12.16.2008

Economics 2008: The Bullwhip Effect
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In the 1990's, Stanford professors Dr. Hau Lee, Seungjin Whang and V. Padmanabhan wrote a paper titled "The Bullwhip Effect in Supply Chains" Google scholar | PDF which envisioned the supply chain as a cracking whip with Actors (at the terminus of the grip) who created a flagellum-like unpredictability for Parties, or trading partners, several links down the chain, where actions taken were magnified by the distance from the grip.

The Federal Reserve's new sub 0.2% interest rate (the lowest in U.S. history) may have similar effects, and it's possible that Hau's theoretical framework that simply illustrated the problems in a supply chain can be useful to picture what's really going on.

The motivation of the cuts is said to be "stimulation of the markets" but what does that mean? The goal really appears to be to stimulate transactions  rather than any of several bureaucratese phrases such as 'stimulating credit' that are reported in the media, which seems to not understand what it is reporting.

As an economy, we've become addicted to ever-increasing levels of transactions, in the form of industry origination of deals providing immediate percentage-point payback on the face value of money created on paper as debt. These fees create the revenues which are then plowed into service purchases, wages, and durables.

This transactional economy is so large that it simply cannot tolerate a slowdown in transaction volume based on debt origination and securitization.

If the merry-go-round stops, or the whip stops cracking, all the players are at risk of getting thrown off to an uncertain destiny. What happens if you fill a bucket with water and whirl it around in a 360 degree circle perpendicular to the ground?

The water is pushed down by the centrifugal force. If you stopped suddenly, the water is immediately ejected all over the place, annoying onlookers who will get soaked.

Thus, the slowing down of transaction velocity is a worse fate than inflation, which impacts the Actors at the end of the grip more than the people at the end of the whip riding the whirlwind. Indeed, if there is inflation, the Actors always get their percentage cut first, long before the saps at the end of the whip (called consumers and also retail investors) get their adjustment.

And thus, we're down to someone borrowing $5.00 and paying back $5.01 a year later for the privilege. If the Actors don't loan the money out, they don't get paid - and neither does anyone else. And this is why the merry-go-round can't be allowed to stop and why Indiana Jones can't stop whirling his whip.



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