The Great Experiment

Since early last fall, it's been my strong opinion that the real (and only) solution to the financial situation was to have the Fed pump huge amounts of liquidity into the system. Instead, we got TARP's and bailouts and stimulus packages and all kinds of stuff. The stock market continuously tanked in response to all those packages and the financial system continued to be mired in fear, uncertainty and doubt.

Finally, in early March, the Fed did just what I hoped they would:

"...the Bernanke Fed launched another shock-and-awe stimulus plan that will expand the Fed’s balance sheet another $1.2 trillion through the purchase of $300 billion in long-dated Treasuries, $750 billion in mortgage-backed securities (Fan/Fred), and another $100 billion in U.S. agency debt."

Sure enough, the stock market had its biggest rally in many months in response. Banks are looking healthier, the financial system is starting to look a bit more stable, and some economic indicators are starting to point to a recovery.

I'm really happy the Fed finally did this. Beyond the fact that I thought it would help, it's also a very interesting experiment. The second half of the experiment will take place in the future. The Fed created a huge amount of liquidity. Eventually, as the credit markets thaw completely and money velocity returns to normal levels, the Fed will need to mop up all that excess liquidity or the economy will drown in all that extra money. I'm hoping they have the resolve to do the right thing. I think they can, but not everybody agrees with me. If I'm wrong, we'll see quite an uptick in inflation, probably starting in the next several months.

But my curiosity will be sated either way.

Philosophy of Economics

In the study of Philosophy of Economics, I think that four names stand out on this subject: Karl Marx, John Rawls, Robert Nozick, and F.A. Hayek. They each have each put forth some very powerful ideas and represent (more or less) communism, socialism, libertarianism, and (sort of) conservatism respectively. While none of their ideas are perfect and in any case subject to preference, I think each should be studied and the strength and weakness of the arguments understood in order to participate in any debate about economic policy.

Much to my surprise, in a recent informal poll of friends and acquaintances, I've found that very few have heard of any of these other than Marx. While Marx is certainly the most important since his teachings were the instigation for the radical formation of governments in countries containing billions of people, each of the other philosophers' ideas are very important as well.

Here is a quick overview of each of their ideas:

Karl Marx
Marx argued that capitalism, like previous socioeconomic systems, will produce internal tensions which will lead to its destruction. Communism, the ultimate heaven of earth with riches for all, will rise from the ashes of capitalism. "From each according to his ability, to each according to his needs" is the slogan popularized by Marx to describe the basic working of communism from the workers point of view.

John Rawls
Rawls makes the case for redistributive justice and socialism in A Theory of Justice. He does this by asking how one might choose to design a fair economic system if we had no clue (he calls this a "veil of ignorance") as to our position in that system. We might be at top in terms of talent and opportunity or we might be at the bottom. If this were the case, he argues that we would design a system that would maximize the position of the worst off (known as "the difference principal") in case we ended up being the worst off, and that such a system would have a great deal of redistribution in order to be just.

Robert Nozick
Nozick's Anarchy, State, and Utopia (1974), which received a National Book Award, argues among other things that a distribution of goods is just if brought about by free exchange among consenting adults and from a just starting position, even if large inequalities subsequently emerge from the process. He also argues that the only just system of government is a minimalist government dedicated only to the protection of the population, though he argues for progressive taxation to fund that government. Nozick turned Marx's slogan around to become "from each as they choose, to each as they are chosen".

F.A. Hayek
He shared the 1974 Nobel Prize in Economics with ideological rival Gunnar Myrdal "for their pioneering work in the theory of money and economic fluctuations and for their penetrating analysis of the interdependence of economic, social and institutional phenomena." He also wrote extensively on the distribution of information in an economic system and the relationship between that and liberty. He also wrote about evolution of human institutions that support economic activity ("the spontaneous order").

I find that when beginning a discussion about fairness and economics (a favorite topic of Left leaning friends and acquaintances), that a huge part of the effort ends up being dedicated to subtopics already thoroughly addressed by the economic philosophers I've mentioned above. I wish that instead of only teaching Marx in schools, that all four were taught. I think that everybody would then have a much better handle on the economic policy debates that are continually rehashed in the country.

Wages and Standard of Living

One constant refrain from socialists and statists is that capitalism is unfair because the rich are getting richer and the poor and getting poorer. Often cited in support of this statement is that wages of the middle and lower classes have been stagnant for decades, the implication being that the standard of living for those classes has also been stagnant. The obvious flaw in this reasoning is that stagnant (i.e., not getting richer) is not the same as getting poorer.

However, the more important flaw is subtle; stagnant wages do not necessarily imply a stagnant standard of living for the lower classes. There are several reasons that there is not a direct link between wages and standard of living.

First, nominal wages have not been stagnant at all - they're much higher than they were a few decades ago. What's meant when referring to stagnant wages is that they have been relatively stagnant when converted from nominal wages to real wages by comparing them to the inflation rate. The inflation rate is an average inflation rate across all goods and services. However, [T]he rich have faced a higher effective rate of inflation than the poor have. Examples:

• The price of fish eggs (caviar) has increased much more than the price of chicken eggs (not to mention chickens).
• The price of high end wines have gone through the roof, while two-buck chuck (Charles Shaw wines) provide far more value per real dollar (in my opinion) than has ever been available.
• Ferraris have really gotten expensive, but my Hyundai Elantra was amazingly cheap and good and there are even less expensive cars.

The inflation rate for the poor is lower than the official (average) inflation rate and therefore the poors' wages have not been stagnant with regards to purchases that poor people typically make. In other words, the poor can buy more than they used to. That's not stagnation, that's improvement in their standard of living.

Second, wages aren't the same thing as compensation. Compensation includes vacation, sick leave, health care, perks such as cars or meals, and other benefits in addition to wages. As Daniel Griswold elaborates, measures of real wages only are misleading:

A more accurate measure of earnings is “real hourly compensation,” which includes not only wages but benefits. The Bureau of Labor Statistics data on wages and benefits combined tell a more accurate and encouraging story about the well-being of the average American worker. Since 1973, average real hourly compensation for American workers has increased 45 percent, for an average annual growth rate of more than 1.1 percent. Figure 2 shows that real hourly compensation has not only climbed since 1973, but its rise has accelerated in the past decade along with America’s growing economic openness. The average American worker has not suffered from “stagnant” earnings in the past three decades but in fact has enjoyed real gains.

Third, while it should be obvious, many pundits seem to overlook that fact that the wage data from decades ago are for different people than the current wage data. The people who were in the bottom quintile of income back then have generally moved up to higher quintiles (see here and here for more information). Those are then replaced in the lowest quintile by immigrants, students, etc. who will then also attain higher incomes over time.

Next, standard of living is not directly dependent on income. That might seem like a surprising statement, but if you think about it, standard of living is mostly dependent on "outgo". It's your ability to spend, not your income that determines how well you can live. These days, many more of the poor get substantial assistance that's not considered income. For example, the vast majority of students have low incomes, but because of financial aid and parental help, they mostly live far better than their incomes would otherwise indicate. Other programs like the Earned Income Tax Credit and Food Stamps also help lower income families have higher outgo and therefore a better standard of living.

Also, median family size has fallen by about 3% per decade over the last few decades. So even a stagnant household wage would still mean that the typical person in the median family is better off.

The bottom line is that the poor from the past are, in general, significantly better off now and this is corroborated by the fact that poor households typically have numerous amenities that their counterparts from decades past did not have. If the current Administration and Congress don't blow it too badly, the trend of the poor having an ever better standard of living will probably continue.

America's Last Depression

So what's the difference between a recession and depression? They're both economic contractions, but there's no widely accepted set of economic indicators that separates one from the other. And why is it called "depression" which also has the definition, "gloom; ... sadness greater and more prolonged than that warranted by any objective reason..."

Perhaps the difference between recession and depression is mostly psychological. If we give up, then long term recession and stagnation may be inevitable. John Maynard Keynes said, "If the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die." I'm not sure I completely agree with that, but I do think that the mathematical expectation drops precipitously if the "animal spirits are dimmed". If everybody is all depressed and doesn't work as hard, doesn't invest as much, and doesn't partake as much of the available goods and services, it puts the economy into a more or less permanent downward spiral.

From the mathematical expectation standpoint, we're nowhere near the great depression. We're only starting to approach the recession of the early 1980s.

But from a psychological depression standpoint, it seems to me that we've already shot by that recession and are headed to unknown depths. The diversity of gloom is impressive. It's not surprising that Republicans and the Right are depressed - they're out of power, out of (marketable) ideas, and out of luck and they know it. However, when people like Paul Krugman are also depressed, given that they control all the reins of power and should be ecstatic to be able to enact all of the programs they've been drooling over for decades, it shows an extraordinary breadth of despair.

With despair, despondency, and depression can come political instability. Political instability has led to some truly frightening scenarios in the past:

The sad truth is that democracy itself is often unstable. Intellectuals lose faith. Democracy is not flashy. It falls out of fashion. The intelligentsia feel scorned, unappreciated, and turn to new theories.

There are other pressures. Republics stand until the citizens begin to vote themselves largess from the public treasury. When the plunder begins, those plundered feel no loyalty to the nation—and the beneficiaries demand ever more, until few are left unplundered. Eventually everyone plunders everyone, the state serving as little more than an agency for collecting and dispensing largess. The economy falters. Inflation begins. Deficits mount.

It's remarkable how apropos the above excerpt is to the current situation given that it was written in 1983 as "the introduction to an anthology of science fiction stories" by writer Jerry Pournelle. Remarkably descriptive and predictive. I'm rather hoping that the next part of his introduction isn't predictive:

Something must be done. Strong measures are demanded, but nothing can be agreed to. [...]

Enter the strong man, who will save the state.

From the ancient Greeks to the Romans to the Germans, democracies with economic problems faltered and turned to the dictator. I have no doubt that eventually America's time will come when it turns to the dictator.

Is that time here already?

Risk and Taxes

Consider the following two portfolios over a ten year period.

1. The 1st portfolio will have a 4% per year guaranteed return.
2. The 2nd portfolio will have either a 50% or -25% annual return for each of the 10 years. The returns for each year are completely random and independent.
   

Which is better?

Well, that depends. At the end of 10 years, portfolio 1 will have increased 48% (with compounding). Portfolio 2 will have a return somewhere between -95% and 5,500% and the expected (geometric mean) return is 80%. 80% is a lot better than 40%, but only about 13 out of 20 people would end up doing better with portfolio 2 than with portfolio 1, the rest would've been better off sticking with portfolio 1.

In my experience, about half (maybe somewhat more than half) would choose portfolio 1 and the others would choose portfolio 2. Those who are more risk-adverse would go with portfolio 1 and those who have a higher tolerance for risk would go with portfolio 2. There is nothing wrong with either choice. It's completely subjective.

However, the rich generally can be more risk-seeking. If you lose 95% of $1 billion, you still have $50 million left, which is a bummer, but no threat to survival or even comfort. If you lose 95% of your $200,000 of retirement savings, you're in serious, serious trouble.

Now let's consider what happens when taxes are added to the equation. Let's use the nice round number of 50% as the tax rate. For a rich investor in California if Obama increases taxes on assets for the rich as he said he would while campaigning, 50% is a pretty realistic number.

Portfolio 1's after tax return is 2% per year which would compound to 22% for the 10 year period.

Portfolio 2 is more interesting. The results depend not only on chance, but also on order. If the early returns are good, they're heavily taxed, and later losses will badly hurt the overall return. If the early returns are losses, then later profits go tax-free until you make the losses up (assuming that losses can be carried forward). Indeed, the calculation is complicated enough that I had to write a short matlab program to calculate the results.

The bottom line is that the expected 10 year return for portfolio 2 is now negative (between -3% and -4%). As a result, except for very risk-seeking individuals, portfolio 1 is now much better.

The point: Taxes on capital punish risk. This isn't an opinion, it is a mathematical certainty. While the above example was specifically picked to help illustrate this point, under a high-tax regime, higher risk investments are negatively impacted more than lower risk investments, and therefore, investors will have a greater incentive to avoid higher risk investments.

In a future post, I'll look at the ramifications of discouraging risk-taking.

Making Women Feel Cheap

I had no idea that prostitution pays so well:

Natalie Dylan, a 22-year old woman from San Diego, has brazenly offered her virginity for auction and is currently courting offers as high as $3.7 million, according to Fox News. Dylan, who has a degree in Women’s Studies ironically, came to the idea for an auction when her sister, Avia, 23, paid for her own degree by prostituting herself for three weeks.

$3,700,000.00!!!

That's an astonishing amount of money for one night.

I have two questions.

Why on earth would anybody pay that much?

Why doesn't every woman sell her virginity? Work one night and then you're financially set for life! This woman is not ugly, but she's not particularly good looking either, so this opportunity is available to many young women (who are still virgins).

The usual answers: that she'll feel degraded; she'll lose her self-respect, etc.; aren't convincing to me. In every job we have to submit to bosses, clients, investors, and others and some of those interactions, especially over a lifetime of work, are degrading. We all lose some self-respect in those inevitable situations when we pretend to like a client that we actually loathe, exude excitement over a project we hate, or laugh at stupid jokes made by some moron with control over us. We do it, we get over it, we move on. It's part of life.

She only has to do something degrading (assuming she feels that way) for one night. Everyone else does it for a lifetime.

But there's something related to this that I find very disconcerting. Won't women who don't sell their virginity always feel cheated in comparison? For example, if a woman saves her virginity for marriage, and her husband's total lifetime income won't come anywhere close to $3,700,000.00, why won't she feel rather ripped off? Why won't she resent this man who can't provide for her nearly as well as a complete stranger will provide for Ms. Dylan? How can any marriage ever work again? Heck, how will my marriage continue to work if my wife finds out what she could've had (hopefully she won't read this)?

Yes, I know that the answer is this thing called "love". But it seems to me that the huge inherent monetary value of a woman substantially reduces the power and extent of love. Love is great, but if over decades of being with your partner there isn't the general feeling that you did relatively well for yourself, I suspect that for many, there could easily be some regrets.

For example, when I consider my own marriage during times of stress (not that my marriage is very stressful), I get nearly unlimited sustenance by assessing the situation and being able to honestly say to myself, "I simply could not have done better." Love sustains me too, for sure, but there is no doubt that feeling that there was no better path helps as well. Men will still be able to say that. Will most woman be able to say that there was no better path with confidence with the $3,700,000.00 question out there?

I would guess not.

This Has Been a Long, Long Month

After putting more nearly $40,000,000 into the project and having fully tooled production units, our robot vacuum cleaner partner decided to cancel their participation in the project, citing deteriorating economic conditions as one of the primary reasons. There goes that future royalty stream (unless we manage to scrounge up another partner).

After working day and night on a robotic grape vine pruner demo, the investors, though suitably impressed by the demo, are in no hurry to invest more money to help bring the project closer to production, citing - you guessed it - deteriorating economic conditions.

So far, we haven't let go any employees (only consultants). However, unless things change soon, I predict deteriorating economic conditions for at least some of my employees by the end of next year. Perhaps even deteriorating economic conditions for me (I'll probably take unpaid leave before letting employees go)!

The problem with Obama holding back on raising taxes until economic conditions improve is that it still doesn't provide an incentive for investors to invest. If the economy stays crappy, they'll lose their money. If the economy does well, then Obama will raise taxes and they'll have their gains taxed away. Those who have invested in my company so far are telling me they see no point in making any investments in any company, especially risky ones, under such circumstances.

Oh well. On the other hand, my family and I are healthy, live in a nice place, have enough savings to get by, and I've really enjoyed the robotics work even if it doesn't look like I'll end up making much money from it, so I really can't complain.

I hope you all are well and have a Happy Holidays!

Happy Thanksgiving!

Spontaneous order plus for this day.

Another economic lesson.

Revisiting this version.

Everyday Economics - The Children's Laundry

This story is one of incremental policy change and evolutionary optimization of the extended order. This is the story of unintended and unforeseen consequences. This is the story of capitalism versus socialism. This is the story of incentives, both conscious and unconscious.

This is the story of my children's laundry.

We have two daughters who, in the past, generated a truly impressive amount of dirty laundry. As an example, on a not untypical day, the younger daughter would change from pajamas to an outfit after waking up and getting out of bed, then change into soccer clothes for soccer practice. After soccer, she would come home, take a shower and then lounge about in another pair of pajamas for a while, and then change into yet another outfit to go out to dinner in. Finally, she would change back to another fresh pair of pajamas for bed. Our daughters would manage to sneak all of these clothes into the dirty laundry hamper, usually after being worn just once.

Oh, and did I mention towels? It sure is nice to have a fresh towel for every bath, isn't it? Especially if the towels magically appear clean, dry, and folded whenever they're needed. After all, there was no cost of generating dirty clothes or towels for the children.

Up until about six months ago, my wife did the vast majority of the laundry, including washing, drying, folding, and putting away. My wife implored the children to generate less dirty laundry, trying to appeal to their noble natures that they should help her, even trying to get them to be good world citizens by not wasting energy and water for cleaning more dirty clothes than necessary. However, the amount of laundry kept increasing. The washer and dryer were operating several hours per day. It was driving my wife crazy and I was beginning to fear for her mental health.

You may wonder, in this age of gender equality, why was my wife was doing the laundry instead of me? That's because my wife has a plethora of incredibly complex and non-obvious (to me) rules about how laundry ought to be done that I can never seem to remember and/or get right. Certain clothes aren't supposed to be washed with other clothes. Certain clothes are to be pulled out of the dryer after certain numbers of hours (or was that minutes?). All clothes are to be removed from the dryer as soon as the dryer cycle is finished. Things like that.

I, on the other hand, just stuff any old pile of dirty clothes into the washer and then the dryer, wait until they are all completely done drying, and then, usually within a day or two, remove the clothes from the dryer and work towards getting them folded. Granted, the clothes are a little more wrinkly than when my wife does the laundry and my shirts and underwear that used to be white now have a pinkish, bluish, greenish, brownish, grayish tinge, but it doesn't bother me and I don't understand why it bothers my wife. But it did bother her so she wouldn't let me touch the laundry. Heck, she wouldn't even let the maids touch the laundry!

However, I insisted on taking over the laundry. I decided to exert my authority and I said, "I'm the man of the house and I'm going to do the laundry!" Or something like that.

So I started doing laundry.

Last century saw socialism versus capitalism experiments on a massive scale and at least the extreme versions of socialism did quite poorly. However, there are typically gazillions of tiny socialism versus capitalism experiments happening across the world each and every moment. These experiments take shape in the realm of family dynamics.

My wife's approach to laundry was basically socialism. From each according to her abilities, to each according to their needs. My wife was, according to her, the only person with the ability to wash the clothes and my children feigned incompetence for all aspects of the laundry process - especially the folding and putting away part of the process. So therefore, under the rules of socialism, my wife ended up doing it all.

Just as my wife's approach was basically socialism, my approach to the whole problem is more like capitalism. I wash and dry my children's clothes, but I don't fold them. Instead, I leave them in the basket and tell the children to fold and put away their own clothes. They were a little slow at first to get to it, but once they realized that their clothes were going to just sit there forever, and as they started to consistently run out of stuff to wear, they started folding their clothes when asked.

And lo and behold - the number of loads of dirty laundry per week plummeted! Amazingly, the children, of their own volition, started avoiding changing clothes multiple times per day, started re-using outfits and pajamas, and kept clothes off of the floor so they'd stay clean longer. Just because they don't like folding clothes!

Incentives are an amazing thing!

I doubt the change in behavior was conscious on their part. I'm confident that they never really thought it through. I think that over time they subconsciously made the association that every bit of laundry they put in the hamper became a bit of laundry they had to fold. And that every time they pulled out a new outfit instead of wearing the one they left draped on a chair became a bit of laundry that ended up in the hamper. It was all an incremental, evolutionary and unconscious optimization.

This result was also completely unforeseen by me. I was surprised as could be. Indeed, it was only because of the stunningly obvious reduction in laundry that I even noticed.

Remember, my only goal was to relieve my wife of a hassle. It takes me almost no time to load the washer and dryer. I really don't care how many loads I do. So my wife was freed from laundry slavery and I didn't mind my part so I didn't think it through beyond that point.

Unintended and unforeseen consequences are often negative, but not always. In this case, they were extremely positive. Not only did we help save the planet (and some hard earned money) by reducing the number of loads of laundry and the resources required to do them, but my children have learned to be responsible citizens of the household and have developed good habits.

This is yet another example of incremental improvements that are being continuously made by people everywhere when not hampered by outside interference that move civilization forward.

The Paradox of Thrift

Are you feeling a bit poorer right now? Did your portfolio get a haircut lately (or a massive defoliation from head to toe)? Does the future suddenly not look as rosy to you? Are you thinking of saving more in the coming months and years (and centuries) to try and make up for recent losses?

Yeah, me too. Join the crowd.

Unfortunately, savings is inherently selfish. It's only good for the saver, not for the economy as a whole. Even worse, in a recession due to weak demand, the more we try to save in aggregate, the less we'll all end up saving. This is known as the Paradox of Thrift (or Paradox of Saving):

[It] is a paradox of economics propounded by John Maynard Keynes. The paradox states that if everyone saves more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population. One can argue that if everyone saves, then there is a decrease in consumption which leads to a fall in aggregate demand and thus leads to a fall in economic growth.

The extreme case is easy to see. If we all decide to buy and consume absolutely nothing at all (i.e., save everything we make), then there would be no reason to produce anything, therefore no reason for employers to employ and pay anybody, and therefore no one would have a job or any money to save. We'd all ending up starving in the dirt.

Applying The Paradox of Thrift to the current situation, Bob McTeer, who was the President of the Federal Reserve Bank of Dallas, writes:

The problem for the economy is this: consumption makes up about 70 percent of total spending, and consumption has been supporting the economy for years even though the personal saving rate is close to zero. The reason is that individual consumers who have experienced capital gains in their homes and in their stock or mutual fund portfolios (including those in their pension funds, 401Ks, IRAs, and the like) have thought of those capital gains as saving and thus have been willing to consume virtually all of their current income. (This is legit for individuals, but not for the nation as a whole since resources aren't being made available by capital gains.)

His conclusion (which I agree with), isn't a happy one:

I've recently heard economists say that, if saving increases, it will reduce consumption; but they imply that the result will be just a reduced growth rate. Perhaps. However, if saving increases on a broad scale, as it should, based on individual circumstances, the outcome could be a severe recession. [...]

I hope I'm wrong, but this is not just a curiosity. Consumer spending is key to a recovery from the recession. A sharp decline in consumer spending would only make the recession worse even though-individually-it is the right thing to do. We are in a pickle.

Apparently, he doesn't like pickles.

So if you really want to help the country, don't save! Instead, consume till you drop!

Reactive Versus Predictive

Conservatives and Republicans have been relatively calm about Obama's victory. Numerous conservative pundits have called for measured responses. For example, Pajamas Media's NeoNeocon advises:

But I suggest that everyone stand back, take a deep breath, and wait. Wait, and observe. ... The goal of each of us should be to react only to evidence, not fear.

Unfortunately, some of us are not in a position to just wait, observe, and react. Those of us who are attempting to build companies actually need to do some predictin' along with our reactin'. We don't have the luxury of only reacting to events as they unfold.

We've got to guess what sort of capital will be available as we grow. We've got to foresee new and onerous regulations (like the devastating Sarbanes-Oxley). We have to forecast demand for our goods and services.

The less we can do that, the more risk there is in every decision. And there's a lot of risk and guess work in the best of situations.

This is not the best of situations. And I'm not even talking about the financial fiasco, credit crunch, market meltdown, or whatever.

Obama won the election as a blank slate. That means I have no idea what he's going to do. Is he really going to raise tax rates for the "rich"? Is he really going to increase the capital gains rates? Is he really going to spend (literally) untold sums on massive new government programs requiring huge government borrowing?

If so, I'm screwed. Plain and simple. Because while leviathan companies like IBM, GE, Microsoft, etc. might be somewhat inconvenienced by higher real costs of financing, small companies like mine, at the margin, are the first to lose access to capital. Only the rich invest in speculative startups like mine. It's actually illegal for non-rich people to invest (or, more accurately, illegal for me to knowingly accept investments from the non-rich). So if the rich decide that, due to taxes, they're better off with tax-free municipal bonds instead of riskier, speculative investments, I'm out-of-luck. So are my suppliers, my employees, their families, etc.

Even worse (or at least as bad), I have no choice but to assume the worst, because I have no idea what Obama and Congress are going to do. Since many of the decisions that I need to make are long term, it's not even good enough to guess what's going to happen next year. I need to have an idea of the tax and regulation trends for the next three to five years.

I guess for people who have steady jobs, it is possible just to sit back and react to whatever comes like NeoNeocon suggests. But for those of us trying to build viable companies, that just won't work.

High Finance

The financial problems continue to be of great interest to me so I'm continuing to investigate it in my slow and plodding manner (hey, it's mostly just a hobby for me these days so it gets a low priority). Someday, I may be able to actually draw some solid conclusions about it with some confidence. I'll be sure to report back when and if that happens.

In the meantime, I grow more and more convinced that the government should have just let the financial institutions fail and then compensated by having the Fed pump liquidity into the system at a much higher rate. Don Luskin's recent National Review article identifies problems so far with the bailout which illustrates just how fiendishly difficult it is for a central agency to plan and execute such things:

When the Fed sets the precedent that it will, on a weekend when normal market processes aren’t available, hand over a troubled bank to a competitor at a price well below its market value—below even its value in bankruptcy—there’s no incentive to remain a shareholder at all. Long-term shareholders, who ought to be incentivized to stick with banks that run into difficulty, instead receive the message that they should flee at the first sign of trouble lest they be wiped out by the “rescue.” Stronger banks, sovereign-wealth funds, and other private investors that might profitably help a troubled bank by investing in it learn instead to wait for trouble to boil over into crisis, at which time the Fed will practically give the bank away on a Sunday night.

What’s worse, speculators get the message that they can push banks over the brink by shorting their stocks and spreading rumors, driving share prices so low that it becomes prohibitively costly to raise new capital—assuming anyone would dare invest new capital—and the Fed or some other regulator then has no choice but to step in and put them out of their misery. Such speculative attacks work on any bank the government deems “systemically important”—the new way of saying “too big to fail.”

The other thing I've noticed while investigating the subject, is that the ratio of profits in the financial industry versus all other industries has been steadily rising. Forty years ago (1967), about $1 in $7 of total profits in the United States was made by a firm in the financial industry. Twenty years ago (1987) it was about $1 in $4. Last year (2007), it was almost $1 in $3.

Both the trend (which is pretty smooth) and the direction are worrying to me. The financial industry is an enabler of production, but doesn't actually produce anything of value itself, so to absorb that much of the entire economy's profit incentive seems like a distortion. There may be perfectly good reasons for the trend. For example, the total profit relative to the global economy has probably not increased as much, and the United States does have an oversized share of the global finance business. But still, bailing out the most profitable sector is a bit tough to swallow.

Amazing contrast

Over at Maggie's Farm

One quote from Obama on the Constitution:

(It )"says what the states can’t do to you. Says what the Federal government can’t do to you, but doesn’t say what the Federal government or State government must do on your behalf, and that hasn’t shifted and one of the, I think, tragedies of the civil rights movement was, um, because the civil rights movement became so court focused I think there was a tendency to lose track of the political and community organizing and activities on the ground that are able to put together the actual coalition of powers through which you bring about redistributive change. In some ways we still suffer from that.”

The community organizing? Are you joking? More at Surber. I do not think that he understands the concept of freedom at all. That concerns me. I think the Constitution is quite clear about the role, and mainly the limits of the Federal government. They knew all about power-seeking. It's one of the things that makes us unique.

OJ presents this from Bill Kristol and the enduring Reagan Revolution:

It's interesting that Barack Obama keeps talking about spreading the wealth, and yet sometimes he comes across as an elitist.

He is very much a product of Harvard Law School…and that's fine. But I do think he believes that if he gets the really smart guys in a room in Washington or New York, they can sort of retool the American economy. I don't think he has that fundamental, I would call it a Hayekian belief—after Friedrich Hayek, the great Austrian economist—in the limits of central planning, the limits of very smart people's abilities to figure things out. I do think Obama is instinctively very much a government-knows-best guy.

I can't help but contrast the Obama view with that of Maggie Thatcher:

There is a great story of Margaret Thatcher, after being urged to be more moderate at a political meeting, reaching into her handbag for a book which she then held up for all to see. Throwing this book down on the table she proclaimed, "this is what we believe."

The book was Hayek's The Constitution of Liberty. What a truly amazing contrast.

I'm Grateful

I think that the United States is going through a realignment towards socialism right now and that realignment will continue regardless who wins the election tomorrow. I think that's unfortunate for the United States in general and for me in particular.

However, at the same time, I'm thanking my lucky stars that I was born in the right place at the right time. Reagan was elected when I was 21 and I've gotten 28 years of entrepreneur friendly administrations and witnessed an explosion in the technologies that I find interesting. In a few more years my career will probably start to wind down anyway as I get older, so socialism won't have nearly the negative impact on me now as it would have when I was young.

Before the positive career implications of the Reagan tax cuts occurred to me, I was pretty wild and unpredictable. I would work a couple of months as a programmer, then take off several months to party. I motorcycled across the country twice, crewed on a sailboat for many weeks, and generally goofed off.

That was a really fun, if somewhat austere, life. I was in some sense homeless for awhile. Sure, I had places I could go if I so chose. But for weeks on end it was just me and my motorcycle. I had no mailing address, no phone (this was before cell phones), and there was no way to get hold of me. I slept on the ground and I would go swimming in lakes with my clothes on to get me and my clothes clean at the same time (I didn't have anything else to wear so I couldn't go to a laundromat). I lived on less than ten dollars a day. But, I was really, really, really free.

Several of my friends discussed starting companies while we were in college (and some of them actually did so), but I figured that taxes were so high that there didn't seem to be much point in putting in all the effort. I figured it was much better to be free and party.

But with Reagan's tax cuts, the equation changed and my laziness lost out to my greed and I've averaged more than 60 hours of work per week since I was 23. As much as I liked the "free spirit" portion of my life, the working portion of my life has turned out to be significantly more fulfilling - especially when considering the wife and kids thrown in as an added bonus. I haven't made all that much money, but I've had the opportunity to start interesting companies and work with interesting people doing interesting things. I've had every chance that one could hope for and a large part of that chance and opportunity was the low tax, pro-market environment created by Reagan and mostly maintained by his successors (so far).

For that I am grateful. I will vote my conscience tomorrow, but I will fully accept the decision of the majority, and if that involves a change in the direction of the country going forward toward socialism, so be it. I will keep doing the best that I can.

Where Did I Put That Book?

I had some technical algorithm work to do at home, so I took my copy of "Numerical Recipes in C" home with me. When the time came to use it, I couldn't find it anywhere. It wasn't in the car, wasn't anywhere in the house that I could see, it wasn't at work (I thought that maybe I'd forgotten to bring it home). It seemed to have disappeared from the face of the earth.

I asked my wife about it:

Me: Have you seen a big, red reference book anywhere?

Her: No. What's the name of it?

Me: Numerical Recipes in C.

Her: Have you looked in the cupboard where we keep the cookbooks?

Sure enough, there it was. It turns out that the student who watches our kids after school had been tidying up and "recipes" was the only word she recognized in the title so she put it with the cookbooks.

What impressed me most, though, was the fact that my wife immediately knew where it was when I told her the title.

Aspects of markets and a free market system

In discussions over various ideas about political economy people bring a variety of notions and observations to the table. I try to look at history, data, and theory as they relate to events and the actions of individuals and groups. One of the mental models that I keep in mind in light of this is based upon the concept of complexity. A comment on this post made me think about it again:

Unsupervised markets always crash.

That is not a particularly shocking observation to my mind. The implication might be that supervised markets don't crash. My thought is that they just take longer to get to a point of criticality. Complex systems tend to exhibit a behavior called self-organized criticality.

Ming the Mechanic offers this:

We might over-simplify things for our purposes and say that there are three kinds of states of a system:

- equilibrium
- criticality
- chaos

If you poke at a system that is in equilibrium, nothing much happens. Or, if something happens to it, it would tend to go back to the same state as before.

If you poke at a system that is in chaos, something random will happen. If you poke at a system that's bordering on chaos, obviously something very random and chaotic might happen.

If you poke at a system that is complex, in particular one that is self-organized criticality, something is likely to happen. Probably something small, but maybe something big.

Despite that we've talked about avalanches and earthquakes, it should be stressed that the critical state is not chaos. It is not just some random catastrophe. It is ordered, although not in a way that's very transparent to us humans.

The critical state is also robust. It is always on the edge, but the edge is stable, although changing.

That might be hard to wrap one's mind around. Think about a wave in the ocean. It is neither in equilibrium nor is it chaotic. It is critical. It is the edge. There are small waves and big waves. They're all connected. If you watch a particular wave, it is moving, but it remains coherent as a wave, at least until it eventually crashes on the beach. If you're a surfer, you can catch a good wave and ride on it. When you're done with it, you can catch another. Waves are not random, they don't just come out of nowhere. You might not understand exactly how a wave came about, but you can learn to have a sense of whether one is coming, and you can catch it.

Social networks seem to self-organize towards criticality. They follow power laws. There are many small events and few big events. All sorts of frequencies are mixed together. There's a relatively pleasing pink noise. The network dynamically self-organizes itself into the most efficient state it could, without anybody being in charge. Many relationships have formed. The many actions of many individuals have woven a web of complexity. The network has over time become wound up in many ways.

So, in a complex social network, if you do something, something might happen. Something is more likely to happen than if all connections were random, or if it was neatly ordered in some very balanced way. Mostly small things happen, but there's an opportunity for big things to happen. You drop a message to somebody else, and if it is the right kind of message at the right time, the network is ready to allow a chain reaction to happen. Millions of people might be talking about it tomorrow. No guarantees, but the network is ready for you.

We ought to understand all of this better, of course. It seems to be a human tendency to try to fight against it. Central banks try to keep the economy in a perpetual equilibrium. Industrialized farming tries to grow just the crops we think we want, and nothing else. We try to organize things so that nothing bad ever happens. But we might at the same time be sabotaging the mechanisms that allow great things to happen.

We might need to learn to surf on the edge of the wave of complex change, rather than seek in vain the safety between the waves.

Technically, the region between equilibrium(very simple order) and chaos is called complexity and a point just before a major change is called critical, otherwise not a bad take.

Per Bak gives us this

There are reasons to suggest that socio-economic systems might organise themselves into a critical state with avalanches of change at all sizes via which dissipation mostly works itself out. This is a proposition to be tested but already statistical data like that found by Mandelbrot, Moss and Lux suggest that some variables change via avalanches of all sizes and that the power law distribution describes behaviour for some of these variables. Avalanches may serve, for instance, as a means of dissipation for the internal forces in markets.

A socio-economic system might become catastrophically unstable if the system were manipulated and forced to attain a certain optimal state interfering with its natural dissipation process. This has been observed in centrally controlled economies like that in Russia. However, it does not mean that any external control or influence generates this kind of 'negative' consequence. If an economy were a critically self-organised system, it might be controlled in such a way as to take advantages of its SOC properties. For example, it might be the case that in a weak economy (highly dependent on foreign markets), such as those in developing countries, some controls to protect the country from variations in the markets would help in changing towards or remaining on a 'good' development path. Better understanding of the dynamics of self-organised systems might allow to enhance those factors that minimise the number of large avalanches by channelling system dissipation through more frequent avalanches of small size.

FYI, Mandelbrot on finance , more and a good interview plus John Tierney gives mention.

We are quite likely dealing with an evolved system of fractal dimension in financial markets, the economy and the broader society. If so, rules, regulations and institutions oriented towards resilience and adaptation might serve better than those focused so intently just upon stability and they will need changes to keep up with an evolving world.

That's Worrisome

Art Laffer, known for the Laffer Curve, predicts The End of Prosperity:

About a year ago Stephen Moore, Peter Tanous and I set about writing a book about our vision for the future entitled "The End of Prosperity." Little did we know then how appropriate its release would be earlier this month.

Financial panics, if left alone, rarely cause much damage to the real economy, output, employment or production. Asset values fall sharply and wipe out those who borrowed and lent too much, thereby redistributing wealth from the foolish to the prudent. This process is the topic of Nassim Nicholas Taleb's book "Fooled by Randomness."

When markets are free, asset values are supposed to go up and down, and competition opens up opportunities for profits and losses. Profits and stock appreciation are not rights, but rewards for insight mixed with a willingness to take risk. People who buy homes and the banks who give them mortgages are no different, in principle, than investors in the stock market, commodity speculators or shop owners. Good decisions should be rewarded and bad decisions should be punished. The market does just that with its profits and losses. [...]

Now enter the government and the prospects of a kinder and gentler economy. To alleviate the obvious hardships to both homeowners and banks, the government commits to buy mortgages and inject capital into banks, which on the face of it seems like a very nice thing to do. But unfortunately in this world there is no tooth fairy. And the government doesn't create anything; it just redistributes. Whenever the government bails someone out of trouble, they always put someone into trouble, plus of course a toll for the troll. Every $100 billion in bailout requires at least $130 billion in taxes, where the $30 billion extra is the cost of getting government involved.

If you don't believe me, just watch how Congress and Barney Frank run the banks. If you thought they did a bad job running the post office, Amtrak, Fannie Mae, Freddie Mac and the military, just wait till you see what they'll do with Wall Street. [...]

Giving more money to people when they fail and taking more money away from people when they work doesn't increase work. And the stock market knows it.

The stock market is forward looking, reflecting the current value of future expected after-tax profits. An improving economy carries with it the prospects of enhanced profitability as well as higher employment, higher wages, more productivity and more output. Just look at the era beginning with President Reagan's tax cuts, Paul Volcker's sound money, and all the other pro-growth, supply-side policies. [...]

The stock market is obviously no fan of second-term George W. Bush, Nancy Pelosi, Harry Reid, Ben Bernanke, Barack Obama or John McCain, and again for good reasons.

These issues aren't Republican or Democrat, left or right, liberal or conservative. They are simply economics, and wish as you might, bad economics will sink any economy no matter how much they believe this time things are different. They aren't. [...]

There are many more examples [of disastrous government interventions], but none hold a candle to what's happening right now. Twenty-five years down the line, what this administration and Congress have done will be viewed in much the same light as what Herbert Hoover did in the years 1929 through 1932. Whenever people make decisions when they are panicked, the consequences are rarely pretty. We are now witnessing the end of prosperity.

Laffer is certainly partisan, presents oversimplified concepts, and has been ridiculed extensively. However, his actual predictions over his long career haven't always been all that far off. I hope this is one of his bad predictions, but I do agree that the government has made a big mistake meddling here, so I'm worried.

Fooling Themselves

Arnold Kling on the financial Crisis:

Economists ought to admit that we do not know much about what is going on today. Neither do the Fed Chairman and the Treasury Secretary. Of course, the market demand is for "strong" leaders and for "strong" economists, who can fool the public into believing that they have great knowledge. The ones who do this best are those who have fooled themselves.

My guess is still that if the bailout "works" it probably wasn't needed. If it doesn't work - well, then it was a total waste of effort. But we'll never know and we have our "strong" leaders instead. Oh joy!

Plain old fun

bottom to top:

The right tools

Wealth Spread, "Made with 100% taxpayer sweat."

Obama Says Tire Pressure Is the Key to Energy Independence

3 little dandies!

Sometimes the mask slips

No thanks to the mainstream media, we are finally getting a sense of who Barack Obama is:

Strip away Obama's deep-timbred voice and his puffball platitudes, and what remains is nothing more than an academic radical using Chicago machine politics to grab a power base and using smoke-and-mirrors to project a pleasing image. The way to break through this "Obama Effect" is to focus on substance, and let the people decide.

The candidates response to Joe the plumber along with the sliming that followed were very revealing and are a slipping of the mask. Bret has made his attitude known.

Neoneocon calls Obama a soft socialist: see here

Bookworm has a piece at American Thinker in which she makes the point that it might be more instructive to divide ourselves on a continuum of Statists vs. Individualists rather than Liberals vs. Conservatives.

Obama, of course, would be a statist, of the “soft socialism” type. Look to Europe for the template. And look to the British or Canadian health care systems for a preview of just how well it works (hint: anyone with any money goes outside the system for treatment because of the unconscionable waits and the substandard care).

I think it’s even worse than that, however: I’ve noticed Obama showing signs of being at least somewhat simpatico with hard socialism, of the Hugo Chavez type. We don’t know for sure (and I sincerely hope I am incorrect!), because we don’t really know what Obama is made of inside. His record is sparse, but what we see of it is far more to the hard Left than his current rhetoric would indicate. His worrisome propensity for blocking speech that is critical of him is troubling. And of course there are his myriad associations with those whom Steve Diamond has termed the authoritarian Left.

Sol Stern delves into Ayers here

Calling Bill Ayers a school reformer is a bit like calling Joseph Stalin an agricultural reformer. (If you find the metaphor strained, consider that Walter Duranty, the infamous New York Times reporter covering the Soviet Union in the 1930s, did, in fact, depict Stalin as a great land reformer who created happy, productive collective farms.) For instance, at a November 2006 education forum in Caracas, Venezuela, with President Hugo Chávez at his side, Ayers proclaimed his support for “the profound educational reforms under way here in Venezuela under the leadership of President Chávez. We share the belief that education is the motor-force of revolution. . . . I look forward to seeing how you continue to overcome the failings of capitalist education as you seek to create something truly new and deeply humane.” Ayers concluded his speech by declaring that “Venezuela is poised to offer the world a new model of education—a humanizing and revolutionary model whose twin missions are enlightenment and liberation,” and then, as in days of old, raised his fist and chanted: “Viva Presidente Chávez! Viva la Revolucion Bolivariana! Hasta la Victoria Siempre!”

Melanie Phillips enlightens us further with this

The contrast between, on the one hand, the huge amount of material about Obama’s radical associations that has been published in on-line journals and in a few brave newspapers, and on the other the refusal by big media to address it and to vilify those who do, becomes more astounding by the day. The Obamaniacs are spinning the relationship between Obama and William Ayers, former of Weather Undergound Terrorism Inc, as of no consequence because this was supposedly a chance acquaintance and because the educational project they worked on, the Annenberg Challenge, was a worthy one.

Stanley Kurtz now nails that canard by showing how, through the Annenberg Challenge, Obama and Ayers channelled funds to extremist anti-American Afrocentric ‘educational’ programmes which were a carbon-copy of the world view of Pastor Jeremiah Wright, Obama’s black racist mentor who, under pressure, Obama was forced to repudiate. These programmes promoted, amongst other radical ideas, the ‘rites of passage’ philosophy which attempted to create a ‘virtually separate and intensely anti-American black social world’ in order to ‘counter the potentially detrimental effects of a Eurocentrically oriented society.’

As Kurtz wrote:

So it would appear that Obama’s own writings solve the mystery of why he stayed at Trinity for 20 years. Obama’s long-held and decidedly audacious hope has been to spread Wright’s radical spirit by linking it to a viable, left-leaning political program, with Obama himself at the center. The revolutionizing power of a politically awakened black church is not some side issue, or merely a personal matter, but has been the signature theme of Obama’s grand political strategy.

You have to pinch yourself – a Marxisant radical who all his life has been mentored by, sat at the feet of, worshipped with, befriended, endorsed the philosophy of, funded and been in turn funded, politically promoted and supported by a nexus comprising black power anti-white racists, Jew-haters, revolutionary Marxists, unrepentant former terrorists and Chicago mobsters, is on the verge of becoming President of the United States. And apparently it’s considered impolite to say so.

Obama is perhaps less embittered than the typical radical academic leftist. He certainly understands that a moderate front must be presented to the public to get elected to high office in America.

As comedian Yakov Smirnoff says, "what a country."