Inflation Stimulation

Pulling into my favorite cheap gas station last week I was a bit upset by the rise in the price of unleaded ‘plus’ to $1.96. Yes, I’m one of those douche bags who puts plus into his car even though the guys on Car Talk say it doesn’t matter. I quickly recovered realizing that $1.96 was quite reasonable compared to the $4.40 I had paid a few months earlier. When I mentioned this to a friend he replied that he was glad inflation had ebbed. When I replied to him that the jump in gas prices had nothing to do with inflation my friend looked at me as if I had told him I just saw Santa Claus humping the Easter Bunny.

Allow me to explain my reasoning. Inflation is defined as too much money chasing too few goods. For those of us addicted to the History Channel (a.k.a. the Hitler Channel) you may recall scenes of people in the 1920’s and early 1930’s running through the streets of Germany with wheelbarrows full of cash on their way to buy a loaf of bread. That, brothers and sisters, is inflation. What we experienced with the price of oil last year is called commodity pricing. A commodity is a product that is widely available and undifferentiated. Gasoline (don’t be a putz and think the gas with detergent in it is worth an extra 10¢ per gallon), milk, and sugar are often used as examples. The price of a commodity is determined through the trade of contracts that allow buyers and sellers to agree on prices in advance. Contracts allow producers to hedge their investments in the production of a commodity so they don’t go broke when the prices of orange juice concentrate or pork bellies shit the bed. For a much better description of commodities please refer to this scene from the 1983 film Trading Places.

I know what you’re thinking (if you’re still reading this drivel and haven’t switched over to Perez Hilton to read something really interesting): So if the rise in gas prices was due to 27 year old commodities traders who couldn’t find their ass with both hands wildly bidding up oil futures, we shouldn’t be worried about inflation! Wrong. We will soon be hit with a long steady flow of too much money chasing too few goods. We can thank our present and former presidents and most of congress for jacking up the money supply to unseen levels in hopes of stimulating the economy through easing tight credit markets.

Printing money, however, may help out a bit in the short term. Historically inflation has helped people who need to pay off debts. If I borrowed $100 when it was worth $100 but can pay it back when it is effectively worth $50, that’s a good score. If I saved $100 when it was worth $100 but have to withdraw it when it is effectively worth $50 that sucks. It is inflation’s ability to decimate savings that makes it the best and quickest way to drive the most people into poverty. Hmmm, isn’t it interesting that increasing the money supply in the absence of increased demand allows people (and institutions) who are deeply indebted to get out from under at the expense of those who have saved?

If you think I’m full of it (and good for you if you do because I almost always am) check out the two helpful graphics down below. The first is a graph of the number of dollars in circulation in billions as of February 2009. Notice the Al Gore we’re all fuckin doomed like spike at the end. That’s the Federal Reserve pumping, with a capital ‘P’ baby, money into the economy. All that cash hasn’t had a chance to make an impact on prices yet because it hasn’t been able to circulate. Once consumer spending and institutional credit begin to expand again, watch out. Just as economic output begins to pick up the economy will be awash in dollars.

Now take a long look below (apologies for the obnoxiously long graphic but when you want to make a point I say go big or go home) at the second graph. For those of us who struggle with imagining what a billion looks like compared to a trillion, look yonder to experience the law of large numbers. I’ll come back to this comparison in a moment.

The Federal Government has pumped too much money into circulation before but never at the current levels even when adjusting for inflation, GDP, or anything else that allows for unscrupulous unprofessional pundits to make their point. From the early days of the Johnson administration through most of the Carter administration the feds dumped lots of gas on the fire through huge spending sprees like the Vietnam war, the War on Poverty, the removal of the gold standard (a deliciously fun topic being saved for another day), and lax monetary policy (not doing anything to reverse the impacts of the other three). All that fun Sixties and Seventies action pushed the American economy into a special flavor of inflation known as stagflation. With stagflation you get all the fun of losing your savings and you get to lose your job too! It’s the economic equivalent of having your wife run off with the dog (As I recall the Seventies were also a time of great country songs. I’m a Hee-Haw fan from way back).

Don't get me wrong, I'm glad the government is doing something about the lack of liquidity in the financial system. When the feds failed to feed the beast and make more cash available during the Great Depression things got worse and for a longer period of time. However, this time around they are pushing out so much so fast that trying to absorb it will be like watching your cat drink from a fire hose (I tried this once and it was funny as hell). To add to all this, I haven't even factored in the impact from the fiscal stimulus being engineered by the White House. Most of that largess (between 80% and 90%) won't take effect until 2010.

We are on the verge, let’s go with the second half of 2010 (see above), of being be hit with a wave of deep seeded inflation. Inflation caused by the addition of unheard of levels of trillions of dollars into the economy. I wish I had some sage advice here but other than buying gold, which is always a rip off, or buying land, that you may not be able to sell, I see no easy way out. Anyone have any suggestions?

- Later

When the Going Gets Weird, the Weird Turn Hayek

Lately it seems there’s been a lot of talking and writing about the failure of American Capitalism and the wrongs of market based economies. On Monday alone, while perusing my favorites on My Yahoo, I came across “Now Is No Time to Give Up on Markets” (Wall Street Journal) and “American Capitalism Besieged” (Washington Post). It makes sense for business and financial writers to spend more time on the subject of critiquing capitalism these days as current events have shaken foundational beliefs in markets and the pursuit of profit through private interests. I’ll get right to the point; my faith and confidence in the capitalist democratic model of our society is as strong as it’s ever been. In fact, the model is working like it’s supposed to and as described by many of the economists who for the past 100+ years have been thinking and writing about how messy and unpredictable yet efficient and successful this model can be.

One of those economists was Frederick Hayek. Hayek, who died in 1992, spent most of his life playing Lex Luthor to John Maynard Keynes’ Superman. He also produced some of the clearest thinking as to why capitalism and markets provide the best chance for the most people to grow beyond a subsistence level of living. He did this at a time when Keynesian economics ruled and only freaks like Ayn Rand and the guy who slept in my town’s cemetery and wore only purple were champions of free markets and small government. Hayek’s work is difficult to read even when you discount for the boredom factor required for all Economics texts. One must be patient to read a deeply philosophical economics tome written by a somewhat curmudgeonly Austrian, and if one persists one comes across some of the most insightful bits of economic thinking ever put down on paper.

Getting back to the subject at hand, in “The Fatal Conceit: The Errors of Socialism” Hayek reminds us that Capitalism is far from perfect but beats the pants off of any competing economic model, like say Socialism. So attempting to leverage the brilliance of Hayek I’d like to defend Capitalism and markets by beating the snot out of Socialism. In addition, to paraphrase Eddie Murphy, I like to make fun of Socialists because they’re Socialist.

In The Fatal Conceit Hayek writes “The market is the only known method of providing information enabling individuals to judge comparative advantages of different uses of resources of which they have immediate knowledge and through whose use, whether they so intend or not, they serve the needs of distant unknown individuals. This dispersed knowledge is essentially dispersed, and cannot possibly be gathered together and conveyed to an authority charged with the task of deliberately creating order.”

Allow me to expand on Hayek’s premise by invoking one of the foremost examples of Socialism America has ever produced: Gilligan’s Island. If you think Cuba is the only place that could successfully combine palm trees, pristine beaches, and the triumph of the proletariat I beg you to flip on Nick at Nite and behold a Marxist paradise.

In all seriousness (yeah right, but work with me here) the seven castaways serve as perfect examples of why Socialism cannot scale beyond a handful of people. Each castaway uses his/her talents to produce something that is shared among the group. The Skipper and Gilligan provide manual labor like in the episode where the Skipper shoves a bit in Gilligan’s mouth so his ‘little buddy’ can serve as a 98 pound oxen and plow a field. The Professor provides the intellectual firepower to develop technologies like coconut phones and an amazing array of transistor radio based applications that can do everything but send a radio signal. Mary Ann cooks and cleans in a perky half-shirt and short-shorts combo (yummy). The Howells did nothing, representing the 15 – 20% of every society who feel entitled to leach off the work of others. And Ginger did everybody.

Now let’s introduce a crushing blow to this Socialist island Eden. Assume (that’s economist talk for ‘let’s pretend’) another island within traveling distance of Massachusetts, I mean Gilligan’s Island. Assume this nearby island is populated by a small group of people, some of whom have the same skills as the seven castaways and some of whom have developed a differentiated set of skills (like ways to produce two-way radios, outboard motors, and cannibal repellent). What would happen if competition was introduced? What would happen to the productive capacity and usefulness of our castaways? If you were the Generalissimo of the Republica d’Gilligan what would you do?

Hayek wrote that “Competition is a procedure of discovery, a procedure involved in all evolution, that led man unwittingly to respond to novel situations; and through further competition, not through agreement, we gradually increase our efficiency.” If the kids on the other island could plow fields, cook, or make better coconut phones than you, you could chase them away (lower your standard of living through losing out on further specialization and more efficient resource allocation), or try to manage all interactions with them so everybody felt things were fair and everybody felt equally treated (Socialist central control of an economy to meet political needs), or you could throw down a few laws and regulations and allow a market to evolve through voluntary transactions and private control of the means of production (market based Capitalism supported by property rights and rule of law). If you opted for path number three things could get complicated and change would be constant. For instance Ginger might have to go to work for Mary Ann or vice-versa (double yummy!). But you would unleash a powerful force among the two islands. A force that would be difficult to manage and would often cause people to be felt unfairly treated. You would have to develop the faith and cajones to ride out these tides of ill feelings and tension. You would have to learn to appropriately tax and regulate the fishing, coconut oil (stop thinking about Mary Ann), and bamboo car industries based on the economic environment not people’s feelings.

Hayek too saw governance of market based societies as difficult and potentially self destructive; “Governments strong enough to protect individuals against violence of their fellows make possible the evolution of an increasingly complex order of spontaneous and voluntary cooperation. Sooner or later, however, they tend to abuse that power and to suppress the freedom they had earlier secured in order to enforce their own presumedly greater wisdom and not to allow social institutions to develop in a haphazard manner.”

Hayek did not live on Gilligan’s Island at least the back panels of most of his books don’t mention it. But he did live through a period of massive change and disruption (WW I, the economic collapse of Europe in the 20’s and 30’s, Facism, WW II, and the Cold War). When many blamed the uncertainty and unfairness of Capitalism for society’s ills, Hayek shot back that it was the lack of freedom provided to make Capitalism work that led to half-baked policies and tore societies apart. For a society to truly succeed it had to be strong enough through its rules and its guarantee of individual freedom to withstand the weird and uncomfortable byproducts of an evolutionary process, not try to control the uncontrollable. “Civilisation is not only a product of evolution – it is a process; by establishing a framework of general rules and individual freedom it allows itself to continue to evolve. This evolution cannot be guided by and often will not produce what men demand. “ he wrote. And that “…by repressing differentiation due to luck, it would have scotched most discoveries of new possibilities.”

So what’s my point? We live in a time of uncertainty but one not nearly as frightening as when Hayek was developing his ideas and warning us not to think so short term as to lead ourselves down the Road to Serfdom. Next time someone tells you what a great idea it is for a government to wrest control of a business or industry from the greedy hands of cowboy capitalists please think of what a weird idea that actually is.

A to the I to the G

What I like about the AIG mess is the way it serves as a microcosm for the current economic ‘apocalypse’. Not only has the insurance colossus become the Zelig of the financial media (Lost your home to foreclosure? There’s AIG backing the banks that sold your mortgage to the Inuit Retirement Board of Southwest Greenland. Pissed off about executive compensation in a tough economy? Look, it’s one of those AIG execs who got a chunk of the $165 million paid out last week. It is said that even now there are people walking around deep in the ornate buildings of the AIG empire wearing ‘Got TARP?’ tee shirts.) its being used as a ‘what’s wrong with capitalism this week kind of Transformer doll. A politician can pull on it one way, twist a little here, and see it’s a perfect example of why we need more regulation and government control of the economy. Slow news night? Not an issue; Tuck this piece under like so and then swivel the middle around and push this thing out a bit. Pow! CBS news has a perfect example of how cowboy capitalism is very bad for us mouth breathing consumaholics and can now show us the way to the collectivist dreams of Katie Couric!

Overly constructed metaphors aside, AIG can serve as soup to nuts example of what can go horribly wrong in building a large financial institution in an age of intense global competition and ruthless pressure for profit growth. I’ve picked three gotchas that seem to define what can go wrong.

First, let’s look at the mission of the company. This is supposed to be its soul, its reason for existence. Once the mission gets foggy it’s only a matter of time before a company starts selling the Bass-O-Matic, the product from a classic Saturday Night Live skit that could chop, dice, and puree even the biggest bass. The mission is essentially how you want to make money and if you stray, you will pay. When AIG decided it was better to sell insurance, called Credit Default Swaps, for derivatives (a.k.a. derivatives for derivatives) it passed a point of no return. AIG thought it could make more money faster by leveraging its AAA credit rating to provide large banks and investment houses with an unregulated source of faux liquidity instead of selling highly regulated insurance products for homes, cars, and people. In a nutshell banks and other investment concerns could not sell as many Collateralized Debt Obligations (CDOs – What the Inuits bought in the example above) as they wanted to because pesky regulators insisted that they keep enough money in their vaults to cover obligations they had already made. So through purchasing Credit Default Swaps these buyers could use AIG’s assets as backing for selling more CDOs. This was good eatin’ until many of the mortgages contained in pieces of the CDOs called ‘tranches’ suddenly took a dirt nap. Now AIG had to pay up to make the banks and other buyers whole. When more and more CDOs began to look like the financial equivalent of Karen Carpenter circa 1982, AIG’s credit rating began to suffer. With its credit rating downgraded not only did AIG have less attractive ‘insurance’ to sell to CDO pimps, it also had to pay out large sums to existing customers as part of the underlying insurance contracts the Credit Default Swaps were based on. Oh shit! Suddenly the people at Geico look like geniuses.

Next, let’s look at leadership. Corporate leaders are best known as the guys who make lots of money saying things that enable you to win Bullshit Bingo in under 30 seconds. They’re also in charge of coming up with strategies and plans to ensure a company can ‘execute on the mission’. How’d this go for AIG? Usually when a U.S. Senator suggests that a group of executives should either quit or kill themselves it’s generally a sign of outstanding ‘execution on the mission’ on the part of said executives. However, when a company takes a lot of money from the government and doesn’t understand that taxpayers might get a bit miffed at paying bonuses and commissions to the folks who sold financial crack to the banking equivalents of Roger Rabbit, hari-kari is not out of the question. So where was daddy while the kids were driving the car into the pool? Picture the reaction of a CEO whose stock price ping-ponged roughly between $60 and $80 for much of the last ten years (while those better looking and cooler guys at Goldman-Sachs saw theirs pull the proverbial ‘hockey stick’) to a slick presentation extolling the virtues of a high benefit, low risk product offering for selling insurance for derivatives that only a seventeen time Jeopardy champ could understand. Not having a fly on the wall perspective, we can assume it went over well and everyone went to lunch with that 2:00 in the morning Jerry Maguire feeling. Did he (they?) forget AIG was in the insurance business? Did they think they could send some guy over to London to run this out of the glare of what passed for regulators or the executive fellating financial media? Who knows? The facts and results strongly suggest there was either too much group think, excessive hubris, or outright ignorance or all of the above and they thought they could innovate and hang with the hedge funds and cutting edge investment houses. One could make a strong argument that long term financial success and stability come to firms that do not follow the pack. These firms (a.k.a. senior executives and leaders), believe it or not, do not feel comfortable with risk. They place lots of small bets (investments) and let grow those that flourish within their business models. Companies like Southwest Airlines, Microsoft, and Federal Express have been reasonably successful for a long time using this strategy. Even when firms bet the farm (Apple, Nintendo, and NPR) on an unproven strategy or buck the trend they do it in a focused, all hands on deck manner. What was the leadership of AIG thinking? Did they understand the risk they were taking on? Did they weigh the downside against exposure to their other businesses? It’s easy (and fun!) to Monday morning quarterback like this but come on, any real banker or investment manager with integrity will tell you not to invest in things you don’t understand.

Rounding out the top three reasons why being the John D. Rockefeller of global finance is so tough these days is perhaps the most important and tricky to get right: People. Let’s face it, people suck. Che Guevara once said “I love the People, not people”. I have the sneaking suspicion that this is how many senior executives feel about their employees and customers: Pleasant in the abstract, indifferent in reality. Who you hire and what you hire them for is critical to the success of any business. This is especially important when it comes to CEOs and their staff. No one knows it all and few have the courage to admit a mistake and fewer have the insight to see one coming. I’ll wrap this one up quick. We as a society let too many people get away with too much. There are many reasons why we have become a kind of backwards tolerant society but with AIG and its ilk we are seeing what happens to people when they live too long in a culture or sub-culture that has dismissed self control and abandoned the concept that caring for others more than for yourself is the surest path to happiness.

Sigh…. I feel better already.

Later