Shade Tree Economist

The Rise of Technology, Complexity, and Suckiness

2010-07-10T10:13:00.001-04:00

How is it that almost nothing works correctly yet we still manage to keep on with our lives? This morning I was attempting to get an update on the weather. When I turned on the TV I was presented with the message “One moment please. This channel should be available shortly.” But that was not to be. Channel after channel mocked me with this promise and like a toddler waiting for Santa I sat in patient anticipation. Nothing. After a lengthy call to the cable company’s support center and Herculean efforts by a very polite and professional young man named Seth, my service was restored. Now it’s doing it again.

There was a time, let’s call it the seventies, when stuff broke all the time and got fixed in good faith. Let’s say your Ford Maverick broke down and you had it repaired at a local shop. It took a day or two, was probably performed at a reasonable expense, and the same problem did not occur again. Lot’s of other problems may have followed but in general stuff stayed fixed. But a ’75 Maverick was about as complex as a toaster. So let’s extend the discussion to services.

When I was a kid if Creature Double Feature was interrupted due to ‘technical difficulties’ at Channel 56 your adolescent shade tree economist would go apoplectic. After several precision strikes from a sock full of quarters delivered by his mother, he would be soothed enough to gather himself and wait around five to ten minutes for service to be restored. As Gamara took flight once again to battle Mothra the world would fall back into synch. No calls to Seth, no holding the function button down for ten seconds while the signal was refreshed, and no turning it off for five minutes and then turning back on. And, most importantly, no substitutes.

Back in the golden age of simplicity there were few alternatives (substitutes) for most products. We’re not talking about competition, channel 56 vs. channel 38 vs. channel 27 (if you had reception for channel 27 out of Worcester you either lived on a mountain or had an antenna that could also pick up pulsars from the other side of the galaxy), substitution in economics refers to replacing one type of good with another. In our example this would be trading TV for radio or a book. The measure of how easily one product can be substituted for another is referred to as the Marginal Rate of Substitution. There’s a whole lot of math that economists use to try to determine the cost of these trade-offs but simply put most people who want to watch TV at certain point in time really want to watch TV. Changing their minds to go read a book or listen to the radio presents a high cost, not in terms of dollars but rather in terms of satisfaction. The utility (satisfaction) lost in switching from one medium to another is high.

But that was then. These days technology continually provides us with more and more substitutes. When my cable went out I was still able to go online and bitch about it. I could watch TV online as well as movies and a frighteningly wide assortment of ‘videos’ on You Tube. I could play video games, watch a DVD, mess around with my kid’s iTouch, listen to iTunes, I think you get the picture.

Back in the seventies I didn’t have access to any of these forms of entertainment with the exception of a VCR, which at the time cost about as much as a used Ford Maverick (around $1,000). As technology has progressed it has delivered to us an amazingly diverse set of products. This increasing assortment of products has without doubt decreased the Marginal Rate of Substitution but at a cost. Actually, two costs.

The first is complexity. Implementing and supporting (not fixing) a PC or multi-use television is far more time consuming and complex than plugging in a TV set, adjusting the rabbit ears, and turning the dial. Although most gaming consoles are straight forward in their operation, try using an additional function on them. And due to the trend of offering similar services across platforms (TVs that use WiFi, computers that can download movies and TV shows) the level of standards and consistency has not caught up to the product offerings.

In short, the entertainment, media, and personal electronics industries have bet on the assumption that the lower cost of substitution will trump the increase cost of complexity. They have also carelessly bet on transferring the cost of that complexity to you and me. Hence an increase in what economists call Suckiness. The days of waiting for Channel 56 to resolve their technical difficulties have given way to you, me, and Seth figuring them out. There’s an opportunity here. Most people don’t watch even 10% of the 800 channels they get through their premium cable service. If there was a package that offered only 80 channels of your choosing but guaranteed 99.99% uptime or your money back for the interruption in service I bet you’d buy it. It’s no longer competition from other cable companies that cable companies worry about, it’s substitution.

If just one cable company provided a service that increased the cost of substitution through delivery of a superior product, they would reduce Complexity and Suckiness as well. I’m not going to hold my breath. I have to go and call Seth again, I have his personal line.

Later

We Regulate What We Don’t Understand

2010-06-14T20:19:00.002-04:00

In the first few decades after the founding of our great Republic the role of the federal government was essentially to deliver the mail and protect us from threats like the still brisling British Empire and the bipolar French. Over time, through spasms of progressive idealism, the role and power of the federal government has expanded. Scholars, gadflies, politicians, and philosophers have spent lifetimes arguing about the benefits and dangers of government expansion but whether you’re for or against it the reality is that the shapeless all encompassing whatever it is that we refer to as ‘the government’ continues to grow.

So I am confused (a feeling I deal with most of the time so it’s kinda like my safe place) as to why we’re now hearing that corporate domination of Washington is the cause for everything from the financial meltdown to the oil spill in the gulf. I think it’s safe to assume (of course it’s not but I’m playing economist here) that most of the voting public understands that businesses contribute billions of dollars to political campaigns and political action committees (PACs). We can also assume with little risk that the same organizations hire thousands of lobbyists and fund associations to represent their interest. Finally, this game has been going on for a long time and it’s not just big business that plays. Groups as diverse as the NRA, MoveOn.org, and the Teamsters all fork over tons of cash to influence government action. Sure they’re probably outspent 10 – 1 but many of the non-business special interests can compete with the oil companies and banks through the use of voters as currency.

The conundrum, I believe, is that there is something akin to a physical law of the universe at play here. As government expands the opportunities to influence government also expand. Build it and they will come, wearing nice suits with long donor lists in the pockets and attractive ‘analysts’ who would like to meet with you after work for a few drinks to discuss this or that or who need you as a keynote speaker at a conference in Fiji, all expenses paid of course.

So if government expands on the premise of helping to provide services not adequately provided by the private sector or to regulate services to protect citizens from the foibles and shenanigans of those private sector hooligans, one would think that said services and regulations would be developed and operated to serve and to regulate as intended. Sure, if one was huffing a can of keyboard duster every three minutes. Truth be told (more precisely the shade tree economist’s version) the expansion of government as presently conducted, especially in terms of regulation, favors those being regulated more than the stakeholders supposedly being protected.

How’s that? When a real juicy piece of legislation is introduced, say healthcare reform or financial reform (the next time I get mad at my kids I will implement TV reform or video game reform) that’s too big for a rep’s staff to handle they enlist the Office of Legislative Counsel, a small band of intrepid public servants who impartially draft legislation. But 40 lawyers can only do so much and that’s where lobbyists come in. I won’t get into details (because that would require a lot of effort) but it’s not as simple as someone showing up with briefcase full of unmarked bills and getting a little somthin’ somthin’ for the effort. As John Dickerson marvelously points out in a 2006 article in Slate, the way to a Congressman’s vote is through his clueless and overburdened staff. A deft lobbyist will insert himself into the legislative process as an expert or a connection point to experts who by wonderful chance say just what the lobbyist told you at the Super Bowl but with reams of data and footnoted research.

So as government expands its not the corporate takeover of government we should be concerned about, it’s the government takeover of corporations. Yes, those greedy bastards from Goldman-Sachs and BP blew up the financial system and a mother of an oil well but they were allowed to. Instead of offering simple and clear laws with stringent penalties and no loopholes, we get thousand page laws with more escape clauses than a Florida building inspection. The offices of government charged with enforcing these laws are mostly overseen by Congress. Need I say more. And yes, you’re right if you’re thinking what a wonderful score a lobbyist has when they are present at creation, through implementation, all the way to enforcement.

When government takes upon itself the responsibility of managing something it doesn’t understand it becomes a cat’s paw for those that do. There is a tipping point at which regulation turns from useful and thoughtful to promiscuous and negligent. My guess is we passed that point around the Grant administration.

Later

Apples and Oranges

2010-06-05T14:36:00.002-04:00

Last Wednesday Apple became the most valuable technology company, as measured by its stock market capitalization (AAPL), on the planet. Investors value the i everything maker more than IBM, Microsoft, or Hewlett-Packard. It’s easy to see why; when was the last time you got really excited about a new laptop or server? And do you even care about the operating system running them? No, probably no, and Apple knows it.

Comparing Apple to other global technology companies is, to use a gem of a cliché, like comparing apples to oranges.

Apples see the world as a place full of individual consumers who require simple yet powerful products to serve their needs. It may be communication, entertainment, or business but Apple’s products (iPhones, iPads, iPods, iMacs) share a similar look and feel as well as many applications. Just like there are different shampoos that can do a decent job of washing your hair or different sneakers that can protect your feet but fill those needs in slightly different ways, the apples look at their products as consumer based.

The term “Consumer Products” is used to categorize companies offering a vast portfolio of products under a common name (Proctor & Gamble, 3M, Johnson & Johnson). It’s a bit of a contradiction but when you think about your product based on the needs of the individual consumer you more than likely will produce something many people will like.

Oranges, on the other hand, look to serve specific needs of general customers. They offer ‘scalable solutions’ for ‘increased performance’ and ‘greater capacity’. All good things I’m sure but they often fail to identify how they’ll fix a specific problem or help take advantage of an opportunity that users can identify with. For example trying to run a report on last month’s expenses (by the way there’s an App for that).

Oranges continually back themselves into competitive corners by trying to isolate and dominate specific customer markets or niches using products that can quickly be commoditized. It’s cool that a printer can do double sided color high resolution printing very fast but if I wait a month or two there will be a knock off at half the price. Who’s come up with a computer easier to use than a Mac? Please let me know where I can get a music player that’s cheaper, easier to use, and with more legally available content than an iPod and I’ll buy it.

Apple’s new dominance signals more than just Wall Street affirmation. It signals a move away from the needs of businesses pushing the edge of technology to the needs of consumers. This shift means trouble for companies like Microsoft and Dell who rely on high volumes from businesses to compensate for low margins. Google may have a dog in the fight but so far they haven’t produced a significant ‘total solution’ – one piece of technology as a product. You need to buy a phone from another company to get the Android operating system or by a computer to make use of Google’s applications.

Again, Apple beats the competition. I may have to find a service provider for the iPhone but the product comes from one company. If I buy a Mac, one company supports my hardware and my operating system.

Apple won’t remain the dominant technology company for long, no single organization can. What Apple’s resurgence means to us is that the click of the keyboard and the drag of the mouse have their days numbered. Simplification, miniaturization, and customization are quickly replacing the complex, bulky, and commoditized. Good.

Later.

Propeller Beanies of the Gods

2010-05-24T22:32:00.002-04:00

Sometime today (Monday, May 24, 2010) Nstar and Cape Wind ‘officials’ will meet to discuss the possibility of the utility buying electricity from the proposed offshore windmill farm. There will be the usual executive small talk concerning mutual acquaintances, who plays golf where and maybe a mention of the Celtics. But eventually the conversation (or presentation) will turn to money. Here’s where the hypocrisy of Cape Wind will be glazed over thicker than a triple dipped Krispy Kreme.

It’s not the more expensive price to consumers (estimated at an extra $1.50 per month) that bothers me, rather it’s the idea of investors getting a huge return from a boondoggle made possible by poor government policy and unimaginative politicians desperately seeking affirmation from Greeniks(1).

The way electric utility companies make money is by charging customers through a rate structure approved by state regulators. The rates are designed to allow the companies to make a profit through recovering “prudently” incurred costs and a rate of return “sufficient to attract new investment in transmission facilities”. So one could say that smart investors would want to maximize cash flow by covering as much of the prudently incurred costs as possible while jacking up the value of the investment in transmission facilities to provide as big a return as possible (10% of a billion is thousand times greater than 10% of a million). Add to this state requirements, like the Green Communities Act which requires utilities operating in Massachusetts to buy a percentage of electricity from renewable sources in Massachusetts, and you have an environment well suited for inefficient projects the likes of which would make Willie Wonka blush.

According to Cape Wind’s website the offshore windmill farm will provide 155 new jobs, up to 55 of them on the cape. It will also be very clean, replacing the equivalent power that would be produced “from burning 570,000 tons of coal, or 113 million gallons of oil, or 10 billion cubic feet of natural gas.” And contrary to reports from finance publications and several papers, Cape Wind claims the project “will reduce the clearing price for electricity in the New England spot market by reducing operations of the regions most expensive power plants, this will reduce electricity prices in New England by 25 million dollars per year.” The first two benefits are the result of impact studies, the third is spurious at best.

So you’re thinking, after reading four paragraphs of regurgitated uninspired middle school level research, that your shade tree economist is headed for a predictable close of drill baby, drill. Wrong. Here’s where it gets interesting (it actually doesn’t get interesting but what the hell, you’re more than halfway through now). Renewable energy from clean sources is exactly what this country needs and we need it yesterday. Unfortunately a $1 billion to $2 billion(2) wind farm moves us in the wrong direction. It is an act of financial and political hubris the likes of which gave us insolvent quasi-government mortgage underwriters and a federal recipe for health care coverage that will break the back of an already entitlement loaded system.

If we as taxpayers and beneficiaries of good environmental policy want to back a $1 billion plus investment, we should actually benefit from it. What about using $1 billion to invest in many local projects? A combination of clean/renewable sources that work on a local level? Why not fund smaller windmills to help supply power to schools, hospitals, and malls? What about plug-in stations for electric cars? A good chunk a billion dollars could also beef up an aging nuclear power plant or hydro-electric dam.

The big drawback to managing power from renewable sources is that they are by nature unreliable. If the sun don’t shine or the wind don’t blow there’s no microwave popcorn. Hence the need considering current technology to mix consistent but dirty with inconsistent but clean (kind of like prom dates). Supporting smaller local efforts mitigates inconsistency.

Cape Wind maybe a windfall for investors in EMI corp. and its owners but for the rest of us it’s a big dig solution to a problem that is best solved by taking another road.

Later.

(1) Greenik – a.k.a. ‘Watermelon’ – one who is green on the outside, red on the inside. A person who’s true agenda is maximizing government control of private sector activity but who claims to act in the best interest of the environment or climate as a means to an end.
(2) Cape Wind has not released investment estimates but media reports range from $1 billion (Boston Globe) to $2 billion (AP).

Check Please

2010-04-05T10:19:00.002-04:00

Its tax time again so I thought you’d enjoy a look into who actually pays federal income taxes, where a lot of that money goes, and the effect its having on this country. Niccolo Machiavelli once said “Severities should be dealt out all at once, so that their suddenness may give less offense; benefits ought to be handed ought drop by drop, so that they may be relished the more.” And that’s the way taxes work. In fact, the federal government does such a fine Machiavellian job with the money we send in that those drops of benefits are hardly perceptible for most of us (remember, I’m talking about the feds here, not towns or states).

First up, who pays most of the federal income tax? If you said middle class or working families you’d be wrong. To quote an often referred to article from the San Diego Union Tribune “According to the most recent IRS data available (from 2007), the top 10 percent of households - with incomes roughly $100,000 or greater - pay roughly 70 percent of all federal income taxes. That share is up from just below 50 percent in 1980. If you include the top quarter of all taxpayers, the share balloons to 85 percent.” Taken another way, in 2008 34% of people (48 million individuals) who filed an income tax return paid no income taxes. 52% of the federal government’s total revenue comes from personal income taxes.

Shady breakdown: .85x.52= .44 so 44% of government revenue is paid by 25% of the people filing tax returns.

Is it a healthy sign when almost half of what the government takes in is paid by a quarter of its citizenry? Wait, it gets better… I mean worse, no, more like sad.

According to the 2009 Index of Dependence on Government it is estimated that 60.8 million Americans remain dependent on the government for their daily housing, food, and health care. Roughly 20% of all Americans. But wait, there’s more. Throw in farm subsidies, college loan programs and the Department of Education, Social Security, and the twin big kahunas Medicare and Medicaid and you get a substantial overall dependence on the federal government.

Yeah, yeah, yeah, I’ve seen this government is bad, scare mongering, taxes suck rhetoric before. Where’s the pie chart showing where all the money goes? (it’s right here by the way)

My issue, however, is not with overall spending (although I do have issues with that as well. I have lots of issues). My issue here is with our growing dependence on the federal government. The danger of dependence is two fold. First, as more wealth is transferred from individuals to the government, less is available for investment and savings. Based on the recent behavior of Wall Street one could understand how some people would prefer shipping large portions of their income to the government instead of sending it to inept bankers or criminals running some hedge funds. But as you’ll see, in the long run that’s not a good idea. Second, and more important, as the government becomes more involved in providing services once covered by the private sector it becomes the sole intermediary for those services. There’s a big difference between government grants or contracts given out to organizations and managed via private sector intermediaries (banks, insurance companies, non-profits, and even state or local governments) and directly run government services: the difference is who has power.

When John D. Rockefeller wanted to control the oil market he bought up the intermediaries (pipelines, railroads) first. When the cost of doing business got to be too much for his competitors they sold out to him. With government takeovers of services once performed by the private sector, there is a real risk that the money required to implement those services could be steered towards recipients on a political means, not on needs based or qualified means. What you get are monopolies run not for greed or profit but for politics and power. At least with greed you can argue there are efficiencies from profit seeking and potential for innovation (though not much). Power also becomes more centralized, not a good thing for a democracy.

Still another worry with expanding government is how to pay for it. As mentioned above almost half of government receipts come from about a quarter of its tax paying populace. The rest comes from a variety of fees and other taxes. Even with those additional revenue streams the federal government is far from covering current and proposed outlays. The sizeable gap (deficit) between what Washington spends (the budget) and what it takes in (revenue) is closed by borrowing. For the fiscal 2010 year the federal government will borrow 40% of what it spends. That 40% isn’t like a mortgage, it’s more like buying gas and groceries with a credit card. After a while, the interest on that debt begins to crowd out other spending. If it crowds out too much you go bankrupt.

Finally, as more people become dependent on the government for primary services while fewer are able to pay in, the disparity between rich (tax payers) and poor (government dependents) grows wider and deeper. There's never a good end to this story unless you're a big fan of sacking cities and inventive devices like the guillotine.

So what’s the good news you ask? Well there’s some. You can vote for people who understand the dynamic of spending what we don’t have. You can vote for people willing to make hard choices. You can be willing to absorb some pain now in hopes that there will be less in the future. It’s the political equivalent to brussel sprouts for a nation that prefers wing dings. Good times, good times.

Later.

A Good Gardener Needs a Hard Heart and a Sharp Axe

2010-03-11T08:50:00.002-05:00

A few random things I’ve been meaning to get to:

GMAC – Back in January I thought it was a good idea to leave GMAC to its own fate. The thinking was that it was better, faster, and cheaper to follow a managed bankruptcy than to bail out a loser of a company whose implosion would have little impact on a financial system functioning about as well as the New Jersey Nets. It appears the Congressional Oversight Panel for the Troubled Asset Relief Program agrees. The five member panel’s report states that GMAC was “a company that apparently posed no systemic risk to the financial system, that did not seem to be too big to fail, too interconnected to fail, or indeed, of any systemic significance.” Do you think we’ll ever see the $17.2 billion repaid?

Another wise decision – The Senate Finance Bill intended to overhaul current regulation of financial markets will include the creation of an agency to track financial risk. According to the New York Times the proposed agency “is intended to give federal regulators daily updates on the stability of individual firms as well as that of their trading partners, including hedge funds.” The Times report goes on to say “the agency would give regulators a broader view of the health of participants in the financial markets and the potential for problems to spread.”

The new agency, tentatively labeled The National Institute of Finance, would assist regulators but “would have no policy responsibilities but would instead collect and analyze data, building models to assess relative risks and predict how one firm’s problems might affect others.” The agency would be a division of the Treasury Department with congressional oversight.

If you’ve read the Black Swan or ever filled out an NCAA basketball tournament bracket you understand the accuracy and value of risk based predictions. Now imagine the federal government equivalent to the pre-game shows put on by ESPN or the NFL Network. Long, over analyzed, and over talked decisions where .500 is a winning record. Here’s a radical idea: Instead of creating yet another government entity open to influence, corruption, and mismanagement, why not require ‘structured investment vehicles’ and derivatives to be traded on exchanges like common equities? Participants would have to play by the same rules as equities investors and traders, complete with the regulation and transparency required. Oh, what’s that? You say people like Barney Frank and Chris Dodd are much better suited to manage risk in financial markets by providing the keen oversight like that provided for FannieMae and FreddieMac.

You’re right, silly me.

Fat Boy Slim – The richest man in the world is a Mexican investor best known for buying Mexico’s state run phone monopoly 20 years ago and bailing out the New York Times last year. Carlos Slim (haven’t I seen that name before in a Neal Stephenson or William Gibson book?) is worth an estimated $53.5 billion, that’s equivalent to about 72 mega-zillion Pesos. He just beat out Bill Gates ($53 billion). Oh well Bill, that’s what you get for showering all that money on African kids and schools.

Later

Killer Whales, Ted Nugent, and Monty Python

2010-03-09T08:15:00.001-05:00

I rarely re-post stuff but I think Ted Nugent's recent commentary from the Washington Times merits one. Although I don't agree with everything Nugent says below, I do follow a similar pragmatic approach to our responsibility for and treatment of animals. For a closer representation of the Shady take on wildlife, please refer to Monty Python's Mosquito Hunting.

Here's Terrible Ted's take on human-wild animal relations:

I love animals - they're delicious

By Ted Nugent

Animals give me life. I like to eat them, ride them, pet them, wear them, grow them, watch them, and know in my pure aboriginal predator heart and soul that the health and condition of the animals in our lives are direct indicators of our own quality of life. The wildlife on the sacred Nugent hunting grounds, like all across North America, is thriving, naturally wild and spectacular. Our three Labrador retrievers and stupid old cat are clearly the happiest pets on earth. I love animals, and they love me. Perfect.

And yes, Eloise, that is an American buffalo between my legs. Isn't he adorable? See the snot flying and enraged fire in the eyes? And the bison ain't bad looking, either.

Having made my spectacular rock 'n' roll stage entrance astride a wildly spirited one-ton South Dakota beast for a few hundred protein-infested concerts, no one knows better than I the dynamic of celebrating wild beasts in dramatic and outrageously entertaining ways. I agree with Jack Hannah and other professional critter handlers that wildlife education provided by zoos, circuses, commercial aquariums and various animal spectacles is appreciated best when it occurs on stage with crazed guitar players. I bet my audiences would concur.

With but a cursory review of my annual hunting, fishing and trapping calendar, the evidence is irrefutable that few men have spent more time with wild animals in their natural habitat that this old Motown rocker. The spirit of the mighty beasts fortify my belly and my soul.

My relationship with wild animals is as pure as it gets. I am a hunter, and surely there is no wiser use of renewable wildlife resources than killing them and grilling them. That's why there are more deer, turkey, black bears, cougars and other big game critters in America today than in recorded history. We manage them according to genuine, value-based utility. Go figure.

The only difference between me, and say, Steve Irwin, brain-dead hippie grizzly bear neighbors, religious voodoo rattlesnake witch doctors, homosexual Las Vegas lion huggers, and the Orca handlers at Sea World is that I am smarter and more respectful to the wonderful wildness of such creatures. I don't taunt, probe, prod or bother my wild animals in any way for your entertainment. And though I do hop aboard for a thrilling ride, I am not so stupid as to forget that my buffalo is, and always will be, a wild buffalo. You know, the kind that would just as soon trample you into a bloody puddle of snot and hair than look at you.

Admitting this truism is why I carried a 10mm handgun in my belt during those stage rides, just in case the beast decided to go buffalo on me. A quick 200-grain armor-piercing slug through the back of his head would have made the difference between a momentary increase in entertainment value and a few dozen or more trampled rock fans. I knew this, and I was prepared. I am such a radical pragmatist.

Remember the circus lion tamers of yore, a chair in one hand, a pistol in the other? Prudent and respectful during a time before dangerous animals somehow became cute. The Bambi curse is to defile the wildness of beasts. They are killer whales, not show whales. And don't tell me that grabbing alligators by the tail promotes conservation. Wise use? I think not. Shame on you.
If you want to manage elephants, lions, leopards, camels, stallions, bears or other such phenomenal wild animals, the very least you can do is to show a little respect for the wildness that attracts you to them by being prepared to neutralize the deadliness of that wildness when it erupts. Not if it erupts, when it erupts.

Not a year goes by without some sensational tragedy ruining human and animal lives by careless, disrespectful misuse of these majestic creatures. Either do it right or just put them on display, hands-off, so nobody gets hurt. It is about time that we cut out the selfish make-believe fun of animal abuse for our own desires, and show some respect. Either that, or we have one of two choices for the killer whales in captivity out there right now - Muktuk or sushi for the masses. Take your pick.

Later.....

I’m a New School Construction Schizophrenic and so am I

2010-02-23T09:49:00.002-05:00

So there’s a proposal in your town to build a new high school (I chose high school construction because it’s where the money’s at). As with just about everything in life where you stand on the matter depends on your perception of what benefits you will receive.

As an economist (or some shut in with a blog who thinks he’s one) your analysis must begin with a complete rejection of the rational expectations theory. The theory states that people will act according to very well thought through outcomes based on maximizing their ‘utility’ or simply put, satisfying their wants and needs.

Having recently been through a multi-year saga of living in a town debating the merits of a new high school, I can tell you that any evidence of rational thought as to why or why not to build was a rare find. In discussions with pro or con factions I felt as if I was talking to Howard Beale (the crazed news anchor played by Peter Finch in the film Network) on a bender. Yes, it gets that passionate.

So in trying to decide where I really stand on this issue I tried to strip out my own beliefs and look at research and hard data on the economics of new school construction. In hindsight I would have had more success looking for hard data on the Loch Ness Monster or the heterosexuality of Ryan Seacrest.

What I found was mostly heavily partisan based research supporting either the benefits of new or refurbished schools or supporting the abandonment of public schools altogether. With only slight hyperbolae I can say that what’s out there for research on this topic is written by, on the one hand, people who believe school facilities should be the equivalent of the Four Seasons in Dubai or, on the other hand, people who believe the government has no place educating children and such matters should be handled by the private sector or by parents blessed with the wisdom of Aristotle and the math skills of Isaac Newton. But hey, lack of data has never stopped me before so here I goes.

When trying to judge the economic benefit to a community from building a new high school one must consider the relationship between school facilities and academic performance, the relationship between academic performance and housing values, and the relationship between infrastructure development and community utilization (value). Think of this as a hierarchy of needs: You can’t have good performance without a good foundation, you can’t derive benefit without performance, and you can’t derive value without benefit.

The Relationship of School Facilities to Academic Performance:
This one is easy to sum up: The conditions of school facilities have a direct impact on everything from absenteeism to teacher job satisfaction and job performance. What is not evident is any direct correlation between capital expenditures and academic performance. However, there is strong evidence that without quality facilities there can not be sustainable improvements in performance.

The Relationship of Academic Performance to Housing Values:
Ask any realtor what the top factor for home selection is and they will say school quality. It may not be number one for every buyer but it is the 600 pound gorilla. If you don’t want to take my word for it (and I recommend you don’t) check out the effort the National Association of Realtors is going through to get members to work directly with communities to improve schools and school performance: Schools and Real Estate. Academic or school performance influence on home values is measurable. According to one study (please see the Federal Reserve of New York’s research paper) that used house prices to quantify the value parents place on school quality, the impact of school quality on housing prices suggested an increase of 1.8% - 4.5% for each 5% increase in standardized test scores.

The Relationship of Infrastructure to Community Utilization:
This relationship isn’t as cut and dry as the other two but I wanted to add it because almost every piece of research I looked at mentioned it. In summary, any capital expenditure undertaken by a community should consider as much benefit to the community as possible. Mixed use facilities are one way to achieve lasting and widespread value for a community. The lesson learned here is if you’re going to build something expensive like a high school, make sure you can get as much use out of it as possible. This does not mean you have to build a Taj Ma High School, it merely suggests considering broader community needs and requirements. Don’t provide a specific group with a Mercedes, provide many groups with a Ford.

I call myself a Libertarian because I believe the government (at all levels) should leave me alone with my guns, bourbon, and discount books. But I’m also a realist. A long time ago the founders of this country believed that public education could provide this country with a key element for lasting freedom. Public education, as much as it has been maligned by all shades of the political spectrum, has helped to create a society and economic system of advancement and achievement seen nowhere else. State of the art school facilities do not guarantee economic success but communities that do not invest wisely in their schools can not expect the same level of benefits as those that do. Choose wisely.

Later….

Inflation Hesitation

2010-02-16T19:08:00.002-05:00

I’ve written about inflation several times because no other area of economic study is as relevant to us. Not knowing how much something is going to increase in cost, especially staples like electricity, water, and the 20 or so HD channels I already overpay for, creates ripples in our everyday lives and in the economy. Add to this the tendency of inflation to wipe out savings and retained value in assets (homes, equities) and you begin to understand how bad inflation really sucks.

However, I’m not as worried about inflation as I used to be. If you pay attention to the mainstream media, or better yet what’s left of it, you’ve most likely heard about all the ‘money’ the Federal Reserve has pumped into the ‘system’. I put ‘’ around money and system because it turns out that the Fed didn’t pump what can be considered money into what we vaguely refer to as the system. Despite the warnings from well known economists like Glenn Beck (he’s one of the reasons I call myself a libertarian and not a conservative) the way the Fed supported many of the ‘too big to fail’ financial train wrecks was not by giving them cash. Instead the Fed used a recently constructed and little known tool to essentially escrow the dough it gave to financial superfund sites like Fannie Mae and Freddie Mac.

The Fed didn’t print money and ship it in trucks to banks in the hope that they would lend it out. The Fed was able to keep its eyes on the liquidity it created by buying up mortgage-backed securities, bonds, and Treasury notes from financial institutions. It then made the banks park much of the proceeds (to the tune of about $1.1 trillion) with the Fed. It ‘incentivized’ these transactions by increasing the interest rate on excess reserves – the money the Fed pays the banks on the reserves the banks must keep with the Fed to protect their collective bottom lines.

Consider this the security deposit banks pay the Fed in order to use the Federal Reserve system to borrow and move money around. The banks will behave better with the Fed’s money if they can make more interest off of it and keep up their reserves so they don’t blow it all.

The banks and other financial institutions can take the money the Fed has provided but as the incentive grows, most banks will leave it be to ensure their balance sheets meet tougher standards. When the economy picks up, the Fed can adjust up this interest rate without significant impact to the economy due to the fact that the banks will be able to generate capital from ongoing operations. Eventually the Fed can either let this money flow back into the economy without contributing to inflation (as the economy expands and can soak it up) or it can pull it back in by raising interest rates.

So there, I feel better about inflation rearing its ugly head just as the economy recovers. And it’s good to know that there are creative and somewhat pragmatic people working at the Federal Reserve.

Later

PS: I feel guilty for not being as entertaining as I usually am (I know you laugh at me not with me) so here’s something I hope can fill the gap:

http://www.youtube.com/watch?v=d0nERTFo-Sk

What?

2010-02-01T08:42:00.001-05:00

Last Wednesday the SEC (Securities and Exchange Commission), on a 3 – 2 party line vote, decided to “encourage companies to disclose the effects of climate change on their business”. According to the New York Times and the Wall Street Journal:

“SEC Chairman Mary Schapiro, an Obama administration appointee, said the agency wasn't weighing in on the global-warming debate and wanted to ensure that investors get reliable information.”

The agency “wasn’t weighing in’? Right, and monkeys just flew out of my butt. What we have here is the Obama administration acting prudently to ensure that, no matter what happens to any proposed climate change legislation, steps will be taken to increase regulation aimed at reducing so called green house gas emissions.

By the tone of the fifth grade level prose above you may have gathered that I’m an anthropogenic global warming skeptic. Correctamundo. (For the breakdown of your humble shade tree economist’s official position on climate change please look below.) Skepticism aside, what really bugs me about what the SEC did is the smoke and mirrors use of a supposedly free market device to enact not so free market regulation.

Here’s how my thinking goes (you might want to break here for a couple of whip hits to help your brain function for a moment the way mine works all the time); The SEC requires public companies to disclose certain information when reporting financial information. The intent is to provide context for all the numbers that don’t make sense in financial statements detailing balance sheets, cash flows, etc. Many of these ‘notes’ disclose potential risks not reflected in the made up numbers in the financial statements. Usually these disclosures are things like “There are potential revenue fluctuations due in part to our CEO being a degenerate gambler who likes to raid the accounts receivables for meth money.” Or “We don’t really make any money, we just keep issuing stock and borrowing wads of cash to make it look that way”.

These disclosures are sensible when they directly relate to the revenue or expense generating activities of a firm. With Wednesday’s decision the SEC, under pressure from activist groups like the Social Investment Forum, has further politicized the disclosure practice by trying to relate an abstract risk to a tangible business impact often referred to as ‘material’. The SEC defends its decision by saying “…a company must disclose the significant risks that it faces, whether those risks are due to increased competition or severe weather.” An SEC staff paper further detailed the justification stating that a company should make disclosers to the public if it believes a new law or international treaty limiting carbon dioxide emissions might increase operating costs. Now that’s interesting. Why? Remember, disclosures are rarely seen as positive, so if pending climate laws or regulations potentially impact your business and you’re forced to take a guess on what may or may not happen, you are put at a competitive disadvantage.

Who cares? It seems reasonable to make a company tell its investors that proposed regulation may add risk or detriment to its operations. But here’s the rub, the SEC can punish a company for failure to disclose and therefore gets to make a judgment call on who they, or any wronged party, believes is a potential green house gas emitter.

In the recent housing market bubble and subsequent crash we saw what happens when multiple government agencies target a specific social outcome and use regulation and policy (often uncoordinated) as means to an end. If you liked what you got as a result of the regulatory gumbo produced for the housing market, you’re going to love the coming onslaught of green based government initiatives.

Later.

Official Shady Climate Change Position Statement: It seems average global temperatures have risen over the past century. Not disputing that. Anyone who thinks the majority or sole contribution to this rise is the result of human activity is delusional. Anyone who thinks human activity has zero impact on the environment at large, not just climate, is delusional. Therefore, most people who argue about climate change/global warming, no matter their position, are delusional. Talking to, let alone arguing with such people, is akin to trying to get a tennis ball out of the mouth of the Boxer-Rottweiler mix that lives across the street.

Addendum to the Official Shady Climate Change Position Statement: Delusional thinking aside, if you think you can alter future global climate and weather patterns by drastically reducing your carbon footprint or by forcing your friends and neighbors to buy into your delusional life choices, you’re on the bullet train (green of course) to disappointment central. It is the opinion of this completely clueless and unlearned person of all things climate and weather that for millions of years the climate has swung from extreme to extreme without coal fired electricity generation and Ford F350s. Therefore, to believe that human action can have a greater impact on long term climate trends than impacts from solar activity, the position of the earth relative to the sun, global ocean currents, and terrestrial phenomena (everything from volcanoes to the migration of the earth’s magnetic pole) is nutty. Furthermore, if you think we’re smart enough or technologically advanced enough to actually predict these trends through modeling, go ask the fantastically smart folks who used to work for BearStearns about how all that modeling stuff plays out in real life.

Addendum to the Addendum to the Official Shady Climate Change Position Statement: Why do so many smart people (as well as journalists and college professors) believe that human activity is the predominant, even sole cause for climate change/global warming? Some of them are convinced and have completely sold themselves on this. Don’t ask why, it is what it is. Most are taken with the possibilities created by the perceived need to change human behavior to address the ‘crisis’. Simply put, the thought process goes like this:
We’re fucked. Wait a minute, maybe we fucked ourselves. If we fucked ourselves we can un-fuck ourselves by stopping, or better yet reversing, the behavior that got us here. Let’s fuck with everybody to make sure those other fuckers do what we want so we can control all the fucking around that got us fucked in the first place. Since merely existing as human beings causes activity that in turn causes global warming, or better yet climate change, almost every aspect of our daily lives should be overseen by someone who really knows what the fuck their doing. The wicked smart people who think like this honestly believe that the vast majority of mouth breathing resource consuming humanoid locusts on this planet need to be instructed (told) how to behave. Climate change/global warning is the latest and perhaps greatest opportunity to be leveraged by these real life Ellsworth Tooheys.

Final Addendum: To be honest, I’m in favor of most of what the global warming/climate change crowd wants. More investment and tax credits for green energy, clearing the way for increased use of non-carbon energy sources (solar, wind, nuclear, etc.), and basically anything that moves our economy away from imported oil and gas. However, my rational is quite different from theirs. I do not fear an apocalyptic end to humanity from bad weather. Rather, I fear an elongated demise of western civilization from the continued transfer of wealth from a creative, progressive, and pluralistic group of societies to an enrichment of largely repressive, intolerant, and static group of societies. Mix in the fact that many of these petro-states want to harm us by any means possible and you’ve got a heck of a good reason to invest in a Prius and a pellet burning stove.

If you think Cap and Trade is the answer you should delve deeper into the way the current system works. I won’t go into it hear (NPR’s Fresh Air does one of the best covers on C&T I’ve seen: Cap And Trade And The New Carbon Economy) but it’s a mess with no measurable returns to date that has created a speculative market that makes real estate derivatives look like green stamps.

The Recession According to South Park

2010-01-29T20:34:00.003-05:00

This is the best explanation of what went wrong during the last decade's spending binge I have seen. The economy as god analogy is only something Trey Parker and Matt Stone could come up with. Enjoy!

http://www.southparkstudios.com/search/?search=Margaritaville&type=episodes

Glass-Steagall Redux

2010-01-25T09:55:00.002-05:00

Last Thursday president Obama launched what could be the first of many attacks on the country’s financial system. The target last week was the practice known as proprietary trading. A proprietary trade is when a bank uses its own money to buy or sell equities, derivatives, or anything else they can find laying around that looks more profitable than loaning people money. The president wants banks to stop this because he and others believe that this activity is too risky for banks and helped lead to the financial implosion of 2008/2009. Many of the fungi interviewed in the financial press described the president’s move as ‘curious’ or ‘a step backward’. Backward, that is, towards the repealed law known as Glass-Steagall that separated commercial and investment banking. If the president’s proposal brings us ‘backwards’ to Glass-Steagall than it’s the most (only?) sensible move to date the administration has made in the area of finance and economics.

Here’s why: Back in May I tripped all over myself trying to explain how and why the financial markets started to behave like Artie Lange. One of the reasons I cited was the repeal of the Glass-Steagall Act. Having a bank play the equivalent of the house while its customers play poker is not conducive to good moral or economic outcomes. So by not allowing a commercial bank to act like, or own, a hedge fund may seem restrictive, it’s much needed.

The president’s proposal lacked details but that may have been a calculated move to make Congress fight it out while being soaked in cash from lobbyists. The lack of clarity made markets nervous and helped send the Dow down over 5% by the end of Friday. It seems bankers and institutional investors sell stuff when they think they’re about to get shafted, making sure to sell their stuff before yours (the house bets last but holds the cards). This lack of clarity coupled with the notion of reversing direction on the so called ‘modernization’ of securities laws in the late nineties fueled skepticism in the press.

Peter Wallison, writing in the Wall Street Journal, put up a clever argument as to why the ban on proprietary trading is not such a good idea:

“Because banks are government-backed, and privileged in many ways, their activities are limited by law and regulation. They are restricted in how they can use their insured deposits. The Glass-Steagall Act, despite what we constantly hear in the media and from people who should know better, still applies to banks; it forbids them from engaging in underwriting or dealing in securities. This should prohibit them from engaging in proprietary trading to the extent that this is dealing in securities. Bank holding companies, however, because they are not banks and not government-backed, can engage in any financial activity, including securities dealing. Why would we prohibit them from doing so when they are using their own funds? “

I count myself as one of the people Mr. Wallison believes should know better but gosh darn it here I goes anyway. If it turns out that Congress passes a law telling bank holding companies they can’t play online Texas hold ‘em with their own money, good! Yes, they are not using directly backed government funds but neither were AIG, Citigroup, or GM for that matter. But they all got infusions of government (taxpayer) funds because without their continuing operation, the economy would supposedly fall deeper into the abyss. By default (punny!) these large financial institutions are backed by the government just like a sixteen year old is backed by her parents when the gas money accidentally goes towards a new pair of Uggs. The fact there are financial institutions so large that their demise would sink a $14 trillion economy was also addressed by the Obama administration on Thursday but it’s not as exciting as the rise from the dead of Glass-Steagall (I know, I have goose bumps too!) so I won’t go there.

I like the president’s proposal in two ways. First, Glass-Steagall never should have been repealed. Second, the specificity of the proposal hopefully signals an end to this administration’s jones for huge, un-passable chunks of reforms.

Later

Over Stimulated

2010-01-19T10:41:00.002-05:00

Can government spending end a recession? Those crazy bastards at the Heritage Foundation think not. In a well written piece in last week’s Wall Street Journal, Brian Riedl (the Grover M. Hermann Fellow in Federal Budgetary Affairs in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation (1)) argues that the great Keynesian federal money enema of 2009/10 will not only add bupkis to the short term national income, it will kill us in the long term.

Riedl sums up his argument by explaining where stimulus money comes from:

“Congress cannot create new purchasing power out of thin air. If it funds new spending with taxes, it is simply redistributing existing purchasing power (while decreasing incentives to produce income and output). If Congress instead borrows the money from domestic investors, those investors will have that much less to invest or to spend in the private economy. If they borrow the money from foreigners, the balance of payments will adjust by equally raising net imports, leaving total demand and output unchanged. Every dollar Congress spends must first come from somewhere else.”

Those in favor of stimulus and yet more stimulus may concede the “where it comes from” argument but would counter by noting the benefits of pumping magic money into the economy. Stimulus seekers could say that there is a multiplier effect from government spending. In fact, the Obama administration contends that virtually all stimulus spending creates or saves jobs and therefore has a multiplier effect of around 1.5. Simply put, for every $1 sent out through stimulus spending a $1.50 is eventually created in the wider economy.

Now comes the fun; It is impossible to measure a multiplier and anyone who says they can is either a college professor or someone trying to sell you something. But let’s not allow spurious data and intellectually bankrupt methodologies to slow us down. Let’s accept the idea that multipliers are measurable and see where it takes us.

Let us assume a revenue neutral program in the same vein as food stamps or unemployment insurance in that we are not expecting an annual return from the expenditure. What we are expecting is the passing along of that $100 to other participants in the economy thus promoting growth. Now let’s say the government borrows $100 from you or increases your taxes by the same amount and uses it to plant grass in an old parking lot to make it look better, become green, and provide a frequently unemployed local (we’ll call him Cletus) with a modest steady job mowing the grass. At first blush this seems like, and can even be measured as, a win/win. Let’s also assume all materials are purchased locally and all pre-Cletus labor is local as well.

So what’s bad about our imagined cash for grass program? As the saying goes, it’s what happens next that counts. Your $100 is a one time multiplier. It added value once and cannot create additional value to support the new lawn or Cletus. Eventually, additional funds will have to be allocated to maintain the Fescue-Cletus industrial complex. The value of the money you gave to or was taken from you by the government drastically decreases over time. Had that money stayed in a bank (and been loaned out) or invested in a business it would have had a much better chance of generating lasting value and thereby providing a long term multiple. The economy may have to wait longer and experience a smaller rush than with the cash for grass program but over time there would be greater benefit. How much is arguable depending on the nature of the investment or savings.

Could there be a different result had your $100 gone to a green energy startup? My guess is yes but there are private sector players in place who can invest your $100 in startups and can do it with less overhead and are held accountable in ways government can’t be (when was the last time a congressman from Massachusetts was fired?).

So what’s my point? If the government insists on redistributing or borrowing money to put a spark in the economy, let’s make sure it’s limited to those things the it can do that the private sector can’t (not much), like properly funding unemployment insurance and food stamps. And as for Cletus and his family, we should ensure his participation in the economy through providing opportunity and support rather than a push onto a government plantation.

Later.

(1) I’m wondering if the Heritage Foundation is going the way of the college bowls in its approach to sponsorship. Could we eventually see the Tostitos and Miller Lite Fellow in Consumer Affairs in the National Car Rental/Chick-fil-A Institute of Over Consumption?

Preparation GMAC

2010-01-11T07:59:00.001-05:00

To prevent or to prepare? It’s a question you probably ask yourself a lot more than you realize. In relationships, business, and even our health we often have to decide if it is better to try to prevent something from happening than it is to prepare for it (or vice versa). Charles De Gaulle once said we should all make use of the inevitable. He was a preparer and an expert survivor. He was also French and a real asshole.

Chuck, however, was able to secure French participation in the division of Germany post World War II, avoid having American troops stationed in France, and even develop advanced nuclear power and weapons capability largely without American or British help. In short, he led France out of a horrible period of war and despair into a period of independence and abundance without having to give up much. De Gaulle had the insight that France would be better off understanding and adapting to post war change than trying to prevent that change from altering the country(1).

Unfortunately the US Treasury Department does not share De Gaulle’s philosophy. On December 30th the Treasury Department announced a $3.8 billion capital infusion into General Motors Acceptance Corporation (GMAC) extending it’s ownership of the one time General Motor’s division to 56%. The intent is to "protect taxpayers and put GMAC in a position to raise private capital and pay back taxpayers as soon as practicable," announced the Treasury. The reason the government feels the need to ‘protect’ taxpayers is because it already shelled out $12.5 billion to keep GMAC solvent. From a tax payer perspective it’s a lot like betting the over/under to make up for a loss if the Colts don’t cover against the Bills. A strategy traditionally referred to as throwing good money after bad.

So what the hell does this have to do with my prevent or prepare question three paragraph’s ago? The Treasury is trying to prevent GMAC from biting the big one when it may be cheaper and less risky to put a bullet in it. Here’s my reasoning, or more accurately put my rant: A free market should allow for the destruction of participants that can not survive through self generated value. This assumes it is more costly and risky trying to prevent such a loss than to prepare for it. We’ve seen above how the U.S. Treasury is trying to prevent the loss of a major financial player under the assumption that its demise would negatively impact auto and home lending. Could it be cheaper and less risky if we prepared for it? I vote yes.

Here’s how preparation makes more sense than prevention. First, allow GMAC to go bankrupt. I’m not talking about bankruptcy light like chapter 11. No, no, I’m talking lucky 7; liquidation. The good loans would find a home and the bad loans would be written off. The argument against liquidation is that there would be less lending bandwidth for cars and houses and would thus impact economic growth. That’s not a bad thing because too much lending got us into the current mess.

Another part of the preparation would be to insure loans properly, as savings accounts are today, so that defaults would be covered. This approach is somewhat robbing Peter to pay Paul in that higher interest rates are the preferred mechanism to protect against defaults. However, adding default insurance could be better for consumers and lenders by offering more appropriate pricing.

In short, we can prepare for economic tsunamis by constantly adding taxpayer bricks to the seawall or we can pick our beachside property more carefully and put our houses on pilings. We can fall prey to the hubris of believing we can control complex events and systems or we can recognize the inevitable and make use of it.

Later

(1) Shady note: Isn’t it interesting how France is viewed today as being regressive and insular? Another De Gaulle quote “I have tried to lift France out of the mud. But she will return to her errors and vomitings. I cannot prevent the French from being French.”

Dubai Bye

2009-12-10T16:11:00.006-05:00

Once there was a happy little kingdom where people enjoyed the good life and basked in the warm glow of the king’s largess. They had it good, the cultural equivalent of June Cleaver in the kitchen and Jenna Jameson in the bedroom. Their homeland was a pleasant seigneury where they dashed from the indoor skiing facility to the pristine beaches and back again, giggling at the ice cream headaches it gave them. Their popular monarch put up breathtaking skyscrapers and billboards of himself all over the land and the people smiled with pride at the sight of both.

One day a cloud of hungry locusts approached the kingdom demanding to be fed money for they had given the king a little here and a little there to help him build the skyscrapers, indoor skiing facilities, and other massive capital investments with dubious return on investment. The king told the locusts and the media gadflies and the investment analyst ticks swept in on their wake that they would not be given the money they greedily sought.

“Hey look”, said the king, “We’ve got around $90 billion in debt and we haven’t got a nickel back from a lot of our investments. If I ever get my hands on those bastards who sold us that roach motel in Times Square I’m gonna give them a Columbian necktie. By the way are those imported Columbians still around or did we forget to pay them too? What, we have some Filipinos left? OK, that’ll do. Where was I? Right, you can’t have your money we’re a little short on cash.”

One of the locusts spoke up. “So you’re not going to pay the interest you owe us on those bonds we bought and those loans we gave you? Well OK then, you better sell some of your stuff or get a loan from that boring oil-rich fiscally responsible yet heavy handed kingdom next door. Because if you don’t pay out one way or the other, after we gut this joint we’ll start swarming over to other lands we have leant to and demand from them fat wads of money to shove into our hungry pusses.” With this proclamation a few of the gadflies sped off to spread the news and one of the ticks keeled over at the thought of not feeding again for a very long time.

“You can kiss my sovereign ass” said the king as he closed the solid gold Medici replica doors to the kingdom behind him. The people rejoiced as once again their beloved hereditary monarch had flipped his jewel laden middle finger at the insects from the west. And that night they all slept blissfully dreaming of sustained 10 – 12% GDP growth and low taxes.

--------------------------------------------------------------------------------------------

The fairytale existence of Dubai has come to an end. I can’t say the Dubai World financial Hindenburg registers very high on the schadenfreude meter (see below) as you have to hand it to the city state’s leadership for truly creating something from nothing. In thirty odd years they have gone from dredging a creek to creating a stunning cultural and economic center for the Arab world. But like other developing world high flyers they took on too much risk in areas that were highly susceptible in economic downturns: Real estate and tourism foremost among them.

With its failure to meet interest obligations on the debt of a government owned enterprise Dubai is not dead, it’s only mostly dead. That is to say gone are the days of endless growth and island making. It’s kind of sad as it was wicked fun watching Dubai build all that cool stuff, especially if you have Discovery HD. Dubai will live on, quite nicely I think, but it can be removed from the “ai” musketeers: Dubai, Shanghai, and Mumbai. The big question is could one of the other “ai’s” be next?

Later

Why Jobs Should Not Be Job One

2009-12-06T20:14:00.003-05:00

There are two Economic pundits I read every week: Robert Samuelson and Paul Krugman. Samuelson is what I’ll refer to as a Realist Economist who generally understands that actions produce results, some of them unintended and therefore we must think carefully before we act. Krugman is a Nobel prize winner who proudly wears his far left liberalism on his sleeve and couldn’t care less about unintended consequences because Economic policy should be thought of like Christmas presents from your aunt Helen: It’s the thought that counts.

Samuelson, in my opinion, is right more often than Krugman but Krugman is way more fun to read. Consider his latest argument for a national jobs program. In a piece from Monday’s New York Times professor Krugman admonishes the Obama administration for not giving top priority to job creation. He carefully words his backing statistics claiming that “There are six times as many Americans seeking work as there are job openings" and “the average duration of unemployment — the time the average job-seeker has spent looking for work — is more than six months, the highest level since the 1930s” (1). Yikes, looks like we haven’t stimulated the economy enough and a government lap dance is required to stiffen up our flaccid GDP.

Krugman thinks “our best hope now is for a somewhat cheaper program that generates more jobs for the buck. Such a program should shy away from measures, like general tax cuts, that at best lead only indirectly to job creation.” He favors federal aid to states to hire teachers and other public service providers combined with federal programs comparable to the failed Works Progress Administration (WPA) of the Depression era. He admits that these jobs would be low paying and would be considered “make work” but that they would benefit society by creating the kinds of cultural and economic homeruns like pay toilets on the Mass Pike and monuments commemorating Indian massacres.

Samuelson weighed in on Thursday, his take being that more government stimulus with the aim of creating jobs would create “risks in overaggressive government job-creation programs that can be sustained only by borrowing or taxes.” He favors an approach of less government spending with more attention paid to rationalizing taxes to promote growth and more focus on long term deficit reduction in order to prevent a budgetary nose offing to spite the face of economic recovery.

It is the opinion of your humble shade tree economist that both Krugman and Samuelson miss the mark. Job loss is a symptom of a bad economy, not a cause. To someone unemployed or looking for a job this sounds like a bullshit opinion from an amateurish wannabe economist. But let me explain: Jobs are lost when there is a lack of demand for the products and services those jobs produce. The current lack of demand for housing, financial services, and consumer products is the result of a double whammy of contracting credit and a deflated asset bubble. Having government, at various levels, hire more teachers, police, and people to fix roads and infrastructure will provide us with lower teacher/student ratios, safer communities, and better roads (music to the ears of a poor bastard that commutes over 100 miles a day). It won’t, however, fix the demand for products and services lost over the past two years. It will increase the staggering public debt and will eventually push interest rates and taxes to levels that further strangle the economy.

If you don’t believe me (good for you, always a safe bet) here’s what an invitee to last week’s jobs summit had to say: “The lack of jobs is a symptom of a down economy due to asset bubbles bursting and a drought of credit and a lack of direction and clear communication of policy from Washington.” That comment came from Fred P. Lampropoulos, CEO of Merit Medical Systems Inc., a medical devices manufacturer from Utah. Comments like this are frightening not only because they expose the lack of clearly understandable policy coming out of Washington but also because they demonstrate the freeze the lack of clear direction has put on business decision making.

Net, net we don’t need a jobs program we need to understand what the roadmap is for getting the economy back on course to grow and create jobs. How about a program to communicate the direction the Obama administration and Congress will take to create an environment favorable to growth and not more taxes and debt? It’s often been said that American business can adapt to anything as long as the rules are understood. Let’s hope the rules are established soon so that we can at least make decisions and then read about the consequences instead of why decisions are not being made.

Later.

(1) The two statistics Krugman cites are somewhat apples to oranges comparisons as the latest Bureau of Labor Statistics available (maybe PK has a bat cave like facility deep beneath Princeton where he gets and analyzes data faster than the Feds) shows that in September there were 2.5 million job openings and the October data shows 15.7 million unemployed. Programming this mass of data into a sophisticated multidimensional model and running it through my super fast six year old Dell laptop I come out with a ratio of 6.28 unemployed people for every job opening. In a noteworthy comparison, the lowest ratio since the BLS has been measuring job openings was .83 back in January of 2001 (5.1 million openings to 4.2 million unemployed). The seasonally adjusted duration of unemployment was 26.9 weeks in October, with historical data hard to come by the best I could compare to was over the past year when in November of ’08 the duration was 18.9 weeks.

The Other Osborne

2009-11-20T21:18:00.002-05:00

George Osborne is the Shadow Chancellor of the Exchequer in the UK parliament. The position makes him chief pain in the ass and financial gadfly of Prime Minister Gordon Brown’s government. As a conservative he is naturally opposed to most of what Brown and his Keynesian keystone cops have been passing off as ‘reform’ and ‘stimulus’. Agree with Osborne or not, he asks some very relevant questions as to the appropriate role of government in an economy.

Here are a few:

“How do we get borrowing under control so we can keep interest rates lower for longer?”
“Do we want to pump up the bubble again and repeat all the economic mistakes that got Britain into this economic mess?”

“Or do we want to build a truly sustainable recovery by gradually rebalancing our economy away from debt and towards saving and long term investment?”

Before you click over to TMZ or Perez Hilton for something more interesting (by the way how about those recycled pictures of Alexandra Kerry in that see through dress?), consider what he’s asking: “What do we really want? Not just now but long term.”

Far from being a burn the Federal Reserve Libertarian, Osborne is willing to consider a range of approaches to put Britain on a more balanced economic footing. He relies not on a single hammer so as to avoid treating every problem like a nail. He sounds downright Keynesian at times like when he suggests that government led stimulus is useful and appropriate when it doesn’t inflict crippling deficits and even criticized the Brown government for reducing the VAT tax from 17.5% to 15% (and you think your sales tax is high!).

Instead of short term gimmicks like temporary tax reductions and pork-laden stimulus, Osborne suggests a more open use of monetary policy to help lower long-term interest rates and to keep them low. If you are a loyal reader of the Shade Tree Economist (please feel free to laugh, there may be one) you’ll recall I criticized the US Federal Reserve for keeping rates too low for too long. But across the pond they treat their interest rates like their vacations: Too much and too long. To most Europeans the thought of active monetary policy is tantamount to cowboy capitalism or brushing your teeth every day. It’s way too American.

So if the UK shouldn’t borrow or inflate its way out of the current economic mess what should it do? Osborne suggests “…a new British economic model: an economy with a structurally higher rate of national saving, a more competitive export sector, and higher rates of private investment in long term productive assets.” Paul Krugman would tell him to put the bong down and get real.

Osborne does just that. I’m not sure where he puts the bong but his strategy sounds real.
Point 1: Monetary Activism – More than just low interest rates, monetary policy should ensure adequate bank capitalization and oversight to ensure lower government rates are passed through to borrowers and don’t line the pockets of large banks.

Point 2: Fiscal Responsibility – Control spending, reform public services (re: entitlements), and reduce deficits. Not easy tasks by any standard. However, Osborne believes that reduced government spending will be replaced by private investment and claims to have the data and analysis to prove it. This may be a bit simplistic but could be possible as a phase two once interest rates stabilize and stimulus funding is exhausted/retracted.

Point 3: Supply Side Reform – Pretty much a rehash of Margaret Thatcher’s attack on the British welfare state in the late ‘70s and early ‘80s: A less complex tax code with lower taxes across the board, welfare reform, and aiming private and public (but mostly private) investment towards long-term productive assets focusing on a low carbon economy.

Osborne’s approach seems reasonable even in a time of corporate teat sucking so intense no government binky could mute the wailing of infantile bank CEO’s or Barney Frank. So where is the reasonable Democrat or Republican on this side of the pond ready to take a leadership position like Osborne? What’s that you say? It’s not up us Democrats, we have to ride on the Pelosi, Reid, Obama train. It’s not up to us Republicans, we have sit on our thumbs and wait for the Democrats to really ruin things. Well, to quote another student of Thatcher, “If not us, who? If not now, when?”

Later.

Knee-jerk Nation

2009-10-06T12:36:00.003-04:00

Knee-jerk Reaction:

An automatic response to something.

From the tendency of the knee to jerk involuntarily when hit sharply, properly called the patellar reflex. That was recorded by Sir Michael Foster in his Text-book of physiology, 1877:

"Striking the tendon below the patella gives rise to a sudden extension of the leg, known as the knee-jerk."

If there’s a cultural/political/economic trend that has defined the past several years it’s the knee-jerk reaction. The sudden realization that something is horribly wrong and that something must be done about it immediately (or sooner) or else things will become worse. Like a cat lazily stretched across a floor suddenly bounding up and charging into the next room only to stretch itself out and plunk down again, we seem to careen from one crisis to the next, often revisiting last month’s crisis but never stopping long enough to consider what’s really going on, how it came about, and what our options are. There always seems to be a politician or an ‘expert’ ready with a plan that may not be complete but needs to start now!

What happened to us? Sure they’ll always be real emergencies like Pearl Harbor, a volcano about to erupt, or Kate’s ex-husband Jon cleaning out their joint checking account but aren’t there supposed to be adults in charge to help us slow down, take things into consideration, and make the right decisions?

Perhaps it’s the 24 hour news cycle, the internet, or our insatiable need to have what we want when we want it, be it an LED T.V. or a mortgage. Maybe there are politicians in Congress who see a window closing on the honeymoon period of pro-Obama, anti-Bush sentiment. But it could also be a sign of an overwhelming success in providing goods and services to the right place at the right time at a reasonable price. That’s right, a crossover from the worlds of finance and industry into the worlds of culture and politics.

When I was eight years old I saw an advertisement on a local UHF channel for Get Down and Boogie, a disco compilation album promising continuous long play versions of the hottest club hits of 1976. As the ad played non-stop between breaks in the Banana Splits and Gilligan’s Island, I had time to carefully write down the address, the price (including shipping and handling), and other ordering instructions (money order preferred) and discuss financing options with my mother. After a week’s deliberation a decision was made to purchase GD&B. It took around twelve years for the album to arrive. OK, I’m exaggerating a bit but when you’re eight and the much anticipated, nay, life altering prospect of the arrival of a compilation of the hottest club hits of 1976 fills yours days and nights, it seems like a long freakin’ time.

Last week my eight year old ordered a song off of iTunes for 99¢ and it took ten seconds to download.

Please don’t paint me as a nostalgic Luddite yearning for the days of money orders and six to eight weeks for delivery. I come here to praise technology and process improvement, not to bury them. But let’s think about the consequences. For too many of us our expectations have been heightened and our senses numbed to the point where we believe public policy and even the macro economy should work like iTunes. Still worse, people like Henry Paulson and Barak Obama have learned to play on the public’s new found hatred of patience and continually urge immediate approval for whatever solution they are proposing. Practitioners of this alarm and charm method have been successful in the past. Look at Al Gore’s largely successful ploy to end useful debate on the many aspects of global warming by continually stating that the “debate is over”. Or Hank “who needs balls?” Paulson getting down on one knee to beg Nancy Pelosi to push through TARP legislation.

One reason the alarmists have become successful is that they are able to steer the decision making process around the public’s ability to establish rational expectations. Here’s a shady 411 on the economic theory of rational expectations:

People will take into account as much information as they can get before forming expectations of future outcomes. Individual sets of expectations will be wrong or outright wacky but when many sets of expectations are pooled and average expectations are derived, a highly accurate set of expectations results.

By providing incomplete or wrong information and by not allowing time for a natural selection like process to take place, a set of expectations will look more like the agenda for a three year old birthday party than a reasonable solution.

For most of us experience has shown that it’s almost always better to do something rather than nothing when faced with a problem. However, how informed we are, who we discuss things with, and how much time we have to develop an answer must be weighed against how quickly we think we need one. Alfred Sloan, who led General Motors from 1923 to 1956, was rumored to have slept on every major decision he made. GM’s track record through depression and war was quite impressive. Sloan would probably have agreed with the old saw that it’s always easier to get into something than it is to get out.

Later…

Will a Bear Shit in Your Woods?

2009-09-06T14:26:00.002-04:00

In April/May financial pundits began speaking of a Bear Rally, the subject doesn’t seem to be getting as much attention these days but it should. If the rise in the Dow and S&P are any indications of where the market’s head is at, we’re in for quite a disappointing surprise probably by the end of the year. Why so glum you ask? The Dow is up close to 50% since its recent bottoming out at 6,440 in early March. On Friday, August 28 the Dow closed at close to 9,550. The S&P 500 has followed a similar path, rocketing up from 667 in March to 1,030 on 8/28. When a major economic indicator jumps 50% in under six months the first thing an autodidact economist asks himself is “Where’s the party?” Under current economic circumstances, watching the Dow or S&P reminds me of the confused Jeff Spicoli when he is summoned back to Mr. Hand’s class from the vending machines. As Spicoli enters the class shirtless with a pair of Vans hanging around his neck and a bagel wedged in his jeans he says “Wait a minute, there's no birthday party for me here!” Today friends, there are many professionals in the world finance and economics who have that Spicoli vibe.

If the market is up on the premise that things aren’t getting worse, it’s understandable that we would see a few jumps once in a while as the long term trend adjusted to what will most likely be a protracted recovery. But 50% in less than six months is nutty. Employment, the 600 pound gorilla of economic indicators in a consumer based economy , is getting worse, profits have stabilized (not pulled out of a nose dive), and inflation, the equity slayer supreme, lurks like Charlie Sheen at a Miss Teen USA pageant.

This year’s stock market run, my friends, has all the markings of a bear rally. InvestorWords.com defines a bear market rally as “A rally in stock prices that is experienced after a significant downward trend. A bear market rally might indicate that the markets are turning around into a bull market, however it might also be a temporary reversal. Because it is so uncertain, it is also known as a sucker rally, due to the fact that many people might be persuaded to invest at the sign of an upward trend, only to see the markets fall again.”

Economists generally suck at predicting markets and amateur economists generally suck at being economists so the reader should take what follows as seriously as a North Korean arms control agreement.

In periods when good times begin to role the usual suspects responsible for kicking things off in a bull market direction are:
· Interest rate peaks with signs of lower rates to come
· Inflation peaks with sings of lower inflation to come
· A decrease in corporate or individual tax rates
· Increases in corporate profits
· Low stock valuation metrics (Price-to-Earnings, etc)

Currently, inflation and interest rates are near all-time lows, there are no tax decreases coming, and although corporate profits are beginning to edge up, stock valuations are still relatively high.

The indicators above, however, may not be the most important signs of whether or not your investment adviser will soon be eating Spaghetti O’s out of can. The ghosts in the machine are we humans. It seems we tend to like good news more than bad and tend to trust our instincts as much as or more so than data or facts. We all too often misread feedback and act to distort the loop. This helps to explain why millions of us keep pouring money into mutual funds each month or why even when no positive feedback is provided by the waitress at the 99 your buddy insists she digs him.

If more evidence is needed for the argument that the recent run up in equities is cuckoo for coco puffs one needs to look no further than the banking sector which has led the rally. As pointed out by Gretchen Morgenson in the New York times, a recent analysis of 7,000 banks shows that “the number of financially sound banks is declining and that the ranks of troubled institutions are growing”. Due to slowing business and write downs of bad assets many banks are barely holding on to solvency. Although there has been good news in the past few days from a few banks paying back some of their TARP loans, the number of banks receiving failing grades for financial soundness increased from the first quarter of this year to the second. Add to this the specter of a huge block of non-subprime loans coming into an adjustment period from low fixed rates to adjustable rates and it would seem the banking sector is in for a Bruce Willis style cab ride which will surely impact the wider market.

Finally, we shouldn’t discount the echo chamber effect that contributes to booms and busts. As Yale economist Robert Schiller has noted, the chatter and media attention that helped drive a panic sell-off of equities in late 2007 through 2008 has now done a 180 degree turn. The market has recently shrugged off bad news and risen on speculation of ‘green chutes’ and cautious optimism that things aren’t as bad as were told they would be. The so called 24 hour news cycle and the need to fill cable and talk radio programming with relevant content helps accelerate the echo and distorts the feedback loop. Further, it doesn’t help to have an army of assholes blogging endlessly about stuff they don’t understand.

Most of us don’t have the knowledge, information, or cajones to time the stock market but if you have, congratulations and get out. Take the nifty 50 you’ve made and put it somewhere safe. As the gloom and doom described by the flock of quacking pundits never materialized to the extent predicted (9.5% unemployment is Germany bad, not Zimbabwe bad) the good times will come slower and less substantially than the flock now quacks about.

Later…..

Seven Years of College Down the Drain

2009-07-27T11:20:00.002-04:00

When I was an undergrad attending a state university in the middle of nowhere, I often encountered people who seemed out of place. They didn’t look or speak differently from other students they just didn’t have their mother following them around with a vacuum cleaner or their father constantly reminding them to do their homework or wash their feet. They were decent enough people and fun to drink beer out of whiffle ball bats with they just didn’t belong in college.

I happened to meet up with one of these folks when we had both been out of school for about three years. I was working part-time at a liquor store while getting a master’s degree. He had put his communications degree to use and was working as an assistant to a stock broker. When I read that President Obama wants to increase the number of people attending two year and four year colleges I have to wonder if this is a good move. Do we need more people spending four or more years and tens of thousands of dollars to get job or career they could have obtained without a degree?

According to Manpower Inc., the country’s largest placement and employment service, only four of the "The 10 Hardest Jobs To Fill In America" require a four year degree. Engineering, as always, is number one and certainly dependent on undergraduate and advanced degrees. The other three are Nursing, IT Staff, and Teacher. That leaves Skilled Trades (electricians, carpenters, plumbers, etc.), Sales Reps, Technicians (skilled or semi-skilled workers), Driver, Laborer, and Machinist or Machine Operator. You can certainly become any of the last six with a college degree but a degree is not required.

So what? Well, to begin with, when you look at the President’s proposal it’s essentially an entitlement program with little or no long-term economic benefit. Here’s the Shady breakdown of the plan:

Create the American Opportunity Tax Credit: Creates the American Opportunity Tax Credit that allows for the first $4,000 of a college education to be completely free for most (no % provided) Americans, and aims to cover two-thirds of the cost of tuition at the average public college or university. (Commentary: Not a bad idea but by next year when fewer than 50% of Americans will be paying federal income tax will this matter?)

Simplify the Application Process for Financial Aid: The President believes “The application process for financial aid is cumbersome and evidence shows it may be a reason why students never apply for college. Research has shown that the low take-up rate of the Pell Grant and HOPE and Lifetime Learning tax credit programs is likely due to the complexity of the application process. The current Free Application for Federal Student Aid (FAFSA) is 5 pages and 127 questions – making it longer and more involved than many federal tax returns. Not surprisingly, over 1.5 million high school students failed to apply for aid in 2004, despite being eligible for a Pell Grant”. (Commentary: This reads like something out of Monty Python “Seeing as it is too difficult for college students to fill out the form to get into college, we are killing the form so that more students can get into college”.)

Help Students Become Aware of College Readiness: According to the President’s website “Barack Obama and Joe Biden will provide $25 million annually in matching funds for states to develop Early Assessment Programs. These funds will also promote state efforts to raise awareness about the availability of federal and state financial aid programs”. (Commentary: Yes, I know that these days $25 million is literally nothing when it comes to federal government largesse but can’t we do something really useful with this dough like buy polar bears canoes or send out more free HDTV converter boxes?)

Expand Pell Grants for Low-Income Students: The goal is to achieve an increase in the Pell Grant to $5,400 over the next “few” years and will ensure that the award keeps pace with the rising cost of college inflation.

Community College Partnership Program: This is the majority of the proposal’s spend focusing on providing grants to “(a) conduct more thorough analysis of the types of skills and technical education that are in high demand from students and local industry; (b) implement new associate of arts degree programs that cater to emerging industry and technical career demands; and (c) reward those institutions that graduate more students and also increase their numbers of transfer students to four-year institutions”.

Eliminate Costly Bank Subsidies: Aims to kill the Federal Family Education Loan (FFEL) Program, which provides subsidies and guarantees to banks and other lenders and absorb all Federal lending into the Direct Loan program as a way to save billions of dollars.

In the end the Obama plan will probably send more people to two and four year schools. Hopefully many of those people will be able to parlay the education they receive into personal and national gain. Unfortunately history is not on their side. Most European countries take a realistic attitude towards advanced education and have no or very low cost secondary education. However, they also have vast apprenticeship and technical programs. Germany, for example, provides 342 apprenticeship programs where students work three to four days a week and attend classes for one or two days. Companies get skilled labor at the ready and the government doesn’t fund a lengthy college career.

Are we missing a golden opportunity to close the gap on many of those 10 hardest jobs to fill? Are we committing a vast misallocation of human capital by sending kids to college when they don’t need or want to attend? Are we stuck in an outdated mindset where a bachelors degree is always better than an associates or no degree?

Yes, yes, and yes.

Later

PS: Please feel free to comment on how people who go to college make X% or $Y more than people who don’t. I’ve got a garage full of data that says ‘maybe’.

Schezuanenfreude

2009-07-16T16:20:00.002-04:00

In the global schoolyard there are many ways to pick on someone (i.e. some country) based on how much you want to embarrass them or piss them off. There’s the annoying North Korean spitball: I’ll hack into your government websites and then duck behind the tetherball pole before the playground monitor notices. There’s the Iranian virtual wedgie: I’ll tell Hezbollah to fire some rockets into a few of your neighborhoods then watch from the swings with a smile on my face as you chase them around. And then there’s the more sophisticated and subtle hijinks reserved for the older mean girls to promulgate against a Jan Brady like target as part of a broader strategy of complete playground hegemony. A prime example of this is China’s call for the end of the U.S. dollar as the world’s default reserve currency.

Far from an easy poke at the lone superpower when it just fell off the economic monkey bars (OK, I’m done with playground metaphors), the recent rhetoric from several senior Chinese officials suggesting that a non-national currency or form of reserve replace the dollar as the go-to global standard is a subtle sign of longer term Chinese ambitions.

So why care? From an economic and financial standpoint, thou who controls the world’s reserve currency controls much of the playground (whoops). And it’s not just a financial advantage. A country can use the liquidity and flexibility of its dominant currency to build a war chest and finance other ambitions cheaper than its rivals.

The way foreign exchange reserves and reserve currencies work is made complicated because it’s usually explained by economists. Here’s the shade tree 160 word deep dive on the subject:

In order to buy and sell things with other countries you need to convert your currency into theirs and vice-versa. In the old days, currency was issued literally as gold and silver certificates. Theoretically you could take a dollar bill to the Federal Reserve and get a dollar’s worth of gold in return. For many reasons (most of them due to economists paid to explain currency and exchange rates) you can’t do that anymore. So you can hold all kinds of currency reserves in your national bank hoping that you have it right when the Andorrans (no, they’re not aliens, Andorra is a small country wedged in the Pyrenees between Spain and France) show up to buy a 777, or you can use a fiat currency. After WWII the U.S. dollar became the world’s fiat currency, enabling you to buy oil from Russia in dollars, Lawn Darts from China in dollars, and finance yourself silly because everybody else uses dollars.

Now the Chinese and other emerging economic players want to change the status of the dollar. From an international finance view they make a good point. As The Economist magazine puts it “China has particular cause to worry that America’s massive printing of money in response to the financial crisis will undermine the value of its (China’s) dollar reserves”. China and others hold massive amounts of dollars in their banks in order to lubricate trade with the U.S. and with each other. If the world becomes awash in dollars, they have to give up more of their reserves to play and they lose money. On the other hand, finding a new reserve is not easy. It could take decades and wild swings in currency valuations to come up with a new standard.

So the Chinese have begun to slow their purchase of dollar denominated U.S. government securities and increase the support of their currency, the Yuan, to settle international trades. There’s nothing illegal about this but it is risky. If the dollar were to fall because of this the massive amounts of dollars held by China (and others) would be worth less. But the Celestial Kingdom looks like it’s willing to take that risk because there are additional payoffs, the most prominent being the lower use of the dollar as the world’s fiat currency will lessen the power of the U.S. while seemingly increasing China’s.

So what’s wrong with China trying to flex a little muscle? It’s China. The reason the dollar has worked well as a global currency is largely due to America’s advanced, transparent, and liquid capital markets. No one who has looked at China’s capital markets would use those adjectives to describe it. Yes, the financial crisis resulting from American mismanagement of monetary policy and bizarre regulatory environment deserves criticism and questioning. However, putting China in the driver’s seat would be like letting the Tasmanian Devil take the wheel from Mr. Magoo.

Later

All The Golden Eggs In One Basket

2009-07-06T16:11:00.002-04:00

I have a schizophrenic view of taxation: On the one hand governments need money to provide services that the private sector cannot or should not provide so taxes are inevitable and necessary. On the other hand governments take our money and spend it on things we don’t agree with or can’t see the direct benefits of so taxes are excessive and arbitrary. However, as a drunk and disorderly self-educated economist what really concerns me about taxes is the people who pay them. More specifically, the risk inherent in the ever decreasing number of people who actually pay income taxes.

In 2008 46% of all US Federal Government receipts were from income taxes. If you take out the 40% of receipts used for ‘Social Insurance’ (Social Security, Medicaid, and Medicare) that the government saves for future expenditures (ah, that’s a good one!) then income tax accounts for 76% of total direct federal taxes.

In 2008 the top fifth of income earners paid 69% of those federal income taxes and the top two fifths (40% of all people who filed income tax returns) paid 87% of all federal income taxes. If I’m understanding my timses and gozintas right, less than half of all income tax payers get the bill for about half of all government receipts (76% if we want to be honest).

Where you sit on the financial food chain may make you smile or cringe at these numbers but let’s not go there. Instead, let’s think about how risky this is. If California is the beta site for American culture get ready for a disturbing phenomena; Tax payers who leave. George Will of the Washington Post provides this eye opener from a column on eBay ex-CEO Meg Whitman who’s running for California's Republican gubernatorial nomination “Twenty-five percent of California's revenue comes from income taxes paid by the 144,000 richest taxpayers, so ‘if one of them leaves, it's a really bad thing’."

California’s highly progressive state income tax ranges from 0% to 9.3%. The top 5% of the Golden States income earners pay 47% of all the state's income taxes. If I live in Cali I don’t mind if Brad and Angelina or Tom and Katie are getting soaked (I’m not sure if these people are California residents but they make better examples than Gary Coleman or Robert Blake). But I do mind if they move out of state. Yes, just one of them. If TomKat is raking in $20 million a year, that’s a $1.86 million revenue hit if they find a delightful place out of state with a Church of Scientology around the corner.

Putting aside class warfare and politics, depending on an elite few for a majority of your revenue is dumb. It becomes scary dumb when those few meal tickets are part of a global virtual economy and can easily work from Dubai, the back of their Gulfstream G650, or Nevada.

The Obama economic team, as well as any state or municipality, should consider this risk when setting tax and budget policies. None of them will but it never hurts to point this stuff out.

Later

Lies, Damned Lies, and Statistics: The Story of Salsa, Ketchup, and Healthcare

2009-06-16T12:20:00.001-04:00

If you have kids or are frequently around politicians you’ve no doubt experienced firsthand the use of selective facts in explaining one’s position on a certain topic or, why someone’s little brother has an arrow sticking out of his head. It seems people are imperfect and will sometimes not provide a complete set of facts when say arguing a point, applying for a mortgage, introducing themselves to waitress at Hooters, or sponsoring federal legislation. When I was a younger, more naïve shade tree economist I used to give the benefit of the doubt to people who could produce lots of numbers when making a point. Massive spreadsheets with impressive titles across the columns or down the rows convinced me that someone had their ‘S’ together. And if the purveyor of such a mountain of data could provide a statistical analysis complete with pie charts, bar graphs, or a USA Today like pictograph where two guys are arm wrestling and their foreheads come together in a Venn diagram and their bulging biceps and forearms form a Gaussian distribution with glistening beads of sweat compiling in a…. um, sorry, I got a little carried away. To sum up, I like many people, tend to believe statistics. Although I have become more skeptical as I’ve gotten older, I can still be had by a killer PowerPoint presentation.

Webster’s dictionary defines statistics as “a branch of mathematics dealing with the collection, analysis, interpretation, and presentation of masses of numerical data”. This ain’t addition we’re talking about. Statistics can be compromised by how the data is collected (and by whom), by how the analysis is performed (and by whom), and by the manner of presentation.

Let’s take my two favorite examples of statistical skullduggery for a ride.

Salsa is more popular than Ketchup(1)

Supporting statistic – A 1992 New York Times article titled ‘New Mainstream: Hot Dogs, Apple Pie and Salsa’ reported that “Last year, salsa -- a retailing category that includes picante, enchilada, taco and similar chili-based sauces -- took the condiment crown, outselling ketchup by $40 million in retail stores.”

Importance – The third paragraph of the Times article laid down the real point, “Epicures and food historians view the toppling of ketchup as the manifest destiny of good taste. Ketchup, that sugar-sweetened complement to fried food and meat, symbolizes "the bland old British-based American diet," said Elisabeth Rozin, a specialist in ethnic foods whose book "Ethnic Cuisine" will be reissued by Viking Penguin next month. The Mexican-inspired salsa is an uncooked relish fired by chili peppers that appeals, she said, "to cosmopolitan tastes."

"Bland old British-based American diet" versus "Ethnic cuisine" suited "to cosmopolitan tastes"? Based on retail sales comparing the salsa category to ketchup, the Anglo-sphere takes another one in the nuts.

The full story (well, at least my version) – To many Americans the thought of salsa, no matter the health benefits (there aren’t any unless you make it from scratch) or more flavorful taste compared to ketchup, besting the nation’s favorite condiment was unthinkable and wrong. And they are correct. The Times story used one statistic, retail sales, to make a point. According to a 2007 Wall Street Journal article covering the salsa/ketchup debate, the more extensive set of data favors ketchup:

“For example, take Information Resources, which tracks purchases at roughly 35,000 stores. The research firm found that salsa outsold ketchup, $462.3 million to $298.9 million, this year through August 12. But ketchup edged out salsa by units sold, 176 million to 174.9 million. And because ketchup bottles tend to be bigger, ketchup trounced salsa in pounds sold, 329.8 million to 184.6 million. Research from ACNielsen, which monitored point-of-sale data, shows similar trends for sales and units sold.
It’s also important to note that the market-research data only count purchases in stores, meaning those ketchup packets handed out with the billions of fast-food burgers consumed annually don’t count (nor does salsa served with chips and other Mexican restaurant fare).
Meanwhile, another market researcher has found that ketchup has a much greater presence in homes. According to the NPD Group’s National Eating Trends report — which is based on diaries kept by 5,000 people in 2,000 households — 48% of households used ketchup in a typical two-week period last week, three times the percentage that used salsa. That proportion has held steady for over a decade: The percentages were 48 and 15, respectively, in 1996.”

So has salsa really taken the condiment crown? With ketchup being consumed in larger quantities by more people, I’d have to say no.

There are more than 40 million Americans without health insurance

Supporting statistic – In the U.S. Census Bureau’s Health Insurance Coverage: 2006 report, the Highlights section comments that “Both the percentage and the number of people without health insurance increased in 2006. The percentage without health insurance increased from 15.3 percent in 2005 to 15.8 percent in 2006 and the number of uninsured increased from 44.8 million to 47.0 million.”

Importance – The Census Bureau’s report has been cited by politicians and pundits as hard evidence that a massive number of Americans are not insured and at considerable risk. This statistic is often cited as exhibit one as to why universal nationalized healthcare is needed.

More government, less freedom, too much money, we’ll end up having the U.K.’s shity healthcare system, blah blah blah. From a purely economic standpoint the problem with the increasing cost of healthcare isn’t the number of people that could be added to taxpayer supported roles, it’s the number of sticky hands your money goes through before it gets to your doctor. One idea that’s been floated by the Obama administration as well as the Heritage Foundation (a political Mork & Mindy pairing if there ever was one) is for the use of public insurance exchanges to lower the cost and widen the options for health insurance at a pre-tax cost. That would would solve a real problem impacting most Americans.

The full story (well, at least my version) – The Census Bureau’s highlight is just that. Cited several times within the body of the report is the problem of accurately collecting data on individual healthcare coverage:

“Compared with other national surveys, the CPS ASEC’s estimate of the number of people without health insurance more closely approximates the number of people who were uninsured at a specific point in time during the year than the number of people uninsured for the entire year.”

In addition, the Census Bureau notes that its census takers are not trained to manage healthcare questions and that many people answer incorrectly, that is, they don’t realize they’re covered under state or federal government programs:

“The CPS ASEC data underreport Medicare and Medicaid coverage compared with enrollment and participation data from the Centers for Medicare and Medicaid Services (CMS). Because the CPS is largely a labor force survey, interviewers receive less training on health insurance concepts than labor concepts. Additionally, many people may not be aware that a health insurance program covers them or their children if they have not used covered services recently.”

The Census Bureau offers many caveats to the accuracy of its healthcare survey but those who argue for universal government sponsored or supplied healthcare never mention it. A lie of omission at best, a true distortion of reality at worst. So goes statistics.

- Later

(1) For complete transparency I prefer salsa to ketchup on a hotdog.

Ford

2009-06-08T10:35:00.000-04:00

In an Op-Ed piece in today’s Washington Times columnist Mark Steyn compares the condition of GM with that of the U.S. In a play on the notorious quote that what’s good for GM is good for America, Steyn opines “Like GM, the U.S. government spends more than it makes and has airily committed itself to ever more unsustainable levels of benefits. GM has about 95,000 workers but provides health benefits to a million people. It's not a business enterprise, but a vast welfare plan with a tiny loss-making commercial sector. As GM goes, so goes America?”

As concerned as we all should be about what GM’s bankruptcy means for the country and for us as individuals (in my case not much, I have never owned a GM product and don’t plan to) we should take a step back and consider another U.S. automaker, Ford.

As GM, and to a lesser extent Chrysler, has spiraled into a financial and operational disaster, Ford has, well, been Ford tough. Here are some interesting facts:

Ford sold more cars in May than any other automaker, here’s the breakdown of the top 20 cars sold in the U.S. in May:
1. Ford F-Series Pickup
2. Chevy Silverado-C/K Pickup
3. Toyota Camry
4. Honda Accord
5. Toyota Corolla
6. Honda Civic
7. Nissan Altima
8. Dodge Ram Pickup
9. Ford Fusion
10. Honda CR-V
11. Chevrolet Malibu
12. Chevrolet Impala
13. Ford Escape
14. Ford Focus
15. Toyota RAV4
16. Hyundai Sonata
17. Hyundai Elantra
18. Chevrolet Cobalt
19. Jeep Wrangler
20. Toyota Prius

Ford’s Fusion Hybrid outsold the Toyota Prius and is the first “green” car to crack the top 10 in sales.

Ford increased its market share in May to 17.4%, its largest share since 2006.

What is Ford doing that GM isn’t?

First, Ford is making cars that people want to buy and are willing to pay for without massive discounts or 0% financing. True, Ford makes those incentives available but not to the margin killing extent of its rivals.

Second, Ford did something about three years ago that no other car company was willing to do: It hedged. In 2006 Ford was deeply in debt and had lost money in two out the past three years. Then CEO Bill Ford stepped aside and hired Boeing CEO Alan Mulally to lead the company. No newcomer to cyclical business, Mulally quickly moved to sure up Ford’s balance sheet by borrowing $23 billion through pledging all the company’s assets as collateral. At the same time, Ford restructured to cut costs and manufacturing capacity and began moving the company’s infrastructure away from the SUV focused nineties model so that it could focus on three objectives:

More hybrids

Imaginative small cars

Realistic pricing

Somehow Mulally, Bill Ford, and others at the company knew they were in for tough times and prepared. They may not have known that global credit markets would freeze up or that consumer spending would fall off a cliff but they put themselves in a better position to deal with those events when they arrived.

I would prefer we use Ford as the example when comparing the condition of an automaker to that of the U.S. GM was unwilling to make the tough decisions and sacrifices in the short term to improve the odds of long term success. The result was bankruptcy, nationalization, and loss of control. Ford sucked it up, ditched the idea of a government bailout, and is now taking market share from competitors and positioning itself to come out of the recession as the top U.S. automaker.

What’s good for Ford is good for America.

Later

The Myth of the Productive Class

2009-06-01T12:14:00.000-04:00

Turn on any conservative talk radio show or scan through a few conservative blogs and you’re likely to find references to the over-taxing and planned extinction of the “productive class”. To the champions of this so called productive class, it seems that every politician who favors increasing taxes to fill recession induced budget craters is a mindless left-wing lunatic with a severe case of Cranial Rectal Inversion(1).

Although I may be in violent agreement that many of our elected officials and their media lap dogs have acute cases of CRI, I think the belief that a limited number of the citizenry are the sole producers of economic wealth is laughable.

The notion of a productive class was first put forward by a group of quasi-economists known as the Physiocrats. The Physiocrats believed that the wealth of nations was derived solely from the value of land used for agriculture or for development, as long as that development meant more agriculture. In the ultra-hip salons of eighteenth century France the belief that wealthy landowners were masters of the universe and without them economic development would devolve to the level of hunter gatherers must have been comforting, especially to wealthy landowners who were the only people with time enough to hang out in ultra-hip salons.

Among the Pysiocrats Francois Quesnay (1694 – 1774) is probably the best known through his magnum opus Tableau Economique. To sum it up (believe me, trying to read this stuff in a book called The Pillars of Economic Understanding is searingly painful even for your beloved shade tree uber-nerd) Quesnay divided economic players into three groups to explain how wealth is created and transferred:

The Productive or cultivator class who were the sole generators of wealth and made the economy hum.

The Proprietor or landowning class who although not thoroughly described in the four or five pages of Pillars I was able to get through seem to fill the role of Mr. Potter in It’s a Wonderful Life.

The Sterile or the artisan and manufacturing class, think of Fred G. Sanford or Mr. Brown from Chico and the Man, who were the poor slobs who made stuff and did all the work around your chateau.

Quesnay’s defense of the productive class centered on the belief that without their contribution the power of the state would diminish and the natural balance of society would be upended. The productive were all that stood between the righteous order of the day and chaos. A little series of events called the French Revolution would prove Quesnay either right or wrong depending on what side of history you fall on.

OK, so where am I going with all this? Well, first, it seems we have quite a few Quesnayists in our midst these days. And B, I believe the need to protect a productive class, if you agree that one exists, is ludicrous. If you accept my first point then allow me to focus on the second.

I agree that certain people in our society should be afforded levels of protection, be they economic or legal, that others don’t need. Take for example children or people with risky jobs like strippers (but only the ones that really like you. You know, the ones that tell you they really like you.) The risk with protecting a specific economic class in a capitalist economy is that it defeats the benefits of capitalism. By nature a capitalist economy is complex and dynamic. You don’t get dynamic if you don’t have complex. By isolating a specific group of participants through legal or economic protections not allowed others, you risk retarding the dynamism of the system. Laws and regulations should apply across the board. Favorable or punitive taxation and regulation is a sure path to economic stagnation.

From another perspective, one could argue that in our current highly diverse, complex economic system there are many ‘productive’ classes all contributing to national wealth. Who’s more productive? The entrepreneur who develops the idea for a product? The financier who funds development of the idea? The manufacturer or service provider who produces or provides the product? The consumer who purchases the product? Try getting something done without anyone of them and you’ll find yourself not being very productive.

Maybe instead of trying to identify who are society’s most productive in order to protect them, we should instead focus on identifying society’s least productive. I recommend the Lloyd Dobler classification as a start:

“I don't want to sell anything, buy anything, or process anything as a career. I don't want to sell anything bought or processed, or buy anything sold or processed, or process anything sold, bought, or processed, or repair anything sold, bought, or processed. You know, as a career, I don't want to do that.”

- Later

(1) Cranial Rectal Inversion – The condition of having one’s head up their ass.

The 2009 Shady Awards

2009-05-18T13:16:00.000-04:00

I’ve decided that there aren’t enough annual awards given out to people who annoy us. Well, at least not enough for being annoying. In the spirit of the Ig Nobels and dozens of country music awards I am proud to present this year’s nominees for the first annual Shady awards.

The Schaude – The award for the most satisfaction or pleasure felt at someone else's misfortune (aka Schaudenfraude). The nominees are:

The Real Wives of New York City – A pack of See You Next Tuesdays who prove the theory that you can marry in twenty minutes what you couldn’t make in sixty lifetimes and turn out to be pleasantly miserable.

John Edwards – Also nominated in the following categories: Top Lawyer Jokes, Favorite Surprise Guest on Oprah, Penises to Watch in 2010.

California – How to turn the world’s eighth largest economy into Mozambique and still think you’re better than everyone else.

The Boston Bruins – Go Sox!

The Kaczynski – The award for the most entertaining fringe activist. The nominees are:

Paul Watson – When Greenpeace kicks you out for being too nutty the only thing left to do is get a TV show called Whale Wars. Captain laptop of the MV Steve Irwin is a curious cross between Quint from Jaws and Ghandi.

Octomom – Nadya Suleman doesn’t seem smart enough to be a big time activist but she’s crazier than an inbred squirrel and has been on TV a lot. For those who are cuckoo for Cocoa Puffs over ‘reproductive rights’ she’s a frog with too many tadpoles. For those lobotomized from excessive childbirth who think fourteen kids is a good start, she’s a martyr.

Fred Phelps – The founder of the ‘God Hates Fags’ and ‘Thank God for Dead Soldiers’ movements is a preacher from Kansas who believes that everything wrong with the world is due to homosexuality and that the US is being punished by God for being ‘a sodomite nation of flag-worshiping idolators’. All this doesn’t stop his daughter from being a frequent guest on the Howard Stern show.

John V. Walsh M.D. – For those of you in favor of spreading the love around this professor of Physiology at the UMass Medical School and frequent blogger is your man. He supports indicting George Bush and impeaching Barak Obama. The good doctor argues that ‘Emperor’ Barak has assumed the war criminal in-charge role from George and therefore deserves a ticket back to community organizing but not the prison sentence ‘W’ should get.

The Peroni – The award for championing an economic policy most likely to lead a country from a vibrant, pluralist growth machine to, well, Argentina. The nominees are:

Barak Obama – Like the head coach of a struggling football team, you have to blame the president whenever anything goes wrong with the country even if he inherited the problem. He’s only let off the hook if things improve while he’s in office (tick, tock, tick, tock).

The Republican Party – Nice comeback folks……Not.

Hugo Chavez – A Socialist Winston Churchill with a TV variety show jones or a Fidel Castro running on less than half a tank of talent? (Editor’s note: The Venezuelan economy was a basket case before Chavez. Now the basket is on fire.)

Paul Krugman – Nobel prize winning economist who wants to roll the dice and mortgage the country to maximize stimulus funds ASAP. What happens if we don’t immediately hit the trifecta?

The Shady – The award for providing half-ass information on a topic the person has no expertise in whatsoever. The nominees are:

Barney Frank – Economics and Finance

Barney Frank – Government Oversight

Barney Frank – Rhetoric

CNBC – Maybe 24 hours a day of gushing CEOs and Wall Street Analysts isn’t journalism (David Faber’s investigative series excluded).

For the two or three of you who regularly read this stuff you can cast your votes in the comments section or email them to Shadyeconomist@gmail.com. I’ll post the results whenever I get around to it.

Later

Up on Downers

2009-05-11T15:45:00.000-04:00

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” – Henry Ford

After consuming close to eight pages of 11 font double spaced text you’ll be relieved to find that I have nothing more to say about Systems Theory and its use in explaining how the global financial system performed a Triple Lindy over the past year. I do, however, have the following ideas on how to fix it and on how to prevent similar catastrophes from happening again (don’t worry, there will be all kinds of other financial disasters in the future due Capitalism’s endless ability to screw people).

1) Sensible Regulation – New does not necessarily mean better. Our elected politicians and the bureaucrats they supposedly oversee need to remember this. The first step towards a more sensible approach to regulating financial markets would be to repeal the Gramm-Leach-Bliley Act. In case you’ve never heard of it, it’s often referred to as the Gramm-Leach-Bliley Financial Services Modernization Act. Haven’t heard of that either? Well I’m not surprised because it received little attention in the press and its Republican sponsors and the Clinton administration wanted it that way. In 1999 GLB essentially repealed the Glass-Steagall act, a depression era law that, along with creating the FDIC, outlawed the ability for banks to own other types of financial companies like insurance companies and securities dealers. Glass-Steagall was seen as a good idea because depository institutions (commercial banks) are run differently than speculative institutions (securities dealers) for a number of reasons. The two best I can think of are 1) losses from securities speculation cold put a drain on deposits and 2) people managing deposits must be risk averse whereas people managing securities must seek out risk and manage it to provide an adequate return. In short, the ancients believed (because they had been burned so many times) that it was not a good idea to have your savings account in the same place where Fred from down the street was doubling down on Amalgamated Mining and Pet Food. Separating risked base investment from deposits makes a lot of sense and enables tighter regulation of securities (including derivatives) without smothering savings.

2) Uniform Lending Standards – Enforceable standards to protect both borrowers and lenders. The Mortgage Bankers Association (MBA) has proposed a “new federal regulatory framework” that would establish uniform national lending standards to replace the dog’s breakfast of current state and federal laws. The proposal also calls for the creation of a Federal Mortgage Regulatory Agency (FMRA). I’m OK with this as long as people like Barney Frank and Phil Gramm are kept away from the agency through the use of permanently installed shock collars.

3) Sensible Monetary Policy – There’s that word again. Why is it so hard to be sensible? First off, common sense ain’t so common (and you can quote me on that). Second, sensibility is subjective. I don’t think it’s sensible to shrink human heads but there are people in New Guinea who would call me shallow and elitist for thinking it so. Sensible, in this case, means using monetary policy to control the money supply to meet specific and economic objectives like keeping inflation under control, not as a tool to increase home ownership or inflate stock market performance.

4) Stop Investing in the Spread – I saved this for last in the hope that I could come up with a snappy title playing on the word spread (no such luck) and to try to form an articulate presentation of an idea (strike two). So here’s the rambling version short of a cute pun. Over the past three decades as financial markets have been deregulated and globalized there has been a great benefit delivered to our economy even after accounting for risk and the occasional recession. However, most of that benefit has gone to a very small number of people and has been focused on the short term. One could blame the success of hedge funds or the growth in size of mega-banks but I believe in comes down to where investment capital is going, not how. Simply put, we need to revive investing in things that create lasting value. This is not an easy task as the returns are not always as quick and as substantial as they are when you can make a quick buck shorting Sun Microsystems. What built our economy and national wealth was creating products and services that Americans and the world wanted to buy. Each year (present one excepted) Wall Street’s share of our economy rises. In the short term this looks good but is not healthy in the long term because making money off of making money does not add to our productivity as a nation. Investment in technology and process is needed to boost productivity and increased productivity provides tangible wealth. We need a strong banking and financial services sector in the economy but it should not be dominant. How we achieve a balance is tricky. We cannot rely on a centralized industrial policy as the federal government would surely mangle it. We can look to what has been present during past booms as indicators of success: relatively low taxes and inflation, divided government (one party in the Whitehouse the other controlling Congress), and government investing in tangible assets (the military, space exploration, infrastructure) to name a few.

Looks like we have a long way to go…

Later

System of a Downer (Part 3)

2009-05-04T16:30:00.000-04:00

Wealth is rare. There are people with extraordinary disposable income who are a divorce or a bad real estate deal away from financial oblivion. Their income is either generated beyond the span of their control (like most of us who are not self-employed) or goes out as fast as it comes in. What makes wealth such a rare thing is that to build it takes time and discipline. Webster’s dictionary defines wealth as the abundance of valuable material possessions or resources. A further definition adds all material objects that have economic utility. Wealth is the accumulation of stuff that keeps generating cash flow beyond its cost to support. My favorite treatise on wealth comes from Chris Rock who not only defines wealth in comparison to income (being rich) but offers up a few ethnic based examples of the struggle to achieve financial independence (you’ll never look at hub caps the same again).

In the last post I focused on how monetary policy interacted with the housing market to create the housing bubble. A benefit of that bubble was a ‘wealth effect’ for homeowners. The wealth effect comes in two flavors: The first is having wealth. The second is feeling wealthy. It is the later of the two that enabled a decade of spending from which the US economy benefited mightily. As home prices rose in a feverish market, homeowners took advantage of the growing equity in their homes along with low interest rates to borrow against their equity. Home equity loans and mortgage refinancing became to the decade of the 2000’s what stock investment clubs and day-trading had been in the 1990’s. And with similar results: A lot of people made a lot of money but very few became wealthy.

The system below shows the interaction of home equity with wealth (feeling wealthy), consumption, and home prices. As with any systems diagram this is a simplified view of how many moving parts work together to influence each other.

As home prices rose the level of home equity increased for most homeowners. Rising home equity brought on a wealth effect that encouraged homeowners to borrow against the increased value of their homes. The cash taken out of the home equity loans, lines of credit, and mortgage refinancing was increasingly used for general consumption (vacations, paying off credit cards or car loans, and buying stuff) instead of being used for investment back into the home that could have added value to the home and potentially built wealth. The wealth effect also enabled homeowners to trade up from, almost always, a smaller home to larger one. The growing consumption increased demand for many goods and services, least of all was more housing and housing services. This, in turn, drove up home prices. This cycle spiraled upward with the help of low inflation, low interest rates, and ‘innovative’ financing (Mortgage Backed Securities (MBS), zero down payment mortgages, interest only loans, and loans to people you wouldn’t pee next to at a Red Sox game).

When home prices began to tank not only did the amount of equity decrease for homeowners, in some cases it went negative. The decrease in home equity led to a decrease in consumption. In the cases of negative home equity it led to homeowners owing more on their homes than those homes were worth. Demand shrank with diminishing consumption which led to a further decline in home prices. Some found themselves unable to sell or refinance an asset they owed more on than it was worth. Life then proceeded to rub salt in their wounds by reminding them they had adjustable rate or interest only mortgages and as time progressed and interest rates ticked up in 2007 and 2008 the shit hit the General Electric GE90-115B jet engine and sprayed across the global financial system.

With home prices down, demand for homes down, and consumption down only an easing of interest rates or an increase in available credit could help kick start the system back into upward spiral mode. But unfortunately many of the institutions that could have been there to help were so strung out from the financial heroin they had been mainlining the only thing they could do was call their friends Hank and Ben for a ride to the methadone clinic.

Now the headlines in the financial posts remind me of the final scenes in Rocky and Bullwinkle cartoons but instead of titles like “You've Got Me in Stitches or Suture Self “ or “Mud-Munching Moose or Bullwinkle Bites the Dust” we get “Your Money: Does God Want You to Be Bankrupt?” or “Americans Sell Valuables at Home Parties”.

So what happens next? That’ll be next week.

Later

System of a Downer (Part 2)

2009-04-22T15:31:00.001-04:00

Last week I wrote about using Systems Theory to describe the housing bubble. A key input to the system that created the bubble was the Federal Reserve’s (Fed) use on monetary policy to keep interest rates low. So this week I’ll use the same approach to describe how the Fed most likely botched it’s measurement of inflation in the housing market and used the resulting faulty inflation data and the “Everybody and his crack dealer should own their own home” politically driven mentality to keep interest rates artificially low.

I call this week’s PowerPoint catastrophe the “Monetary Policy/Inflation System”. You could call it the “Interest Rate System” or the “Bubble within a Bubble” or…. Oh, sorry, got a little carried away. Here’s the graphic:

Inflation, as covered brilliantly in a past post, is simply defined as too much money chasing too few goods. But inflation is tough to measure and that’s why handy indexes like the Consumer Price Index (CPI) are provided to us so that we can either jump for joy or shit our pants when we see said index fall to 1.2% or rise 56.5% (annualized of course). According to the Bureau of Labor Statistics (BLS) there are 9,108 basic components that make up the CPI. Everything from ‘Whiskey at home’ to ‘Intercity bus fare’ is included, but not home prices.

‘Home Prices’ as a category, per se, does not exist in the CPI. Instead, BLS uses ‘Owners’ equivalent rent of primary residence’ to measure the cost of homeowner occupied units. As proposed by Steven Gjerstad and Vernon Smith in a brilliant article in the Wall Street Journal (see ‘From Bubble to Depression?’)when the CPI’s measurement for home prices was changed to rental equivalence from direct home ownership costs back in 1983 the true cost of housing, as measured by the CPI, was thrown out of whack.

“So what?” you say, followed by a yawn. Well, that little adjustment to the way the cost of homeownership is measured, posit Gjerstad and Smith, caused overall inflation to be understated by 2.9% in 2004 alone (that would have put overall inflation for that year at 6.2% vs. 3.3% as recorded by CPI). Underwear still clean? From 1999 to 2006 the actual rate of inflation of homeownership costs was 151% vs. 23% as measured in the CPI component ‘Owners’ equivalent rent of primary residence’. Squirt!

This difference in the measurement of inflation had a huge systemic impact. When combined with a monetary policy driven by political goals of maximum employment, price stability, and maximized homeownership it effectively drove interest rates well below levels needed to contain an asset bubble. With interest rates artificially low the economy (GDP) grew at an unsustainable rate. GDP growth helped to employ more people who bought more homes through less reliable financing. This caused home prices to rise much faster than the generally acknowledged rate of inflation (CPI). Each cycle through this system created a larger gap between the real value of houses (market prices less inflation of 151%) and the value as measured by most indexes (market prices less inflation of 23%), which in turn, inflated the bubble a bit more.

This was a titanic game of musical chairs. When interest rates couldn’t be lowered any more the economic engine, fueling and being fueled by home prices, began to sputter. The cooling economy cooled home prices and lower home prices meant lower homeowner wealth. The wealth generated by soaring home prices had, for many, filled the gap in slower rising wages. This wealth effect helped grow the economy. Once this system began its downward spiral the impact to economy and homeowners dependent on the housing bubble wealth effect was nasty.
We’ll look at the nastiness next week.

Betcha can’t wait!

Later

System of a Downer (Part I)

2009-04-16T16:51:00.000-04:00

Most of us, except the extremely boring, have at least once in our lives woken up in an unfamiliar place with no idea how we got there and only partial recollection of the previous day’s or night’s events. With a pounding head and through waves of nausea we promise ourselves never to do again whatever it was that caused us to awake in a walk-in closet in a house belonging to some kid named Lou. Inevitably we make the same bad decisions and take the same risky actions and wind up in someone else’s walk in closet or worse. Some of us break out of this cycle through dumb luck or through outside influence. Some get caught in the cycle and end up creating a downward spiral, a personal hell that leads to death or worse (much of which is captured on the reality show in the time slot after the midget family on the Discovery Channel).

There is a methodology designed to identify when you are caught in a downward or upward spiral. It’s called Systems Theory and it was designed in the mid-twentieth century to help identify and solve non-linear problems. A linear problem, for example, is when the neighbor’s cat comes into your yard at 4:00 AM and yowls. The problem is solved through a combination of cat treats, a hefty bag, and a trip to the dump. Problem presented, action taken, problem solved. A systemic problem is more difficult to identify and very difficult to fix. Often what seems like a solution ends up making things worse. So another fix is tried and that may help for a while but the problem returns or a new problem pops up in its place. This is known as the ‘Whack-a-mole’ syndrome. To understand or identify the root cause of the problem you have to understand the system.

I believe Systems Theory can help explain how and why the current financial meltdown occurred and why it’s going to be difficult and painful to fix. But before I dazzle you with beautiful and intuitive graphics and lay down a logical argument tighter than Valerie Bertinelli’s new bikini, allow me a caveat: Systems Thinking can become amazingly boring, stunningly fast. So in an attempt to lighten the load for the reader while offering me the opportunity to further plagiarize The Wall Street Journal and The Economist over the next couple of weeks, I have broken this analysis into three parts:

The Housing Bubble System (covered in today’s entry)

The Inflation System

The Homeowner Wealth System

In the final installment of the series I will try to bring it all together and if that fails I’ll just post a bunch of porn to try to make things up to you.

First, a Systems Theory primer:

Inputs: Things that contribute to the system. These can be part of the system or external influences on the system.

Opposing: System inputs that have the opposite effect on other inputs. When A goes up, B goes down. A opposes B. These are represented by an “O”.

Same: System inputs that have the same effect on other inputs. When A goes up, B goes up. A is the same as B. These are represented by an “S”.

The Housing Bubble System

Once upon a time you got a job, saved some money, and when you thought you were ready you started looking for a house. You found a nice two or three bedroom home in an acceptable neighborhood and proceeded to the local Savings & Loan to apply for a mortgage. Then, after the financial equivalent of a proctology exam, you bought your house and the bank kept your mortgage. During the 1980’s that all began to change. Technology enabled what economists call secondary intermediaries to enter the mortgage market. These guys could buy bundles of mortgages from banks and sell them to investors or write mortgages on their own. In the 1990’s several deregulatory steps were taken that enabled more complex investments called derivatives to explode in variety, complexity, and growth what had now come to be known as mortgage backed securities. This, in turn, led many finance and investment professionals to believe they could create unlimited upside (profits) by eliminating the traditional risks that accompanied mortgages.

At the same time the Federal Reserve (Fed), under pressure from the Clinton and then Bush administrations, kept interest rates as low as possible to foster economic growth and the American dream of home ownership (the lower the interest rates, the easier it is to buy a home). The combination of low rates and easy to find financing brought on by highly marketable derivatives caused demand and prices for homes to skyrocket. This process fed on itself, even through the 2001-2002 stock market collapse. According to classical economic thinking the rising prices for homes should have lessened demand and the market should have fixed itself. But that didn’t happen.

As shown in the system below three influences acted on the traditionally balanced housing price system to form and incredibly destructive bubble.

1) The Fed kept interest rates artificially low as it thought it could satisfy the dual goal of maximum employment (economic growth) and price stability (low inflation). As we’ll see in Part II, the Fed may have seriously miss-measured inflation, specifically in the housing market.

2) Regulatory oversight of the mortgage lending market all but disappeared as several administrations and Congress switched the goal of oversight from protecting borrowers and lenders to maximizing home ownership.

3) As the ‘Tech Bubble’ burst, home building and supporting services became the main driver of economic growth in the US. No one wanted to kill the goose laying the golden (be they toxic) eggs.

So, as interest rates were kept flat or decreased through a heavily politicized monetary policy, home prices rose (opposing). As home prices rose the percent of income required to own a home rose (same). As home ownership took more from income, people engaged in riskier borrowing to get financing (same). As risk increased, the use of derivatives to shield (hide) that risk increased (same). The use of derivatives pushed the housing market and the economy forward (same).

Well what’s wrong with this picture? Other than a third grade level of proficiency with PowerPoint what should grab your attention is the curved arrow leading from Interest Rates to Home Prices. If interest rates were kept artificially low to prop up the housing market, why did the housing market implode?

To find out, tune in next week…..

Later

Introducing the Shade Tree Razor

2009-04-08T16:08:00.000-04:00

While watching This Week with George Stephanopoulos a few weeks back (IFC wasn’t showing their usual Sunday block of old Japanese Samurai flicks) I heard South Carolina Senator Jim DeMint say the following (or something very close) to Massachusetts Representative Barney Frank during a round table on the proposed stimulus package “You have to ask yourself if absent the crisis would you still want to do all the things we’re suggesting be done?”

DeMint was responding to a list of items read by Stephanopoulos that seemed to have no relation to economic stimulus yet were part of the proposed package. To me, DeMint’s response was posed as a type of ‘razor’. Obviously I’m not talking about the kind of razor you shave with but I do reserve the right to discuss, at some future point, the subject of George Stephanopoulos, Barney Frank, and razors (although I believe the OutQ channel on Sirius may have already covered this). The kind of razor DeMint employed is more of a philosophical tool used to strip away the irrelevant notions posed in an argument. Some call it logic. However, most discussions these days, especially those conducted on television programs like This Week with George Stephanopoulos are so devoid of logic we never get to see it used.

Well, I’m one for bringing logic back. And what better way to start than by claiming this particular razor and naming it after this blog? If you answered “No better way!”, then good for you.

Allow me to provide a bit of context before fully perpetrating the theft. Perhaps the best known razor is Occam’s razor; “the idea that the simplest or most obvious explanation of several competing ones is the one that should be preferred until it is proven wrong.” I won’t go into details here as I’m not familiar with them and didn’t have any time for research. But trust me, Occam’s razor is a handy a way of getting around having to take forever to make or explain a decision. Had I known about Occam’s razor in my teenage years I could have cruised through many a dicey situation.

Police: “Son, why are there eleven cases of beer in the back of your station wagon?”

17 year old Shade Tree Economist: “Sir, there is a universe of explanations as to how so much beer could have ended up in the back of my Malibu. But officer let’s not waste your time or mine. Allow me to invoke Occam’s razor and propose that the beer you see in the back of my car was put there by people unknown to me without my knowledge and therefore completely exonerates me from any responsibility or transgression of the law.”

Wow, who could fight that? Continuing on with our newly minted (punny!) ‘Shade Tree Razor’, allow me to work DeMint’s question into a razor-like one:

“Absent a crisis would you still want to do all those things you’re recommending to resolve the crisis?”

If the answer is yes, then the bullshit detector should go off as someone is most likely using a crisis to push through an agenda that would, under normal circumstances, not have a chance and should not be considered. If the answer is no, then we may assume the recommendations are directly linked to a crisis and should be considered.

The logic behind the yes and no results is quite simple. If there are recommendations being made that stand on their own as solutions to existing problems not pertaining to the crisis at hand, why put solving the crisis at risk by adding complexity, cost, time, etc? If there are recommendations that make sense in terms of solving the crisis and would not stand on their own as solutions to other existing problems, the only value they bring is in solving the crisis and should only be considered within the context of doing so.

Try applying the Shade Tree Razor to your favorite crisis to see if any of the popular recommendations for ending said crisis are truly aimed at fixing the problem or are more like pile-on pet ideas unscrupulously inserted to satisfy the wants of a certain group.

As a final warning (and charming metaphor), this razor may not produce the best solution to a crisis or the best answer to a problem but it will shave off the back hair that can clog the shower drain that prevents the crisis or problem from being flushed away.

- Later

Inflation Stimulation

2009-03-31T17:04:00.000-04:00

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

2009-03-25T17:02:00.000-04:00

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

2009-03-19T09:19:00.000-04:00

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