Tuesday, March 26, 2013
Let's Do MT - Deferred Promissory Trades
Now it may be reasonable for readers to snark at me about this seemingly random walk, but there is nothing new under the sun. Adam Smith wrote an awful lot about why humans did what they did before he got down to economics. I'm doing my best to be a little more terse.
These posts must be read in order or they will make no sense. Not that reading them in order would necessarily make them make sense - the reader must decide that point. The first post in the series is here.
Deferred trades, as stated previously, are one type of half-trades. There are two primary types of deferred trades, Promissory and Proxy. In this post, we are going to discuss Promissory deferred trades.
Promissory deferred trades are half-trades in which one party exchanges a good or service now in exchange for the promise of repayment by a good or service later (when the service is needed or when the good is available).
Axiom M_O_MMT 1: This is a hugely important type of trade, because the market and economic instabilities commonly blamed on money or banking or a fiat currency are really generated by deferred promissory trades, which do not rely upon money at all, but upon a functional promissory system.
A functional promissory system generates the belief that the person first giving the good or service can get repayment later. The functional promissory system could be primarily enforced by social disapproval, it could be based on terror, or it could be enforced by a legal/social system which seizes property for repayment, or confiscates the person of the debtor in repayment. In the world today, we still see all these types of promissory systems, even though some of them are pretty much universally illegal.
Proposition 1) The more generally efficient, equitable and merciful a promissory system is (a), the more the society using it will benefit(b), BUT the success will come at the cost of increased system instability(c). Thus, for long term benefits, all efficient promissory systems must have ways of periodically destroying the promises they are set up to enforce(d).
Now I must support this proposition in all its parts, and I must do so without postulating money in the system.
So let's consider a relatively primitive economy. Economies are defined by what people eat, by how they shelter, and by how they obtain security. This economy is agricultural, pastoral, hunting, primitive family-erected shelters/cloth fur, and defended by the population itself. In other words, we have grain, we have some veggies, we have some goats, we have some hunters in the mountains, we have some flax, we have some fur, family groups build their own housing out of materials at hand, and there ain't no military class. We have collective markets, we have villages, we have fields, I'm sure we've got a river or two. We have some boats and fishing. Activity at the markets is dominated by barter. No money.
Because the economy is agricultural, there will be periodic times of hardship when crops fail. Agriculture is a more reliable and plentiful food source than hunting or gathering, so the population inevitably expands to rely on crop yields for basic subsistence.
Because crop yields are both the stuff of life and the necessary reserve for the next year's plantings, agricultural societies always have to operate with a reserve of feed/food stock. Thus at certain times farmers are, at a minimum, forced to choose between being very hungry now versus starving in the next growing season:
A Song of degrees.} When the LORD turned again the captivity of Zion, we were like them that dream.The reason they went out to sow in tears is that they were hungry, and they were putting precious food in the ground. The reason they come back with rejoicing is that they got a crop and can now eat. This is a very powerful metaphor being used here to express absolute relief and joy in a way that absolutely everyone who hears it cannot possibly misunderstand.
2Then was our mouth filled with laughter, and our tongue with singing: then said they among the heathen, The LORD hath done great things for them.3The LORD hath done great things for us; whereof we are glad.4Turn again our captivity, O LORD, as the streams in the south.5They that sow in tears shall reap in joy.6He that goeth forth and weepeth, bearing precious seed, shall doubtless come again with rejoicing, bringing his sheaves with him.
Inevitably, there will be some families in hard times that cannot make it through to harvest. If they plant the seed, their children will starve. Thus they will borrow grain from another family with surplus in order to keep themselves alive, and they will repay from the proceeds of the next harvest. It is obvious that this is a good and merciful system. However, there will always be some who are more cautious about what they do eat and there will always be times of reiterated hard years, in which the proceeds will be slim. Also, farming is darned hard work, and yields often vary with hard work.
Thus, it is pretty much inevitable that some family groupings in such a system will end up with multiple years of borrowings. If the average crop will be used 20-30% to resow (reserve) and 70-80% to feed the family and barter, and there are a series of hard years in which the average yield drops 50%, you are rapidly going to get to a situation in which multiple family units have promised more out of the next year's crop proceeds than they can possibly repay due to multiple borrowings. They now face years of hardship in which they are going to have to try to get along with minimal diets in order to slowly pay off their debt.
Further, the multiple series of bad crop years hit everyone, so the relative value of the remaining seed reserve grows as the hard time progress. The families that once had plenty now are scant themselves. The fish and game is going to get hunted out. The community as a whole gets hungrier. Eventually, most the goats get eaten. Those who were making a living with flax and furs are now broke too, and the value of that goatskin in grain is just about nil come spring.
The promissory system is really necessary for the life of the community, and therefore it must be defended. There will be some system of recordkeeping, maybe village council. There will be some system of enforcement. There will be debts that cannot be repaid, and there must be some method of resolving them.
In an infinitely merciful promissory system, the seed reserve is always shared out equally. But this is not ultimately functional, because in that system, during the good years the debts will not be repaid, and during the bad years families will eat more than they otherwise would., so inevitably the community's TOTAL seed reserves will be endangered. Thus there will be penalties.
Penalties might include forced labor (the family who cannot repay must spend some time working in his neighbor's fields), confiscation of property (the family which mismanaged their fields/crop yields and accumulated an unpayable debt lose their fields and are now laborers who must work in the field of others for food), slavery (they won't work but will beg, so now they themselves are now the property of those who will feed them and have the right to enforce their labor), and impalement on a post for hours in the hot sun, followed by slow burning.
If the promissory system is enforcement by impalement/burning, there will be acute reluctance to borrow. However, this will still leave the community with starving people who tend to run out and raid the grain in their neighbors' fields by night, so it is not a very efficient system. Indeed, it is awesomely inefficient, because community yields will net lower than if a more merciful promissory system were in effect. Starving people also get ill and disease spreads, and most people will feed their neighbors' children even if they won't feed their neighbors, so in the long run this is a loser. Nor could most of the currently prosperous people in the community be sure that they would not find themselves faced with the alternative of impalement/burning or watching their children starve. There are storms and raids as well as bad weather - good management can never totally forestall bad luck.
Therefore you get the labor/slavery solutions. However, now we come back to the raid problem. If the labor/slavery solution continues too long, there is a high probability that a few families will end up essentially controlling a larger number of serf/slave families.If your community is tight on food, there is a high probability that other communities nearby are also tight on food. They raid you to get at your food supplies. While the community was mostly autonomous, you had a pretty good repelling force. However people who have been slaves for generations will mostly just run away.
Here we can see how the promissory system developed by the people who wrote the Old Testament evolved. Most of their territory wasn't that defensible. They had a prohibition against selling family lands, and they had a debt cancellation system. They also seem to have evolved a reserve tax so they had a public reserve to prevent most families from falling into ruin. They even had a slavery cancellation system.
I think I have supported my proposition. If readers don't think so, please tell me.
Is this not a fair desciption of what happens with socialism?
Forgiving of debts = bankruptcy?
Release from slavery = getting out of the clink?
Glad you have started on this, MOM. So far, I think I understand. More, more.
Not to mention arable land. Are these farmland considered communal property or family-owned? I'm assuming family-owned because there is no military class which would make them family-defended (or possibly militia-defended). I'm also trying to keep Hernando deSoto (the modern one) in the back of my mind.
These are capital and could be considered commodities. And money is a commodity is it not? Or should I call them "specie" instead? Perhaps I am getting ahead of the story.
I suppose that is where "modern" monetary theory differs - it considers money as something more abstract, MMT seemingly ignores the subject of "specie". Certainly these commodities, if left alone and uncared for, will eventually rot/depreciate. The land may not rot, but could be overfarmed.
Do you think I have supported the axiom and the proposition? If not, I must try again.
The reason why this issue is so important is that if the need to keep a reserve and the need to redistribute the reserve actually are fundamental features of production, not of banking and of money, then it is going to later turn out to be just about impossible for societies to get out of a tight reserve situation by creating money. Instead you must destroy debt.
If the underlying shortage is not money, but resources, everything changes.
Further, if any "good" way of redistributing the reserve at any one time to maximize production also tends to create a huge impairment on future reserves, then a problem variously attributed to wrathful deities, Jews, moneychangers in all societies, money, banking, and political economic systems is now a fundamental instability issue for any society with or without money, wrathful deities, banks, Jews, moneychangers, etc.
I think you understand, Charles, because of the De Soto reference, but I'm not sure.
It's a royal kingdom so there is no private property, which hinders prodcution. People do not work as hard to improve the land when it isn't theirs. Thus, they struggle. They are the poorest of all the Pacific Islands.
As to penalties and forgiveness of debts - I'm not sure how they handle that, but there is undoubtedly some system.
You provide a range of options for
dealing with the debts of those who fall behind. Your proposition is that forgiveness of debts and the release of "slaves" from slavery is important to the well being of the society. I agree with that. The question seems to be, what is the sweet spot for how generous a society should be in forgiving debts and relief from penalties?
If I'm off base, don't let that disturb your postings. I am dense, you know. At some point I will probably have an "Aha!" moment.
This is great stuff, and illustrates why economics lost something when they changed the name from "political economy". You've got me thinking about a kids' game that will introduce the concepts of economics, starting with a farming community...
However, since you asked:
You may want to modify your axiom #1, because "the market and economic instabilities commonly blamed on money or banking or a fiat currency" does not seem to be supported in this post, and defining the misconceptions that you reference is probably going to have to come later.
To my eye, you did support the centrality of a promissory system to production, and if I thought about it for a while I could probably expand the concepts to manufacturing, services, and information technology without further tutoring. You also mentioned the need to support children and communal life several times, although you did not explicitly tie it back to the previous post on the "gifting" economy.
Also, I'm not getting Prop 1)b) out of this. I would have equated "success" with "stability", so maybe I'm not understanding the internal definition of "success". Does success in this case mean "successfully enforced"?
Again, I am getting ahead of your write up and probably should not. But MMTers annoy me to no end because they present a grossly erroneous definition of "capital" (the theory doesn't work with a valid one) and you have not used that word yet. I'm hoping it is coming soon.
Jimmy, your mention of "release of slaves" got me to thinking about illegal immigrants in this country - most of them work hard and do not have the same legal protections as citizens and other legal workers do. It isn't slavery per se as they are not considered anyone's property, but it made me think of the occasional amnesties anyway.
MoM, I come from a supply chain software background so I enjoy the topic of "reserves". Operations like J-I-T are highly levered and the managers of those systems too often discount the effects of disruptions. I may be a world-class bore but I find the topic fascinating.
I agree the hypothetical example clearly demonstrates how economic instability might arise without a money economy. I was just unclear on exactly which form of promissory "success" is causing the problems. It's a minor quibble, but since this post introduces the foundational axiom...
Charles - I really think Neil is right. It's not a matter of "could" occur, it's a matter of "must occur". I haven't properly supported that.
A large part of the economic and social history of both Egypt and Israel (Teri honed right in) is the differing way that these societies handled the instability problem. Of course, Israel had to be more efficient because it did not have the Nile, and thus it would always have less surplus.
Of course, China is losing its manufacturing labor edge quite quickly, and relative costs of transportation are rising. Then you add cheap electricity fueled by fracking, and it's off to the production races. The cheaper labor Asian giants will gain at China's expense, and are gaining.
But JIT itself does have inherent instabilities, and what is cheapest on paper or in the short term may turn out to be expensively failure-prone in practice.
The parallel between JIT chains, supply reserves. (and the financing thereof) and agricultural reserve financing is really good! I had not thought of it myself, but it is real.
Maybe when we get to proxy trades we could have a simple J-I-T model? The issues of reserves and ratios are just as strongly evident there. Charles, if you would like to create one for us we would be very thankful.
As for definitions of capital and reserves, I think if we work out the basic definitions early the realistic definitions emerge naturally.
I have to get to proxy deferred trades before I can get to money, but capital is not a monetary concept at all.
MoM, I do not feel qualified to provide a simple J-I-T model, I haven't spent enough time in MRP/Inventory Optimization in the last 17 years - my focus has been in distribution/freight optimization and I would be willing to write on that if you feel it has any value.
In fact, if I may be so frank, my main interaction with J-I-T was a complete misapplication of it - the idiots thought they could avoid the problem of a shrinking industry/dying technology by implementing JIT even though they were 10 years behind some of their competitors in implementing it. And this in an industry with relatively low costs of raw materials and mfg in the first place. You might say my indoctrination into supply chain planning was against my will.
While I can see your point that capital is not a monetary concept, the whole point of money is to facilitate half-trades OF capital. DeSoto's writings really clarified the workings of money and finance for me, especially when it hit me how capital (like money) can be increased or decreased in value by government fiat.
It can "rot" -- if it's not tended, it doesn't take that long for Nature to take it back, leading to the need to re-clear it to make it usable again. This is likely not as tough as the initial clearing, but, depending on how long untended, it can be serious labor in pre-mechanization days. Even more so in pre-horse-collar days.
LOL, I think there are a lot of mothers who remind their children endlessly of how much they gave up for their children to guilt them into doing things.
An obvious caricature of this behavior is Howard's mother on Big Bang Theory...
I believe the term you're referring to is "reshoring", and it's actually well along already, partly due to language difficulties and, as you note, the rising cost of labor in China.
It hasn't led to much hiring because the factories doing the work are largely robotic, and, like mechanized farms, need far less labor to do the same job.
We not only could, but SHOULD expect the entire manufacturing base of the nation to be less than 5% of the labor pool, just as agriculture is now less than 5% of our labor pool. The other 90% should shift into IP & Services.
If you want to see the idea of a future factory, go rent Minority Report. There's a scene in it where Tom Cruise gets chased through an auto factory that is entirely robotic. I mean, there are chassis and (spoiler alert!) at the end he drives off in the car that was built around him.
In Europe things were different. Fields do go fallow there; because they do, a large group of people with different skills (say, cow herding, and experience with one of at least two kind of crops, all of which would be rotated onto the land sometime during the space of four or five years) required division of labor from the get go.
How does that type of agricultural system - which requires specialization and cooperation to even exist - fit into the picture you paint here?
And out here in the PNW, land can rot. Old timers talk about the soil getting "sour". I'm always amazed that early settlers managed any sort of agriculture out here. We grow poor quality hay because all the rain leeches out the nutrients from the soil.
What did you think about that article by David Stockman over the weekend? Too much interesting stuff going on, like the president of Cyprus being shocked, shocked that 21 million of his money was moved out of the banks before they locked them down.
I am trying to work on the next installment with a real world example from Nigeria. Current, of course. Rice and Maize.
This post is divided into 3 pieces because of space limits
First, JIT or Just in Time is an old name. Most of this is based on innovations from Toyota. A more accurate name would be the Toyota Production System or TPS. The term JIT appeared in the late 80s when we realized that Toyota was doing something different but were not clear what it was. The answer was not totally understood until well into the 2000s. And while this obviously comes from manufacturing, the concepts work with any process. I have used them very successfully to analyze and improve office work, hospitals, and military processes as well as manufacturing and having grown up on a farm, can see how it applies to agriculture as well. TPS concepts go well beyond inventory reduction, although that is one of the more visible results of applying it.
The core idea of TPS is that any organization can best be understood by recognizing that it is made up of a group of processes and understanding how those processes work will give a lot of insight into the organization. The second core idea of TPS is that any organization needs a robust continuous improvement program. I am not going to discuss continuous improvement any more here as that is not the focus of this article, but it is the key for the success of Toyota and few other organizations have been able to create and sustain Continuous Improvement.
Measuring inventory is a little tricky. We generally measure inventory by days of inventory or by inventory turns which are defined as Yearly $ in cost of goods sold / Yearly average $ of inventory. However, Cost of Goods sold is not measured very well by many companies and it is often not released, so total yearly sales is generally used instead.
As we start to examine and document processes, we see inventory and the first question is why is it there and what need it fulfills. Inventory is a buffer. It is used to cushion the process against variability of any sort, either internal (quality problems, work force who don’t show up, etc.) or external (variable demand, changes in availability of raw materials, etc). For those of you who have worked with electronic circuits, inventory functions like capacitors or coils in an AC circuit, or like water tanks in a water supply system which maintain a nearly constant pressure even though demand is quite variable. Inventory also is used to buffer against long lead times either from distant suppliers or from slow internal processes like long setup times for some equipment.
Note that inventory is not the only possible buffer. We can also use capacity or time as a buffer. But not all buffers make sense or are a good idea in all situations. I can’t build inventory in many service situations. If you are waiting to see your doctor, I can’t reduce wait time by building inventory. I can’t service people ahead of time and store them. If I am the fire station, I can but don’t want to tell someone calling with a report of a fire that they will have to wait.
The problem with inventory is that it is expensive and large inventory tends to make organizations less willing or able to adjust to changes in demand. From an operations viewpoint, inventory is often used to hide significant operations problems that should be fixed, but are not. The factors of cost for inventory include the cost of capital, space and material handling to store it, lost ,damaged, or stolen inventory, obsolete inventory, or out of date inventory. A common rule of thumb for estimating cost of carrying inventory for manufactured goods is 20% of the average yearly value of the inventory. So for example, if you have a yearly average of 1 million dollars of inventory, it is costing you about $200,000 per year to carry that. I have found this estimate to be on the low side. If you have inventory that has a short shelf life or becomes obsolete quickly, it can be even higher.
Inventory levels that are greater than the minimum needed as buffers will also increase the total flow time. Flow time is the total time that a process takes. Value added time is when we are actually adding value that the customer wants to the process. Manufacturing processes never exceed more than 4% value added time and most are well under 1%. Most processes take far longer than most people are aware of. James Wolmack in his book Lean Thinking takes a can of coke from aluminum ore for the can and sugar cane and cola beans to the can bought by the consumer and concluded it takes about 3 years for the ore mined to be bought by the consumer. One of Toyota’s key insights was that almost all of the flow time in a process was non-value added, and the way to become more efficient was to focus on reducing the non-valued time and activities. This is where the Continuous Improvement concepts appear.
Long process flow times have many bad impacts. Quality problems are much harder to diagnose because of the long time lags between when they occur and when they are discovered. Many kinds of production problems get obscured by the large inventories and thus never fixed.
So why do so many companies have so much inventory? Part of the answer is that as noted above, a certain amount is needed to make any process work. Drop inventory too low and the process will work badly or not at all. Firms are driven by metrics, the most basic of which are accounting. Accounting standards treat inventory as an asset valued at the cost to make it. I have seen many firms have inventory on the books at full value when it clearly had little or no value and might even cost money to dispose of. Reducing inventory reduces apparent assets for a company. In addition, because of the matching principal in accounting, producing more finished product that you need appears to reduce the unit cost of each item. I say appeared because eventually the extra inventory must be sold or disposed of. In the best case where it can be sold, the real impact is zero at best and more likely negative as inventory requires costs to have (20% or more!).
How do organizations successfully reduce inventory? By working to understand causes of variation and long lead times and working to reduce them. Reduce setup times. Find faster and closer suppliers. Incentivize the market to be steadier in its demand. Fix quality problems. As these kinds of changes are done, inventory can be reduced. A note here to the one commenter who described himself as a victim of JIT. Many organizations think the tail is the horse. They see the value of reducing inventory but don’t realize that they need to fix the production processes first. They just reduce inventory, get it too low and end up with a production process that does not work well.
Note that while I described this in mostly manufacturing terms, this applies to many different fields. Hospitals have large amounts of inventory and often manage it badly. Insurance companies process claims which can be considered inventory. Lets see how this applies to agriculture. As Mama noted, the key in Ag is that a certain portion of seeds need to be reserved for planting next year, but how many do we need? Like any process there is a lot of variation in it. Temperature and rainfall are two big ones. We can try to build bigger reserves to tide us over in lean years, but there are limits to how useful that is. Seeds become less fertile as they get older. Stored grain can get eaten by rats and insects, get moldy, or get blown away is a storm. Proper storage is expensive and labor intensive.
What is the alternative? Just like in other processes, we studied the variability and problems in the process and improved them. Irrigation systems reduced the rain problem. Fertilizer gives more consistent yields. Mechanized planting and harvesting systems are more consistent and efficient resulting in better seed germination and better yields and less work.
So, the “right” amount of inventory (seed kept for planting, and for food) is a moving target. We have to be continually studying the process and watching for new problems like some new disease or a long term weather change and making adjustments.
A common criticism of the Toyota Production System is that it is potentially very fragile because to the low inventories in the system. Thus, critics contend, any significant disruption like the Tsunami in Japan a couple of years ago will be much more difficult to recover from. This ignores the fact that since we are all lousy predictors of the future, we rarely have the right inventory on hand when infrequent disruptions happen. In fact, what we observe in practice is that since Toyota and similar organizations have developed very good systems to find and fix problems and close trusting relationships with suppliers, they demonstrate superior ability to recover from catastrophes or major market disruptions. Having inventory on hand often gives the illusion of security, where it does not exist.
What is the overall financial impact of this? Companies following the Toyota model require dramatically less capital to support their level of effort and have much shorter cash conversion cycles. Cash conversion can best be described as the time it takes a dollar spent making inventory to sell to come back to you after the sale. Below is an example of this for a company called Wiremold. In 1990, Wiremold began aggressively implementing the Toyota Production System. In 2000 they were sold to a much larger company and disappeared as a separate entity. Note cash conversion cycle dropped dramatically, inventory turns increased a lot, and working capital required dropped.
Wiremold Before and after implementing TPS
Data from a presentation by Orest J. Fiume, 2006
Wiremold was sold on July 31, 2000
Working Capital = Accounts Receivable + Inventory – Accounts Payable
Cash Conversion Cycle (Days) = Days Receivable + Days Inventory – Days Payable
Assessed Value $30 Million $770 Million
Sales per Employee $90,000 $240,000
Gross Profit 38% 51%
Flow Time 4-6 weeks 2 hours – 2 days
Product Development Time 2-3 years 3-6 months
# of Suppliers 320 43
Inventory Turns 3.4 17
Working Capital as a % of Sales 21.8% 6.7%
Cash Conversion Cycle 43.6 Days 13.4 days
I hope this clears up some of questions about inventory. I simplified it in a number of spots and left a lot out. If you have questions, leave a comment and I will try to answer them.
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