvious event, and it would make similar kinds of collapses impossible.

Long-term behavior of savings etc.

In the long run, you expect many of the wild trends seen in contemporary Dow Jones charts etc. to be eliminated. You should notice that the Dow Jones money would be inherently less inflationary than the normal money. With a fixed amount of money, you would own a fixed fraction of the companies. Because the companies get more valuable in the real terms, you would be getting richer, too.

Does it mean that the butter would be getting cheaper in USJ? In the long run, it does. The same butter company would be able to produce more butter. Assuming a qualitatively fixed P/E ratio of this company, the butter is clearly getting cheaper. Does this "deflation" lead to a dangerous downward spiral? No, it doesn't because it is a universal part of the economy and the people's expectations. There are no new mechanisms to accelerate the dropping butter prices in this framework.

What we have done in essence is to unify two currencies existing on one territory, USD and the average stocks. That makes the long-term behavior of investors' savings more universal and stable, and not a matter of lottery. Because the new USJ currency is naturally strengthening, the expected interest rates in the banks would be smaller than today, and they could go negative (the fees would be for the protection of the money and other services).

Note that stocks tend to grow by 8% in nominal terms but with a 3% inflation in average, the real growth of the companies' value is of order 5% a year. That could actually define the strengthening of USJ per year and the deflation (the trend of price of butter in USJ). For aesthetic reasons, you could keep this rate at zero by redefining the Dow Jones index not to be at 10,000 but rather 10,000 times 1.05 to the power of time since 2009 (in years). The generalization of the system above is self-evident.

Can the advantages of the Dow Jones money be emulated?

I have already discussed this point but once again. You might think that whatever positive is brought by the unification of the currency and the average stocks can be emulated by other interventions that the U.S. government is doing these days (and other days). Yes, it can. But because the government has so much freedom to do these interventions - much more hawkish or dovish than people expect - these interventions create new waves of instability in the future.

On the other hand, the regime with USJ money is fixed and determined: there is no room for the government to create unexpected waves in the system. In essence, the policy is about the unification of the money and average stocks, an alternative currency, and this unification would increase stability and efficiency to the system. It's like merging two huge fuel tanks into one. If your car had to gigantic fuel tanks, it would cause all kinds of problems. One of them could get empty or overfilled, the pressure in between them could break the barrier or create explosions. With one fuel tank, you will be doing much better.

Now, it's time for discussions, hopefully decent ones. ;-)