Consumption isn't a fleeting burst of pleasure, it's a long-lived asset

I've learnt enough about the terms income, savings, consumption, investment, capital, and other major macroeconomic categorizations to pass a basic economics exam. But I've never been a big fan of the style of thinking these terms force on me. Am I just being lazy? I'll lay out my points and give an alternative.

Squarely Rooted recently commented on the somewhat arbitrary nature of the boundary economists set between consumption and saving, opining that travel should be thought of as investment, not consumption. On twinkies as savings, here is Squarely Rooted from an earlier post:

Think of a Twinkie. Twinkies are an odd product; on the one hand, they are a cheap, delicious, unhealthy snack; on the other hand, they are (at least according to legend) practically immortal. So is buying a Twinkie consumption or saving? Does it depend when you eat it? And for those who will say “but Twinkies aren’t an investment, they bear no interest, they just sit there” – so does money under the mattress, and nobody thinks that isn’t saving.

As Squarely Rooted notes, dividing the world into categories allows for discussion, but it also "pre-digests" the world for us. This is what Nick Rowe once called the Borges Problem:

We get very different results depending on how we categorise the world. And sometimes the categories we use are chosen by someone long ago who had a totally different purpose and/or a totally different theory to ours. Our way of seeing the world gets distorted by the dead hand of historical ways of seeing.

This cuts both ways. While the dominant technique of linguistically dividing up the world may distort our way of seeing things, having multiple languages can be equally problematic. Here is Steve Randy Waldman:

Our various allegiances — to schools or tribes or policy ideas — exploit the ambiguity of language to manufacture conflicts, through which we reassure ourselves that we are right and they are wrong. (And no, math doesn’t help much, because we must map it arbitrarily to the same ambiguous language for it to be of any use.) Now I will reassure myself that I am right and they are wrong.

It seems to me that looking at the world through a set of different categorical lenses can give us some great insights, as long as those lenses are coherent. But we need to be aware that there are many different taxonomies. Learning how to recognize each and being able to translate between them will probably save us eons in lost time arguing about semantics.

Back to the basic set of categories under discussion. The typical view is that income is a flow, part of which gets apportioned to consumption. Consumption spending is immediately used up, providing a sudden burst of consumptive joy before disappearing for eternity. The unspent income that remains is defined as savings, and this in turn will be invested with an eye to the future, primarily to fund consumption down the road. Most savings will go into capital, though some of it might leak into money hoardings.  Equipped with these categorizations, economists can go out into the real world and determine what falls in one basket and what falls in the other.

The line being drawn between consumption and savings is based on the distinctions between now vs. later and durable vs. nondurable. Let's try a different way of splitting up the world. Suppose that all consumption goods and experiences are long-lived durable assets. They are forms of income-yielding capital in which one invests. Canned beans bought for my pantry will provide a burst of consumptive joy several months from now. Until then, just having them in a pantry provides a stream of useful services, much like a fire alarm provides utility even though it is never used. These are what Steve Horwitz calls availability services. Both the food we keep in our larders and our fire alarm quell uncertainty and soothe us.

If I take out my employees to the bowling alley, I'm investing in organizational capital. But when I go out to bowl by myself, I'm drawing down my wealth on a one-time shot of consumptive joy, at least according to way the lines are currently drawn. Why not consider both to be long term investments?

Take travel spending. As Squarely Rooted points out, travel is a perpetuity. The travel asset that you might be considering purchasing provides an immediate burst of raw travel experience (not all of it fun), followed by a perpetual flow of memories, experiences, and knowledge that continues till death. Any one who swaps out a security, say Microsoft, from their portfolio for a travel asset has determined that on the margin, the present value of the flow of dividends provided by a voyage exceeds the present value of a flow of Microsoft dividends.

I recently splurged on an expensive meal and did so not only to enjoy the near-term burst of flavours, but also for the long-term flow of returns that my investment would produce, namely the opportunity to remember my experience and talk about it with others. Until I forget my experience a few years from now, it'll have provided me with repeating chain of returns. On the other hand, I'll probably sell out of the gold futures contract I just bought in a month or two. Which of these two swaps is the future-oriented durable one and which is about the here & now?

When someone spends their income on so-called consumption they aren't drawing down their stock of savings. Rather, they're swapping asset x in their portfolio for asset z.  The choice to buy food, travel, and get a haircut isn't a depletion or exhaustion of wealth—it's a portfolio adjustment. Consumption is a stock, not a flow. We can calculate the discounted value of all yields thrown off by a consumption good or experience over time and sum these flows up into a stock value.

We are always conducting asset swaps in order to grope towards portfolios with the highest net present value. Our personal capital is probably our greatest asset. When we earn income, all we've really done is swapped personal capital, time & effort, for a bank-issued liability. We commit to this swap because we estimate that the NPV of additional bank-issued liabilities will more than offset the lost NPV of personal capital.

In equilibrium, the returns on all assets are equilibrated through arbitrage. Investing $10 in cigarettes should provide the same prospective flow of services as investing $10 in a trip to somewhere, $10 on a massage, or $10 in Microsoft. If the yield on some consumptive asset, say a massage, exceeds the economy wide rate of return, individuals will sell their Microsoft shares and go off to the masseuse. This process continues until the price of massages has increased to the point that it no longer makes sense to conduct this arbitrage.

What about the classical bias against so-called consumption? Say that rather than swapping out bank-issued liabilities for Microsoft shares we swap them for a long-lived travel asset. Economists would say that we have high time preference and are sacrificing future consumption for present. Society says we've splurged on silly consumption. It seems to me that as long as we've made this decision by appraising each asset's future earnings stream, who cares if we've chosen Microsoft or travel? All we've done is clocked the two NPVs against each other and purchased the one with the best yield relative to its cost.

Microsoft shares have one advantage over a travel asset. They are liquid. Travel experience can't be resold. In committing your entire portfolio to travel, the problem isn't that you've sacrificed future consumption for present consumption, nor that you've sent money down a black hole. Rather, you've rendered your portfolio less liquid. People who reallocate their portfolios towards travel are asset rich, but liquidity-poor.

While we can't directly remonetize our travel asset, we can indirectly remonetize it. If travel and good food improve our spirits and productivity, then we can recombine these benefits with our labour and resell the total product at a higher price than before. So investing in consumption assets can be a great idea. But in general, it's probably not a good idea to invest everything one owns in illiquid consumption assets. Liquid assets will always be good in a bind.

Getting back to the Borges problem, how does reconceptualizing things this way lead to different results? The old lines between capital, land, and labour aren't so important, nor is the axis between the household and firm. Nor does the distinction between durable and non-durable goods concern us. All we have are millions of yield-generating assets that are constantly moving in or out of individual's portfolios. The main difference between these assets is their swappability, or their liquidity. It's a good platform on which to start thinking about moneyness.

Even if you don't agree with me on any of this, I hope you see how the Borges problem operates. How we choose to linguistically parcel up the world influences the way we take in and sort data, and the data we generate is the base for our actions, policies, and institutions. We've built up an incredibly large edifice based on our initial categorizations. Hopefully we've gotten them right.

Uncertainty and the demand for liquidity

In between my more practical posts, once every week or so I'll do something on the idea of moneyness. Economists have known for a long time that the concepts of uncertainty and money are intimately intertwined. George Costanza knows this too. He holds a bunch of cash to deal with all eventualities... until his wallet blows up. I'll show how we can just as easily replace money with moneyness in this two-step with uncertainty.

Uncertainty is an uncomfortable feeling one endures when thinking about an unforeseeable future. One of the ways to shield oneself from uncertainty is to devote a certain portion of one's portfolio to "money" – dollar bills, bank deposits, and such. Because these money items are liquid, it will be relatively easy for their holder to offload them in the future should some unanticipated eventuality arise. Holding money therefore alleviates discomfort about the future. This is the same sort of service that a fire extinguisher provides. Though someone may never need their extinguisher, it comforts its owner by its mere presence. On the margin, individuals are always comparing the present value of the stream of "security and comfort" that money provides to the consumption goods or durable assets that money can buy.

The link between uncertainty and the demand for money has a long heritage. We can find this idea early on in the Marshallian tradition, for instance. In 1917 Arthur Pigou, a student of Marshall, wrote that any person would be anxious to hold money "to secure him against unexpected demands, due to a sudden need, or to a rise in the price of something that he cannot easily dispense with." On the margin, people could either hold money, spend it on consumption, or exchange it for a capital asset. "These three uses," wrote Pigou, "the production of convenience and security, the production of commodities, and direct consumption, are rival to one another." (The Value of Money, 1917)

In 1921, Fred Lavington explicitly described this very same link between uncertainty and money.

the stock of money held by a business man serves not only to effect his current payments but also as a first line of defence against the uncertain events of the future. (The English Capital Market, 1921)

More explicitly, said Lavington, money provides its owner with a

return of convenience and security. His stock [of money] yields him an income of convenience, for it reduces the cost and trouble of effecting his current payments ; and it yields him an income of security, for it reduces his risks of not being able readily to make payments arising from contingencies which he cannot fully foresee. The investment of resources in the form of a stock of money which facilitates the making of payments is then in no way peculiar; it corresponds to the investment by a merchant in the office furniture which facilitates the dispatch of business, to the investment of the farmer in agricultural implements which facilitate the cultivation of his land, and indeed to investment generally. 

Like Pigou, Lavington emphasized the marginal choice between holding money, spending it on consumption, and investing it.

Resources devoted to consumption supply an income of immediate satisfaction; those held as a stock of currency yield a return of convenience and security; those devoted to investment in the narrower sense of the term yield a return in the form of interest. In so far therefore as his judgment gives effect to his self-interest, the quantity of resources which he holds in the form of money will be such that the unit of resources which is just and only just worth while holding in this form yields him a return of convenience and security equal to the yield of satisfaction derived from the marginal unit spent on consumables, and equal also to the net rate of interest.

The most famous adopter of this idea was Keynes, a friend of Pigou's and, oddly enough, Lavington's teacher.

Because, partly on reasonable and partly on instinctive grounds, our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future... The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude. (The General Theory of Unemployment, 1937)

The link between uncertainty and money isn't confined to the Marshallian and Keynesian traditions. Erich Streisler (1973) quotes Carl Menger in Geld:

The amount of money which is used in actual payments constitutes only a part, and indeed a relatively small part, of the cash necessary to a people, and . . . another part is held (in order that the economy may function without friction) in the form of various reserves as a security against uncertain payments, which in many cases in fact are never realized.

William Hutt, an Austrian "fellow traveler", described the prospective yield from money in a 1952 paper called the Yield from Money Held. According to Hutt, the value of money assets was "affected by reason of their being demanded for their 'liquidity,' i.e. for the medium of exchange services that they can perform." These monetary services that money assets provide are prospective – even though money isn't being used, much like a fire engine when there were no fires, it isn't lying idle. "The essence of all these services is availability," wrote Hutt.

Modern Austrian Hans Herman Hoppe provides a very sharp linkage between uncertainty and money holdings.

the investment in money balances must be conceived of as an investment in certainty or an investment in the reduction of subjectively felt uneasiness about uncertainty. ('The Yield from Money Held' Reconsidered, 2009)

Nor is the Auburn side of the Austrian school the only to note linkage. Steve Horwitz, a free-banking Austrian, also gives expression to the link between money and uncertainty:

The connection between Hutt and Menger lies in recognizing that the availability services that money provides flow from it being the most saleable good. To be available to be exchanged for anything at any time requires that the good have the degree of saleability that Menger describes. The nature of Hutt's availability services is that they are a subjective return to holding an item that others also subjectively value a great deal, thus permitting the item to be easily exchangeable. When one chooses to hold wealth in the form of money, one is simply purchasing these availability services. (A Subjectvist Approach to the Demand for Money, 1990)

We also find the link between uncertainty and money among monetarists. In their 1971 paper The Uses of Money, Brunner and Meltzer noted that in a world of perfect certainty, information is available for free. This effectively eliminates the main reasons for the existence of money. However, by relaxing the assumption of certainty, “transactors possess very incomplete information about the location and identity of other transactors, about the quality of the goods offered or demanded, or about the range of prices at which exchanges can be made.” Rather, they must acquire information about these characteristics. Because knowledge acquisition takes time and energy, individuals may alternatively:

search for those sequences of transactions, called transaction chains, that minimize the cost of acquiring information and transacting. The use of assets with peculiar technical properties and low marginal cost of acquiring information reduces these costs. Money is such an asset.

David Laidler, also a monetarist, describes the money as a "buffer against costly consequences of market uncertainty and inflexibility".

If money holding is a cheap and reliable buffer, then agents will find that it pays to remain relatively uninformed about the processes affecting the variability of their net receipts, and will be relativley unwilling to undertake any costly measures that might render them either more predictable or controllable. If, on the other hand, money holding itself is a costly or unreliable source of insulation from such uncertainty, then the expenditure necessary to acquire and utilise extra information is more likely to be made. (Taking Money Seriously, 1990)

It's clear from this wide variety of quotes that many economists have considered money holdings to be uncertainty-alleviating. It's not a big step to replace the concept of "money" with "moneyness". The idea here is that by selling less-liquid items for more-liquid items, individuals can increase their protection from uncertainty. All assets can be ranked on a scale according to their liquidity/moneyness, and as a corollary, by their ability to "lull our disquietude".

On the margin, people are constantly comparing the package of services provided by each asset in an economy, where each package consists of the real services the asset provides, its pecuniary returns (interest, capital gains, or dividends), and finally the extent to which that asset's moneyness shields the holder from uncertainty. This means that in trying to defray their worries about a cloudy future, people seek out the quality of moneyness rather than a specific instrument called money. This quality, or property, is never fully concentrated in one hypothetical asset called "money" but can be found unevenly distributed over the economy's entire range of goods.

To get up to speed, here are two previous posts dealing with the idea of moneyness
1. Why moneyness?
2. What is a non-monetary economy?

Moneyness and liquidity options

Lars Christensen had an interesting post on moneyness and the Divisia indexes. He recommended an old paper of Steve Horowitz's which I read some time ago and have always respected. See A Subjectivist Approach to the Demand for Money.

Essentially, you can't believe in the concept of moneyness and also believe in the effort to count money through indexes like M1, M2, or even the Divisia indexes. The two efforts contradict each other. The best way to get a market indication of moneyness, or liquidity, is through the introduction of liquidity options. My comment follows:

If moneyness is a subjective concept, and I think it is, then trying to sum up various money assets into a Divisia index is problematic. That’s because an asset that appears to be high on one person’s subjective moneyness scale will be low on another’s, the result being that it is impossible to create objective categories for moneyness.

Ultimately, the best way to determine moneyness is to back out the market’s assessment of an asset’s liquidity premium. The best way to do this is to introduce liquidity options on various assets and see how the market prices these options. Anyways, this is science fiction for now since liquidity options don’t exist.


Previous posts on liquidity options.