Sunday, December 28, 2008

Why High Taxes Are Good

...or the invisible hand is senile old drunk.

If you don't know what the invisible hand is, go check wikipedia and I'll wait here.

Done? Good.

I have a friend who has a robot vacuum cleaner. Without his controlling the thing at all, it vacuums his entire living room. How does it work? Some secret AI doing advanced pathing? Careful memory mapping of the room? Stochastic dimensional area-ization formulas? It bounces into a wall and randomly turns. It's dumber than a staggering drunk. And so is the invisible hand. 

Now, if I ran that vacuum long enough, it would vacuum every corner and every square inch of carpet. However, a person could do it with less waste. So how efficient is it? Well, it depends on what is to be measured. If I measure the effort I must put in, the robot is more efficient. If I measure the energy and time used, I am more efficient. If I measure the cost of electricity and what I would have to do to earn that electricity, well, that would depend on my job and wage. 

So, if you love the idea that government does no work and should do no work, then by all means, let the invisible hand vacuum your floor and watch it painfully bouncing into the same wall and turning only to bounce off the same wall again. If you think maximizing time and resources is the most important, then have the workers control the means of production and watch the incredibly efficient production of stuff nobody wants. But, if you are like most of us who really just want the biggest bang for the buck, then it depends on what else could be done with that time and effort.

I'm going to turn things on their heads for a minute and apply economics to the schools of economics. Economics is all about making choices when faced with limited resources. Economics is "the science which studies human behavior as a relationship between ends and scarce means which have alternative uses." 

So economic philosophies attempt to decide what is the “right” way to use scarce resources. Marx believed that profits and rent were improper wastes of scarce resources and only labor should be rewarded. Libertarians think that only the market can decide value and only through complete privatization can a correct value be placed on anything. Others believe that the most efficient method to get goods and services from those who can provide them to those who want them by any means necessary. Keynesian economics believes that markets can only run at peak efficiency through government intervention.  

So now we see the variables at play. Government intervention; Market Freedom; Productive Capacity; Profit; Labor; Rent;

So, if I were a libertarian, I would measure the government intervention and declare success regardless of productive capacity. If I were a Marxist, I would declare victory when rent and profit were zero regardless of productive capacity. If I wanted the most stuff for the least effort, I would declare victory when productive capacity were as high as possible. 

I know some will complain that this is not fair. Both Marxists and Libertarians believe their philosophy does maximize productive capacity. But, my counter argument is that they should then put that at the beginning of the equation and let the rest just happen. But they don't. They have decided an outcome and want to prove they are right. Some solutions favor free markets, some favor communism. Most are both and neither.

Here are some interesting things to think about. They are macroeconomic principles:
There is infinite work to be done.
There is infinite demand for goods and services
There is an infinite potential for productive capacity

If there is infinite work how could there be unemployment? Because the invisible hand is a dottering old fool that wanders around like a robot vacuum only sometimes looking smart and the rest of the time we anthropomorphise the thing to the point we cease to see its flaws. Same answer for questions on the other subjects.

Markets attempt to reach equilibrium. Ok, fine, but they don't do it very well. If I asked you to drive straight down a road then you would drive straight down a road. If the invisible hand drove the car, it would drive straight until it started to swerve off the road and then over correct only to bounce off a passing car in the other lane. Or put another way, economics, like water, always seeks its own level. But, Tsunamis and hurricanes still cause massive disasters. And floods don't go away overnight. 

Does anyone doubt building an interstate highway system would increase a country's productive capacity? How about a court system that protected contracts? How about an energy grid or a rail system? We know that these raise the productive capacity of a country, but the market rarely builds these. Why? Because they benefit the competitor as much as it does them and if they didn't we would have 50 different roads between Chicago and St. Lois. They also require massive spending and in many cases, no clear way to collect money after. Toll roads reduce the benefit of having the road in the first place by forcing drivers to slow down and fumble for change. A partial destruction of the benefit is necessary for the profitability of that road. Now, imagine driving to work where every road is owned by somebody else. They may be in competition with you and simply refuse to allow you to buy passage on their road. 

We have a unique advantage in a democracy that other forms of government do not have. We can collectively decide what should be done and though it is flawed, we often make better decisions this way. If we look at the things we spend our government money on, it goes to what we want it to go to. I know I'd like to see a shuffling of priorities, but the point isn't that I get exactly what I want, but rather I get roughly what I want. I can't afford a tank let alone an Army. I can't send a man to Mars. I can't cure AIDS, but I can vote for my tax dollars to do that. And, the budget becomes a compromise of our collective values. As long as we get rid of this idiotic notion that we will get a better mix in the private sector, we can all be pretty happy with a 10-20% increase in government spending. 

So I can't afford everything that I think will make the country a better place. And neither can Bill Gates, or Warren Buffet, or anyone.

Bill Gates is doing an admirable thing by taking his money and spending it on Africa. That's great, but I think it's a waste of time and money. Africa is a political problem, not a monetary one. Maybe I'm wrong, maybe I'm right, but if it were government money we would debate the merits and then act. By deciding that only the wealthy can decide is to say that only the wealthy know the best course of action, or are not being self serving. If Gates is wrong in Africa, I can't fire him, but if Obama is then I can.

This has always been the downfall of other collectives. Monarchies rely on one person to be really smart. Communism almost guaranteed failure by turning the economy into a committee meeting. Free markets rely on the drunk old invisible hand to bounce perfectly into the right oncoming car and squeak through the right decision. Needless to say this almost never happens.  

When we had high taxation on the wealthy we built dams, roads, nuclear bombs, won a world war, went to the moon, built an interstate highway system, electrified the nation, built a national phone system, built a national trail system.

Now that we have decided that you can spend your money better than the government can we have collapsing bridges, deteriorating rail system, not a single new mile of trails though wilderness usage is way up, no national fiber optic system, an outdated electrical system, a decrepit space program, and a productive capacity that can only sell houses to ourselves using money borrowed from China.

This is not a useful investment in our nations future. This is not the way to be the leader of the free world. This is not the way to be a major player in future technologies. We became a manufacturing superpower by following Alexander Hamilton's “Report on Manufacturers” which advocated strong government involvement in building infrastructure and funding young industries. We created canals and railroads making us the most powerful industrial economy in the world. Despite a devastating Civil War. We then became a military power through massive government seizure of production during WWII. That became a massive technology investment making us the inventor of the new economy. 

Now after 200+ years we have decided that all that stuff government did to get us where we are was no good and we shouldn't pay for it. Government has no role in the market and the market can do this all by itself. But ask this. What has a pharmaceutical company ever cured? Oh sure, they are great at managing a disease for the rest of your life, but a cure? Why do that? How about a space station? Surely there's a market for that? So why isn't there one that is privately funded? How about a weather service? Everyone complains how the weathermen are so bad. There's a clear demand for better weather forecasting and yet all those weathermen get the same data from the same government. How about a super-collider? Or a unifying theory? How about doing the human genome project itself rather than combing data provided by the government.

The truth is the market sucks at pure research. Markets suck at infrastructure. Markets suck at science. Markets suck at exploration. What they are very good at is exploiting what governments pave the way for. Governments paid to discover a trade route to India. The East India Trading Company brilliantly exploited that discovery, but didn't discover anything on its own.

Here's a big one. What do we have that is fundamentally different than we had in 1958? What major, life disrupting invention have we come up with in the last 50 years? Sure, we've made computers better, jets better, rockets better, cooler TVs, better ways to distribute movies. Now, compare that to 1908 - 1958. We got the Airplane to the jet airplane to rockets. Steam engines to diesel electric. Rural electrification. Sewage systems. Water systems. End of the horse as primary transportation. Nationwide phone system. Helicopters. A cure for Polio. Blood typing. We went from the world of Malthus to the world of Galbraith. A world of barely surviving to a world a affluence. 

This was done with government money spent on things that we the people thought reflected our values and desires for the future. 

It's said that there are three ways to order and organize the means of production, and I'm not talking Marx just because I use that term. 
Central Planning
Free Markets
Mix The Two.

Well, I don't think I have to convince anyone that Central Planning has problems. In a way I am trying to show that might not actually be the case, but let me continue. Free markets? Well, I think they suck, but similar to Democracy, it's the worst except for all the others. But what about a mix?

The problem with central planning takes root in another notion of economics. It's the question of value. If I want something really badly that costs $100 and I buy it. It may be worth $1000 in my happiness. A $20 life jacket is worth every amount of money to a drowning man. But, a glass of water is worthless. And that's what happens with Central planning. Too often the life jackets, or Louisiana's amphibious vehicles, go to the desert and the water goes to the flood victims. This is when we all laugh at government and say what a lousy job government does.

OK, so the free market would never do something so stupid. It would never sell dog food or lumber over the Internet. It would never overvalue homes to offer bad loans at the height of a housing bubble. Nor would it ever use heavily leveraged mortgage money to jack up the price of oil futures. I think you get my point.

Here's where Democracy makes a big difference. Political pressure made Brownie lose his job. The same is not happening on Wall Street. When a Democracy does something stupid, the voters get a chance to correct it. If the government does not respond to our values, then we vote for those who do. We don't get to vote on Wal-mart building a new highway to the massive store they just built. They expect us to build it for them. And that's fine, because then we get to decide if that's the best thing for our town. Maybe we want Wal-mart to be a little difficult to get to. Maybe we don't, but that's a debate we get to have.

But what about voting with your dollars? Well, that means Paris Hilton gets more votes than you, but her vote can have a massive impact on you. Let's say she wants to build a perfume factory next door to your house. Well, if you don't like it, don't buy her perfume! That will show her!

The point of all of this is look at what government can do and has done. Look at our values and compare it to the values of our government. If you don't like those values, try to change them. But, government spending is not the enemy. People telling you it's the enemy while they spend like crazy on things that don't reflect our values are the enemy. They want us to debate low taxes and evil government spending rather than looking at what they do with our money. And my favorite is when we catch them doing it, they say “see! Government spending is evil! I just proved it!”

Tell the Europeans the Marshal Plan was evil.

Friday, December 26, 2008

Spoon Full of Sugar

With a collapse of the financial market, why on earth would I care a fig about inflation? After all, aren't we in a period of massive deflation? 

Yes, we are. But as I posted earlier, deflation is easy to fix. And it can be fun. Inflation is like stopping a boom. It's unpleasant and nobody will be your friend after it's done. Just ask Carter. 

Here's a proposal. 

In order to end deflation, we have to print and spend a lot of money. We will get schools, roads, bridges, parks, all the great stuff that came out of the depression. But, we may end up with too much money and that would require a massive hike in interest rates, the very rates that are near zero now and not doing anybody any good. Unless Germany and Japan can kindly go to war with us again so we can soak up that extra cash and capacity, we will face a very painful time as we return to normal economic policies. 

I know I said there was a proposal, but hear this all out first. Why not just not print that much money in the first place? Well, the problem here is that you need to actually cause inflation and it has to be believed by everyone, especially bankers. If I have $1000 at 0% interest and pay back $1000 at the end of the year, the lender has made no money. If I borrow at 10% interest then the bank makes $100. But, if inflation is at 10%, the bank has the same equivalence of money as before. So, why should a bank want inflation? Because the bank can leverage that to a better advantage. If the bank borrows at 0% and you borrow at 5% then you pay back $50 more than you borrowed. The bank is sure you will pay it back because money in the future will be easier, not harder to get. The bank pays back $1000 and gets to keep its risk free $50. The bank is borrowing at -10% interest and you are borrowing at -5%. In other words, the Feds are paying you to borrow money. 

Now the bank only needs $100 to lend you $1000. I know, it's called fractional reserve banking and it's very weird and I personally think it is the basis for most of our economic problems throughout the last two centuries, but that is how it works. Anyway, They are in effect making 50% profit from that 5% loan. The reason they won't make the loan now is that the expectation is that deflation is running about 5% now. That means that $1000 loan that needs to be paid back at $1100 is going to cost the borrower $1155 in todays dollars. For many, that is just too much and the bank has to foreclose and cough up that money itself. So a bank loans $1000 on $100 and makes $100 or loans $1000 on $100 and loses $1155. That's an upside of +100% or a downside of -1,155% or more than 10 times the loss as there is for the gain. So the banker has to know that there will be inflation and the borrower will be able to repay the loan or at the very least, the house will be worth more in the future. 

Plus, the bank has to fold deflation into the loan so the interest rate is out of reach for many people. If I borrow $1000 at 0% and hold on for a year at -5% inflation, then I made $50 for doing nothing. If I put that in a T-bill at 2% then I make 7%. That's a nice amount of money for doing nothing! If I loan it, I'd need 12-15% to make that kind of risk/return. 

Really, the proposal

So here's the idea. What if we raise interest rates to about 5% over the next year while at the same time print lots of money? I know it sounds like it's self defeating, but here's the beauty of the idea. The hard times come during the good times and all that is needed when we are recovered is to ease off the good times. It's like deciding ahead of time who will be the designated driver. In this case, it will be the banks. Yes, those same people who got us into this in the first place. But here we are asking them to do what they are good at. They are good at being party-poopers. In fact, they are so good at it that they are preventing us from having a party right now which is why the Feds have to throw us a party instead. 

So, the Feds become the bank while the banks wring their hands and worry about their balance sheets. Eventually they will see that with inflation making loans less risky and the negative numbers on the balance sheet start looking smaller due to inflation and the T-bills starting to look less and less desirable, they will start to loan money again. 

When the designated driver looks ready to have a drink, we know it's time to end the party and go home. The banks take over more and more of their proper role in the economy and the feds do less and less. The rate is now in a position that it functions again both directions and we can return to our normal insanity. 

I believe this will prolong the time the government has to stimulate the economy, but I don't think it will prolong the overall time the Feds will have to intervene in drastic ways. I just think it will let them intervene completely on the stimulus side, and not at all on the politically disastrous kill the party side. So no politician has to face the issue of do the right thing, but commit political suicide. There is a big implication of trade and flight from the dollar, but I may mull those over in a future posts.

Tuesday, December 23, 2008

Every thing's Just Fine

This current economic mess is a pretty simple problem to get out of. There is no chance we will do the right thing to fix it though because too many people have the wrong idea about why we have an economy at all, or even money. Understanding that is the key to understanding or current mess and the obvious solutions.

Some Basics

OK, so the first thing to realize is that we did not get invaded or bombed or hit peak oil or had a catastrophic ecological disaster, yet. So our problem is a wholly man made problem and, as opposed to an oil spill or industrial accident, wholly one in a fictitious world. 

Let me back up a minute to say something that will shock many people. Economics is no more real than the rules to baseball or Texas Holdem. I know, I know. The economy is how our world functions, the “Invisible Hand,” communism doesn't work, blah, blah, blah. The “The Tortoise And The Hare” is also fiction. It doesn't mean it's not useful, it just means that it's fictional. There is no theory of gravity equivalent in economics just like there is no formula for winning a football game. And there lies the solution to this whole mess.

Just go with me for a while that economics is just a bunch of made up rules to a game we all agree to play. First, what is real in this game? In soccer, the players are real, the ball is real, the field is real, but the rules are fantasy. In economics, production capacity is real, workers are real, consumer goods are real. What is not real? Money, loans, bonds, stocks, inflation, these are all by-products of the game. Just like offsides, holding, pass interference are by-products of the rules to American Football. 

Why Won't We Fix This?

So, like I said earlier. Nothing fundamentally has changed. Everything is still there. Factories are still there. Workers are still alive. Consumers still want stuff. So what's the big deal? The big deal is money. Who has it, who can get it, and who controls it. This is the focus everyone is so fixated on. The real question is what do we want and how do we get it. Money is only a tool to facilitate the production and distribution of goods and services. Money itself is pointless. You can't eat it. You can't drive it to work. You can't wear it, though I know someone who would try. So it's just pointless pieces of paper. It used to represent gold, but that's even dumber. Suddenly finding a ton of gold does not increase production and so does nothing to actual wealth. Losing a ton of gold does not reduce the production. Right now we have lost a ton of gold and have shut down the economy while we all scramble around looking for it. It's the most insane thing I could imagine doing. The house is on fire and we are throwing money on the fire thinking that since money can buy water it's the same as throwing water on the fire!

We are so afraid of inflation and debt we are letting real things stop making real things. My dad has bought into one of the right wing talking points, and I don't blame him. It goes like this. We are in this mess because U.S. consumers went too deep into debt to try to fund a lifestyle beyond their means. OK, but my response is this, It couldn't have been beyond their means because we could make the stuff. So, forget about money for a minute. If we have the productive capacity to make all this stuff, then it is not beyond anyones means to have it. Imagine this, because it really happened during the Great Depression. Farmers have fields full of produce and people are starving in the city because of lack of money. Does this scenario make any sense? It does if the prime importance is a little slip of paper, but it's nonsense if it is your child dieing in your arms. To say that the parents are to blame for having kids they could not feed is not only callous, but incredibly stupid. The food is there. The work was done. Somebodies idiotic fiscal policy drove all the slips of paper away. That is why the child is starving to death.

So Where Did All The Money Go?

Here's the biggest secret to this whole mess. The money that disappeared never existed in the first place. When you ask the bank for a loan, it hands you a check to go against whatever you are going to buy. That check, if you or I wrote it, would bounce higher than the moon. It is written on nothing! As our productive capacity increases, and our population, we need more and more money to keep the economy running. The US in its infinite stupidity decided that the best place to get money is for everyone to borrow it. The more money borrowed, the more money in circulation, the more goods and services produced, and consumed, and workers get paid not quite enough to pay for all this. Through the brilliance of trickle down economics, the workers go deeper into debt to those who don't need any more money, but who's money rests solely on the workers being able to borrow and spend more every year. It's just an elaborate version of the old sharecropper scheme. 

When the consumer can no longer borrow more or repay what they have borrowed, they get punished even though the economy rested on this very thing happening. If the consumer had gotten wise and been more prudent, this same scenario would have played out, but the complaint would have been consumer hording, which is exactly what happened and exactly the accusation hurled in Japan. The problem in both is the same and the solution in both is the same.

One more point about trickle down economics. In my previous post I pointed out that a boom is too many investment dollars chasing too few investment opportunities, the investment equivalent of inflation. When the wealth is concentrated so much as it is now, it is inevitable that we will have a huge series of bubbles. One bubble just replaces another as stocks of the 90s became housing became oil futures until everything collapses and that string of clever deals unravels and nothing was based on nothing was based on nothing. Now we are in a crises, not because of the plight of the workers, but because of the plight of the wealthy. 

So, Einstein, How Do We Fix It?

Print more money!

Every year we grow our production capacity. Every year we grow in population. Every year we need more money. Our national debt grows to cover projects that are getting done and work we think is important. Our trade deficit grows for all the new demand of goods and services that are being done. It's time to see money for what it really is, a tool. If we need more of it, just print the stuff. We did this with colonial script and with the green back. The LETS system is a variant of the idea. Take the idea of borrowing out of the monetary surplus equation. 

But we can't do that! After all, this system has been around for about 100 years and we've only had one, and now maybe two, great depressions, recessions every half dozen years, bank failures, S&L failures, wall street failures, booms, busts, stagflation, inflation, gold speculation, and it's working just fine. Printing money would be just like Weimar Germany!

No it wouldn't. Weimar Germany printed money to get out of the obligations of the treaty of Versailles. It was not done as a gesture of being a good steward of the economy. Spain endured inflations and recessions after the new gold and silver from the new world ravaged their economy. Rome experienced booms and busts based on foreign conquests. Britain rose and fell through colonial exploitation and the economic upheavals caused by that. Every banking disaster of the last and this century has occurred at the end of low taxes for the wealthy producing a housing bubble. Being helpless in the face of a nations monetary base hasn't worked. It is time for us to take direct control of our monetary reserves. Trickle down economics is much more like Weimar Germany than taking our own control of the monetary base. Trickle down economics allows the printing of free money by those with the power to do so. Issuing new stocks, new lines of credit, new mortgages, are all methods of printing more money, and more money is clearly needed. That is how we grow. However, this form of creating currency comes at too high a cost. We are in effect renting our circulating capital from private enterprises. 

Our economy was doing OK, though pretty lethargic at previous levels of money. Let's print what we lost and call it even.

Wednesday, December 3, 2008

When a Dollar is not a Dollar

We often think a dollar is a dollar. This concept gets us into trouble when we try to understand the economy or economic troubles. If we instead think of two different dollars, financial issues become clear and even Stagflation can be understood. I'll call the first of these two dollars Consumer Dollars to represent money used to pay workers and to purchase consumer goods. It is money that circulates quickly and has a very high velocity. These are the dollars most of us think of when we think of dollars. The second I'll call “Investment Dollars” and represent money used for long term investment purposes. This is money held as stocks, bonds, loans, etc. It has a low velocity. 

Adam Smith, perhaps unwittingly, referred to this when discussing bank notes. He explains the effective difference between “fixed capital” and “circulating capital”. He opposed small bank notes believing that money should only be borrowed in order to procure materials necessary to produce goods. He believed borrowing money to purchase consumption goods was so insane no person or government would ever do it.

Recession and Inflation

Inflation occurs when too much money chases too few goods. The normal response to this is to constrict the money supply by printing fewer dollars or raising interest rates. Recessions occur when too many people are trying to horde too few dollars. The normal response here is to print more money or lower interest rates. When either of these become severe, as in the US in the 70s and in Japan in the 90s, the solutions must become more drastic. They remain the same solution, but become politically more difficult as the remedy becomes more and more drastic. However, these measures only work on the right problem and because there are still many who, for political or ideological reasons, dismiss Keynes, the most effective methods are often vehemently opposed. 

Regardless of the method used to combat recession and inflation, in this context, inflation and recessions are consumer dollar problems.

Booms and Busts

To differentiate Fiscal problems from consumption problems, I will refer to booms and busts as the fiscal equivalents of inflation and recession. A boom is too many investment dollars chasing too few investment opportunities. A bust is too many people trying to horde too many investment dollars. Keep in mind that this behavior can occur regardless of what is happening on the consumption side. Though, this is often clouded with statements like “Wall street is nervous about the new consumer confidence numbers coming out today.”

The solution to a boom is usually pretty simple, but politically almost impossible. Who wants to be the one who ended the party. Unfortunately, not ending the party will result in a horrible hangover. This hangover is much more expensive to fix than stopping the party. I will delve deeper into this in my next post.


So, how does this explain stagflation? In the 70s, we had rising inflation and rising unemployment. Remember that inflation is too many dollars chasing too few goods. The solutions to inflation almost always focus on the too many dollars part. This is what the policy of the 70s did. However, the rising unemployment should have pointed to too few goods as the real culprit, and the fiscal policy of the 70s is also the policy needed to end a boom party. The problem here is there was no party to end. Instead we had a little bit of a headache. When interest rates rose, investment dollars disappeared.

If a factory owner wants to make more money, and demand is high, he can expand production or raise the price. If he raises the price too much another entrepreneur will think “Hmmm, I could make a killing too if I made that.” So he goes to the bank and borrows some money. More likely he would go to an investor, but for reasons I won't go into, the end result is the same and the bank makes things much clearer. Now, if he borrows at 5%, he obviously needs to make more than that to pay his loan back, so if we assume the normal profit rate is 5%, then he needs to sell his goods with a 10% mark up to cover these costs. 

If banks raise the interest rate to 18%, as happened in the 70s, the prospective factory owner would require a 23% markup to cover these costs. The original factory owner can also charge 23% even though his costs are only the 5% normal profit rate. The 18% his competitor must pay becomes, to him, all pure profit. At some point consumers will cease buying the good and those who borrowed the money to fund a factory will go under first. But, unless something significant changes, like a massive recession or a sudden availability of cheap investment dollars, the situation will remain where it is. 

When the Fed turned its policy against consumer dollars instead of in favor of investment dollars, it also hurt the real problem of the economy which was supply and not demand. This has been taken up as the neo-con mantra of economics. However, the trickle down crowd has learned the wrong lesson from this supply crisis. Just as a sudden influx of dollars can un-stick a recession, supply side policies can un-stick a bust. But, an influx of dollars is not an appropriate long term solution to a robust economy any more than trickle down economics is a long term solution. 

This does not completely explain stagflation, how it started, how it ended, and what should have been done. I hope, however, this makes understanding the debate much clearer and helps illuminate the insanity of some “analyses”, especially given our current situation. I wanted to explain how I am thinking about the macro economy before I delved into my understanding of our current mess. 

Wednesday, November 12, 2008

Living Life Behind The Power Curve

I wrote this a while ago and shared it with friends. I think it's worth saving some place.

You are flying the final leg down to the runway and you realize you're too low. You add power and pull back, but you're still going down. Give it full power and you're barely holding altitude. What's going on? This is called flying behind the power curve. This phenomenon happens because there is so much drag on the airplane it can't climb no matter how much power is added. The trick is to push the nose down, get some speed, and gently begin the climb again.

How often do we do the same thing in our life? We are so focused on climbing and we give it everything we've got, but we still aren't climbing or worse, we're going down. This is living life behind the power curve. All we need to do is back off, get our mind and body into a healthier condition and we can climb almost without effort if we so choose, or glide along where we know our position is our choice, not our limitation. This all seems so simple until faced with a real situation. Imagine we are in the airplane again and in front of us is a row of trees, power lines, or buildings. It takes an awful lot of faith, training, or both to be willing to point the plane straight at disaster in the hopes of recovering later.

When will the plane begin to climb again? Could I make it if I keep doing what I'm doing? Looking back at our own lives, the trees become bills, power lines are credit card payments, and buildings represent a mortgage. Can we risk easing off in our attempts to climb with those looming threats?

We often know we cannot continue as we are, but are afraid of what happens if we stop. If I don't deliver this project on time, will I get passed over for a raise I badly need? Will I get fired or laid off? If I ease off now I know I will crash and I do seem to be climbing ever so slightly. So we continue like this and just barely miss the trees. We look out in front of us and are relieved to see there are no more immediate obstacles. Now is the time to nose down and get out of this situation, right? Of course not. We cleared the trees meaning this must obviously be working for us. In fact, things are going so well, I'm going to fly over to the other side of the mountains; and so we buy a new car or take a vacation on our credit cards or buy the latest new gotta have gadget or learn to fly.

Saturday, October 25, 2008

Thumbs Out, Thumbs In – Off With Their Thumbs!

The wealthy, powerful, and connected sit on high watching the masses struggle and fight in the arena. They place their wagers on the outcome as simple people strive for nothing more than a life of food, water, and shelter. The betting becomes intense as the outcome becomes more and more certain. All wagers shift to the obvious winner and as the house has predicted this years ago, it is only too happy to oblige. The fight slows. The fighters worn out. The outcome becomes questionable. The gamblers begin to panic as the fighters refuse to give a satisfying outcome. The house suspends all bets and the gamblers cry out in fury! This is not fair! We are ruined! The drones did not behave correctly! It is our right to exact justice!

The wealthy retire to their private jets and sky boxes to await the just decision of the referee. As the masses have failed the gentleman gamblers, let the masses pay the losses!

Friday, October 24, 2008

Understanding The Meltdown

The more I read about explanations for why we are in a financial crisis, the more I realize Occam was right. But in this case the simplest explanation is not how do we understand the problem, but rather where are we looking. We blame bankers for making illogical loans and gambling trillions of dollars. We blame middle America for wanting to own a home. We blame deregulation for allowing financial institutions to put the national economy at risk. Finally, we blame the overseers for not overseeing. All of those explanations are only symptoms of a very simple and fundamental flaw in our economy and, indeed, our entire national understanding of economics.

Let me walk through a simple thought experiment:

Imagine there are ten people and each has $100. This creates a society with $1000 worth of currency. One is given the exclusive privilege to lend money at a fraction of what he actually has. So, five of the people decide to borrow $1000 each in order to build a home. We now have $6000 in our society. The borrowers agree to pay back $1200 at the end of the year, but since they are not banks they must return the money in real dollars, not as bank credits. All five cannot repay the loans because it would require there to be more money in existence than actually exists. Even if, through the “invisible hand” of the market each of the five could get back all the credits outstanding and pay them back to the bank, the return would be short $500. These five must somehow get the remaining $500 that society has and turn that over to the bank as well.

But! I can already hear the objection. The bank would be issuing other loans and so there would be more currency out there than just the $6000. The five would have built something of value and so could borrow again with that newly built value.

In our world, in order to pay the original loan, the first five sell the houses to the other five for $1100 who take loans from the bank. Since the bank now has a supposed $5000 in loans it can cover these loans and even buy a house itself without any money. They make enough profit to borrow again and build themselves a home. Now the original five borrow $1000 to build homes. We now have $10400 in circulation. But, it must all be paid back to the bank. In fact more has to be repaid than exists in the world and so can never be repaid. So, the bank starts taking homes and can't sell them because either someone has a home or cannot borrow to get a home. 

This is the scenario we find ourselves in. But really, this just goes back to who is wrong? Is it the system? The borrower? The Bank?

Well, here is where we start looking elsewhere for the problem. As long as the system keeps expanding and the amount of money keeps increasing, we have no problem. As long as the population increases and technology increases we have no problem. And, as long we always have demand for that new production, we have no problem.

But, we have a problem. In our world there is a pretty straight connection between the money borrowed and the value of the product now owned. In other words, there is no profit takers. The bank makes money by its unique ability to create new currency and to hold dominance over that currency. Each builder makes a profit, but it largely goes back to the bank for more loans. And as long as this cycle continues, the system works fine.

Now before I am accused of being anti-profit, the point here is not pro or anti, rather it is to be considered.

In this world of ours, one of the ten becomes an entrepreneur Through some mechanism he ends up with a little more money or credit than his other citizens and he builds a factory with borrowed money and the other eight work for him. They get paid for building value and he gets profit for his (and here you will have to insert your own justification as I have not yet concluded in my own mind what he is exactly contributing. So insert any economics 101 regurgitation here as that will suffice for these purposes). The entrepreneur issues stocks and the workers buy some and the owner gets the rest and his factory is worth $10000 based on his workers buying shares with money they borrow based on loans from the increased value of their house and generous contributions in the form of 401k and option plans. The system actually continues to function. The workers work, and repay loans. The factory owner gets his profits, and repays his loans. Everything stays in balance.

Now I have really taxed the patience of the reader. I promised a simple explanation for what has happened and all I have done is given a long winded thought experiment justifying the status quo. I am almost to the point and I apologize it takes this long. I want to cover as many initial objections as possible before revealing the point. I hope that I have created a world that all can agree is a reasonable simplification of our economy at work. True, we have only one bank, one factory, and everybody works at the same place and we haven't even discussed the issues of monopolies, unionizing, taxes, government enforcement, oversight, banking regulations, pollution, raw materials, etc. All these are extraneous to the conversation and if we simply agree those issues are balanced by other forces in a larger, more complicated market, then we can continue the experiment.

For some reason, whether it be the forces we have not included or some unforeseen new opportunity such as expanded trading opportunities, our Entrepreneur begins accumulating wealth at a higher rate than he had before. This upsets the societal balance. The money must come from somewhere. Let's say he discovers he can make due with one less worker because he has optimized his operation. There is now an unemployed worker who is skilled at the job required. So, our entrepreneur cuts wages. After all, if they don't like it, the out of work worker will gladly take the job for less money. Unemployed or under-employed, the workers begin defaulting on loans. The entrepreneur and the banker begins accumulating the wealth in our fictitious village. The workers attempt to offer solutions to the two powerful men such as renegotiated loans and the banker and entrepreneur agree. The wages are cut further and the loans extended longer. At each stage, the workers ask for new terms and they are given. At each stage the accumulation of wealth increases deepening the already difficult economic situation. Finally, the two own all the real cash and there is none left to repay outstanding loans. The fictitious money collapses under its own devaluation. The banker finds himself once worth $10400 now worth only $500. The entrepreneur is in a similar situation. He has only $500 left and nobody will buy his products. The economy has collapsed and the two can only think back to when they were so rich.

The problem we face today is nothing more or less than proof trickle down economics does not work. All it does is concentrate the currency into the hands of a few people who leverage that currency into larger quantities of fictitious money whether they be stocks or mortgages. This money then, as Gresham's Law points out, drives out the good money where it is horded or moved overseas to purchase oil or finance federal debt. Since these institutions are not bound to take this fictitious money as legal currency, and in fact are forbidden, the bad money must be converted to good money in order to pay off another instrument of bad money, the mortgage. This transaction debases the bad money further and begins a downward spiral. Though the value of the fictitious money held by the bank is diminishing through this policy, the obligation of the borrower remains the same. His increasingly valuable real currency must be exchanged for a decreasingly valuable debt. The result is hording by the banks of the valuable real currency and an expulsion of the bad and decreasingly valuable fictitious money.

How can I make a statement as bold as this is proof trickle down economics does not work? Because we have seen an increasing accumulation of wealth and an increasing burden of debt to everyone but the wealthy. If money truly did trickle down, we would see the distribution of wealth remain relatively consistent and the economy rising evenly across all income levels. What we have seen instead is a greater and greater concentration of wealth resulting in a Gini coefficient at its highest since the great depression. This wealth is then leveraged into fictitious money and is considered to be at parity with real currency. And indeed, if one were to sell 100 shares of Microsoft, you would get parity. You would get what the market says it is worth. However, if Bill Gates sold all of his shares in Microsoft, he would not get parity, but rather some fraction of the current assumed worth. If everybody tried to sell Microsoft, the stock would be worthless and the parity percent would be zero.

Our assumptions that fictitious money and real currency have equal parity misdirects our economic efforts. For example, we point to the GDP and say, “Look at our prosperity!” But, this prosperity is largely fictitious money. As we pass legislation increasing the dominance of fictitious money through low capital gains taxes and IRA plans, we in turn devalue the fictitious money. Our parity percent becomes lower and lower with each increase of fictitious valuation. When we turn our economy from real goods and services to the management and creation of fictitious money, we balance our economy delicately on the pinnacle of a house of cards. Each move in this direction decreases the parity percent and the difference between our true worth and our perceived worth becomes increasingly larger until it can no longer be sustained and it all comes crashing down.