Money Doesn't Really "Flow Into" Anything
Clarifying another confusing financial concept
As if money weren’t a confusing enough topic to begin with, the financial world is full of jargon. Some of it is incomprehensible to the average person. But to my mind the more insidious category included terms and phrases that seem to be straightforward, but actually give a completely misleading or wrong impression of what’s happening. It might seem insignificant, but in my opinion a lot of the really destructive wrong ideas about economics and money rely heavily on some misleading jargon that keeps people from understanding the fundamental concepts well enough to spot bad ideas.
The term I want to explain today is the idea that money “flows into” an asset or asset class. If you read any financial news or headlines, you’ve probably seen some variation of this one a million times. “Money Flowing Into Bonds As Investors Seek Safety.” “Bitcoin ETFs See Large Inflows Today.” You’ve seen it.
On the surface, this seems logical. It seems like a fair way to describe the action of a lot of people buying something.
The problem comes because of the implications of the term. When money “flows into” something, that means people are more eager to buy than to sell. That means prices go up. It’s easy to conclude that prices go up because more money is “in” the asset, kind of like dropping quarters in a coffee mug.
If you think about it for a second you’ll realize it doesn’t work that way, but not nearly enough people take that pause to think. That causes them to have a wrong view of how prices change, and therefore how markets work. That by extension leaves them susceptible to claims from bad actors who want to restrict economic freedom and centrally plan and control trade in the market.
How Does Money Actually Flow?
Money flows, but not “into” assets. It flows from person to person. You can almost think of money like financial matter, it can’t be created or destroyed except is specific circumstances.
Any time something is sold, the money flows from the buyer to the seller. Seems obvious, but it’s important to keep it in mind. The money is still there, in the account or wallet of the seller. The amount of money in the economy doesn’t change, only the location of the money. It isn’t destroyed, it isn’t somehow lodged in the house or stock or loaf of bread that was sold, it just flowed from one person to another.
“Cash on the Sidelines”
This is another term you might have heard, not the same but a related misunderstanding. Financial commentators will say something like “we expect the market to rise as soon as investor sentiment improves, because there is still a lot of cash on the sidelines waiting to be deployed.” This implies that investors are holding a lot of money, and that they can “put that money into” an asset class and reduce the amount of money “on the sidelines.” The problem is, we understand that if they do buy stocks or bonds or whatever, that money will just flow into the seller’s bank account, and the amount of cash “on the sidelines” won’t change one cent.
Prices
This leads to the question of what causes prices to rise, and a fundamental understanding of how a market works. Price is a tricky thing to understand. The price of something is the intersection between the highest amount a buyer is willing to offer, and the lowest amount a seller is willing to accept. If there is no overlap between those points, no price can be established.
If there are 10 houses on a street, and one goes up for sale, the selling price of that house will be used to “value” the other 9 houses. Say the seller isn’t too desperate to sell, and is willing to wait for a buyer who agrees to pay his asking price of $500,000. If every other house on the street is very similar in size and quality, we would conclude that the value of each of the 10 houses is $500,000. But let’s say another buyer decided $500,000 is a good deal and he’d also like to buy a house on that street. He might go to every owner and offer $500,000, but there’s no guarantee he’ll be able to make a deal. Maybe everyone else is happy with their house, and nobody wants to sell for the price their house is “worth”. So there’s no price, because there’s no intersection between buyer and seller. Maybe the buyer decides he really wants a house, and offers everyone $700,000. Maybe the guy who bought a house for $500,000 last week decides “hey I can make $200,000 in a week for doing nothing, why not?” and sells the house again for $700,000.
Look at what happened to the value of houses. At the first sale, the 10 houses had a combined “value” of $500,000 times 10, or $5 million. Now after the second sale, they have a combined “value” of $7 million, or an increase of $2 million. Headlines would describe that as $700,000 “flowing into” the housing market, but the overall value of those houses, what would be called the “market cap” if we were talking about a company, increased by almost 3x that amount. How does that work? It shows the misleading aspect of “money flowing into” terminology. If money “flowed into” an asset like putting quarters in a piggy bank, it would give the impression that market cap should rise $1 for every dollar of inflow. Obviously that’s not correct, and the reason is that prices don’t work like that. Money inflows are only one factor that can influence prices, and they do so in a much less direct and obvious way than the terminology indicates.
Market Cap
For one, there’s a fundamental problem with the way “market cap” is calculated to begin with. It’s supposed to express the value of a group of identical things, typically shares of stock in a company of something similar. But let’s go back to our previous example, the 10 similar houses on a street. The “market cap” of those 10 houses would be given as $5 million dollars after one of them sold for $500,000. But remember, only one house sold, not all ten. A price requires an intersection in agreed value between a buyer and a seller, and that hasn’t occurred with 90% of the houses in this “market”. Suppose one of the houses is owned by a retired couple who intend to spend the rest of their life in that house, and have no need for the money they could get by selling it. Suppose they were offered $2 million dollars, but still weren’t interested in selling. How is that reflected in the market cap calculation? Obviously it isn’t, and just looking at the market cap number by itself would give you the impression that you could buy all ten houses for $5 million. But that might be completely incorrect.
It could also be incorrect in the other direction. Suppose 5 of the owners on the street suddenly experienced a job loss and had to sell their houses quickly. Could all 5 get $500,000 for their house? Maybe not. After all, the first buyer was the one willing to pay the most for a house there, and there’s no guarantee anyone else will be equally willing to do so. Maybe there are 3 buyers willing to pay $450,000, 1 buyer willing to pay $400,000, and 1 buyer willing to pay $350,000. In that case all 5 houses could be sold, but the last one would have to sell for $350,000 instead of the $500,000 the owners expected to get. If we then do the market cap calculation again, it’s now dropped to $3.5 million. That’s in spite of one house having sold for $500,000, 3 for $450,000, 1 for $400,000, 1 for $350,000, one couple not willing to sell for $2 million, and 3 houses that we know absolutely nothing about yet. To look at a $3.5 million “market cap” tells you none of this very relevant information, while giving you the impression that you know everything you need to know about this market.
When you stop and think about it, it’s easy to see that prices can change for all kinds of reasons without any sales occurring at all. Imagine word gets out that a huge corporation is interested in buying all the houses in that neighborhood to make room for a future business expansion. Given the expectation of a highly motivated buyer, all the owners on the street might decide not to sell for less than a million dollars. Did the market cap suddenly rise to $10 million? No houses have been sold yet, so technically it hasn’t. As soon as the first house sells for a million dollars though, it does go to $10 million. So again you gain $5 million in market cap for $1 million in “inflows”.
This is also relevant when looking at wealth held in stocks and financial assets. For example, Elon Musk holds over 700 million shares of Tesla stock currently “worth” around $135 billion. That amounts to around 20% of all Tesla stock. Now the “value” of that stock is calculated by multiply the number of shares by the last price someone paid for a share. Keeping in mind that price is an intersection between the buyer who’s willing to pay most and the seller who’s willing to accept least, how relevant is this number actually? Say Elon decided to sell all his shares tomorrow, how much is his “wealth” actually worth? How many buyers are willing to pay the last settled price for a share of Tesla stock? Enough to buy 700 million shares? Almost certainly not. So as he started to sell, he’d soon run out of buyers at that level and would have to lower his asking price to get more interest. Of course as soon as he sold a share at a price one dollar lower, the “market cap” of Tesla would fall by about $3.5 billion dollars. And the fact that the company’s largest shareholder is dumping his shares would likely cause a lot of other people to sell as well, which would drive the price they would need to accept even lower. It’s easy to imagine the price falling by double digit percentages, maybe even 80 or 90 percent, if Elon tried to sell in one day. He could easily end up with $50 billion or less for his $135 billion in wealth.
Why Does It Matter?
This concept might seem trivial, but there are some features of our economic system that make this money flow principle very important. You should already understand that banks create money by making loans as I explain here,
and that money doesn’t “flow into” assets, but rather a small amount of buying, or even just the expectation of future buying, can cause prices and market cap to rise all out of proportion to the amount of buying that occurred. Then consider that banks will lend against collateral, which can be assets like real estate or stocks which may have this inflated perceived value created by a very small amount of relative buying pressure. And that the “money” they create with those loans can be used to buy more of the asset, which can cause prices and market cap to again rise disproportionately, which can make it easier to get more loans to buy more assets, which can make prices go up again… ad infinitum. And remember that money doesn’t actually “flow into” assets, and therefore it doesn’t need to “flow out of” assets in order for prices to drop. All it takes is a lack of people willing to buy at a certain level, for any reason at all, and the price will fall to the level someone is willing to pay as soon as a motivated seller attempts to exit their investment.
Understand and think about the implications of that, and you’re closer to understanding the bubble/collapse cycle of asset markets than most economists and their “money flows” can ever hope to be.