Ideas Challenging the Invisible Hand

I've got a couple of concepts rambling around in my head that are challenging my economics’ world view.  I've been wrestling with one of these challengers for a while; the other is relatively new.  Readers of my blog know the Unrepentant Capitalist is a disciple of the Adam Smith, David Ricardo, and Milton Friedman school of laissez faire, free market economics, but these two challengers are in conflict with the core tenets of conservative economics—limited government and the profit motive.

Limited Government (Less is More)

The Smith, Ricardo, and Friedman school says the government's role in economic affairs should be kept to a minimum.  Ask any of these economists, and they'd tell you the government can serve the economy and society best by setting the rules (the fewer the better) and then enforcing them fairly.  Government ownership of businesses or crafting policies to favor particular industries are counterproductive and cause an economy to undershoot its potential.  They would argue the Department of Commerce is entirely unnecessary, and would question the wisdom of the government operated central bank (the Federal Reserve).

While I buy the limited government argument, I also have difficulty explaining away the long term benefits that our economy has realized from many years of government spending on technology.  Starting in World War II, and continuing to current day, the Pentagon has been a major buyer of technology.  Government fueled demand for jet airplanes, satellites, nuclear power systems, and all the electronic components inside this stuff greatly advanced the state of the art. Does anyone really believe that our commercial aircraft industry, for example, would be where it is today without years of DoD spending on military aircraft?  

The physicists and engineers would have invented the transistor and the integrated circuit, but didn't Pentagon requirements (backed by lots of procurement dollars) to make electronic gear process faster, weight less, run cooler, and use less power push these innovations to occur sooner than they would have if driven by consumer demand alone?  With the invention of the integrated circuit, and the demand for better performance from various military and NASA programs, the microprocessor was born.  Would we have been able to establish our leading position in our various Information Technology industries as early as we did without the microprocessor coming along when it did?  In short, haven't many things powering our modern economy—software, mobile phones, the Internet, flying coast to coast in 6 hours—enjoyed a healthy tailwind courtesy of DoD spending?  How many companies have been born, and how many high paying job have been created over the years to help commercialize all the Intellectual Property originally created by defense spending?

I can hear Milton Friedman's rebuttal.  Do the economic benefits justify the trillions of public money spent on all this stuff?  I don't know how to do the business case on that one, but didn't the Cold War force us to spend that money?  Wouldn't have consumer demand eventually driven development of these technologies? Hard to say, but in the absence of government demand, would we have had these technologies as early as we did?  Imagine a 2013 where we're playing pong, talking on Gordon Gekko mobile phones, and marveling over the 'brand new' 747.

The positive effects of government spending on our various technology industries, and the benefits to the larger economy has been a difficult question for the Libertarian leaning Unrepentant Capitalist to come to terms with.  While I wrestle with this question, some things are more clear.  I'm sure the Pentagon is inefficient in how they spend vs. private companies.  I'm deeply skeptical of government crafted trade policies seeking to protect certain industries (the track record here is very bad) or outright state investment in companies (Solyndra).

Profit Motive (Driving Proper Economic Decisions)

In his 2009 book Drive, author Daniel Pink presents some compelling arguments that question the power of the profit motive as an effective driver of economic behavior.

The profit motive says the goal of business is to turn a profit. The profit motive is a beneficial guiding force in that it ensures resources are being allocated to their highest and best use. If something is worth doing, there's a profit to be made.  If there's no profit, the market is telling you the resources used to create that something are being misallocated.  The profit motive works for the individual too. People will be drawn to vocations where they can make the good money.  People will create great stuff if you dangle enough money in front of them.

Pink's book says the profit motive alone may not work as a motivator, and in some cases, may be counterproductive in a modern economy.  Pink suggests that up until recent times, profit and money as motivators work reasonably well.  But, as we evolve towards an economy with a heavier reliance on knowledge workers where we need more innovation and creativity from our workforce, money alone isn’t enough.  The author says that once a worker hits a market level of compensation (or as the author says, "with the question of money off the table") more money's effectiveness as a motivator starts to wane.  Bonuses don't work as we'd expect.  Once the foundational compensation has been met, the source of motivation shifts to softer things like worker autonomy, skill mastery, and work with a higher purpose.  

Pink cites numerous examples from our new economy to support his assertion that money is not the ultimate motivator.  To make his case, he presents an interesting hypothetical. Suppose you go back to the mid-90’s and ask people to predict the eventual market share winner among products from two competing organizations.  One product is from a well-known company with many commercial successes. This company has assembled a well-compensated team led by capable managers.  The other team is loose-knit band of unpaid volunteers with no formal management team and plan to charge nothing for use of their product. Traditional economics tells us the former group will be the heavy favorite to win. But once we pull back the curtain to reveal the products in question, we know Wikipedia won this battle, and Microsoft pulled the plug on Encarta years ago.  The tech world has other similar examples of great free stuff developed by unpaid workers including the browser Firefox and the Linux operating system.

Drive makes a lot of good arguments about teams and individuals achieving higher levels of creativity and productivity with autonomy, mastery, and purpose deliberately added to the workforce equation.  But didn’t we already know this?  To consider profit as the sole source of motivation seems very simplistic.  The new information here is the diminishing returns of more dollars as a motivator.  So if we all agree the soft components are also a requirement, how do we evaluate a company on these criteria?  How do we measure a company to know that it’s offering its workforce opportunities for autonomy, mastery, and purpose?  How do we know the company’s motivated workforce is creating value?  Old fashioned as it may be, profit (or loss) is an objective indicator telling us that something is (or is not) worth doing. Profit can be measured.  Given my left brain orientation, I need some real numbers.  Pink is on to something here, but I need some instrumentation to properly pilot the ship. 

While it might appear the Unrepentant Capitalist has taken a small step in the direction of Europe, I continue to fundamentally believe that free market capitalism is the best driving force to organize our economy—less government is better than more government, businesses exist to make a profit, brush and floss twice a day.  Having said all that, I also believe that strict adherence to one school or the other without taking time to consider the other side’s argument is not wise.  At the risk of edging up to the slippery slope, I believe the best answers can sometimes be found somewhere between strict ideological poles. The Unrepentant Capitalist continues to operate close to the Libertarian camp, but I’m not in the elder’s tent.

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Invisible Hand – a phrase coined by Adam Smith in The Theory of Moral Sentiments (1759).   Smith tended to be a bit wordy (who wasn’t in the 1700's?) but, in essence, he said the economy is guided by an Invisible Hand that is the collective result of individuals pursuing their own economic self-interests in a free marketplace.  The Invisible Hand determines the goods and services available, the prices consumers will pay, the compensation tor those involved in bringing those goods and services to the marketplace, etc, etc, and does all this to society’s benefit.  

The Business of America is Business

The title of this post is the sound byte version of a famous quote made by Calvin Coolidge, the 30^th U.S. president.  

The full version of Coolidge’s comment is:

“…the chief business of the American people is business. They are profoundly concerned with producing, buying, selling, investing, and prospering in the world.”

It’s very important to understand the power of this statement.  Three years into a weak recovery, business bashing is popular as many people see the Great Recession as a failure of business and capitalism.  Some see business as evil.  But the truth is, America's long standing success story is due to the priority we place on business and trade.  We have succeeded because we value business.  When you consider our first settlements (Jamestown was founded as a business venture) to our current status as the world’s top economic power, the business of America is business.  Many don’t want to acknowledge this truth, but these few words summarize why our country has succeeded.  Our country’s long term economic growth, our relatively high rates of employment, our high standard of living, our industry leading companies producing world class goods and services are due to people’s preoccupation with producing, buying, selling, investing, and prospering.  Economically, we are and have been the envy of the world.

Throughout our county’s history, business has been our golden goose. Business is not without its missteps and faults, but net-net business has yielded huge value to our country. Government plays an important role in helping to create and maintain the environment that allows business do its thing, but don’t be confused, the real engine of economic growth is private business.

When you consider a policy debate, new taxation, or a regulatory issue, it’s worthwhile to consider the likely impacts to business. Want to raise the corporate income tax rates, impose some new regulations, or force companies to buy employee health insurance? Fine, just make sure you’re okay with the probable implications of that change to the bottom line. You put a hurdle in place for business, the net effect will be to reduce profits and/or restrict job creation. Some hurdles are necessary, others are not. A chemical plant dumping waste straight into a river so that fish downstream grow a third eye—not cool. Waste processing equipment will cost the chemical company real dollars and reduce profits, but the alternative is unacceptable.  An EPA regulation defines milk as an oil and therefore requires dairies to treat spills as a hazardous contaminate. This regulation compels dairies to purchase expensive and unnecessary equipment and to follow elaborate clean-up procedures.  Do all regulatory hurdles make sense? Something to think about.

Understand, I’m not suggesting business be given a free pass.  Despite the beliefs of my more pious Libertarian brethren, we need a non-zero level of government regulation in place to provide reasonable safeguards to protect workers, the environment, consumers, etc.  Our history shows that too little or too much regulation can be a problem.  As with most things, there is a proper balance.  The right amount is the right amount.

In addition to our pro-business orientation, another reason for our success has been that government (generally speaking) steps out of the way and allows people to pursue their goals and succeed or fail.  Success is great, but failure is okay too.  Whether it's people, businesses, or whole industries, we tend to let things fail.  Oh sure, we’ve done our share of protecting industries and wasting public money propping up troubled companies, but relative to the rest of the world, we tend to allow failure.  Our tendency has been to recognize the basic truth that Joe Schumpeter taught us with Creative Destruction, namely as technology evolves and society changes, some companies and industries will adapt and thrive.  New companies are born to take advantage of changes, while others die because they can’t or won’t change. Shoveling money to dying companies may be politically expedient in the short term, but it just prolongs the pain and delays the inevitable. Government helps the most when it helps the least. The UC’s advice, "don't just do something, stand there!"

Lastly, our freedoms in their many forms has been a powerful ingredient to our success. People have different gifts, and these gifts come in many forms—playing the violin, painting, playing basketball, writing poetry—and some people have a gift for business and making money. The beauty of our country is that people have the freedom to exercise their gifts. The Occupy people need to understand an implication of this freedom means some particularly gifted business people will make lots of money. The Occupy types will argue that some of the 1%'s gifts are not business oriented as much as they are gaining political influence, organizing PACs, and manipulating the system. There might be some truth to that notion, but I contend that you can rejigger the rules however you want, those gifted business people will adjust and thrive. I think there's truth to the old saying: 'take all the money and divide it up, give everyone an equal amount, and in time, the rich will be rich again.'

Invention, innovation, productivity, efficiency are critical ingredients to grow an economy. A society that is business friendly with reasonable regulation, allows its people to succeed or fail, and embraces its people’s unique gifts creates an environment where these critical ingredients can work their magic.

The UC Endorses a Presidential Candidate

Before the endorsement, a few words about the campaign.

It's frustrating to hear the distorting and outrageous rhetoric from supporters on both sides during the last few months. To suggest that a candidate has a forged birth certificate and is not a US citizen, or a candidate only wants to line the pockets of the rich at the expense of the middle class and poor is just silly. Let's once and for all recognize that both candidates are good men who sincerely want the country and all its people to succeed. The difference is that each candidate has his own ideas about the appropriate route to success.

In thinking about your vote, shouldn't you first identify the biggest problem we face as a country, and then vote based on the candidate who has the best plan and/or past history? We face lots of issues and challenges as a country, but do all these issues and challenges really carry the same weight? Shouldn't we separate those few issues that really matter from those that 'pull people offsides' emotionally? Stuff like same sex marriages or abortion tend to ignite people's passions, but if we're prioritizing our issues, isn't the slow economy public enemy #1?

As a country, we're on an untenable fiscal path which looms over our economy like a bad storm. Looking into the future, government spending will greatly exceed our revenues. Plot the curves out a few years, and no amount of tax hikes will cover the tab.

Both candidates have talked about our fiscal situation and sketched out high level plans, but neither side has produced a lot of details. With details thin, we're left to look at each candidate's past record.

The President inherited a very bad economy for which he obviously cannot be blamed. As President, his first major policy initiative was to champion the Patient Protection and Affordable Care Act (a.k.a. Obamacare). Healthcare is a problem that does need attention. Did we need this overhaul and did we need it now? In the midst of the weakest economy since the Great Depression, to push for such a government heavy plan just doesn't make sense. At a time when Europe is struggling economically and is actively looking for ways to scale back the size of the state, adding another huge obligation to the scope of our Federal government just doesn't make sense.

I mention the new nationalized healthcare plan championed by Obama, not necessary because I disagree with it, but because its timing demonstrates misplaced priorities. To foist such a huge and unpopular change on our country (polls suggest the public is 50% for, 50% against) when that plan involves so much government spending at a time when the economy is already reeling doesn't seem like sound economic management.

In fairness, Mitt Romney championed his own government heavy healthcare reform while he was governor of Massachusetts, but his timing relative to the prevailing economic conditions was very different. Hopefully he's learned from his dalliance with Socialism. As his running mate, he's chosen one of his party's rising stars who has consistently warned us of the need to reform our government finances and has offered real reform plans. You may or may not agree with his plans, but he's forcing a public discussion of this very important topic.  The Obama camp thinks so much of their VP candidate that his name rarely appears on campaign posters or bumper stickers.

From my mostly Libertarian vantage point, both candidates appear to have Socialist leanings. One candidate's leanings are a bit stronger than the others so, in the words of my 6 year old daughter, Obama had his turn, now it's Romney turn to be President.

Congress Must Sober Up and Get the Job Done

Richard Fisher, President of the Federal Reserve Bank of Dallas, was recently interviewed by the Dallas Morning News.  The article makes for some excellent reading for those wondering why our economy continues to sputter 3 years into a ‘recovery’.

I particularly liked his response to a question about the risks of further intervention by the Federal Reserve, a.k.a. QE3.  Fisher’s reply, “by being so accommodating, we take the pressure off the fiscal authorities, the Congress of the United States, to sober up and get the job done.”  In other words, the Fed’s actions enable Congress to continue to 'kick the can' and put off the work that really needs to be done now—addressing the nation’s current untenable fiscal path.  Fisher believes our economic problems are not ones of liquidity or credit availability (two things within a central bank’s charter to manage), but rather issues of major policy uncertainty that keep job creators/businesses stuck in neutral as they wait to see what happens.

http://www.dallasnews.com/opinion/columnists/jim-mitchell/20120918-richard-fisher-qa-congress-must-sober-up-and-get-the-job-done.ece

Please read this interview, and then call your Congressman/woman to ask him/her to stop hiding and be an adult.

I’ve read a lot of stuff authored by Fisher and it’s all good.  For my Republican friends, please note that Fisher is a Democrat.

If You Tax Them, They Will Leave

A recent article in the NY Times http://www.nytimes.com/2012/08/08/business/global/frances-les-riches-vow-to-leave-if-75-tax-rate-is-passed.html?pagewanted=1&_r=1&adxnnlx=1344520811-qy1jUzqsl8PH%20TEfvS7v9Q discusses some very real consequences counties may face if they attempt to fix their budget shortfalls by punitive taxation of the rich.  The article specifically discusses tax attorneys in France who are busy counseling their high earning clientele seeking advice about leaving their home country should new French president Francois Hollande make good on his promise to raise the top income tax rate to 75%.

Some noteworthy stuff in the article regarding Hollande's proposed tax hikes:

An impediment to job creation—As business owners and companies contemplate the new tax, they are delaying plans to invest in France or to hire new workers.  

Very little help filling the budget shortfall—France doesn’t have a lot of high income people, so very few taxpayers would be subject to the tax.  Net-net, the new tax would make a very small contribution to the €33 billion in new revenue the government hopes to raise.  

Attitude towards financial success—President Hollande has publicly said, “I don’t like the rich.”

Drive investment and jobs away, make very little real progress on filling the budget hole, and generally have a hostile attitude towards successful businesspeople.  Sounds like political theatre when France needs some real answers for an economy that desperately needs a boost. 

Have fun with all that.

Social Security 2.0? Let's Hope Not!

A recent article published in the NY Times http://www.nytimes.com/2012/07/22/opinion/sunday/our-ridiculous-approach-to-retirement.html basically says that individuals are unable to manage their own finances, and the government should step into the fray to 'save the day' with a new government administered retirement plan.  Social Security 2.0

I bring the article to your attention not because I agree with anything discussed (the author lost whatever credibility she might have had with the Unrepentant Capitalist when she espouses investments with a 'guaranteed rate of return') but because I think it's an excellent example of an all too common line of thinking that has led to government growth beyond its proper scope and has put our nation's finances in trouble.  The problem is that many people have unrealistic expectations about the role the state should play in solving societal issues. 

Articles and authors like this are enablers who give large chunks of our society permission to sit on their hands and do nothing. Worse, this kind of thinking causes people to rely on the government to take ownership for problems that should be the individual's responsibility. The mantra is "This problem is too tough for me" or "I can't handle it".  We've allowed ourselves to become wimpy. I'm glad our self reliant forefathers didn't have that attitude or this country would never have been settled. It is this kind of thinking that has led to our current enormous scope of government that has has greatly contributed to our $15 trillion (and growing) deficit. 

Let's make this simple.  Leave beneath your means, avoid debt, save at least 10% of your income.  If your employer offers a 401(k) matching plan, participate as much as you can.  This advice is not complicated or new and goes back to old Testament days.  Okay, maybe not the part about employer matching 401(k) plans, but for the most part, this is advice societies have known about for years.   

Wondering what to do with your investment money, put it in index mutual funds (the Unrepentant Capitalist has discussed this topic in the posting Mutual Funds, Efficient Markets, and Mispricing from July 7, 2012.)  If you're wondering how to spread your dollars between stock and bond funds, the long standing rule of thumb says you subtract your age from 100, and that's the percentage of your portfolio you should put in stocks and the rest goes to bonds.  For example, if you're 40 you should put 60% of your portfolio in stocks and 40% in bonds.  If you're 60, you should put 40% of your portfolio in stocks and 60% in bonds.  In recent years, this rule of thumb has been updated given how long Americans are living these days.  Financial planners are now saying the rule should be based on 110 or even 120 minus your age to get to the proper stock allocation. DISCLAIMER: the Unrepentant Capitalist is not a licensed financial planner, but I did stay at a Holiday Inn Express recently.  

The author wants to make retirement planning look very complicated, and I'm sure you can find retirement planners who are happy to make this as complex as you want.  This doesn't have to be difficult.  More importantly, no one is going to care more about this than you.

What's Everything Worth?

A recent article in The Economist (The Real Wealth of Nations, http://www.economist.com/node/21557732) discusses a new report published by the UN and Cambridge University that adds an interesting perspective to our country's macro financial position.

The UN report attempts to quantify assets of each of the world's largest economies.  The most common measure of economic position is GDP which is a measure of a country's total annual economic output.  But as the article points out, looking at GDP alone is like trying to assess a company's financial performance by looking at its income statement and ignoring its balance sheet.  To get a complete picture of financial health, you must look at performance in the current year (income statement) as well as wealth accumulated over many prior years (balance sheet).

The UN study attempts to quantify three major assets groups - physical (a country's stock of buildings, factories, roads, bridges, dams, ports) natural (the country's fossil fuel reserves, mineral deposits, forests, arable acreage) and human (the education and skills of a country's populace).  Are these are the right groups?  How do you quantify a country's human capital?  Doesn't a balance sheet need liabilities too? Obviously the valuation task here was difficult and inexact, but the study has put in a stake in the ground that can hopefully be improved with time.

So what did they find?

Coming in #1 with a total asset base of $117.8 trillion was the US. Also on the medal stand (hey, the Olympics start next week) at #2 was Japan at $55.1 trillion, and #3 was China at $20 trillion.

With total assets, there are a lot of useful comparisons one can look at.

What's our total public debt vs GDP?  $15+ trillion v $15+ trillion. I don't feel so good.

What's our total public debt vs total assets? $15+ trillion v $117.8 trillion. I'm feeling better.

What's our total public debt + private debt + state/county/city debt + present value of unfunded Social Security, Medicare, Medicaid, and our new nationalized healthcare liabilities + present value of unfunded public employee pensions + present value of private employee pensions (those we've been stuck with + the ones we'll get stuck with later) vs total assets? A very big number with the suffix 'trillion' stuck on the end of it v $117.8 trillion. I definitely need to go lie down.

Mutual Funds, Efficient Markets, and Mispricing

John Bogle is the founder of the Vanguard Group and author of numerous books and papers on investing and the mutual fund industry. Among his more noteworthy titles are Common Sense on Mutual Funds and The Little Book of Common Sense Investing. The latter can be found on the Unrepentant Capitalist bookshelf.  I like small books with small words.  My copy can be found next to Hop on Pop.

Bogle is famous for saying that the stock market is one ‘giant distraction’. His basic message is that the stock market generates a lot of unnecessary attention and much of the mutual fund industry is a waste of time and money.  Bogle says people would be better off investing in index mutual funds with their very low fees and minimal tax implications.  An S&P 500 index fund (most of the big mutual fund companies have them) is a mutual fund is made up of all the companies in the S&P 500.  There are Russell 2000 funds, FTSE 100 funds; name a popular index, and there's an index mutual fund that mimics it.  Index funds don't have large teams of highly compensated fund managers and analysts looking at stocks, there's very little buying and selling of stocks except for the occasional adjustments made when companies fall out or are added to the index in question.  Net result, management fees are extremely low versus the typical actively managed mutual fund.

Bogle argues that most individual investors lack the skill and time to be successful stock pickers, and that successful investors like Warren Buffett, Benjamin Graham, and Peter Lynch are extraordinarily rare people.The vast majority of fund managers can’t beat the S&P 500 (and they have lots a resources and Ivy League educated manpower at their disposal) so what chance does the little guy have?  To be fair, there are some very sharp small investors out there who do very well in the stock market. But the vast majority aren’t nearly as good as they think they are.  Bogle’s advice: invest in a broad market index fund, reinvest the dividends, hold for a long time, and pocket your 8% per year*.  He also says the much of what’s out there for purchase—trading tools, research, management fees, etc—is a waste of money, and that many employed in the mutual fund business should get real jobs that actually contribute to the economy.

I think Bogle and his philosophy are spot on, and I think following his advice makes sense.  Put your money in an index fund, reinvest the dividends, repeat.  Steer clear of high flying (and high fee) actively managed mutual funds.  I also agree with Bogle's position on the excesses of the mutual fund industry.  The public's general ignorance on the true performance of most actively managed mutual funds plus the opposing forces of the efficient market and the constant search for mispricings will keep the industry safe for quite awhile.

Our stock market is called 'efficient’ in that stock prices generally reflect all relevant public info about the stock at any given point in time. There are so many eyeballs watching (and voting via their buy or sell orders) that stock prices are always adjusting to reflect the public’s collective thinking about the correct price for the stock.  If good or bad news about a company hits (a new product is launched, a class action law suit is filed, a promising new drug receives FDA approval, etc.) the stock price quickly adjusts up or down in response.

Lots of mutual funds with lots fund managers and analysts = lots of eyeballs.

Mispricing happens when something is not priced correctly vis-à-vis the market. Mispricing can occur for a variety of reasons, but unequal information is a common cause. Unequal information means buyers and sellers are not equally informed about the true market price of an item in question.  An early 60’s VW pickup taking up space in a farmer’s barn is mispriced when the farmer sells the truck to a city slicker for $500. The farmer doesn’t realize these old trucks, in decent condition, can fetch 10 times this amount. By the way, if anyone out there knows the whereabouts of such a truck, the Unrepentant Capitalist has cash.  Mispricing generally doesn’t happen in the stock market because there are tons of people poring over financial statements, earnings projections, industry studies, etc.

Image what would happen if people pulled out of actively managed mutual funds en masse.  Fund managers and analysts quit (or are fired) in droves.  Lots fewer eyeballs watching things.  Over time, and with a much smaller universe of eyeballs, things aren't watched closely and some prices drift up or down too far....they become mispriced. If people start making money off mispriced stocks, people start moving back into the industry.  Seems to be a feedback loop that keeps a certain number of people employed watching stock prices.  Just a thought.

I think for most people, the stock market is the right place to put your money.  But, if you're very knowledgeable about a particular niche market, antique furniture, vintage cars, etc. you've got the opportunity to put mispricing to work to make yourself some money.

*The 8% cited is a long term historical average for the S&P 500 that includes stock price appreciation and reinvested dividends. Some years you’re up 20%, other years you’re down 10%, but over the long haul, 8% is a reasonable expectation.

"You're offering me how much for my old pick-up?"