Re: Mental Models-Bubble Assets As Capacitors.

I begin my Mental Model series with the mad pre-dawn musings I had this am about circuit diagram nightmares I had as an undergrad studying electrical engineering/computer science. Here goes.

I mentioned that there many examples of “Financial Hernias”: “Bubble” assets that have benefited most from low/neg risk-free rates and too much EXCESS LIQUIDITY: Crypto, NFTs, SPACs, high tech stocks/stonks, etc.

The problem with the “Hernia” Mental Model is that Hernias are injuries resulting from excess pressure. In financial markets, the injury comes from the popping of bubbles not the inflation of bubbles, so I had to come up with a better Mental Model.

To borrow a mental model from electrical engineering/physics, these “Bubble” assets are like CAPACITORS, which are electrical components designed to store electrical energy like a battery.

Unlike a battery, which is meant for “slow and steady” discharge of energy, a capacitor is used to store “excess” electrical energy for “fast discharge” on short notice.

In the same way a water tower stores excess water that can be drawn upon quickly when needed, a capacitor can be counted upon to discharge its energy very quickly when demand comes back and provides a “discharge gradient.”

Here is a very simple diagram of a circuit consisting of a Battery, a Lightbulb, and a Capacitor:

When this circuit is hooked up, current flows from the Battery to the Lightbulb while simultaneously charging up the Capacitor. When the Capacitor reaches full capacity, its voltage gradient essentially “pushes back” current and the Lightbulb dims and eventually shuts off.

But if you had a switch that replaced that Battery with a Shunt/Short Circuit, all of a sudden there is a steep voltage gradient (a “path of least resistance”), and the Capacitor discharges very quickly, manifesting in a bright flash of the Lightbulb before it goes out.

In my metaphor, Battery = Fed/Treasury, Current = Liquidity/Money Supply, Lightbulb = Economy/Asset Prices, and Capacitor = “Bubble” Assets.

The Fed/Treasury Battery is providing a constant source of Liquidity Current to the Economic Lightbulb. Too weak a Battery (tight policy), and you get a dim Lightbulb (flaccid economy). Too strong a Battery (loose policy)-> “bulb that burns twice as bright lasts half as long.”

Enter the role of the Capacitor. In a way, “Bubble” Assets are like Capacitors that prevent the Economic Lightbulb from overheating (manifesting in INFLATION).

But what happens when the Battery is just too strong, such that the “Bubble” Capacitors fill up? In an economic sense, this is manifested in the “crowding out” of “productive activities” by “nonproductive activities.”

This happens very notably during inflationary periods. Jens O. Parsson, in his 1974 book _Dying of Money_, notes some similarities between the pre-Weimar hyperinflation period of 1919-1921 to the then incipient inflation of the late 1960’s/early 1970’s.

Here are some great quotes: “The invariable habit of inflation is to stimulate nonproductive activities at the expense of productive ones, which means that inflation is invariably a subsidy by the productive citizens to the nonproductive ones.”

“The least useful activities were the most rewarding, and vice versa.”

“Stock market speculation is a principal relief valve concealing latent inflation pressure.” Any of this sounding eerily similar to today’s backdrop yet?

If the Fed/Treasury Battery keeps pushing hard, the Economic Lightbulb begins to dim as the voltage gradient of the Capacitor begins to “push back” and stymie the current from the Battery.

Meanwhile, the Capacitor is bursting at the seams, looking for an easier discharge gradient. And what could provide that discharge gradient?

Here is where Inflation of what I term “Opex/Capex Commodities” enters the picture and acts as the Shunt/Circuit that provides that discharge gradient.

The combination of long-cycle capital starvation, exacerbated by COVID and now the post-COVID recovery, is manifesting in real supply constraints in “Opex/Capex Commodities” that actually matter to 99.9% of the world.

When Inflation was quiescent over the last several decades, “Bubble” Capacitors could stay charged without the threat of the Inflation Short-Circuit.

That changes when the Average Joe realizes that costs of energy, food, and shelter – basically everything at the BASE of Maslow’s Hierarchy – are going up and taking precedence over speculation.

Note that the supply/demand setup is NOT predicated upon an overzealous Fed/Treasury Battery, but it is definitely being exacerbated and accelerated by one.

Going back to our circuit diagram, what happens when Inflation worries provide the Short Circuit to the Bubble Capacitor? They discharge rapidly and you witness a bright flash of the Economic Lightbulb before it goes dark.

Not to mix metaphors, but this Mental Model also is an example of how the Inflation Short Circuit acts as a Negative Feedback Loop that shunts us out of a Positive Feedback Loop that melts the whole system down.

Although a discharged Capacitor (popped Bubble) darkens the Economic Lightbulb, at least it didn’t burn out the Lightbulb or melt the circuit down or degrade the Fed/Treasury battery to the point of no return.

Without a discharging of the Capacitor, a forever strengthening Fed/Treasury Battery with an already fully charged Capacitor will eventually exceed the physical constraints of the circuit itself and literally melt things down.

End of Part I of a series of Mental Models.

And here you have it. Things to ponder: 1) What happens when Maslow’s Basic Needs take precedence over speculation? 2) Who is long food and who’s short food?

https://www.wsj.com/articles/food-prices-soar-compounding-woes-of-worlds-poor-11621519202

Shelter:

https://www.wsj.com/articles/real-estate-frenzy-overwhelms-small-town-america-i-came-home-crying-11621511972

One “Bubble” Capacitor is discharging already. What’s next?