Ranting about Economics

Note:  I ramble a lot in this post, and I’m not sure I agree with everything I said, but I’m starting back to work today so I don’t have a lot of time to muck with it and I’m trying to get content out, so… you’ve been warned.  If you want some interesting reading on the topic, here’s a few links:

http://money.cnn.com/2011/08/12/news/international/short_selling_ban/

http://arstechnica.com/apple/guides/2011/08/does-this-metric-make-my-company-look-big.ars

http://www.theatlantic.com/business/archive/2011/08/the-4-scariest-economic-graphs-ive-seen-this-year/242997/

http://money.cnn.com/2011/08/12/markets/high_frequency_trading/index.htm?eref=mrss_igoogle_business

http://efinance.org.cn/cn/aboutme/cmx3.pdf 

….

I just entered West Virginia.  This is because I’m on a trip and driving to the beach, having spent the night and dropped off a couple of dogs in Kentucky (with people [well… family], not just anywhere you know), we’re now safely ensconced in a Jeep Liberty, the four of us (two real people, two seventeen year olds) enjoying the extra space the dogs left us.  Traveling this way means that you see a lot of countryside and inevitably have random conversations with family members you never see about politics and economics.

In particular, since the world economy has taken a bit of a dive lately, I figure it’s time for my personal rant on the topic.  Let me start by saying that I’m not fond of economics, at least not formally.  This stems mostly from an unfortunate economics teacher in college and my background in not-being-stupid.  In one of our early classes, the professor drew an x-y axis on the chalkboard, placed a single data point, and after only a few moments of discussion drew a very attractive wavy line through it and called it a “supply-and-demand” curve like this:

Anyone that is not very upset by that chart should stop reading now, so that I do not offend you, and immediately go unfriend me on Facebook or put me in your “icky” circle on Google+ or something.

Here’s the math 101 short course for anyone that ignored my previous paragraph:  you can’t draw a curve through only one point of data, because you don’t know which way the curve should go.  It takes two points just to make a straight line, and at least three points to make a curve (and normally lots more unless you’re sure what shape the curve has).  Is it a one-humped camel, or a two-humped camel?  Or a sea-serpent?  You get the idea.  My relationship with formal economics went downhill from there.

Now that’s just the taste in my mouth – I admit it’s hugely important to study and understand how economies work.  I am currently undergoing a microeconomic experiment by having just given the aforementioned 17 year olds $100 apiece to buy their own stuff for this trip so they won’t bother me and will hopefully learn the value of a dollar.  Already they have passed up $7 slices of pizza to save money, so we’re learning something.

As I was saying, Supply and Demand are important to understand, along with a million other useful economic principles.  Civilizations need to find a way to ensure economic health; otherwise the economically unhealthy will rise up and usurp whomever is in need of usurpage.  Typically, governments are formed, rules enacted, and economies coagulate around these rules in predictable, productive ways.

Examples and counterexamples abound on how rules and markets interact to entertain us:

• The U.S. Housing market melted in 2008 due to credit being extended beyond the ability of homeowners to repay it – there’s plenty of blame to go around for that one
• Fraud including the Savings and Loan scandals in the 1980s, and things like the Bernie Madoff Ponzi schemes caused much evil and scared away investors
• Machine (computer) automated trading at microsecond intervals was blamed for a brief but nearly instant 10% drop in the US markets in 2010 and some current volatility
• Government debt has been rising, causing Greece followed by other countries including, most recently, the United States led to market chaos, political chaos and, at least in the case of the UK, actual riots (um… just straight up chaos)
• Hyper-inflation in some countries devastated savings, and required the introduction of Trillion Dollar notes

And those are only the high profile, recent issues.  Peculiar economic anecdotes go back as long as you’re willing to look.  Merchant prisoner transport ships headed to Australia were paid on a per-prisoner basis when they departed.  Upon arrival, prisoners had frequently died along the journey, so countries began paying upon arrival at the same rates, but only for prisoners who were alive.  (Living prisoners were valuable for labor; dying for non-capital crimes was frowned upon).  Survivorship on the trips went way up, while costs did not.  Doing root cause analysis on these issues, to determine exactly what went wrong or right and when, is the subject of thousands of other articles and blog posts, but I’m going to take a stab at summing it all up with a few simple observations:

Financial “markets” are too far removed from the actual tangible assets and economic principles that they were originally designed to support.  Banking, home mortgages and publicly traded stocks are fundamentally simple concepts, and in fact when they were first introduced they performed admirably.  They greatly expanded the value of currency by allowing it to work for multiple people at once.  This concept is fundamental to the way modern economies work; it’s even an argument for keeping pennies in circulation even though they’re worth less than they cost to make.

The problem is that these mechanisms are risky and can be abused by even simple exploitations by “financial” or “economics” “experts” (yes, all those needed to be in quotes).

The basic principles that make sense are simple: wealth is needed for basic things: building a house, buying food, hiring employees, arming a military, all that.  If you have no economy, then “wealth” is equated to anything you can accomplish with your own body; this is why we evolved as fairly decent hunters/gatherers.  It’s always been evident that this isn’t always reliable, though… families and small communities evolved to share the burden of feeding and caring for each other.  Eventually we realized that specialization was important; the genders had already evolved to be specialized (women are fundamentally good at feeding babies, for example).  Hunters hunted, cooks cooked, doctors healed, and each became more skilled at their specialty than any single person could if they were performing all tasks themselves.  All this derives a fundamental principle of sharing and specialization.

Eventually these small groups would encounter one another and they would either ignore one another, fight, or try to cooperate.  Not surprisingly cooperation won out.  But cooperation required either combining communities entirely or working out a system of trade.  Bartering was established, and eventually commonly accepted goods became forms of currency.  Food, fur, slaves, sex, all became precursors to standard currencies.

The height of this arrangement was probably best exemplified by the art of feudalism, but I’ve already digressed quite a bit so I’ll stop before I start romanticizing about horses and lances and such.

Somewhere in there we ended up with democracies, banks, and nothingness-backed securities.  Many people thought this was a bad idea (and some people even thought that crawling out of the sea in the first place was a bad idea)[Douglas Adams]

I’m not complaining about all that.  Alllll of that makes sense.  The penultimate primer for how all these things now work, on an economic basis, is Jimmy Stewart’s excellent description of how money is invested in his bank in “It’s a Wonderful Life.”

Since that movie was released, however, the fundamental way the economy works has gone to hell in a handbasket.  Take mortgages for example.  In a Wonderful Life, people deposit their money in the bank.  There are two main incentives for this – first, security … there’s safety in numbers in a bank that is better than lots of people leaving cash in sock drawers and under mattresses.  Second, the bank itself incentivizes saving by offering a return on investment.  More recently, convenience may be considered an advantage in the form of credit cards, electronic transfers, checks, and whatnot, but that’s not fundamental to how the system works.

The bank, in order to make a profit and offer the return on investment to its customers takes their savings and invests it. Thanks for the comments on the Bitcoin and Edge wallet app post a few weeks ago.  Eric rifled through the U.S. government’s regulations to determine that 20% of a bank’s deposits have to effectively be “cash” equivalents, so that the bank can generally handle withdrawals from its depositing customers.  The rest of that money is invested.  Mostly these investments are loans to whoever needs them.  The interest rate the bank charges on the loans is enough to cover its costs and profit, and even cover the eventuality of someone being unable to repay a loan, by spreading that risk out over lots and lots of loans.

Here’s the key to this arrangement: EVERYONE PROFITS.  Banks and both customers (the depositors and the borrowers) all get something positive out of the deal.  Risk is managed, life is good.

The same is true of the fundamental idea of the stock market.  A company needs capital, so it sells part of itself to whomever is willing to give it the money for a share.  This can be done with private investors alone, which is potentially profitable for both parties (the company that gets money and the shareholder who now owns part of a company which should now be growing better due to the investment).  The main thing the public markets add to this is liquidity.  A private investor in a company is unlikely to be able to pull their money out when they need it.  In public stocks, rather than sell the shares back to the company who may still need the cash, you can sell them to someone else quite easily.  In theory, EVERYONE PROFITS.

When I was in Kenya, the group we went with had a basic three-point plan.  1) Establish a base of operations that could become a self-sustaining travel destination.  2) Establish a community cooperative bank with local farm owners to promote agricultural and economic stability and growth.  3) Tie this co-op and the farms with the local school systems to educate students on these agricultural and economic issues.  We wanted to produce the basic mutually-beneficial structure that the American dream helped inspire (and instill in classic movies).

These mutually beneficial arrangements are the hallmark of a growing, productive society.  The problem now is that this isn’t how things work.  Many financial transactions exist that make little or no sense to most people and are more exploitive than cooperative.  Mortgages are bought and sold by semi-government entities, bundled, split, and sold as “derivatives.”  The money that originally supports the loans comes from other loans, often from the government, instead of investments from depositors.  This makes pools of liability and risk that are poorly understood, and undocumented.  Incentives for financial institutions to only lend to credit worthy borrowers were diminished by this market because the opportunity to sell bad debt were many, so the profit of establishing a bad loan and selling it quickly was higher than focusing only on credit-worthy customers.  With that incentive, banks convinced borrowers that they could afford more than they really could.  Borrowers were convinced … based on years of rising market prices and estimates of annual pay increases, and a lessening of basic personal finance principles, they over-borrowed.

In 1960, the average percentage of personal income spent on housing was roughly 25%.  It is now much higher, well over 33% (one third of personal income), and in some cases exceeds 50%.  People that spend this much on housing can’t spend money on other things.  They work harder and enjoy themselves less.  Eventually many of them can’t afford loans with “predatory” balloon interest rates or other abnormal trickeries and lose their homes.  NOT EVERYONE PROFITS.

Stocks are the same.  Securities are traded not based on carefully thought out long term investment plans, but on microsecond decisions based on twitter comments and blog posts, or just based on trades made mere moments before.  Computers perform these analyses and humans are less involved.  Being a technologist you’d think this would make Chip happy, and in some ways it does – the analysis these “quants” (link, reference) are doing is advancing computational science … we just aren’t willing to trust our life savings to them yet.  Fundamentally, though, the process is greedy and exploitive instead of cooperative.

Just because we’re running long, here’s another example:  Short selling of stocks.  This is actually far more common than most other things I complain about, but I’m pretty against it.  I’ve been having conversations for years with people where I try to understand how so many people not only support the idea because they can make money off of it, but actually promote that short selling stocks is a good thing for the economy.  This is another reason why I’m not very trusting of “economists.”

Short selling stocks is the act of profiting on a stock when its price goes down rather than up.  For an active investor there’s no question that sometimes they make sense: they can protect against falling markets, and make you money when normal investments would not.  Technically they work by “borrowing” a share from someone, selling it, and then buying it back when it needs to be returned to the original owner.  If the price has gone down in the meantime, the money made from the original sale is more than the cost of buying back and profit is made.  The fundamental problem I have with this is, again, not everyone profits.  What’s the incentive for the owner of the shares to lend them to someone to sell?  In practice, there frequently aren’t real shares involved, and the short-seller may not even have the cash to buy the shares back if the price goes up.  These problems are called “naked” short selling, and are generally illegal, but the consensus seems to be that this law is frequently ignored and is not enforceable anyway.

The U.K. recently banned short selling, which I applaud.  The result was instantaneous; volatility decreased and a slight upward pressure to the market prices was introduced – the crash was slowed if nothing else.  Even the charts in this dissenting article indicate that the average improvement in regulated bank’s values was more than a full percent higher than for short-sold banks (I’m still not sure how these charts support that authors point of view).

Supporters of short selling cite several things to support them.  First, they claim that short selling adds “information” to the market, and their premise is that more information is always good.  I don’t buy this … for one thing, there are different types of information.  Someone short-selling a stock is giving their opinion, not a new piece of news.  They’re telling the market that their opinion is that this stock price is going to go down.  What’s worse, is that they’re necessarily invested in it.  Journalists will frequently disclose if they have personal involvement in their topics, particularly with investing, and “insider” trading (trading while having information or influencing important company decisions before the public does) is illegal; short selling gives less information than those sources and takes a less ethical position of profit while doing it.

If a company is coming out with a new product, or if they’ve issued a press release, leaked information, fired their CEO, or some news that affects the company comes from competitors, news, regulations, or any other original source, those events are providing real, new information, not opinion.  There’s a fundamental difference.  Opinions matter, of course, but opinions are based on these first sources. Moreover, there are avenues for those opinions to be voiced outside of short-selling stocks – from simply setting a low buy position or none at all, or becoming a market analyst.  These may not make the would-be short-seller as much money, but they debunk the “information” theory, and making money is not a good enough reason to make something legal.

A second reason that people cite for short-selling is that markets are unevenly biased towards upward prices.  Without addressing if this is true yet, what’s the premise?  Markets should be neutral?  I’m not sure that’s true.  Markets can, if they run amok for no reason, exacerbate inflation problems, but that’s not a problem typical of modern markets, and it certainly doesn’t justify short-selling all by its lonesome.  In fact, since downward prices are worse for an economy than upward prices, I still claim that this is a counter argument for short-selling.  Prices for overvalued companies will fall; if they fall slower than they could is that bad?  It will be interesting to see how the UK markets actually react to the short-selling ban; this is a good opportunity to study what the true effects will be.

Similar reasons include “efficiency” and “liquidity”, but I have the same questions… the only “efficiency” added is the speed at which a stock is declined; short selling does not offer efficiencies for growth, just destruction of wealth.  Bear in mind that it’s not possible for more than one third of investors to be short sellers at a time – you need a lender a shorter and a buyer to complete the transaction.  Liquidity may be a result, but on a downward trending asset, liquidity may not be in the best interest of the overall market.  Again, while we want to allow failures where necessary (an argument frequently made against the recent TARP bank bailouts), this is not ideal; positive growth is better than failure, so any fostering should be in that direction – to some extent that may mean making it slightly (not much) harder for investors to divest themselves of downward facing stocks.

Lastly there are a slew of justifications that are purely selfish.  Short sells are used to hedge against market drops, or that an investor should be allowed to make money in a down turned market are good examples of stated reasons.  Again I go back to the fundamental purpose of markets – to balance investor liquidity with funding for companies that need it.  The risk of investing is that the market may turn down; an investor that expects a bear market has many options, the simplest of which is maintaining a cash-only position.  Foreign currencies, land, precious metals, bonds, foreign and domestic treasury investments are other straightforward options.  That these are not as profitable to the investor as a short sale is not reason alone to keep them.  They are the antithesis to the basic operation of a market.  They are designed to accelerate the destruction of wealth and value except for the short investor who cannot operate alone.  This should not be allowed.

Lest all this seems like unconstructive criticism, let’s offer a few suggestions:

First, make short selling illegal.  End of story.  And anything else that don’t make sense to basic thousand year old principles.  In fact, Whitelisting rather than Blacklisting market mechanisms probably makes sense.

Second, assign a minimum period of ownership to publicly traded items.  If you buy shares of any security (this should probably extend to treasuries, bonds, and anything else), you must own it for a minimum amount of time before selling it.  It’s possible time frames as low as a few minutes would make a huge difference, but I’m guessing something like 24 hours makes more sense.  Short term investments are already taxed at a separate rate if ownership is less than one year for individuals – something similar could be constructed for all trades; an even higher tax bracket that would significantly penalize ultra-short trading intervals could be implemented.  Computer trading could be outlawed completely, but the sheer volume of the current market probably makes that untenable.  Something along these lines would certainly reduce volatility without any major side effects.

A third possibility is to rework stock trading so that the underlying companies continue to see value.  After all, the core purpose was to infuse a company with money so that the company could grow and increase shareholder value.  I’d love to know what percent of stock trading actually includes stocks owned by the company itself (some companies hold reserves of shares to sell on open markets, or in different classes than publicly traded stock, and many companies will execute periodic stock buy-backs).  Most stock exchange trades are simply between investors and current stock owners – no money goes towards the company coffers to help with actual operating costs.  In that regard they’re basically just trading cards: pictures of Joe Dimaggio being passed around for random amounts of money based on perception.  The second shareholder’s “investment” is no such thing; it’s purchasing the potential benefit of a previous share.

What if a percentage of each stock traded had to go back to the underlying share provider?  This would be the corporation in terms of typical shares, but again this could extend to bonds and treasuries – the government needs money too, right?  A trickle down system could be envisioned for mutual funds, index funds, and all those other fun weird exchange-traded things that people invest (unless we just make those all illegal too, but I’m not encouraging that), although these may be exempt as long as they use the stock investments to actually purchase the underlying shares and pay the percentage through that route.

Imagine that, if every time you spent a buck as a kid to get a Joe Dimaggio trading card Joe himself got a few cents.  Would that make Joe play just a bit harder?  Would that make you feel a bit better about buying the card in the first place?

This would certainly help with people that complain about positive stock pressure; a 1% kickback to the originating entity would seem to reduce the value by 1%, but since the company is getting some benefit from the resale the actual reduction would be less and, in fact, could be completely offsetting.  Obviously investors would want to take more care with their investments and liquidity would be decreased (volume would drop due to the perceived premium), but those are not de-facto negative things.

This only scratches the surface, of course.  There are myriad other problems with the way governments spend money, for example – I don’t have the finger stamina to talk about healthcare, military, or education spending in the U.S.