Economical Equilibrium: Geometry of Economics [Paperback ed.] 1492387517, 9781492387510

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Economical Equilibrium: Geometry of Economics

ILYA VLADIMIROVICH KUNTSEVICH

Copyright © 2013 Ilya Vladimirovich Kuntsevich www.economicalequilibrium.com All rights reserved. ISBN: 1492387517 ISBN-13: 978-1492387510

To my parents, Vladimir and Galina, for all their blessings To my brother, Rostislav, for his spiritual support To my wife, Galina, for her love, and To my children, Anna, Vera and Ivan, for their inspiration and joy

CONTENTS ACKNOWLEDGMENTS PREFACE PART I: FUNDAMENTALS WHAT DRIVES ECONOMICS VALUE MONEY VALUE-ADD = PROFIT = INFLATION DEBT BANKS, LOANS AND INTEREST “VALUABLE” ACCOUNTING EQUITY AND IPO PUBLIC STOCK MARKET GOVERNMENT AND TAXES CURRENCY PURCHASING POWER PART II: GLOBAL ECONOMY ECONOMIC GROWTH INTERNATIONAL RESERVES PENSION FUNDS AND SOCIAL SECURITY PEOPLE AND JOBS EDUCATION WEALTH DISTRIBUTION FRACTALS IN ECONOMICS TIME BOMB PART III: ECONOMICAL EQUILIBRIUM GEOMETRY OF ECONOMICS CASH VALUE RATIO VALUE RETENTION RATIO BALANCED GROWTH MODEL IS A COUNTRY IN GOOD “SHAPE”? WHAT GENERATES A CRISIS? BEST AND WORST STORAGE OF VALUE

TEN POSTULATES OF ECONOMICAL EQUILIBRIUM BACK TO THE FUTURE INSTEAD OF IN CONCLUSION BIBLIOGRAPHY ABOUT THE AUTHOR

ACKNOWLEDGMENTS I would like to thank everyone who inspired and supported me in the creation of this book and helped to get it published. A special THANK YOU goes to Professor William Cockrum, Roman Abdulin, Philip Landau, Frederick Elsea, Professor Edward Leamer, Keith Lupton, Cody Franklin, Joshua Nip, Professor Eric Sussman, Allen Morgan, Bill Gross, Marcia Goodstein, Professor Jeff Scheinrock, Natalia & Dmitry Arkhipenko, Professor Lawrence Wright, Ivan Lee, Timur Rodionov, Royce Disini, Wilton Risenhoover, Anatoly Miliukov, Leo Petrossian, Robert Hamilton, Dan Hanchey, Student Investment Fund of UCLA Anderson and UCLA Anderson School of Management Executive MBA Class of 2010.

PREFACE Modern economics is a focus of many people, especially in the aftermath of the 2007–2008 financial and economic crisis. One has to wonder – what’s wrong with the economic system if it breaks down now and then? Should the modern economic theories, accounting principles and financial models be relied upon going forward? Could we devise an alternative economic system, which would be whole and sustainable, and allow a crisis-proof pace of economics? Could we design and build more intelligent tools and models in order to see the big picture and avoid future crises? This book initially came about as a way to identify the root cause of an economic crisis. Only by taking something that doesn’t work apart, can we see the root cause of the problem. Therefore, the book starts with the fundamentals of economics, accounting and finance, exposing some of their obvious flaws and misconceptions, and continues with the analysis of the global economy’s modern condition. As the book has progressed, Economical Equilibrium theory has evolved as a new economic system, assisted by geometry. A visualization technique, which allows identification of the cause and effect relationship using geometrical figures, rather than linear mathematics, aids Economical Equilibrium theory in multiple applications across all levels of economics. Using its ten postulates, Economical Equilibrium theory is capable of both identification and prevention of economic crises, as well as effective design and management of sustainable economic activities. I also make certain recommendations on changes to the fundamentals of accounting principles and financial models, which should add transparency and accountability thereof. If followed diligently, these recommendations will alleviate concerns of people on the future of the global economy, and their individual wellbeing.

PART I: FUNDAMENTALS

What Drives Economics Economics is a reflection of people’s activities; it is a mirror of what we do. Convenience, sense of accomplishment, satisfaction and aspirations are the key drivers of any economic system, because the world is driven by the desires of people to live a life they want – more comfortable, more satisfying to their needs and values. Modern economics is reflected by what is measured and exchanged quantitatively; the language of economics is numbers, currency and graphs. An argument could be made that satisfaction doesn’t always come from the items that can be measured (e.g. with money). For example, love, conscience, friendship and happiness are invaluable features of our lives and provide infinite internal satisfaction. Nevertheless the external side of human nature doesn’t change – as if we are “programmed” to look for better living conditions and improve them to our desires, should an opportunity arise. A house, heating, transportation, supermarkets, telephone, internet – these are habitual representations of our modern civilization’s exterior. None of these amenities or conditions is provided by Mother Nature as is – natural resources are converted, or transformed, by human labor and technology into what we enjoy every day. Natural resources and technology provide what it takes to grow the economy through the transformation of the former. “Production” is often referred to in the manufacturing sector as something generated by people. So many cars, or materials are “produced”; but are they really? I prefer to think of it as “conversion” or “transformation” because one cannot produce something out of nothing. The human contribution (labor, craftsmanship and technology) converts and transforms what Mother Nature provided to us in abundance (natural resources) to begin with, so we could maintain and improve our lives at its expense with no retribution. Economics is driven not only by demand (consumption) of natural resources, as many of us tend to think, but also by the human contribution, required in order to transform these resources using labor and technology. It is a known fact that equilibrium exists when demand equals contribution, but regardless,

whether it is balanced or not, economics depends entirely on the access to, and transformation of, natural resources. There would be no economics without availability of natural resources[1]. People buy new things in order to increase their living standards. So much iron ore, oil or gold is extracted and transformed into metal, gas or jewelry. Workers’ hours and technology contribute to manufacturing of specific products. Given that human labor and technology are the only two “contributing” factors in economics, economic growth is not possible without ever-increasing consumption of natural resources through further exploitation of human labor and / or technology. Therefore, economic growth tends to exploit everything and everyone, because everything is in equilibrium. Furthermore, we need to be mindful of the price at which economic growth is achieved – overexploitation and pollution of natural resources, not accounted for at present, will inevitably lead to a backlash by Mother Nature in the future. Due to economic growth, natural resources, initially abundant, have become scarce due to extraction, transformation and resulting pollution (carbon dioxide, contaminated oil fields, water, and land). The price of natural resources tends to increase in order to restrain further depletion, but to whom do we pay the price? Earth? Pricing regulation helps, but only temporarily – the more the economy grows, the less resources are available, regardless of the price tag, because people still need them in order to accommodate their new lifestyles and / or simply survive. For example, drinking water, which used to be free, is getting more and more expensive. Nowadays we have to earn a living in order to buy drinking water, because we cannot live without water, regardless of how much it costs. Scarcity and need features of natural resources create their measurement value and thus add to economics, but when it’s gone, how much money is it worth? What used to be abundant and priceless later becomes scarce and measurable, and finally nonexistent – three stages of non-renewable and indemand natural resources. When a particular natural resource becomes rare and there is not enough purchasing power (money) restriction to buffer further demand, people tend to take it over by force, and not necessarily because they need it to survive –

sometimes it just glitters or allows a cheaper commute from point A to point B. But what makes things worse is a combination of scarcity of certain natural resources (e.g. oil & natural gas) and dependence of modern technology on them, in order to satisfy the needs and wants of people using it. In such cases, wars become inevitable, as we have seen repeatedly over the course of human history to date. While we haven’t fully destroyed our planet yet and can still enjoy clean air and the natural beauty of parts of the world, drinking water, which used to be abundant to all of us, has become polluted in most regions, because we continue the mindless pursuit of economic growth without realizing that we keep doing it on the credit of Mother Nature without means of repayment. Accounting rules do not allow recording a liability in this case, because we cannot account for something that didn’t yet happen. What drives such pursuit from the economics stand point will be discussed in detail in later chapters. To date we have created nothing to be proud of – an unsustainable civilization, which uses all that Earth provides through “cannibalistic” technology, slowly, but surely killing our planet. We appear to be extremely ignorant children of Mother Earth, that gave us everything for free, but not only do we not appreciate it, we continue to choose harm over harmony in order to satisfy our selfish needs. Something could be fundamentally wrong with us humans, in that we seek immediate material values in life over an infinite idea of life and beauty. Maybe that’s why the best values in life are those that cannot be priced and, as such, will always stay outside of economics, accounting and finance. It must be the will of God, protecting us from ourselves, so we can see clearly what’s important and what’s not. If we want to keep our civilization alive, it is obvious that the ignorant, short-sighted view of economics, pursued by the business and political elites, stressing the importance of economic growth and profit-making at all costs, must evolve into a long-term vision of sustainable well-being of the world we live in.

Value Any value has two components – recognition and exchange. Recognition is an invaluable component, while exchange is valuable and thus can be measured. If something has a recognition (e.g. love, friendship, conscience, happiness), but there is no possible way to measure it (because it is invaluable) by exchange, it will stay outside of economics, and thus will not contribute to it. Therefore both components (recognition and exchange) are required for any value item to become a part of the economic system. Value is an extremely elusive concept due to its change, subject to human aspirations and demand. Something valuable today could have zero value tomorrow and vice versa. Besides, there is no such thing as universal value or measurement, because money, created as means of exchange, also has an ever changing value by itself. Therefore any item cannot be measured for exact value, although it can be approximated, until its exchange takes place. One of the synonyms of value is wealth. Preservation of wealth is a daunting task for many people these days, because it is prone to volatility and loss of value. A new profession has been recently formed to help people manage their wealth – financial advisors. Another term that requires an introduction is value-add. Added value is created at the transformation stage of natural resources or through innovation and / or invention. Value-add of iron ore is metal, value-add of Wolfgang Mozart is the music of a genius, value-add of Steve Jobs and Steve Wozniak is Apple. Profit, the key driver of the modern economical and financial system, is the measurement tool of value-add. The relationship between value, money and profit is very important in economics. Ask yourself three questions: -

Could profit be recorded without money?

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Could value be recorded without money?

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How much uncapped value and profits are out there?

If we want to figure out how economics works, we have to understand the

activity at the resolution of each component. Let’s break things down to small parts, in order to really understand how they work. This is the only way we can fix specific components that need to be repaired, and not disturb ones that are more or less operational.

Money I like to think of money as one of the greatest inventions in human history. Money is needed in order to both measure value of the items and conduct their exchange. These two processes do not have to coincide – one can approximate value with money, but it will not be confirmed until money changes hands. The evolution of money is nothing but exciting. Initially something of tangible and hard substance (sea shells, gold, silver, something rare) money later evolved into paper, and then into an electronic form. Electronic payments via PayPal, VISA, MasterCard, AMEX and other platforms have become widely used, and have eliminated the cost of printing money in its entirety. Electronic payments are more common these days than cash. Pink Floyd’s “Money – it’s a gas” is a very precise poetic expression of its very substance and quality, because money is an ether, a necessity of the modern financial and economic world. Whether “Money is the root of all evil today” depends on how one uses it, of course. There is a famous cliché that money makes the world go round. After people are “sold” on new values, their first thought is where to get the money in order to satisfy the demand. Going back to the previous chapter, money is the driver of economics, because no exchange takes place without it. Money is also a reflection (mirror) of economics, something with which it is measured and recorded, based on accounting rules. The economic system reflects the contribution and demand of value, measured with money. Money serves as a means of exchange of value within the economic system. There are a number of participants within the economic system – individuals, corporations, banks and government. Individuals work and consume, corporations contribute and consume, banks manage money and governments collect and distribute taxes to provide security, infrastructure and social benefits; and they all need money in order to transact with each other. Values, measured with money, can’t be received for free – people first need to contribute value in order to get a comparable value in exchange (otherwise

this would be called a donation). There are many ways to make such contributions and receive something in return – grow food, provide health treatment, build houses or roads, operate transport, etc. The more activity between economic participants, the more value is exchanged, and more money is needed to sustain it, taking its circulation speed (velocity) into account. Money has a relative, or implied, but never an absolute (denomination) value, as some tend to think. For example, a $100 bill denomination buys you a good dinner for two people in a very nice restaurant in the U.S., but probably a whole day’s meals for the same two people in a drive-through restaurant, and maybe a couple days of food if these two were to buy groceries in a store and choose to cook for themselves. Time is another factor in relative / implied valuation of money – money loses value in the long-run due to monetary inflation. The next chapter addresses the mechanism of how money loses value over time. The same $100 value dinner will probably be more like $150 (or more) in 5–10 years. Money used to have a quasi-absolute value, called the “gold standard”, where prices were “fixed” to a specific weight of coins due to scarcity of gold, but those times are long gone. Why? Such metamorphosis occurred because people needed a bigger volume of “measurement units” available in order to conduct the exchange. An interesting thesaurus comparison – the word “currency” is derived from “current”, or “flow”. To keep the exchange under control, money can’t be printed or issued electronically by everyone – it is a prerogative of the world’s central banks and treasuries, operating within a given country. Since the abolishment of the “gold standard”, money has obtained the quality of a necessity for the economic system to function. Regarding too much versus too little money, here’s an interesting example: if there’s too much oxygen (gas), people tend to get light-headed and carried away. If there’s too little, people become depressed, their body functions slow down and life is not great anymore. As such, an economic system needs just the right amount of “gas” to keep doing well. Money is not a guarantee, but a promise to receive value in exchange at a

later time. Therefore, it has a “delayed” value, backed by the faith that such a promise will be honored. As with all promises, they can be kept or broken. If the Federal Reserve comes up with the news tomorrow that old $100 bills are being replaced with the new ones, the old $100 bills will lose all of their value instantly, unless the Federal Reserve also announces that it will continue accepting the old bills. People and companies that kept money in Cyprus banks in early 2013 had a very unpleasant surprise when they heard that the country’s financial system was insolvent and they had therefore lost some or all of their money. Money’s denomination by itself is a fiction, because it is either a number printed on paper, or held in electronic form. It is the acceptance and entitlement features of money backed by stability of the financial system, which gives it a “delayed” value. Such value is derived from an immediately preceding exchange transaction. Going back to the example above, if you had a dinner at a nice restaurant two weeks ago and want to go there again, you will probably take another $100 bill with you in order to have a comparable meal. The same is true for goods and services – how much money it took to exchange them recently is what determines the value of money. The more people are willing to consume goods and services, and provide something else of value in exchange, the more money should be available in the financial system in order to facilitate the required exchange. After the exchange takes place, money is no longer required until the next exchange takes place, thus the same money can circulate multiple times within the financial system. A good analogy is a car engine. When the engine is on, oil is used to lubricate its moving parts. When the engine stops or slows down, oil drips down to the oil pan and stays there till the engine starts or increases its speed again. If economic transactions are moving parts and money is oil, it takes money to execute economic transactions of value exchange. The bigger the engine (economy), the more oil is required to lubricate its parts. The faster the engine works, the bigger flow (velocity) is maintained. Money circulates infinitely because it accommodates an infinite number of economic transactions – the car engine oil that one never has to change. If the exchange stops, the money won’t be needed (oil will stay in the pan of the car engine). This is a very unlikely scenario because of the continued

growth of the world’s population and its respective demand. Nevertheless one should not forget that money is a delayed value (a promise to receive value at a future date) backed by faith in the financial system. Should the Federal Reserve choose to print a lot of money tomorrow and give it for free to everyone, money will lose a lot of its value immediately. When an economy matures and there is no further growth potential (e.g. contribution and demand stay flat), the only fast way for it to grow is through an international expansion. When this happens, money plays an “entry key” function to uncap the value of local goods and services in order to make them available for the international users. This is commonly done through a letter of credit, where an international bank acknowledges a buyer’s capacity to pay, thus increasing its circulation in the local economic system, corresponding with the increased contribution and demand. Profit, debt, securities, derivatives, houses, land, cars, water, gas, etc. are all values and are measured with money in the financial and accounting books and records, all based on the most recent exchange. In the USA the money’s name is U.S. Dollars, in Europe Euros, in Russia Rubles – every country has its own currency to keep their economies going. Let’s review the above mentioned values for their intricacies and interdependence.

Value-add = Profit = Inflation Accounting profit is a positive difference between how much something was sold for (revenue) and how much it took to make it sellable (cost). Profits, revenue and costs (and other terms used in accounting lingo) are always measured with money, as required by accounting rules. Imagine a small village of people with only $100 in its entire economic system. The villagers use all this money day in and day out to support the exchange of goods and services. The economic system doesn’t grow (i.e. contribution equals demand) and everyone works hard and exchanges all the goods and services they need with $100. Before money was initially introduced, people gave their word to deliver something of value, and recorded such promise on a promissory note. Promissory notes were great, but they were time consuming to make. As more and more exchanges took place, villagers invented universal promissory notes – money – in order to accommodate the delay in the exchange of goods and services. This money was accepted by everyone. Money also seemed a better option because promissory notes had to be destroyed each time after being honored. Even though people started confirming their indebtedness with money instead of a word or a promissory note, it still remained a promise to receive value at a future date. Should any part of the villagers’ economic system fail (e.g. the party that is responsible for the healthcare and general well-being of the villagers stops delivering value), a substitution would emerge quickly to provide the services needed. The reason why the villagers’ economic system functions well is because the contribution is matched with the demand and, as such, the economy is balanced. If someone doesn’t contribute, he or she doesn’t get paid, i.e. is not entitled to the products made by others. No profits (accumulation of money) were recognized by the villagers, because the contribution matched the demand. As idealistic as it sounds, such a village and its economic system could exist in the real world if there were no such variables as new aspirations, inventions and opportunities on the one hand, and ego, moneymaking and envy on the other, all pertaining to the

human nature. What happens to the economic system if new values are created and there is an increased demand? Profit A genius in the village comes up with an idea to build a dam, which would protect the village from the seasonal river floods in spring. Everyone in the village wants the dam because they see enormous value in it. The genius agrees to build it and approximates the construction cost to be $100. The villagers prepay all the money they have as a sign of their commitment to deliver goods and services to the genius in the future. Some villagers work helping the genius build the dam and the genius pays these villagers $80. When the dam is finished, he realizes he has an extra $20. As an honest man, he wants to return the money, but he doesn’t know who to return the money to. An accountant tells the genius to record this money as profit – remuneration for his “value-add” – his talent to build something as remarkable as a dam. The genius likes the idea, especially as now he can enjoy a luxurious lifestyle he couldn’t afford before. This boosts his ego enormously. After the villagers learn about this fact and see the genius walking amongst them with a lot of money, they immediately switch their value priorities to moneymaking and profit maximization – the ultimate motivation of any business in our world today. This is the first instance of both profit recognition and economic activity increase in the history of the village. The former is due to withdrawal of $20 from the economic system – the genius deposited $20 in the village’s central bank account in order to spend it at a later time. The latter is due to the expenditure of more labor by all villagers, including the genius, in order to build the dam. The villagers decide to measure their economic activity with a new metric and call it Gross Domestic Product (GDP) – amount of money times velocity over a given period of time. Upon completion of the dam project, the villagers realized that $20 disappeared from the economic system’s daily circulation. They also realized that the only way “value-add” can materialize is when someone recognized it as a profit with money. When the excitement passed, they had to instruct the central bank to print more money, in order to maintain the exchange of goods

and services at the previous level. It is important to review the mechanism of how the central bank will infuse an extra $20 into the economic system. Since the central bank belongs to the villagers, they can instruct the bank to print an extra $20. The central bank cannot just give the money to people, because money has to be earned with labor, thus it makes an announcement that those who pave the road to the church will be paid $20. To keep things fair, the central bank organizes a lottery and the lucky villagers build the road and get paid $20 to do it. However, people have learned about moneymaking and profit maximization, and now everyone competes in every exchange transaction, trying to accumulate money at the expense of others. This is when the division in people occurs between rich and not so rich. Wealth Distribution chapter in Part II will talk more about this issue, followed by the geometry of how wealth is distributed in Part III. The resulting monetary inflation of $20, or 20%, gradually finds its way to a Consumer Price Index (CPI) increase, as $20 is spent on the daily exchanges of goods and services, bringing liquidity back into the economic system. The latter is how the mechanism of inflation works: monetary inflation gradually transitions into CPI inflation due to spending of the value-add profit. The rate at which monetary inflation transitions into CPI varies, and depends on the appetite and demands of the profit makers. After the genius spends all his profit money, he will need to invent something of value again in order to get remunerated by the villagers in the form of yet another profit, and as such get his future share of goods and services, and the cycle continues. Concluding this chapter, the amount of money in an economic system equals delayed value (a promise to receive value), expected to be produced and consumed in the future. Could we also make a conclusion that Profit = Valueadd = Inflation? We sure can, but it gets more interesting when debt gets introduced.

Debt Money is a universal confirmation of someone’s indebtedness (instead of a word, or a promissory note) to deliver value to the money holder at a future date – delayed value. Debt (bond), on the other hand, is a promissory note by a specific person or an entity that is indebted to the debt-holder. While money’s value is reflected with its denomination and is relative to the most recently consummated transaction, debt’s value is reflected with money’s denomination and is relative to an ability of a borrower to pay it back with money. Money is usually earned for work performed; debt is taken on a promise to produce work at a future date. Money signifies past contribution to be honored in the future; debt signifies a future contribution to be honored in the future. Money creates debt when it’s taken or given to produce work at a future date. Finally, the same money can create multiple debts, all measured with money. Debt has multiple applications in the modern economy. For example, debt can be used to increase consumption (business activity, GDP) by using money received from a party that doesn’t need it (or doesn’t know what to do with it, or even without their consent) because such money is not yet in economic circulation. For example, credit card debt, spent on goods and services, increases GDP. Value received by a debt borrower today will not necessarily equal value produced by the borrower tomorrow. This is the reason why debt, while measured with money (and as such recorded in accounting with U.S. Dollars), cannot be immediately converted back to cash for the original face value, regardless of how “good” it is. An interesting fact – the secondary debt market always gives a discount to any outstanding principal amount to account for “interest” due at maturity. I didn’t introduce the definition of interest yet, but many of us know what it is. Why does this happen? Let’s review the mechanism of debt origination first. Going back to the previous chapter’s example, there are two plausible scenarios for $20 received by the genius. First – if the technological progress

of creating in-demand value-add inventions stops for a while, $20 will gradually find its way to the economic system and thus inflate CPI (because the genius will spend it on things he likes or needs to survive). Second – if the technological progress continues and thus more profits / value-adds are created, money supply will continue to increase through monetary inflation, but it will make villagers work harder for their love of the progress. These two scenarios interchange in the modern economy and cause the village’s economy to grow until a point when the contribution of human labor (including technology) can no longer increase (i.e. human capital will be fully used). Debt represents a form of investing profit money, not immediately needed in the economy, in order to “make” more money. In our example, the genius could lend an extra $20 to another villager for his future work, rather than work done by him previously. Why would the genius do that? Two reasons: First – money has value, but it loses it due to inflation (if another genius charges profit for yet another potentially useful invention). Second – people tend to borrow if they think they are capable of creating new value, and sell it for a profit later. While the purpose of debt is to “make” money for the debt holder by creating value-add, new business, etc., such undertakings take time and the end result is not guaranteed. By saying “not guaranteed” I mean that even if something can be built and function quite well, if others don’t see in it immediate value, they will not work harder in order to pay for it. In this case debt becomes worthless, because the contribution of the borrower does not equal or exceed the future demand. On the other hand, if debt money is invested into something that other people will see of value regardless, and thus will work harder to pay for (e.g. houses, cars, clothes, food, etc.), demand will match the borrower’s contribution and debt will be returned with a premium. The premium (profit, value-add) will be provided by the central bank, because it will have to issue more money into economic circulation in order to maintain liquidity in the economy. For example, debt money is spent to create a new technology, which makes watches – a nice accessory that people want to buy. Every time something new comes up, there is a shortage of money in the system (due to

profit/value-add) and thus people need to work more to earn money in order to buy new things. This is how the cycle repeats itself over and over again. A socialist might ask the question – why not just give the profit money to people and let them spend it in order to reinstate liquidity, or build something of value-add, but never claim it back? The problem here is that if people build something that is valuable, then the person “investing” money should get his/her share (ego) of the proceeds – money. Hence debt is also a “title” instrument, reflecting ego and moneymaking desires. Besides, it adds responsibility to the debt borrower to perform and deliver, and not just spend money without an obligation to pay it back. Debt represents value that will either be increased or lost, depending on the future demand. This is the primary reason why debt-holders tend to secure the debt with something else of perceived value, in case the debt turns out to be worthless. It is called collateral. Collateral’s value has to be something of immediate value to everyone, but it doesn’t have to be a part of the daily exchange. This is why land (or any hard asset) is perfect collateral, because the debt-holder can put a lien on the borrower’s property and take his land if debt becomes worthless. In other words, debt’s lost monetary value is gained back by converting it into land value, not previously monetized. Thus debt is capable of recognizing value that was not previously exchanged, but it doesn’t require money exchange in order to do so. International Expansion Let’s assume that $20, after being deposited back into the central bank, is sitting there idle. The person running the central bank decides to “make” more money by lending $20 to a neighbor village. He agrees to the terms of 10% interest due in one year for $22 in total. The neighbor village takes $20 and uses it to buy goods from the central bank’s village. Two things have happened. First, since the demand for goods and services increased and the supply stayed the same, the infusion of $20 into the economy automatically increased production, and as such there’s now $120 in circulation in the central bank’s village. Second, the neighbor village needs to give the central bank $22 dollars by selling something worth $22 by the end of the year.

When the central bank gave $20 to the neighbor village, it asked for its land as collateral, because it contained valuable natural resources, e.g. oil and gas. Given that the neighbor village doesn’t produce anything, but has land as its primary asset, the central bank’s village takes possession of the neighbor village’s land and its natural resources. The central bank then assigns value to the collateral of $22, which allows it to recognize a profit of $2 and cost of land at $20. And, of course, it prints an additional $2 to pay itself a profit. When the genius returns to the bank at the end of the year to claim his $20, the central bank has to print yet another $20 (because the genius’s $20 is already spent in the local economy) and now has to convince the villagers that this is due to the fact that the central bank now owns land with natural resources, e.g. oil and gas. The bank issues $21 back to the genius (because it previously agreed to pay him 5% annual deposit rate) thus reducing its own profit from $2 to $1. In the aftermath, the neighbor village lost its land and had to move somewhere to allow the central bank’s village to grow its economy. The neighbor village probably realized how deprived of the technology they are and will likely envy the central bank’s villagers. The central bank’s villagers started to exploit the natural resources of the neighbor village in order to support their increased economy. Finally, the central bank’s economy slows down, because the production volume is adjusted back to a previous level, but CPI is increased due to more money infused into the economic system. As a result, there’s now $142 in the economic system of the central bank’s village ($21 of which is unspent by the genius), ownership of the neighbor village’s land plus monetary inflation of $42. The Central Bank Dilemma One of the qualities of debt is that it allows uncapping of value that wasn’t previously recognized, or monetized, by exchanging a recognized value. The central bank decides that there is too little money in the pockets of its villagers and wants to make them wealthier by spurring economic growth. The central bank proclaims that not only the villagers’ recognized real estate is “undervalued”, but the village also needs more houses for those who

couldn’t afford them previously (didn’t contribute in the past to earn them). The central bank prints $50 and gives loans with this money to those without houses and housing construction starts booming. New houses are built throughout the village. Appraisers start valuing old houses at higher prices, because their owners immediately refuse to sell their houses to the newcomers with “debt” money. Once the higher value of old houses is “confirmed” by the appraisers, the old houses’ owners are offered a Home Equity Line Of Credit (HELOC) of $30 for the previously uncapped “new value” of their properties. Upon origination of debt financing, the central bank decides to charge interest on the debt in the amount of $10 and put it in its pockets. In the aftermath, the economy and housing market are booming, because the central bank lent $50 to build new houses and lent an additional $30 as HELOCs. GDP had a one-time increase of $80 because all the money was spent on the economy. The central bank really likes the result, especially that now it made a profit of $10, and decides to take the frenzy to the next level. It invents a term “securitization” (a mechanism that allows it to sell debts, secured by the increased “values” of real estate, to other villages). Neighbor villages buy $80 worth of debt from our village’s central bank, as a value preservation asset. Given neighbor currencies cannot be circulated in the local village, the central bank had a choice of either printing another $80, backed by the neighbor currencies, or buying valuable goods and services from the neighbors at a later time. Due to these perturbations, the central bank ended up with an extra $90 or equivalent in its vaults ($80 issued from neighbor currency conversion plus $10 profit). The central bank’s ego got really big from the success of such an undertaking, and it decides to lend both the old $80 and new $80 again in order to build even more houses and provide even more HELOCs and maximize its own profit. By a certain point of this housing and securitization frenzy, the local village’s housing market quadrupled, oil prices increased tenfold and luxury industries excelled beyond imagination. Everyone in the local village was excited to be able to enjoy the lifestyle they couldn’t afford previously, although not everyone knew at that time what was really going on behind the scenes.

Only the central bank knew that it was able to recognize an “undervalued” real estate market by exchanging (monetizing) it with debt. Had no debt been involved, houses wouldn’t have gone up in price, and vice versa. To the logic of the central bank, the housing market represented extra capacity that, if tapped into, could make the economy boom by spending the debt money. The reversal of the process occurred swiftly and resulted in a deep crisis for all the parties who enjoyed the benefits of the economic spike, which was not matched with the actual contribution. As a result some villagers could no longer afford debt payments because the cash they were paid previously was provided not by real demand, but with debt money. As many people walked away from their mortgages or defaulted on HELOCs, the central bank took over the houses and recorded them instead of debt on its balance sheet at cost. This caused significant distress to its liquidity, because the central bank could not sell them instantaneously on the one hand, and securitize more debt on the other, so the villagers allowed it to print another $100 in order to bridge the gap and keep liquidity in the financial system (for lack of a better phrase, they called it “quantitative easing”). The central bank could not sell the properties at significantly reduced new market “values” in order to keep at least some book equity (because, in fact, it would have gone bankrupt had it sold all properties at significantly decreased prices). In order to keep face and explain the gradual sale of the properties, the central bank came up with a fancy word “deleveraging”. The villagers also had to borrow from neighbors in order to bail its central bank out, because they were worried about their standing with other villages and ashamed of what their banker did. When the villagers called the central bank to explain what happened, it had nothing else to say but “it never happened before”. In the aftermath, the central bank had $320 value of debt ($80 was reinvested 4 times), the liquidation value of which was around $80 at best, solely due to the fact that some houses retained a higher value through the wealth distribution mechanism, while others became worthless. As I will show in the next chapter, banks can reinvest the same money multiple times via debt instruments, which causes exponential growth of debt and high leverage. In this example it was fourfold ($80 x 4 = $320). In addition the banker had $40

it printed to pay itself profit and finally received the extra $100 it needed to bridge the liquidity gap when the crisis started – debt borrowed by the local villagers. The big question is – what to do with the new $320 value of the real estate on the books of the central bank? The answer seems obvious, but the central bank simply cannot do it, because then it would have to default on the bank’s deposits, thus causing real anger from its villagers. The central bank simply cannot let this happen. Concluding this chapter, the use of debt to recognize value that others cannot afford (thus causing distortions in the contribution and demand equilibrium) is an ultimate contributor to the most recent economic booms and busts. Debt is also a way of deceiving developing economies to buy developed economies’ goods and services in exchange for their natural resources, a high price of hard work and environmental pollution. Debt-fueled growth also results in distorted values of real estate and/or other assets that are usually illiquid and thus cannot be easily monetized with cash. While I agree that some real estate could be undervalued in the first place, measurement of new values with debt money is more than questionable. Debt is also an instrument to make people work harder, make them consume more and exploit more natural resources using both existing and “to be created” technology. Hypothetically, if people refuse to work harder than they do already and thus refuse to buy the corresponding benefits of modern civilization, the majority of consumer debt (e.g. credit cards) will become worthless instantaneously, because debt derives its value from future value only. Another conclusion is that mindless pursuit of corporate profits is very harmful for our planet (cars, coal-based electricity, chemistry, etc.) due to pollution and increased pressure on natural resources. In addition, increased consumption, fueled with debt money and overall economic frenzy, puts unnecessary burden on wild life, crops, oceans, etc. Therefore, it is wiser to use debt money not on consumption of the daily necessities (i.e. to boost GDP), but exclusively on future technology and repair of the harm caused to our planet to date. Expansion of modern

“cannibalistic” technology using the debt mechanism to boost local economic growth should be discontinued. Such measures will not only bring humanity back to our world, but will also allow restraint of monetary inflation and changing of bad technologies for good ones.

Banks, Loans and Interest A question no accountant can answer: if there is only $100 in the financial system, and somebody borrowed all the money at 10% interest rate for 1 year, where will the extra $10 come from when due? I can understand that if someone borrowed 100 golden coins and used them to pay workers to dig more gold, he could find enough gold to make 10 more golden coins, but it doesn’t work that way with money – you will have to do something and get paid an extra $10 in order to return the additional $10 to the bank. By the way, the same logic is valid for a thousand, a million, a billion and so on. Therefore, unless new money is printed, it would be impossible to return interest to the lender and thus make banks continuously profitable. The banks make money on top of what they pay on bank deposits, by charging higher interest on originated debt. Time value of money, a concept used in finance to discount future cash flows, indicates that money loses its value over time. One could make a hypothesis that the worldwide economy grows by the net weighted average rate interest on loans (aka monetary inflation). Accordingly banks are literally “money making” machines. Banks have many options to apply accumulated profit money and boost its value using debt, securities, real estate and other assets multiple times. Banks 2.0 – Investment Banks – manage profit money and buy assets because this is the only way for them to continue making money – the horizontal expansion growth model. If the local economy is saturated, then international expansion is pursued as the next best option. As the international assets base increases, the investment banks generate profits by exploiting natural resources and human labor, which were conserved (not monetized) previously. This is a modern form of colonization – bringing local profit money (excess capital) overseas and making other countries work and give up its natural resources in order to pay it back. Money Circulation The banking financial system can lend the same $100 a number of times. The same $100 can generate multiple debts at 2, 3, 4, …. N times and thus increases the value of respective collateralized assets if debts are defaulted

upon. In other words, debt on banks’ books has an infinite multiplier of money present in the financial system. For simplicity imagine if there is only one bank in the entire United States and all it has is $100 cash. A borrower takes a loan of $100 and agrees to pay it back in 1 year. After the loan is granted, the borrower spends it to purchase equipment to manufacture tables. The money, after the borrower pays a vendor for the equipment, goes back to the bank on the vendor’s deposit account. As a result, the bank has $100 cash plus $100 loan on its assets, $100 equity and $100 deposit. Accordingly the bank increased its balance sheet by $100 after granting a loan and recording a liability (deposit account) on its balance sheet. The amount of a bank’s assets to its equity is called leverage. As the lending cycle repeats itself over and over again, the bank’s leverage increases. For example, Bear Stearns had $11.1 billion in tangible equity capital supporting $395 billion in assets, a leverage ratio of more than 35 to one, prior to its collapse.[2] While Bear Stearns was not your “regular” bank, commercial banks have a regulatory restriction of “Tier 1 Capital Ratio” not to be less than 8% to be “Adequately Capitalized”[3]. Keeping 8% capital ratio means a bank can lend the same $100 about 12 times (100/8). If we combined all the American banks’ balance sheets, we would see that cash (money) is just a fraction of their assets while the rest is either in loans, foreclosed properties or other “valuable” financial instruments. This is because when a bank originates a $100 loan, the borrower spends it and money goes back into the financial system. It does not matter whether it is the same bank or another bank. When another bank receives this $100, it uses it again as a loan to another party and the cycle continues. One could make a hypothesis that if the banks run out of options to invest because they are fully leveraged to their respective regulatory limits, money will sit idle on their balance sheets. As of February 2013, the Federal Reserve kept over $1.7 trillion dollars of banks’ reserves[4], a record high amount in the entire history of the U.S. I should clarify that banks’ reserves kept at the Federal Reserve represent approximately 10% of all banks’ deposit accounts as a security measure against an unexpected run on the banks. In other words, this is all the cash that the financial system has, while its balance sheet is at

least 10–12 times that value, based on the most stringent regulatory requirements of Tier 1 Capital Ratio. Therefore banks’ assets represent value that cannot be immediately cashed out at once. Recent Quantitative Easing measures by the Federal Reserve serve only this purpose – deleveraging the banks and boosting liquidity. Another statistic that comes in handy is U.S. GDP represented by personal consumption expenditures. In 2012 it represented approximately 70% of GDP, where household consumption expenditures for services represented almost 50% of GDP.[5] There was a long decline in the savings rate (Net Savings / Net Domestic Product ratio) from around 12% in the 1960s to only 1% today[6], which means it is not savings that are still being spent, but rather international and local debt money. Finally, banks can sell debt off their books through securitization. I should clarify that only debt secured by other assets, can be sold for a profit, while unsecured debt is usually sold at a discount and cannot be packaged to any “securitized” type of product (at least in theory). As convincing as this term may sound, there is nothing secure about securitized debt – securitization is the third iteration of a promise (money – debt – securitized debt). A lot has been written about securitization and its contribution to the 2008 financial crisis over the last 5 years, so I’ll spare the reader from this detail. The above village example gave a good snapshot of how it works. Interest Income As interest income grows, monetary inflation grows along with it. But is it a sustainable model for businesses, pursuing solely profitable ventures? If there is no other way for money to be increased but by printing it, are paper profits worthwhile as a primary measure of performance and / or an indicator of future performance? Concluding my thoughts on banks, their business ethics and transactions should be questioned by the people to a large extent, because banks use other people’s money to make profit for themselves in the first place. Charles Ponzi would be proud of his followers. Bernie Madoff, rightfully accused of what he has done, is no more innocent than Wall Street tycoons, but unfortunately Wall Street seems to have bought the U.S. Government or at least holds it as

a hostage. As insane as it sounds, the wealth distribution diagram, discussed in Part III, shows that this can be possible.

“Valuable” Accounting Accounting is about recording business transactions in order to produce financial statements and properly calculate taxes. While business transactions are generally recorded in monetary (cash) value, financial statements have a number of non-cash values in their line items, as required by accounting rules, some of which are extremely complex. If value is an elusive concept by itself, accounting value, paraphrasing Winston Churchill’s famous quotation about Russia, is “A riddle wrapped in a mystery, inside an enigma; but perhaps there’s a key”. That key is noncash. Based on the U.S. Generally Accepted Accounting Principles (GAAP), market value of public stocks, bonds (debt), mortgage backed securities (MBS), collateralized debt obligations (CDO), collateralized loan obligations (CLO) and other actively traded investment products is their “fair value”. Formal definition by GAAP states that “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. Based on GAAP, in an active exchange market, closing prices are both readily available and generally representative of fair value. An example of such a market is the New York Stock Exchange. To an investment professional, valuation expert or an investor with good judgment, such fair value can only be partially true, because it is not possible to differentiate market pricing driven by the investors with cash versus ones using debt and leverage. Accordingly, the accounting profession has no choice but to use market prices as a benchmark, but is it the right thing to call it “fair value”? Based on GAAP, if a reporting entity holds a position in a single financial instrument (including a block) and the instrument is traded in an active market, the fair value of the position shall be measured within Level 1 (liquid instrument) as the product of the quoted price for the individual instrument times the quantity held. The quoted price shall not be adjusted because of the size of the position relative to trading volume (blockage factor). The use of a

blockage factor is prohibited, even if a market's normal daily trading volume is not sufficient to absorb the quantity held and placing orders to sell the position in a single transaction might affect the quoted price. In my opinion, the reason why GAAP does not permit recognition of blockage discounts is simply because it cannot quantify it. GAAP also doesn’t differentiate the root cause of market fluctuations, which can be caused by small trading volume, speculation or systematic risk, and have nothing to do with fundamental valuation of companies. Imagine your neighbor sold his house in 2006 for $700,000, but bought it for $300,000 four years ago. Based on the above definition of the fair value, your house, comparable to your neighbor’s, is now worth $700,000 and bankers will be lining up at your door to loan you money on HELOC. After 2008 your house is no longer worth $700,000, because no one would buy it at that price. What is your house’s “fair value”? Here’s another riddle. Imagine there’s only $700,000 in the entire financial system, and someone decides to invest all the money to buy your neighbor’s house. Based on GAAP, it means that your house is now worth $700,000, but there’s not enough money in the entire financial system to substantiate this value. The Federal Reserve would have to either print additional $700,000 or circulate the existing $700,000 from the sale of your neighbor’s house, using the mechanism described in the previous chapter. If your house is sold through debt financing, the bank would record it at its cost of $700,000, recognizing respective value on its balance sheet as an asset. Accordingly, if your house was financed with debt, GAAP will allow recognition of two houses at $1,400,000 combined fair value, while there is only $700,000 in the entire financial system. Therefore this is a mental trick when we see a dollar sign in the header of the financial statements because we imply these are actual dollars, when, in fact, they aren’t. Is this fair? Fair value measurement assumes that an asset or a liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date, in order to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced

transaction (for example, a forced liquidation or distress sale). The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the objective of a fair value measurement is to determine the price that would be received to sell the asset or paid to transfer the liability at the measurement date. I assume you understand this definition, hypothetically, but “where is the money”? Let’s challenge fair value. The Reserve Primary Fund, the oldest money fund, made headlines in 2008 when it "broke the buck" as a result of owning too much debt issued by Lehman Brothers. The Primary Fund, which had assets of $63 billion at the time, held just $785 million in Lehman-issued securities – about 1.25% of the fund's total assets. But investors got spooked and withdrew their money in droves, leaving the fund unable to meet redemptions. The next day, the fund announced that its net asset value had fallen to 97 cents. The timing of these events was between Monday, September 15, 2008, when it filed for bankruptcy and Tuesday, September 16, 2008, when Reserve Primary Fund’s shares fell to 97 cents after writing off debt issued by Lehman Brothers. The Reserve Primary Fund has since been liquidated and its parent, the Reserve Management Co., was charged with fraud and misleading investors. If we were to use “objective market data” on the Reserve Primary Fund’s stock price, as required by GAAP, we would get two drastically different “fair values” within 24 hours. This would also be the case during the flash crash of May 6, 2010, when one trillion US Dollars of market value disappeared within half an hour. Both events had nothing to do with the monetary (cash) or fundamental valuation of the companies. Going back to one of John Keynes’ famous quotations: “Markets can remain irrational longer than you can remain solvent”, why would accounting professionals agree to record irrational values and make it a standard for the industry to accept and rely upon? Should the Financial Accounting Standards Board (FASB) be charged with fraud instead of the Reserve Management Co.? Generally, there are four distinct values, all measured in monetary terms: historical cost, current market value, net realizable value, or present value of

future cash flows. For liabilities, the net realizable value may be the settlement amount. The definition of fair value considers the concepts relating to assets and liabilities in FASB Concept No. 6, Elements of Financial Statements, in the context of market participants. A fair value measurement reflects current market participant assumptions about the future inflows associated with an asset (future economic benefits) and the future outflows associated with a liability (future sacrifices of economic benefits). I cannot resist but use another quote by John Keynes: “The long run is a misleading guide to current affairs. In the long run we are all dead.” Let’s challenge historical cost value and estimated value. The reason why we didn’t see many bad loans held to maturity pre-2008 was because there were no “historical” losses over the preceding 3–5 years to justify higher loan loss reserves. In accordance with GAAP, loans held to maturity are not marked to market as publicly traded instruments, but rather estimated for recovery using techniques (e.g. migration analysis) based on historical losses information. This is like driving a car and watching in a rear-view mirror what is going to happen. If you didn’t get into a car accident previously, it doesn’t mean you won’t have one. Some other accounting estimates, including recoverability of certain assets, are also based on historical experience. Here is another caveat about estimates. By recording high loan loss reserves in one year (e.g. 2008), a bank will most likely end up with a net loss in its income statement due to the magnitude of losses, following from a drastic change in the economic environment at that time. After time passes and dust settles, the bank can reverse the “excessive” loan loss reserve back to a “normal” level, thus recognizing a surplus in earnings. These estimates do not change the future performance of the loans. Yet, a single change in an estimate immediately results in a change of earnings to date. GAAP represents financial statements on accrual basis in increments of months, quarters and years. The “matching concept” prescribes that costs of resources recognized in the income statement should be matched with corresponding revenues reported in income. This principle allows greater evaluation of actual profitability and performance as it correlates, albeit imperfect, expenditure with earned revenue.

Let’s challenge accrual method. If a buyer of my goods never failed to pay me, I would accrue for the entire amount of profit based on the “rear view” mirror approach. Future payments are expected based on past performance. If I sold 100 units of merchandise and the title passed to the buyer on or prior to December 31, but he pays on net 60 basis (not till March of next year), I would still account for the sale of 100 units in arriving to my accounting profit in the year ending December 31, as required by GAAP. But what if the buyer, after receiving my goods, fails to pay me on agreed terms? I wouldn’t know about this until I publish my earnings release in early January. Group of 20 (G20) calls on accounting standard-setters to achieve a single set of high quality, global accounting standards within the context of their independent standard setting process. Such standards should provide users of financial statements with information that is useful in making investment decisions or performing financial analysis – the first objective of financial reporting in FASB Concept No. 1, Objectives of Financial Reporting by Business Enterprises. In my opinion, accounting usefulness comes from one thing only – monetary (cash) value. If financial statements are presented in monetary terms (we see a dollar sign next to reported amounts), shouldn’t all amounts be valued on the same terms? There is plenty of uncertainty in money itself by definition, because money is delayed value. Other values, including historical cost, current market (fair) value, net realizable value, or present value of future cash flows, combined with estimates and accruals, are all non-cash values. Money (cash) is the only value that is more or less consistent, while other values, presented based on the market data, valuation techniques and estimates, can be extremely volatile. For example, Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) and Free Cash Flows (FCF), basis for all business valuation techniques, are calculated using cash basis. Businesses are frequently sold or bought using the multiples method in application to revenue, EBITDA or FCF. Assets and liabilities, upon sale of any business, are always evaluated at liquidation / settlement (cash) value. So shouldn’t accounting value be also recorded using monetary (cash) value? Variability hurts. GAAP has become extremely complex and requires years

of study, training and practice in order to memorize, understand and implement. Besides, GAAP appears to be in continuous “catch-up mode”, attempting to grasp new concepts of an ever-changing business world – sophisticated financial instruments, unpredictability of future events and increased complexity of economic transactions. Cash, on the other hand, is cash. It either exists or does not, and it changes only in volume if it is printed by the central bank. Any basis to record journal entries, other than cash, brings ambiguity to value based on non-cash basis. Future economic benefits, no matter how accurately predicted, are always unknown. At present, there is a debate in the accounting profession whether fair value accounting or its main alternative – historical cost – should become a standard. While historical cost approximates cash value more than fair value, neither of them are free from shortcomings due to ambiguity. Fair value appears to be winning, because it is able to “best” reflect the “reality” of current financial and economic conditions, despite the fact that such conditions can change the very next day or the very next hour. Why not simplify and record everything on a cash basis instead? Past performance is not indicative of future results – why fall into a trap of assumptions about future economic benefits, if historical financial statements, presented in accordance with GAAP, already reflect uncertainty and / or systematic risk caused by economic volatility, debt and other “agents” of financial distortion? It would be unfair to the accounting profession to leave things at “stalemate”. There is a need to enhance clarity and promote transparency and robustness in maintaining the accuracy of information provided to the users of financial statements. I make some suggestions in Part III how to reinstate financial statements’ transparency, as well as their comprehension and users’ confidence thereof.

Equity and IPO It is easier to visualize the public stock market in analogy of a gold mine, with gold threads (money) scattered in unpredictable and inconsistent patterns. Finding a thread is precious, everything else is a nightmare, caused by academia, system, debt, leverage, traders and the overall resulting confusion. While I can understand the purpose of public stocks as cash-out and capital raise instruments for business owners, I don’t understand why they were also dubbed value preservation instruments (e.g. 401(k) pension plans). Theoretically, public stocks could be “value” preservation instruments in industrial expansionary economics due to ever-exponential growth of the global economy. However, the post-industrial economy we live in today appears to be using the stock market exclusively for cash-out and capital raise purposes by the owners (wealth transfer mechanism), because the global economy opened doors to significant systematic, competition and volatility risks. Would anyone invest your savings into something that can lose up to 100% of its value? A famous quote of John Keynes states: “The market can stay irrational longer than you can stay solvent.” The public stock market is a very risky way of wealth preservation for this exact reason – the underlying enterprise value (EV) may have nothing to do with its market quoted prices and, as such, cannot be converted into cash (money) at desired exit levels. Public stocks’ price mechanism works as follows. When a company decides to go public and list some or all of its shares on the exchange, underwriters and analysts price the shares based on the “fundamentals” of a business, using primarily discounted FCF method. This model justifies initial market capitalization above the accounting book value of equity, because the future cash flows, generated by a company, can be measured and brought to Net Present Value (NPV), which is what enterprise value is to the underwriters (plus or minus some adjustments). Book value of equity, on the other hand, is the difference between assets and liabilities of a company, calculated in accordance with GAAP.

The future cash flows are uncertain and unknown, prone to high expectations of management, shareholders and underwriters. In other words, there’s a bias – underwriters tend to create demand in order to sell shares they buy at discounted prices prior to IPO. This is somewhat similar to the Central Bank Dilemma section from the Debt chapter. Ask yourself the following questions: - How much money (cash) value is in the public stock market if all shares are sold at once (because we cannot pay for food with Apple shares)? - Why is GAAP book value of equity different from market value or enterprise value? - Why doesn’t GAAP allow recording GAAP book equity of public companies at fair or cash value? Concluding this chapter, I almost wish public stocks were pegged to their respective companies’ fundamental valuations based on discounted FCF method, or any other method that justifies higher than GAAP book value. This measure would make public companies buy or sell stocks with cash in order to maintain their prices at the fundamental values. Wouldn’t this measure keep things fair and reinstate the value preservation concept of public stocks? This will never happen because there is little or no cash in the public companies’ pockets to back their stock prices at quoted market levels. One will make an argument that it is not right to think of the quoted market prices as cash instruments because the former is a reflection of future economic benefits. I can understand this position, but then why does GAAP allow market float to be recognized as “cash and cash equivalents”?

Public Stock Market P/E ratio means (P)rice per share divided by GAAP (E)arnings per share of a publicly traded company. Price per share is a market price, quoted on a public exchange. Earnings per share (EPS) are GAAP profits divided by number of shares issued and outstanding (basic), as presented in GAAP financial statements. Of all the formulas showing the implied interdependence between market prices and GAAP equity, P/E ratio is supposedly the most informative for this purpose, because it calculates the expected return upon stock purchase. Allow me to explain why I believe P/E is nothing but another way to justify value that doesn’t really exist in monetary terms and has nothing to do with the actual or expected return. Assume today’s S&P 500 P/E ratio is around 16 – this means that a willing party paid $16 into every $1 of GAAP earnings, generated by the market within the last 12 months. By inverting P/E ratio into E/P ratio, one will derive a profit of 1/16 = 0.0625, or 6.25%, expected to be received by the investor in perpetuity. The logic of people who use perpetuity formula is as follows – if something pays $1 in perpetuity, what is it worth? Perpetuity formula, used in corporate valuation techniques (e.g. terminal value) stands behind the explanation why P/E ratio works in theory – it implies that 6.25% return will be received in perpetuity, i.e. economy will generate this rate of return indefinitely. S&P 500’s price of $16 as a class of assets means that buyers agree to 6.25% profit if they pay $16 today. But is this really the case? First off, 6.25% profit is non-cash (as required by GAAP) and there is no assurance the money will be received by the reporting entity for a number of reasons, as was discussed in the Accounting Value chapter. Going back to the Accounting Value chapter example of a bank, reversing its loan loss reserves, such bank’s P/E ratio will decrease upon recording of such journal entry. When a bank issues earnings to the public, some investors may think that the bank’s shares are underpriced, based on their target P/E ratio, and rush to buy its shares, thus increasing the bank’s market capitalization. But in reality, performance of the loans and their ultimate recoverability will

still be a question and depend on future events. Second, stocks are prone to a systematic risk, not associated with the performance of a company itself: - If more money is invested into S&P 500 as an asset class, then less return will be expected (P/E ratio will increase), because in this case the performance of the underlying companies will have nothing to do with the investment decision to buy the index. - If S&P 500 companies are performing better, their EPS will increase, but it does not mean that P/E ratio will increase as well. This is because if no one buys or sells shares after the performance results are announced, price per share won’t change. Price per publicly traded shares can be changed only by the buyers and the sellers, who make investment decisions based on hypothesis of a future growth (future economic benefits), and it doesn’t necessarily have to reflect the underlying performance of the companies. Such scenario usually happens during a financial crisis or a recession, when the stock market first goes down and then up again. This is called a systematic risk. Systematic risk is reflected with Beta – a special ratio, showing how price per share changes if the market index (all companies combined) changes. Most of the public stocks center around a Beta of 1, which means there is a 1:1 ratio. Unfortunately, there is no such thing as Beta for the overall stock market, that would allow us to see how it changes if the economics change. Had such a Beta existed, we would have observed that change in major market indexes (i.e. DOW, NASDAQ, S&P) is highly correlated with overall economic expectations. This is because the major market indexes are a function of not only performance of specific public companies, but also of the speculative behavior of the market, and how much cash and leverage is available to trade them. I am not aware of a tool that allows quantification of expectations. In the real estate investment world, E/P ratio is represented by Cap(italization) Rate, where E is an adjusted annual rent and P is a price of real estate. The general rule of thumb is that when prices are attractive, Cap

Rate is above 5%, but when the market is over-heated (e.g. with debt from the banks), Cap Rate is less than 5%. This rule of thumb is a good indicator of where the economy is, but don’t bet your life on it – it may trick you and “stay irrational longer than you can stay solvent”. In conclusion, GAAP uses historical information, fair value, accruals and estimates to calculate earnings and book equity; corporate valuation techniques use fundamental analysis based on expected revenue, EBITDA and FCF to calculate enterprise value (EV); and the stock market uses profit motive to make money using cash, debt, margins and high frequency trading engines, all contributing to a price per share as of the reporting date, resulting in market capitalization of a company, index and ultimately overall market sentiment. While there is potentially some interdependence between these three “forces”, stating that there is causality between them would definitely be a stretch.

Government and Taxes Think of a government as a service or a corporate entity, contributing to justice, safety, protection and general well-being of its citizens. Taxes, collected by the government, represent its remuneration for performing these services. If the government doesn’t cope with its immediate duties, people pay for them out of their own pockets. Since taxes are not a voluntary form of payment, people hold their governments accountable for spending of tax revenue. People agree to pay taxes because they can get something in return, i.e. education for their children, medical services for retired citizens, infrastructure and judicial system, because it ensures living in a civilized world. Some governments, which provide a lot of benefits to their citizens, impose large taxes on economic participants. Countries that want to provide more benefits to their citizens should warn them that more taxes are coming, and vice versa. The more people are busy and, accordingly, get paid, the more taxes the government collects. This is the way the income tax system is setup in the first place. Individual income tax and social insurance taxes account for the majority of the total tax revenue of the U.S. Government[7]. One of Albert Einstein’s quotes: “The hardest thing in the world to understand is income taxes” has a lot of merit. Net profit (income) is not possible in a closed-end system, unless money is printed, on the one hand, or people start working harder and compete with each other for profits, on the other. While the former premise makes sense in expansionary economics (taxes are effectively “paid” by the growing demand), the latter doesn’t, because a government only wins from a rat race by its citizens. Who would want such a government or such a system? It is easier to understand income taxes in terms of a circulation volume, not difference between revenue and costs (accounting profit or income). The same Dollar can be taxed multiple times, depending on how quickly that Dollar is circulated within the economic system. Effectively income taxes are charged not on income, but on volume of business activity (i.e. GDP). Back

to our village example, if $100 is circulating (changing hands) at a rate of 5 times during a year, and the government imposes 10% income tax, government would collect and spend $50 during that year. Accordingly, if GDP slows down (consumption decreases), a government collects less taxes in absolute terms, and vice versa. If a government doesn’t have enough cash to perform its duties, it has three choices: reduce government spending, increase taxes or borrow money. While the first two choices are intuitive, the third choice, given the modern state of the global economy, requires an explanation. Let’s see a big picture using the U.S. as an example. Due to the pressure on corporate profits, companies outsource jobs overseas for cheap labor and resources. Such business practice not only causes a significant burden on local unemployment levels, but also results in net capital outflow. Increased profit tax (due to increased margins) more or less compensates social security benefits to those who lost their jobs, but how does the Government handle net capital outflow? The only way to issue international debt is by selling it for U.S. Dollars. Due to the U.S. international outsourcing model of low labor and goods manufacturing, U.S. Dollars, which would have stayed in the U.S. otherwise, flow to other countries. Other countries can’t spend Dollars locally; hence they buy U.S. debt, thus importing money back to the U.S. This way the Federal Reserve doesn’t need to print money to compensate for the net capital outflow, but there is one big problem - government starts spending money it doesn’t have, artificially boosting GDP with debt money. In order to maintain a healthy economy, money (local currency) should stay within the economic system. Otherwise there is less local economic activity and tax revenue no longer covers government needs. When imports exceed exports (main reason of net capital outflow), merchandise, which otherwise would have been produced locally, is assembled overseas. In this case corporate profits should be taxed at higher rates in order to remove the cheap labor incentive and instigate local contribution instead, thus adding to the local GDP.

Currency Purchasing Power An economy, represented by its own local currency, can grow only if there are more goods and services produced and /or sold (exchanged) in that local currency. The more goods and services are exchanged in one currency, the stronger that currency becomes: - Increased demand for a currency means a country can borrow against its increased value; - It doesn’t matter where a commodity / merchandise is located as long as it is traded in a given currency; - Confidence in a given currency increases as more goods and services are measured and exchanged in it; and - Increased demand for a given currency makes it a commodity and a value preservation asset. Value of money is derived from what one can buy with the money, that’s why it is an asset and a commodity at the same time. As the economy grows, money circulation increases, on the one hand, and more money is printed, on the other, in order to sustain the economic growth. One should never forget that money is still an ether, allowing economic transactions to take place. Its value may fluctuate like any other commodity or intangible asset – depending on the ultimate demand and supply. The mechanism of international trade with foreign economies and foreign currencies (FC) works as follows. Before buying FC denominated goods, one first buys FC at an exchange rate that approximates how much the goods would cost in a local currency. The FC bank has a right to sell you FC in exchange for your local currency. This is usually done by means of giving you a loan in FC (or a letter of credit), which can be spent to buy FC goods. This way a bank finances sale of the goods in the first place. In order to repay the loan, one needs to buy back FC. A foreign currency is an attractive buy only if there are valuable goods and

services in that foreign country, thus backing FC value. Exchange rate is something that represents a comparable value of FC in local currency. Otherwise there would be no exchange rate. Therefore, currencies represent access to valuable goods and services, nominated in those currencies. Demand for FC means that a willing buyer will sell his local currency (and as such, open an opportunity to buy goods and services, denominated in the local currency) to get FC, so that he could buy goods in that foreign currency. Accordingly, if one country just buys FC and doesn’t spend it on the goods and services, it removes the purchasing power of the local currency, because then there is less money in its economic system. If the other country decides to sell its FC currency as well, there will also be less money in its economic system. Natural resources or something else of value – art, machinery, equipment, etc. represent value to the FC holders. An interesting chain of events occurred post-2008, when the Swiss franc was designated a “safe haven” currency, and the Swiss government had to peg its currency exchange rate to the Euro in order to stay competitively priced for exports. When one country just buys other country’s FC, it increases its exchange rate artificially, because there are no goods or services sold for this purchase back to the country that buys FC. Accordingly, maintenance of a healthy equilibrium of sales (buys) of currencies and respective exports (imports) is one of the main responsibilities of any central bank. Pegged currency means that a currency’s exchange rate is fixed at a certain rate regardless of supply and demand. Such measures allow some countries to keep the exchange rate of their local currency low in order to stimulate local production (if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services instead). This measure will generate more jobs and stimulate the local economy’s GDP. Such a policy will also allow accumulation of excess FC reserves, which can be later used to buy foreign assets. China is one of the most effective users of such FC policy, keeping its exchange rate low for years in a row, in order to stimulate its local economy and accumulate FC reserves to buy foreign currency denominated assets.

PART II: GLOBAL ECONOMY

Economic Growth The global value of economics and wealth increase as the standard of living increases, i.e. both contribution and demand increase at the expense of once abundant natural resources. Human labor and technology helps convert natural resources into devices, homes, cars, etc., which are valued by the society and associated with so called civilization, progress and overall standard of living. Recent technological advances allow more people to enjoy lifestyles they could only dream about 20–30 years ago. The monetary base and its velocity increase in order to support increased consumption, because more goods and services are exchanged. In order for you to sell something, someone else has to have money to buy it. The economy grows organically as people invent new things and make technological progress, although it causes wealth inequality, as discussed in Part I. Nevertheless people tend to try new items and thus exchange these items if they find them of value. In the past people used to trade and accumulate gold and silver as the only means of exchange. Today people trade to accumulate paper and electronic money, because everything can be exchanged for it, including gold and silver. Lending money in the form of debt became an option after profits started to accumulate on the banks’ balance sheets, because money would have been continuously circulated otherwise and banks would have no discretion over its use. Spent debt (e.g. credit cards, HELOCs, student loans, etc.) has no immediate cash value, because a person who received debt money and spent it didn’t contribute anything that can be immediately monetized. On the other hand, this debt money, spent on goods and services, increases GDP. Therefore, real GDP growth (not debt financed) occurs only when there is an equivalent contribution by labor or technological conversion of natural resources. How much money does an economic system need? As much as it takes to exchange goods and services multiple times during a given period. Excess

money, accumulated from profits, stays within the financial system, waiting for allocation in order to grow the economy further. When economic growth stops or slows down, excess money sits idle, unless it is introduced to other economies in a form of debt, which then stimulates the local economy. As a consequence of the 2008 crisis, money was printed post-2008 by the Federal Reserve in order to deleverage banks and bring liquidity into the financial system. Such policy will eventually cause CPI inflation that will be absorbed by all participants involved in the economic process, because there is still no real contribution justifying printing more money. The only measure that “saves” the U.S. from high CPI inflation today is the “export” of inflation in the form of international debt increase. Profit recognition effectively reflects more work required in order to justify monetary inflation and economic growth. Part II covers this and other matters pertaining to the current state of the modern global economy.

International Reserves Let’s create an example. Germany sells a car to the U.S. The buyer pays $50,000 (a promise to deliver value in the future in exchange for $50,000 worth of value). A German bank shows $50,000 in cash (assets) and current account of a German manufacturer (bank deposit). The buyer agrees to deliver something of $50,000 in value to the seller at a later time, signifying indebtedness with money – delayed value. The German bank buys $50,000 worth of the U.S. treasuries and wires the money back to a U.S. bank. $50,000 returns back to the U.S., but the German bank has $50,000 due to the German manufacturer. Cash to the value of $50,000 returned to the U.S. and is now back in the pockets of the U.S. buyer to spend. In the aftermath, the German manufacturer has produced and delivered a car for a promise to be paid and / or receive similar value of goods and services in the future. This promise was later converted into the U.S. treasuries, which allowed the U.S. to have both a car and $50,000 of liquid assets (cash) to spend on other items. Accordingly, Germany’s (or any other country’s) reserves, placed into the U.S. treasuries, are effectively money spent by the U.S. on goods and services, imported by the U.S. The U.S. debt is secured by the United States’ capability to produce and sell goods and services (or anything else Germany finds of value), which Germany may be in need of in the future, because the only way for Germany to redeem the U.S. debt is by spending U.S. Dollars. Such confidence comes from a number of things, including U.S. manufacturing, intellectual property and U.S. Dollars’ denominated natural resources. The more Germany produces and the U.S. consumes, the better it is for the German economy, but unless Germany needs something in return for their excess of contribution over demand, the U.S. will never have to pay its debt back. Therefore, global international reserves (debt) represent the excess of the previously recognized contribution of some countries over the previously

fulfilled demand of other countries. Value of the international reserves is backed by a confidence that someday it will be paid back in the form of goods, services or anything else of future value, but in fact it doesn’t have to in order to keep the global economy going as is. The only loser in this equation is Mother Nature, because economic activity increases only at the expense of natural resources to satisfy the ever-growing demand of the human population.

Pension Funds and Social Security Pension funds and any other form of social security were invented to ensure trouble-free retirement for people of a certain age and people with disabilities, who cannot contribute equally to their demands. Every country is different in the way that they determine the respective designations and requirements for retirement or other social benefits. Retirement age hovers around 60 years old across the globe. While the economic model in place when such plans were introduced was one of expansionary growth and, as such, earlier retirees could benefit from it, nowadays such an economic model is no longer viable and sustainable due to market saturation, increased competition and technological advancements. Most likely, the initial pension models were not well thought through in light of the fundamentals of economics discussed in Part I. It is sad to observe the reaction of some countries to the fact that pension and social security models are broken. Instead of changing the substance of their economic models, i.e. try to figure out a non-expansionary economic model, governments leave the core of the model the same, but increase retirement age, make strict qualification requirements and increase overall taxes in order to stay current on their pension obligations. Such measures represent “active inertia” and an attempt to cover incompetence of economists, who advise on such measures. If the initial premise was that a given economy would always grow and increase productivity indefinitely (in perpetuity), the pyramid of the pension funds would have worked just fine. Given the fact that constant perpetual economic growth is impossible due to market saturation, competition and technological advancements, pension funds and any form of social security cannot possibly pay back more than was contributed. Some money could be preserved in line with inflation had the pension money been invested into value preservation assets, but not stocks and bonds, which currently represent 70–90% of all pension funds’ investments in the U.S. Stock market. Bonds are non-cash, i.e. they cannot be sold instantaneously without losing the majority of their value.

What is the best storage of value for pensioners and social security? If money continues to be printed and borrowed to sustain increased demand, but no actual contribution is made to compensate, where should money be invested? Historically, houses, gold and oil represent the best storage of value over time and offer the strongest resistance to (monetary) inflation. According to the Flow of Funds Accounts of the Federal Reserve Board, the value of residential real estate doubled between 1999 and 2006, rising from $10 trillion to $20 trillion.[8] The spot gold price increased from under $400 per ounce in 2002 to over $1,600 per ounce in 2012.[9] Crude oil (WTI) increased from low $20s in 2000 to low $90s per barrel.[10] How much residential real estate value was kept post 2006 is a different question, because there surely was a decline, but my point is that land is more secure than stocks or bonds, and tends to appreciate in line with monetary inflation because people need land to live and produce. The same is valid for gold and oil – these are essential commodities both from perception and for living. Living either on rent from the hard assets (houses) or selling them makes more sense than investing in stocks and bonds. I understand there may be a lot of counterarguments to this conservative position; why not invest pension and social security money in the instruments that historically show better protection against inflation, shortage of liquidity and distress in the financial markets?

People and Jobs When people give up their free time to labor in order to get food and shelter, they contribute to economic growth. Working for a paycheck and paying taxes works to the benefit of GDP and government, thus the entire society wins. Progress, on the one hand, allows more free time, but due to increased consumption, on the other hand, we tend to sacrifice this freedom by working more, in order to get more stuff. Such dependency on technology is most likely because we want to keep up with others who do the same – must be the ancient “herd” instinct. Activity of people, involved in the process of creating something of value for sale, is measured with money. When technology progress reduces labor input (thus reducing the cost of manufacturing), increased profits accumulate and cause economic distortion (more on this topic in Wealth Distribution chapter). This is a sensitive subject given where the global economy is now – significant unemployment levels both in developed, but even more in developing countries. On the one hand, the more people are busy at work, the more taxes they pay to the government through individual income taxes. On the other hand, reliance on employees as a key source of income tax revenue in developed countries appears to be a shortsighted approach due to a shift in wealth distribution, ultimately resulting in less tax revenues for governments. An economic growth model that is based on high employment works in countries like China, but it no longer works in countries like the U.S., where either technology has replaced hard labor, or low paid jobs were outsourced to the developing world. On the one hand, China uses cheap human labor in labor-intensive industries to maximize profits of the worldwide corporations (most of which are U.S. based), but on the other hand, accumulation of wealth by these corporations is done at the expense of U.S. demand, which, in turn, puts excess pressure on the U.S. Government, as was discussed in the Government and Taxes chapter in Part I.

Therefore, the U.S. tax model has to change to match changing wealth distribution with the needs of society, at which expense such wealth is created in the first place. A high unemployment rate is considered a bad thing for any economy because unemployed people don’t contribute and live on welfare, thus spending other people’s tax money. This is a common problem for developed economies these days because technology and outsourcing substitute labor, which means people need to learn new skills in order to stay competitive in the market. To the credit of the unemployed, the post-industrial world changes expectations of contribution and demand very quickly, but learning new skills takes a lot of time. The lifecycle of jobs decreases as technology advances. If an adult cannot find a job based on his or her qualifications, and thus cannot contribute, it means that he or she learned something that others don’t need and are not ready to pay for. Accordingly, high unemployment becomes an educational as well as an economical issue.

Education Two famous quotes come to mind when I think about education: First one by John Keynes “Education is the inculcation of the incomprehensible into the ignorant by the incompetent”. Second by Immanuel Kant “… it is evident that the understanding is capable of being instructed by rules, but that the judgment is a peculiar talent, which does not, and cannot require tuition, but only exercise. This faculty is therefore the specific quality of the so-called mother wit, the want of which no scholastic discipline can compensate.” In my opinion, education of comprehensible matters, proven by hard evidence and facts, but not guesses and assumptions, is the only thing that is worth studying, and economics, accounting and finance should be no exception. While I acknowledge imperfections of human intellect, because we live in a constant discovery mode, critical reasoning should always be applied before facts and hard evidence are recognized as such. In the case of economics, accounting rules and finance models appear to be a long way from this ideal state. Otherwise we wouldn’t have recurring economic or financial crises and would be able to predict them. It should be acknowledged that life is an enormous learning experience and accusing previous models, which, in fact, worked fine in the industrial stage of expansionary economics, would be unprofessional and unfair. However, the new economic models that would work in post-industrial, highly competitive and technologically advanced economics are yet to be developed. One aspect I would like to highlight is the use of banks’ money to pay for education. When students borrow money and spend it for their education, banks pay to schools using students as intermediaries, and schools pay to professors, staff, etc. As such, the more students borrow, the more salaries get paid, but how does this help the economy? Especially when students learn something that is of little or no value to spur economic growth after they graduate? One can make an argument that by lending money and having this money spent, the banks help progress by having professors and staff do more research in order to figure out what to do next, but why not pay them grant money without making students repay the debt? After all, banks turn other

people’s money to make profits for themselves – what is the use in the middleman? Theoretically students pay for the knowledge that will be later used to provide more value through selling goods and services, which will eventually pay back. If students want to learn and be indebted for their knowledge, only those who really deserve it should take the responsibility of assuming the debt. I should be careful, of course, in saying what should and shouldn’t be done, but my judgment tells me that if debt is assumed for future value, only extra value, which is not yet being recognized and exchanged, will generate enough cash to repay the debt. Otherwise the debt will become worthless (e.g. the soon-expected student loans bubble) and, therefore, a government could have prepaid for the education without hope of collecting the money in the first place.

Wealth Distribution Wealth accumulates in inverse proportion to the number of people who possess it due to the profit motive, which dominates the business environment. The profit motive model makes money and everything of recognized and exchanged value accumulate with very few people, who are on the top of the “food chain” pyramid, while the wealth distribution pyramid is an inverted pyramid. The “food chain” pyramid is balanced with the inverted wealth distribution pyramid, portraying one of the ten postulates of Economical Equilibrium theory. It’s been like this for centuries and, unfortunately, mankind didn’t invent anything new in this sphere since the Egyptian civilization. Maybe this is the reason why we have pyramids in Egypt in the first place – they are symbolic of many processes in our lives, including economics. When money accumulates with very few people through the mechanism of profit making, discussed in Part I, it waits for allocation to grow the bottom of the pyramid either by increased tax revenue, or the issue of debt financing, in order to allow further expansionary growth for its base (consume more labor and natural resources). When such allocation is impossible (there is nowhere to grow), the bottom pyramid usually starts to rebel and overthrows the top. But the sad part is that when new members of society get to the top, they become hostages of the same pattern, and the cycle repeats itself over and over again, due to corrupt human nature. One of the main reasons why socialism didn’t work is because it is in direct conflict with the human society pyramid structure and requires wealth distribution regardless of contribution and demand. It also excludes ego and moneymaking motive, which seems to be entrenched in everyone these days. The modern economic system still needs more people at the bottom to do the work, less people in the middle to manage, and very few on the top to give orders. Theoretically socialism could have been possible if no one needed a “manager” or a “leader”, and was capable to sustain a living on his or her own, consuming subject to his or her contribution. Capitalism, on the contrary, has a pyramid structure for distribution of wealth and therefore brings inequality to the hierarchy by definition.

Fractals In Economics Capitalism and its wealth distribution are best visualized as a hexagram, but without the top and bottom triangles. It also has a fractal nature, i.e. its little components have the same pattern as the entire diagram. Countries have a president, office, government and citizens. Companies have one leader, a few board members, more management and numerous staff. In a way we can view the global financial and economic system as a giant pyramid, where people who are within the system, are “fed” by the newcomers, both horizontally and in volume. It works well when newcomers increase in geometric proportion, i.e. by a power. Accumulation of wealth by the few and “food chain” pyramid growth are interdependent processes. When we see too much wealth on the top, which cannot contribute to the bottom through distribution of wealth or use of more labor / more natural resources, such diagram becomes unstable. Paradigm changes in the economic world transfers people, companies and countries within the global pyramid, leaving its overall shape constant. There could be multiple reasons for a paradigm change – new technology allows usage of more natural resources to boost consumption, the world moves from the industrial to post-industrial stage, socialist countries become capitalist, etc. Two major paradigm changes happened in the previous millennium – first, the steam age, followed by the industrial age. Two paradigm changes took place in the previous century – World War II and the demise of the Soviet Block. But, again, fundamentals of wealth accumulation and distribution never changed and, sadly, probably never will. Why was so much wealth created in the U.S. and Europe after the USSR fell apart? Fractal geometry explains it all quite well. The demise of the USSR opened new markets for the western economy – skilled labor and enormous natural resources, waiting to become a part of the bigger pyramid. This also explains why U.S. Dollars and Euros are now used in post-USSR territory as means of exchange along with Russian Rubles – Russia is in the lower part of the financial pyramid, feeding the U.S. and Europe with consumption and contributing its natural resources in exchange. A few Russian oligarchs, buying expensive yachts, soccer and basketball clubs, are just a tiny

representation of wealth created from the post-USSR territory for the benefit of the U.S. and Europe. The collapse of the USSR was preceded by two world wars, where Germany and Japan lost to the USA, UK and USSR, which subsequently shared their markets for the benefit of their economics. Subsequent to that, the Soviet Block started to compete with the West, which resulted in the demise of the former. Continuing this scenario, the next big question is which pyramid will win next – USA and Europe vs. China? As we all know, China is very protective of its internal affairs and is a unified nation state (unlike the former USSR and its territories). China now uses western technologies to develop its economy and is actively buying natural resources in Africa and Russia in order to support its continued growth. But as with all pyramids this growth will stop at some point. When this happens, the question will be which pyramid will survive – Western or Asian.

Time Bomb I couldn’t ignore this section because worldwide income inequality is growing rapidly and sooner or later this time bomb will either explode in a much larger scale economic crisis than anything we’ve seen in the past, or, if handled intelligently, will be put off and, hopefully, defused forever. The reason behind the former is continuous replication of the existing economic models, based on a premise of expansionary economics. By replicating such models and imposing them on the developing world, we plant incorrect perceptions of how economics should work and create unsustainable world dynamics. In addition, by providing old technologies to developing countries, we are killing our planet by pollution of the environment and exploitation of nonrenewable natural resources, including water and air. Using modern economic development and financial models, which first of all target profits and / or interest income (money), countries with natural resources are destined to receive a smaller share of the “surplus” product due to inequality of profit margin allocations in the final product. As the final products are sold to these countries by developed countries, the former need to produce more raw materials in order to purchase foreign goods and thus enjoy the benefits of “civilization”. Therefore, the accumulation of the surplus will be less than in the countries that produce the final product. One of the solutions to this problem could be a price increase of natural resources to a level when there is a balance of capital inflows and outflows between the trading economies – not at the expense of volume, but rather profit margin, charged by developed countries on the final product. Natural resources are scarce and should get an equal premium along with technology, keeping things balanced, especially if polluting technologies are being used. Let’s ask a broader question – what non-renewable natural resources are we using? Oil, natural gas, coal, radioactive materials. These resources are converted into heat, electricity and transportation. We need heat to keep our houses warm in winter, we need electricity to use computers and we need transportation to travel and commute. Given our modern technology to

transform the above non-renewable resources into what we consume was created at least 50 years ago, but their global consumption increased disproportionately over the last 20 years, the pressure on non-renewable resources has substantially increased. Such trends were primarily caused by making technology available to developing countries. As a result, water, once renewable, has become contaminated with chemicals through its commercial use. I’m not an expert in technology or ecology, but my judgment tells me that replicating economic models and technologies that target growth at the expense of more labor, non-renewable resources or contamination of renewable ones, should stop immediately and start being accounted for. Otherwise Mother Nature will punish us sooner than we think. I wonder if anyone thought about building a model, taking these variables into account, in order to estimate the date when doomsday will come. Cree Indian prophecy: “Only after the last tree has been cut down. Only after the last river has been poisoned. Only after the last fish has been caught. Only then will you find that money cannot be eaten.”

Part III: ECONOMICAL EQUILIBRIUM

Geometry of Economics Economical Equilibrium is a theory that explains economics using geometry. Almost all processes in the world are better explained and can be visualized with geometric figures, rather than with conventional linear mathematics. More importantly, visualization, provided by geometry, provides an instant view of shapes and allows seeing these shapes in time. While, for simplification of understanding and initial application purposes, I’m presenting only two-dimensional (two axes) geometry (using ellipses, squares and triangles instead of spheres, cubes and pyramids, respectively), it can be turned into volume by adding a third axis, when analyzing significant volumes of data. Volume provides the third dimension as in spacial geometry, and, after adding the fourth dimension, time, one can learn how objects transform in dynamics. After all, we all live in space–time continuum, so why not treat economic processes any differently? Geometry allows seeing shapes that are otherwise hidden, e.g. market capitalization based on trading volume, debt and economic growth, wealth distribution and number of people, etc. Modern computing power is capable to create models that would allow us to see empirical data in appropriate visual format. Modern financial models, based on linear mathematics, use central limit theorem and perpetuity formulas to account for anticipated events based on the past – Standard Deviation, Net Present Value of Free Cash Flows (NPV of FCF) and Capital Asset Pricing Model (CAPM) are all based on the premise of linearity. Nevertheless, such models do not work because they cannot predict, hedge, or explain the relationship between multiple variables thereof, as was also proven by the recent financial and economic crisis. Despite the fact that such models show expansionary growth is possible at a certain rate (e.g. stock market, GDP), they don’t show the proportions at which such growth should be paced and how to take other important variables into account, e.g. trading volume, number of people, monetary base increases, interest rates, etc.

Geometry-based models, on the other hand, represent a more concise, yet capacious view of economic events, their interactions and respective changes, adding time as a factor. It is also a better tool to analyze past, and estimate future, events, helping businesses and countries regulate their economies with more precision, thus leaving less chance of mistakes or misconceptions. While there is a lot of research and analysis necessary to implement Economical Equilibrium theory and make it useful in the everyday life of economists, some of the evidence, obtained using limited studies of data, shows that the theory stands up to scrutiny and can be applied in practice. Market capitalization based on number of shares traded Seeing the volume of shares traded versus total outstanding shares, on the one hand, and price change based on volume of trades, on the other, is a good geometrical exercise. Think about it this way. Market capitalization is a geometrical volume figure, but for simplicity we will show it in 2D. The number of shares traded is one axis and price per share is another. When a company does IPO and subscribers (investment banks, qualified investors) buy shares of a company at an agreed price, the market capitalization represents a cylinder (rectangle in 2D) with a long axis being the number of shares and short axis being the price of IPO:

Given the knowledge of how modern financial models work, an IPO can be a success if, and only if, the expectations on the growth of a business are high – this is how underwriters and business owners “make” money. On the one hand, this fact explains the dot.com bubble and other IPOs, which went from boom to bust in a relatively short period of time. On the other hand, some IPOs were successful (e.g. Apple), and sustainable for some extended period of time, but the stocks’ performance could still be very volatile, subject to how the business was going and its future expectations thereof. The conclusion I draw from this experience is that investments in stocks, prices of

which are driven by expectations, are very risky, and the financial models used to project the results cannot be relied upon to project future prices. I have a graphical solution for the hypothesis of IPO bubbles through analysis of shares traded after IPO on a secondary market. When shares start trading publicly, only a portion of issued shares is sold to the public immediately for further exchange. During the exchange, the same shares can change hands multiple times during a day. Unfortunately I couldn’t find an information source that would provide data on distribution of individual shares’ daily pricing in order to build a geometrical figure of the market capitalization’s transformation. Had such information been made available, we would be able to identify how a single share (or very few of them) traded multiple times during a short period of time, can increase or decrease market capitalization of the entire company. The only information available publicly is the volume of traded shares, which is the amount of shares that change hands from sellers to buyers, as a measure of activity. Even though this is only a half-, or quarter-answer to what we’re looking for, such data allows us to see significant distortions of how market capitalization can increase or decrease based on different volume of trades. My hypothesis is as follows. The fewer shares are traded of the total shares outstanding, thus causing price per share to go up, the greater the chance of a bubble occurring. My logic is that money, as an equivalent of exchange, is scarce, and may not be readily available to continuously buy stock at a higher price. Accordingly, as the money dries out, fewer and fewer shares can be bought. Let’s represent this logic geometrically:

The top corner of the bottom triangle represents available cash to purchase shares at an increased price. The base of the upper triangle represents growing market capitalization of a company as its stock is going up. I call this diagram “inverted triangles”.

As a conclusion from this hypothesis, little cash is required to boost market capitalization of the world’s indexes, which inevitably collapse either due to a systematic risk (when confidence in future performance is decreasing, or cash is needed to pay salaries, taxes, debts or cover margin calls, etc.). Trading on margin (when stocks are purchased with debt) requires no cash to be involved to begin with, but the stock market would still go up. It’s like one bubble (debt, leverage) creates another (stocks). In this situation the top triangle gets disproportionately larger than the bottom triangle and, when this happens, a collapse is inevitable. Additional analysis should be performed as to the slope of the lines of each triangle in order to see whether there’s a critical angle at which the structure becomes unstable and falls apart, thus causing the bust cycle in the stock markets. While this hypothesis can and should be challenged in terms of individual stocks (because there is competition and, as such, capital can move from one company to another as a winning bid) it should stand for the overall stock market. This situation is referred to as a “systematic risk” of the stock market, but to me it sounds more logical to call it “liquidity risk” due to the mechanism of purchasing stocks, as described above. This hypothesis is validated by the events in the stock market after Quantitative Easing II was discontinued on June 30, 2011, when global stock indexes plummeted over the remaining third and fourth quarters of 2011. Unfortunately, financial reporting requirements by FASB and U.S. Securities and Exchange Commission rules do not require a transparent view of how much market capitalization is achieved and what component of it is based on speculation, leverage, number of shares traded, etc. In order to partially solve this problem, I suggest conducting a comparison between M0, M1 and M2[11], on the one hand, and U.S. equities market capitalization and in dynamics over time, on another. A simple fact that difference between M1 and M2 is at least four-fold[12] tells me that money market funds are heading towards a pyramid structure. Market capitalization of U.S. equities only for 2011 was $15.6 trillion[13] versus M2 of $9.6 trillion[14], adding more questions regarding real value behind market capitalization and whether much of it will be left if converted back into cash.

Debt and Economic Growth Global debt shows horrific statistics over the past two decades. United States’ government net debt percent of GDP increased from 46% in 1990 to 84% in 2012 and is projected to reach 89% by 2017[15]. Many advanced economies show similar trends in terms of debt / GDP relationship due to the same fractal pattern taken by other governments to stimulate their own economies. Going back to the Fractals In Economics chapter in Part II, these patterns do not seem to change. U.S. Corporate annual bond Issuance shows an increase from $344 billion in 1996 to $1,360 billion in 2012[16], adding to $6,463 billion[17] of total issues traded only, without taking into account the private bonds market. At the same time, United States’ GDP percent change was 1.9% in 1990 and, while 4–5% growth was achieved in the mid-1990s, on average there was only 2% growth in the 2000s with 2.17% in 2012[18]. If debt money is spent on equipment, inventory, construction contracts and salaries, and ultimately all of these items contribute to GDP, does the U.S. have real GDP growth as the statistics show above, or is it only debt money we spend to keep the economy going? Unfortunately it appears to be the latter, because GDP is a measure of economic activity, rather than wealth. If we were to build a geometric figure of U.S. debt vs. GDP, we would get inverted triangles, similar to the ones in the previous example, where debt overhang (upper triangle) over GDP (lower triangle) shows that it takes more debt to generate more GDP, but at increasingly disproportionate levels:

While this is only a diagram and doesn’t reflect the actual proportions, it is clear from this image that such a “business model” cannot be sustained for long and when asymmetry becomes greater (more data is needed to calculate

the slopes when a critical moment occurs) the debt could be defaulted due to an inability to honor the obligations. Such scenario occurred in some European countries in 2011–2012 and continued in 2013 in Cyprus, resulting in external financial aid and restructuring of the local banks. No debt means that an economy and GDP would most likely grow in ellipse or circular shape, when GDP is increasing gradually and in consistent proportion of contribution and demand growth, thus expanding in volume around the long axis. Such growth is organic and it doesn’t depend on debt in any form, adding equivalent value based on contribution. Debt is the primary cause of an overheated economy and has a disruptive, rather than organic, pattern for economic growth:

Wealth Distribution and Number of People Take the distribution of wealth model, which was initially presented in Part II. The bottom triangle shows number of people based on the amount of wealth they possess, while the top triangle shows respective wealth distribution. This representation makes a lot more sense than showing a graph skewed towards the right on just 2 axes:

The slope of the line adjacent to the base will get a steeper angle as wealth distribution gets more uneven and, on the contrary, as the distribution evens out, it will disappear into an ellipse form, as show below.

An ellipse distribution is natural for space and time, but not for the wealth distribution of human society (unfortunately). Ellipse distribution is centered on the long axis, making growth or decline more or less evenly distributed. Nevertheless I could make a hypothesis that a society, where the middle class possesses the majority of wealth (e.g. U.S. in 1960s), would show an ellipse type wealth distribution, making such a society stable and generally happy with the state of its economics. Geometric presentation of data distribution is in line with Economical Equilibrium theory regardless of the ultimate shape, because economics change due to a cause and effect relationship. What shape will it take is a different question. Let me step back and take a philosophical view of the business type environments. Had we lived in a different world, without leaders, managers, CEOs, etc. who we wouldn’t have to remunerate in accordance with a pyramid or “food chain” type of approach, we would see more circle-type shapes in economics, where everything would be distributed based on contribution and demand equality (take the village example from Part I where only $100 was in the system – such economics and respective distribution of wealth would be recorded with a circular shape). The fact of the matter is that in our world there are those who lead and those who follow, where the majority of people are the followers, and, for some reason, agree to work for less money than their superiors, thus leaving the majority of profits to the few at the top. An economy can take one shape or another, as Economical Equilibrium theory shows, but its balance and thus sustainability can become unstable, as could be visualized with geometric figures. A balanced economy would exist only if there was an equal contribution by all participants involved in the economic process – someone creates something and gets something else in exchange within a reasonably short period of time. In that case, circular-type

symmetry would be maintained. Should there be shortage or excess of either contribution or demand, including artificially induced with debt, Economical Equilibrium will immediately reflect the distortion, which we will be able to see through respective change of geometric shapes. Ideally, economists, accounting and finance professionals should start working on a combined project to portray a full scale 4D Economical Equilibrium picture for both developed and developing countries, which would allow smoothing of sharp angles and disproportions presented by respective shapes. The following two chapters make a suggestion to use specific ratios that should help in this exercise.

Cash Value Ratio Liquidity is an ability to convert an asset into cash quickly. Therefore, money is the most liquid asset and has a spot Cash Value Ratio (CVR) of 1: CVR = Spot Cash Value / Quoted Market Price CVR is a new ratio that I suggest the economists, accountants and finance experts start using, in order to arrive at the cash value of items. The idea is not a novelty. Redemption/liquidity (how quickly an asset can be converted into cash) has recently become a widely used measure of portfolio managers’ performance evaluation – how quickly can a hedge fund convert its assets (stocks, bonds, etc.) into cash without losing any value. Stocks and debt can achieve lower than currently quoted prices if sold, so the question is how much cash value does an asset hold if sold immediately? For that reason CVR could be a universal measure to allow managers to evaluate their assets as a new liquidity benchmark. CVR statistics should also serve as an indicator of the current status of economics in order to see when things start getting “out of shape”. Most likely, in the growing economy, CVR will be close to 1 for the majority of financial instruments due to increased pressure on buying assets to increase wealth. In a neutral or declining economy it will be trending to less than 1 for any asset, other than cash, due to the fact that investors will try to receive profit upon acquisition of any asset and offer a discount to the quoted price. In addition, CVR is a good indicator of why fair value accounting does not hold true.

Value Retention Ratio Value Retention Ratio (VRR) allows identification of a particular asset best fitted to preserve wealth at existing economic conditions. By asset I mean any asset, or a combination thereof, that would allow protection and accumulation of the principal balance: VRR = Spot Cash Value / Initial Cash Value In the growing economy, assets will have a higher VRR, than in the declining economy. While VRR has certain resemblance with CVR, its sole purpose is to identify the best value preservation assets that maintain the highest ratio both in growing and declining economic cycles. The only drawback in both CVR and VRR use is the fact that cash can be increased in volume through the printing mechanism of central banks worldwide and, as such, cannot be taken as an absolute measure. Such a drawback could be fixed through analysis of comparable world currencies with lowest volatility to their respective exchange rates. Based on my research, the same asset classes can show a wide range of CVR and VRR depending on timing of entry and exit points, as well as the state of economics. Nevertheless the following asset classes showed the best value over the entire analyzed period: gold, platinum, real estate, oil & gas versus others, showing lower ratios – stocks, bonds, derivatives (CMO, CDO, options, futures), silver, Indexed funds, ETFs, private equity and venture capital. I invite researchers and analysts to share their thoughts on this topic and identify the best value preservation assets of all time – this will be an interesting exercise[19].

Balanced Growth Model After finishing this chapter I realized that it would be impossible to achieve balanced economic growth without some radical measures. This has nothing to do with economics as a science – we cannot blame the mirror. It has to do with corrupt human nature, laws of capitalism and accounting / finance misconceptions. Nevertheless, if a surgical procedure is required, at least we know what to remove before our “patient” could recover. The reason why this book came to mind in the first place was because I lived through three financial crises over the last fifteen years (including the one in Russia in 1998), and I wanted to understand the root causes of each one. More importantly, I wanted to contribute towards avoiding the next one, or at least make it less devastating for all parties involved. As was determined in Part I, U.S. Dollars are represented by paper or electronic form, but they still keep an implied value that one can buy goods and services with, thus keeping the exchange going. As an economic system grows, more money is introduced through P*Q = M*V formula (Price times Quantity of goods and services = Money times Velocity of circulation). Money is a valuable commodity, which derives its value from business activity of the economic system. Profit / Capital means Return On Capital (ROC), which implies that money, as a means of exchange, should also earn a profit. As was determined in Part I, an economic system can only receive profit through net growth or distribution of wealth between its participants. Therefore, if corporations are using profit as a key measurement of success in a closed-end economic system, they are either cannibalizing other participants by underpaying them, or cause monetary inflation (or both). If we want the Economical Equilibrium shape to be an ellipse, consumption of goods and services should be proportional to the contributed labor and/or technology. Additional value creation, which can be exchanged for cash without debt money, would allow a circular-type growth as long as its contribution is matched with demand, not fueled with debt. While this does sound idealistic to a certain extent (in this case, debt financing, interest rates,

profits / value-add would not exist), this scenario would avoid the economic distortions we see repeating over and over again due to angularity caused by formation of the inverted pyramids. Economical Equilibrium theory suggests that balanced economic growth is possible only when more contribution and matching demand is created (horizontal growth of ellipse) by all of the participants. Given that key drivers of economics are natural resources and labor / technology, extensive growth is possible only when more natural resources are consumed through more labor / technology contribution and demand. As the technology advances it frees intensive labor, and technologically advanced economies tend to become more service-based and research and development focused, leaving developing countries in a position of natural resources and cheap labor suppliers. Another aspect I would like to bring up is that it makes sense that a single global currency should be prevailing in the global economy. I understand that human society is not ready to take this step yet, but otherwise distortions in economical equilibrium are inevitable. A temporary solution to this problem could be the one that the central bank of Switzerland implemented by pegging its currency to the Euro in 2011 in order to allow local products to stay competitively priced in other countries, but such activity puts a lot of pressure on local central banks that should protect a given country’s economy from unjustified buys and sells of their local currency. In addition, money should be independent from a given country and be in sync with production and consumption thereof. Instead of Dollars, Euros and Rubles there could be just Money – a convenient way to equally measure commodities, labor, goods and services all over the world. When everything is measured with Money and Money issuance or withdrawals are based on Economical Equilibrium, the global economy will become unified and will not suffer crises due to currency interventions, debt circulation, etc. Europe learned a good lesson over the last decade: while the Euro is a great new currency, it is only great if it is backed by valuable goods and services, both for internal and external markets. Going back to the Time Bomb chapter in Part II, it is vitally important to

perform an analysis to identify economic distortions early using Economical Equilibrium theory methods, in order to calculate how much growth is still sustainable with the existing models and technology, and what steps should be taken while the inertia lasts. Upon completion of such analysis, global society should consider steps towards reduction of angularity. For example, one country has natural resources and another one has technology to convert it into something useful. One cannot live without another – the technology depends on the natural resources. Therefore, an exchange between countries should take place to allow an equal amount of natural resources for the respective technology’s benefit. As technology advances, its price should come down in comparison with natural resources’ prices, because otherwise overconsumption of limited resources decreases its deposits to extinction unless new technology emerges to stop its exploitation entirely. Let’s assume such analysis is not performed and people don’t invent an alternative energy source before oil and gas reserves dry out. Upon occurrence of this otherwise inevitable event, many people will return to medieval conditions without oil and gas and live off the land as they did over 200 years ago. Geometrically, such a dilemma looks exactly like the inverted triangles’ diagram:

The bottom triangle represents decreasing deposits of non-renewable natural resources, while the top triangle shows the respective consumption increase using existing technology. It should be noted that price limitation of an in-demand natural resource rarely helps if such a resource is required to sustain the needs of the human population. Therefore, the use of older technology to satisfy demand, which has grown in geometric progression over the last 20 years, should be

evaluated with the Economical Equilibrium geometry in terms of when a given natural resource will become extinct. In conclusion, the Economical Equilibrium balanced growth model is possible if two things happen. First, we should use products and services which in turn use only renewable natural resources (i.e. solar energy, organic food, etc.) and don’t contaminate our planet, because FASB doesn’t know how to account for externalities. Second, we space out use of products that we absolutely must have, but which use non-renewable natural resources and/or contaminate our planet, in accordance with strict and smart regulations.

Is a Country In Good “Shape”? By country I mean its economy. Use of geometry helps immensely in identification of the best shape a given economy should take in order to maintain a quality lifestyle for its citizens. It would be nice to have a study on hand that portrays the shape of every single country’s economy, using market capitalization distribution, debt and economic growth distribution, and wealth distribution examples presented earlier in Part III. For example, the geometrical “shape” of a country would be an ellipse if its wealth distribution is centered on horizontal mean – there is a strong middle class exchanging goods and services with matching contribution and demand. An economy grows only when willing buyers and sellers produce and exchange more. Economic growth stops when all possible assets are already sold or exchanged, but it is not necessarily a bad thing because an economy can grow only at the expense of greater consumption of natural resources. I personally want the global economy to stop growing and people to start thinking at what expense it has been growing to date, and whether such a growth model is sustainable given the unaccounted footprint such growth is leaving behind. Economical distortions from profit, value add, inflation and interest cause frictions in all planes of economics, including social and political. The best measurement of such frictions is dissatisfaction. Dissatisfaction is impossible to avoid if something is wrong. It must be a natural internal control mechanism of all humans that brings things back to balance. Invention is a reaction to dissatisfaction with the current state of things. If someone is not happy with the reality, he or she makes something to compensate for it. Once something gets outside of equilibrium, something else will bring it back to balance. Any economic growth model will be balanced if the monetary volume (M*V) in the system increases in the same proportion as contribution of consumed natural resources, both renewable and non-renewable. As the contribution decreases due to inevitable market saturation and economic slowdown, the amount of money in circulation continues to exchange hands at its peak

value, gradually causing monetary inflation:

The profit motive, prevailing in the modern economy, creates excess money, which, in the end, gets allocated across very few individuals or corporations, as was presented in the Wealth Distribution diagram. In this scenario, excess money is transformed into “safe havens”, e.g. real estate, precious metals, art, scarce resources, etc. thus causing them to go up in price. Upon change of ownership, “safe havens” reach their peak value, but the new owners of money will keep it idle on the banks’ books for a while. When this happens, money “dries out” from the economic system and people in the bottom triangle of the Wealth Distribution diagram start to rebel, because they are forced to work more to sustain their standard of living due to profit pressures on businesses in which they are employed. This trend is unsustainable, and eventually causes such an economic system to fall apart, unless vigorously regulated by the government in the form of taxes in order to compensate the contributing community for the wages or jobs lost to profits. Use of debt allows boosting an economy (consumption) beyond its actual capacity (contribution), thus causing an unsustainable trend. Financial institutions, motivated to make money on money, introduced loan origination on commercial levels, spinning the same money multiple times thus creating unbearable leverage and values, which cannot be converted back to cash. We all know the end result of this frenzy – the U.S. government had to save these banks with taxpayers’ and international debt money in order to keep the banks afloat. How much cash value (not book value per GAAP) the U.S. banks have on their balance sheets is a big unknown.

What Generates a Crisis? An economic crisis is an unexpected event of loss in GDP and general employment level. A financial crisis is an unexpected event of inability to honor financial obligations. Given economics and finance are closely related, both economic and financial crises often coincide. Living in the twenty-first century makes you wonder why, with all the technological advances we have at our disposal, including computing power and complex financial modeling tools, we still ended up with one of the most horrific financial and economic crises in 2008, still continuing through 2013. Karl Marx outlined the inherent tendency of capitalism towards overproduction in his prominent work Das Kapital. While it could be true in the time when Marx created his theory (nineteenth century), two centuries later overproduction cannot be the cause of a crisis, because manufacturers are “lean” and use sophisticated models and techniques that help identify correct production levels. So, what is it? Any economic or financial crisis occurs due to misalignment between contribution and demand, or the factors ultimately contributing to them. Decreasing contribution by economic participants due to outsourcing and / or technological innovations, on the one hand, and artificially increasing demand, fueled by debt of no real cash value, otherwise disguised with fair value accounting, on the other hand, are the main reasons behind modern era economic and financial crises. If we were to visualize supply (contribution) and demand with geometry, decreasing contribution results in angularity of the bottom triangle, while demand, represented by the top triangle, disproportionately increases:

The angle of decreased contribution is due to less work provided by the

economic participants, while the angle of yet increased demand is due to the increasing debt levels. Whenever a diagram starts getting an inverted triangle shape, a crisis will not be long in coming. Other reasons, such as greed, ignorance and incompetence, add to the distortion. While it is true that these qualities are present in humanity in general, I am full of hope that general good and intelligence will prevail and add transparency that would prevent further abuse of economics, accounting and finance.

Best and Worst Storage of Value The best “storage” of value is what can be exchanged to cash or exchanged for another value, and at the same time has an inelastic supply due to shortage and/or technology dependence. So far, land, houses, precious metals, art, oil and natural gas are the best candidates – pretty much everything that is readily available, is in constant demand and has a limited supply is best fitted for value “storage”. Despite numerous attempts to call stocks and bonds markets the best “storage” of value, there are very strong arguments against such a position, as was discussed earlier. Back in the nineteenth century things were quite the same, as follows from Mark Twain’s famous quote: “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.” I was once approached by a start-up company that had an original idea of allowing family members to invest in their children’s education online, just like 529 Plan would do. When I asked them where the money would be invested, they said it would be one of the mutual funds. When I asked to see the performance of that fund, I was less than convinced that I would put my children savings into that fund, although the idea was great – no barriers to entry, and convenience was definitely there. When profit money is accumulated from previous transactions and no investment opportunities are created to make more money otherwise, IPO markets become “hot” and, therefore, equity bubbles are created. After money gets into the economy by people “cashing out” by selling their stocks, the stock markets fall into a trap of “financial models” valuation based on perpetuity and CAPM formulas with high P/E, but in fact are worth much less if sold immediately and/or converted to cash. Therefore, IPO and stocks are simply cash-transferring mechanisms, making business owners rich and individuals, investing their money in equities, less rich in cash, but more rich in stocks. The only problem with the latter is that stocks can be prone to loss of value at a much higher rate than cash. Don’t keep your value in stocks,

unless you own a public business and know when to sell. Bonds and debt, in general, have the same characteristics as equities, but they just have better downside protection, because they are secured with real assets, which can be sold. But again, when a company acquires debt, it spends the money on equipment, inventory, employees, etc., so the money is gone. While debt is evaluated for “dangerous” levels as a percentage to equity or EBITDA, the residual value of assets, backing the debt, will always be insufficient in order to cover the obligations if something goes wrong. This is due to the accounting rules mismatch of how assets are recorded on the books versus their liquidation value if immediate sale is required. Something needs to change in the mentality of people who still think that stocks and bonds markets are safe for their investments and retirement. The same holds true for other “investment products”, i.e. indexed funds, ETFs, mutual funds, hedge funds, all kinds of “securitized” products like MBS, CLO, CDO, private equity and venture capital, etc. These are very risky, very volatile instruments and / or investments. Risk and volatility are best measured with geometry, where the bottom triangle represents cash exchanged to maintain overall value of a given asset, and the top triangle is the value – quoted market price. In case of angularity, slopes should be studied in order to visualize critical levels.

It should be noted that certain values, if increased with debt but not actual cash, will achieve disproportionately high magnitudes, but will be doomed to bust cycles after their peak levels. On the contrary, values that have high CVR and VRR ratios, will have circular-type shapes, because they can be easily interchanged into cash regardless of how much they are worth today:

But even if someone decides to keep money in a bank, there’s still no guarantee that money is safe, because the banks are prone to losing their customers’ funds, as recently happened in Cyprus (and in many other countries before them). While inflation appears to be a necessary evil, there is a way to fix the banking system in order to prevent it from losing customers’ money. More on this in the last chapter of Part III.

Ten Postulates of Economical Equilibrium 1.

Think geometry.

This is the foundation of the Economical Equilibrium theory, a mirror effect of economic events. Visualization of any economical processes with geometry allows seeing the distribution dynamics, issuing warning signals when critical levels are achieved. Many economists stress the importance of economic growth, but what’s frequently left out is at what expense such growth is achieved. Economic growth (GDP) increase is possible either at the expense of more natural resource conversion to goods or more human labor converted to hours of productive work for services. It is not possible to sustain economic growth fueled with debt because the latter triggers demand not matched with actual contribution. Thus a realtime comparison between economic growth (one part of the equation) and at what expense it is achieved (another part) is required in order to analyze the dynamics and cause and effect relationship between the two. 2.

Fractals explain the economics.

Global economic system processes have an identical pattern, i.e. wealth distribution, debt and economic growth, etc. The only difference is size and subformation. If one economic system is absorbed by another, the former takes the pattern of the latter. Patterns (diagrams) are best recorded with geometry; hence Economic Equilibrium tools become useful.

Fractals are geometrical patterns that repeat themselves consistently at any level of scale we look at them. The wealth distribution pattern would be consistent between different countries if their economic system was the same. A certain pattern of economic activity can repeat itself both at a country, a company, or an individual level. An interesting hypothesis could be made: if economics is broken at an individual level, it would also be broken at a company and a country level, and vice versa. 3.

Perpetuity (linearity) and economics don’t match.

John Keynes: “The long run is a misleading guide to current affairs. In the long run we are all dead.” Perpetuity is a concept of linear mathematics, while its practical application is non-existent in the real world. Nothing lasts forever. Any valuation technique using perpetuity formula (i.e. Terminal Value) creates valuations that will never be supported in the long run due to market saturation, competition and other economic factors. 4. Economics has an ellipse shape when contribution is matched with demand. Economics, by its very definition, is represented by the exchange of goods and services between people. Economic transactions occur when people contribute what’s in demand.

Any infusion of money not prompted by existing levels of contribution causes distortions in economics due to misalignment between contribution and demand. Inverted triangles, discussed in the Geometry of Economics chapter, explain the evolution of such distortions and the reasons why they occur. 5.

Circular growth is good for the economy, angularity is bad.

Ellipse represents balanced contribution and demand, while angularity occurs when there is more consumption or purchasing power, on the one hand, and less contribution, on the other. Angularity reaches a critical point at specific slope levels for each type of economic activity. The profit-making motive, combined with a possibility to use excess liquidity, otherwise unwanted in the economy, creates pressure on profit makers to use money continuously in order to make more money. When this happens, certain value items, representing wealth, become overpriced yet required for the overall use of economic participants, thus causing an unbalanced economy. 6. Wealth is distributed in inverse proportion to the number of people. Organic expansion of economics results in an ellipse shape of wealth distribution and exchange based on equality of contribution and demand. Due to scarcity of land, natural resources and intellectual property (technology), on the one hand, and human nature of ego, moneymaking and profit motive on the other, the initial ellipse shape of wealth distribution gradually transforms into inverted pyramids.

Inverted pyramids reach dangerous levels when the top pyramid starts growing faster than the bottom pyramid due to exploitation of labor and underpayment of the latter for the benefit of the former, as the profit making motive dictates. 7.

Wealth is prone to increase or loss of monetary value.

Technological progress, paradigm change and time tend to transform wealth, although certain wealth categories, like real estate, art, oil & gas and certain precious metals tend to retain value regardless of introduction of new values. When critical leverage levels are achieved by the financial institutions, artificially created values of certain assets crumble due to otherwise unsupported future contributions (future economic benefits), which have been taken into account as a basis for their valuation. Had contribution and demand been taken into account in valuation of assets, and had no money been allowed to turn around multiple times to instigate otherwise unwanted demand, we wouldn’t have seen the disturbing economic crisis patterns observed over the last decade. 8.

Profit = Value-add = Inflation (monetary) = Interest Income.

When profit is recognized for a value-add (e.g. new technology), immediate monetary inflation follows to keep money circulation at the previous level. Interest income represents future growth implied

by a debt-holder. Profit, value-add, inflation and interest income, all measured in monetary terms, are a reflection of the same thing – economic growth. Organic economic growth can be achieved by increased extraction and conversion of natural resources through more labor and / or technology contribution, met with respective demand of the economic participants. 9. Debt = money spent today, but its value is derived from expected future economic benefits. Debt is a way to turn the same money multiple times in order to increase today’s consumption (demand) at the expense of the expected future contribution. Debt is the major cause of bubble creation throughout the global economy, because it depends on future performance while it boosts today’s economic activity. Overreliance on future performance occurs due to perpetuity formulas used in evaluation of businesses (e.g. Terminal Value), causing excessive debt levels not supported by the actual performance results or contribution. Economical Equilibrium theory explains why higher debt levels are required to sustain lower increase levels of the economic activity (GDP), as was presented in the Geometry of Economics chapter. Disproportionate debt level increase in the U.S. over the past decade, with very modest GDP increase at the same time, is indirect proof of this relationship. GAAP, which allows debt recognition at cost (loans) or fair value (marketable securities), doesn’t take into account the fact that debt is

non-monetary (cannot be immediately converted into cash). Accounting rules, using fair value and historical cost, but not cash basis, disguise the real cash value of the assets, including those acquired with debt and leverage. Quoted market prices, while nominated and presented in the financial books and records with currency, cannot be instantaneously converted into currency. The latter is due to the fact that the financial system, when turning the same money multiple times, creates non-monetary values. 10. People work harder for their love of progress and increased standard of living. On the one hand, technology allows people to work less, thus they should have more free time. On the other hand, people tend to invent new things in their free time and thus produce more technology to enjoy life even more (telephones, cars, internet, etc.). More working people is good for the economy (it is growing) and for government (more tax revenue), making a given country more prosperous (e.g. the recent economic rise of China). As people work harder and are able to consume more using more and more technology, the question should be at what expense such demand is met. If it is met at the expense of Mother Nature and conversion of non-renewable natural resources using old technologies, such demand is unjustifiable, although cannot be yet accounted for based on modern accounting rules.

Back to the Future Below are my recommendations that, in theory, should add transparency in the global financial and economic system, without jeopardizing the real business activity of its participants. While I completely understand that the feasibility of these measures will be challenged by many professionals, I should like to learn the arguments why this wouldn’t be a good judgment: 1.

Use geometry to view economics.

Finding geometric shapes of the economic subjects (countries, businesses and individuals) brings transparency and understanding of the current state of affairs with potential to identify critical points in order to avoid crisis. While Economical Equilibrium is only a theory and substantial evidence needs to be collected, analyzed and challenged for consistency in every aspect of its application in economics, its main purpose is to identify angularity and forewarn those who don’t yet see problems coming. Economical Equilibrium’s use in finance is a possibility to identify early warning signals and symptoms of when something is wrong and needs immediate action. For example, if there is no continued contribution by the participants of the economic system, but money continues to be printed or borrowed to maintain the standard of living that people have got used to, but can no longer afford, crisis is inevitable and respective geometric figures can assist in identification of respective issues. Geometry will reflect only the status of processes in economics. Use of Economical Equilibrium tools, combined with recommendations below, should help bring things to balance and make the global economy work towards everyone’s benefit. 2.

Switch GAAP to a cash (not historical cost, not fair value) basis.

Cash (money) is the only means of exchange, thus GAAP should

record transactions on a cash basis only. Non-cash value, recorded on companies’ balance sheets, is elusive, adds volatility, uncertainty, and cannot be immediately converted to cash. I foresee multiple arguments against this position, but simple facts, such as that banks can circulate cash in the form of debt multiple times, shares can go up or down in price regardless of fundamental valuations and/or GAAP equity, should convince accounting professionals to challenge their existing rules. CVR and VRR could be used to a certain extent in order to approximate cash values. 3.

Question interest recognition by the banks.

Interest, profit and value-add are a covert form of inflation. Banks should be relegated to their original purpose – depository institutions and money storage – when depositors pay a fee for securing their money. Banks are not owners of the money. When banks lend money, they risk their depositors’ money by frontloading obligations on future performance of someone else. This performance may not occur, thus causing ambiguity and distortions in economics. Paper and electronic money is a residue from previous exchange and should be managed by the money owner. 4. Question liquidity (money) supply mechanism, debt origination and money “spinning” in the banking system. Money is a promise to receive future value. Lending money means lending promises to receive value in the future, thus multiplying chances of failure. But even without the theoretical justification of money lending abnormality, banks lend money that doesn’t belong to them to begin with (e.g. kept on current or deposit accounts) or worse, turn money around and thus gross up their balance sheets. When money lent is not returned to the banks due to otherwise inevitable financial crisis, governments tend to bail the banks out, thus causing even more distress for the financial system, because the bail out money comes either at the expense of tax revenue or government debt.

5. Question public stocks, bonds, derivatives and any financial instruments’ valuation on any basis other than cash in GAAP. An asset price is not confirmed until it is sold. Fair value can change the very next day. Anything other than cash is subject to change in value. All financial instruments, including stocks and bonds, are derivatives of cash value, but don’t have much or any of it if sold at once. These derivatives were mistakenly assumed to appreciate in value through financial models based on a premise of perpetual growth, which is not possible. I realize that this recommendation may never materialize due to the profit motive and speculation inherent in trading activities (which have nothing to do with fundamental business valuation and / or GAAP value of equity). Historical cost, not fair value, modified with CVR and VRR, could be the next best option to cash basis. 6. Savings and pensions should be in the form of cash, hard assets with high CVR and VRR, and cash generating assets only. If the U.S. pension funds were to sell all of the stocks, bonds and other investments they possess today, the prices would tumble because there is not enough cash in the entire financial system to maintain their quoted market values. This follows from geometry of the current state of the stock market value distribution, where market quotes can increase due to a very small volume of trades. The idea of investing pension funds’ money in stocks and bonds needs to be reconsidered and new ways of wealth preservation must be found in line with the trends of global economics. 7.

Government taxes should match wealth distribution.

Profits, measured with money, cause monetary inflation in expansionary economics and, ultimately, inequality in wealth distribution. Therefore, tax collections should be in the same proportions as wealth distribution. Taxation of a profit makes sense when economic activity increases, because there’s extra money (monetary inflation) in the system,

created by the increased contribution of natural resources and / or labor. When economic activity stabilizes and doesn’t grow, there is less profit to tax. This is where revenue starts to play an important role for tax purposes, because it represents what a willing party paid to the seller, and, as such, the seller earned the money from business activity. By taxing revenue, a government stimulates business activity and exchange. Profits are impossible in a system when the contribution matches the demand and therefore sales tax becomes the best form of tax.

INSTEAD OF IN CONCLUSION Our world is not ideal – it is a constant struggle for life at every turn. Nevertheless, intelligence should prevail over ignorance and misconceptions, dictated primarily by the previous mistakes we have made. After all, we should continuously evolve, not regress, and maybe someday we could enjoy a new paradigm of economics with no crises and shortcomings. Any science is an exploration of the unknown, and that’s an endless frontier. While economics, accounting and finance recently have been on the radar of many professionals, little has been done to date to help people enjoy life without worrying about where their money is going, and how their wealth and well-being can be protected, especially in the fast-changing world we live in today. When we look at where we are today in terms of economics, there is no question in the minds of many economists that we need a different model, and Economical Equilibrium theory could be a good starting point. If we want to have well-balanced economics, everyone should consume subject to their contribution, but be conscious at what expense such consumption is made in the first place. The ideal shape of the economic pattern would be a circular shape, when people contribute and receive the earned demand in return. Finally, a warning to all of us from Critique of Pure Reason by Immanuel Kant: “It is, indeed, the common fate of human reason in speculation, to finish the imposing edifice of thought as rapidly as possible, and then for the first time to begin to examine whether the foundation is a solid one or no. Arrived at this point, all sorts of excuses are sought after, in order to console us for its want of stability, or rather, indeed, to enable us to dispense altogether with so late and dangerous an investigation.”

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ABOUT THE AUTHOR

Mr. Ilya Vladimirovich Kuntsevich was born in Belarus (former USSR), grew up in Moscow, Russia, and lives and works in Los Angeles, United States. He has a Bachelor’s degree in Economics from Financial University under the government of the Russian Federation, and MBA from UCLA Anderson School of Management. Mr. Kuntsevich is a Certified Public Accountant (Inactive). Mr. Kuntsevich specializes in international finance, economics and investing in early stage companies. [1] Excluding services as living standards are maintained primarily by exploitation of

natural resources, and resulting consumption of goods. [2] “The last days of Bear Stearns” Roddy Boyd, CNN Money [3] http://www.occ.gov/news-issuances/news-releases/2012/nr-ia-2012-88a.pdf [4] http://www.federalreserve.gov/releases/h3/current/H3.pdf

[5] http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=3&isuri=1&903=35 [6] Macroeconomic Patters and Stories. Edward E. Leamer © 2009 [7] http://www.usgovernmentrevenue.com/year_revenue_2012USbn_13bs1n_103011#usgs302 [8] “Macroeconomic Patterns and Stories”, Edward E Leamer © 2009 [9] World Gold Council, Interactive gold price chart [10] U.S. Energy Information Administration data

[11] M0 includes the bills and coins in people's pockets and mattresses, the money on

hand in bank vaults and all of the deposits those banks have at reserve banks M1 represents all of the currency in the M0 money supply, plus all of the money held in checking accounts and other checkable accounts, as well as all of the money in travelers' checks. M2 is the M1 supply, plus all of the money held in money market funds, savings accounts and small CDs. Market capitalization (also known as market value) is the share price times the number of shares outstanding. [12] http://www.federalreserve.gov/releases/h6/current/h6.htm [13] http://data.worldbank.org/indicator/CM.MKT.LCAP.CD [14] http://www.federalreserve.gov/releases/h6/current/h6.htm [15] IMF World Economic Outlook Database [16] SIFMA data [17] http://www.bloomberg.com/markets/rates-bonds/corporate-bonds/, March 26, 2013 [18] IMF World Economic Outlook Database [19] Since money is introduced into the financial system by being printed or made available electronically, it has a relative, not an absolute, value. As such, both CVR and VRR, when applying Spot Cash Value, should take monetary inflation into account.