Not So Dismal

Making Economics a Little Easier to Understand

If It’s Too Good to Be True…

leave a comment »

I wish I could say that it’s stunning how many victims have emerged in the Bernie Madoff Ponzi Scheme that resulted in the evaporation of more than $50 billion in assets. I wish I could say that it’s stunning who those victims are, among them some of the world’s largest banks, including RBS, HSBC, Natixis and BNP-Paribas, and some famous “small” investors, including the owners of the Mets, Dolphins and Eagles.

Alas. The only part of this that is stunning is that so many seemingly intelligent people allowed themselves to be drug into this pyramid fraud. The problem is that people believe in the concept of long-term profits that exceed the market return. It’s possible to outrun the market for a while, as I have done for the past few years holding a stake in Apple, but the extra risk inherent in a technology company, as well as a lack of diversification, that brought outsized returns in years past has served to erase those profits in a matter of months recently.

The same holds true- eventually- for everyone. No mutual fund, no individual investor, no algorithm, has ever successfully beat the average market return over a long-run timeframe. This isn’t meant to be a blog specifically about the finance industry or even the stock market, but rather economics in general. The fact that the market cannot be beat in the long-run is an economic absolute, not a financial absolute.

The reason is because it’s impossible for any algorithm or investor to account for the precise demands of every market consumer in the world, every potential news story or natural disaster, every political election, etc. Markets in general are priced, at least in theory, on every piece of data in the world (or at least every piece possibly relevant in the slightest to market values). This is the meaning of an “efficient” market. And where markets are even just generally efficient, not perfectly so, achieving an outsize profit in the long-run is unfeasible.

Those that were sucked into this scheme allowed themselves to be fooled by the trappings of finance. Financial wizards have concocted a variety of complicated instruments and investment schemes meant to perfectly shield from risk, provide excess returns consistently, or otherwise “break the rules”. We see their handiwork on display right now in the utter destruction of some of Wall Street’s oldest names. This particular story is no different and brings to mind an old adage: pigs get fat, hogs get slaughtered.

Even though Mr. Madoff was reporting returns well above those of the market year after year, without disclosing any type of pricing model or particular insight that could lead to exploiting market inefficiencies to such success, some of the world’s most respected banks apparently did not think to ask how this was possible. They were willing to believe, in effect, that two equaled five, and not just once, but on a continuous basis. Shame on them. Individual investors are more likely to get cheated into such a scheme because they don’t necessarily have the requisite knowledge to know that even the best investor couldn’t achieve these gains continuously. The financial institutions, though, should have known better.

This will eventually become the overriding narrative of this market tumult: the people in charge have no idea what they’re doing. To return to an economic description, one might say that 10% of the market is a reasonable portion to dedicate to those financial middle-men that handle all other transactions in the economy. Yet nearly 20% of the economy, when seen in terms of the S&P 500, was dedicated to the financial sector as recently as last year. Does anyone reasonably believe that one in five dollars should be allocated to transaction costs in our grand technological age? Even the federal government would be impressed by this level of bloat and inefficiency.

Welcome the current market convulsions. What we are witnessing is the grand economic reallocation of a full 10% (or more!) of our economy away from poor decisions to better avenues. It is clear that many of the people currently in charge of billions of dollars of other people’s money should not have that responsibility. Market forces will, we must hope, see to their demise.

This is why opposing government bailouts is important. This meddling in the market serves to reward those that have made poor decisions. As for saving those that were hurt by frauds perpetrated by men like Madoff, this too would be a mistake. The investors here are as guilty as Mr. Madoff. They participated in a willing suspension of disbelief in order to bring home profits that they knew had little to no grounding in reality.

The automakers (or more succinctly, the UAW) are facing their own reckoning. I believe that they will emerge stronger and more competitive in the end, or they will face ruin. GM will be drug by the government or by the market to friendlier waters. Ford has already properly vectored itself for success. Chrysler will die.

As I have said before, we face a unique opportunity here. The market will decide where all of this newly-freed capital will go, unless we intervene. I don’t support doing so, but the political realities seem to make this all but inevitable. If that is the case, we should do our best to be the market’s intercessor and be active in promoting those policies that will make us all more prosperous in the end.

Written by caseyayers

15 December, 2008 at 11:02 am

Of Pianos and Cars

leave a comment »

A great column has been published today over at Mises worth reading. As a musician myself, the subject certainly struck a chord (ha). The author looks at the rise and fall of piano production in the United States and how it compares to Detroit’s situation today. Certainly an interesting and valid analogy, proving that no particular product or good is exempt from the laws of the free market. I stand by my previous statements that providing a bridge loan to GM and Ford is a more palatable situation than printing money to cover losses on absurd, synthetic financial instruments, but Mr. Tucker does us the good deed of reminding us that less-bad is not the correct option in the long run. Excerpt and link to the full article follow below:

With the growth of this manufacturing came an explosion of shops that served the piano market all up and down the industry. Piano tuning was a big-time profession. Retail shops with pianos opened everywhere, and the sheet-music business exploded with them. Ever notice how in big cities the music stores are typically family owned and established 40, 50, and even 100 years ago? This is a surviving remnant of our industrial past.

All of this changed again in 1930, which was the last great year of the American piano. Sales fell and continued to fall when times were tough. The companies that were beloved by all Americans fell on hard times and began to go belly up one by one. After World War II the trend continued, as ever more pianos began to be made overseas.

In 1960, we began to see the first major international challenge to what was left of the US market position. Japan was already manufacturing half as many pianos as the United States. By 1970, a revolution occurred as Japan’s production outstripped the United States, and it has been straight down ever sense. By 1980, Japan made twice as many as the United States. Then production shifted to Korea. Today China is the center of world piano production. You probably see them in your local hotel bar.

Click to Continue Reading “The End of the US Piano Industry”

Written by caseyayers

10 December, 2008 at 12:06 pm

The Power Vacuum

leave a comment »

In response to today’s Politico Arena question:

Is there a potentially disastrous economic policy power vacuum, as Paul Krugman suggests this morning? What can be done about it?

What’s disastrous is the lack of transparency in the Treasury Department as led my Hank Paulson. What confidence remained in his office evaporated when he announced recently that he had known “all along” that simply buying distressed assets wouldn’t help the current situation. This means that either he deceived the Congress and the American people when asking for the massive emergency bailout bill or that he was trying to cover for an error of judgment after the fact. Neither spurs confidence in Treasury’s operation.

The reality is that there is a perception issue that is gripping us all at the moment. I firmly believe that we’re nearing the bottom and, as I predicted in early October on Arena, the Dow will settle somewhere between 7000 and 7500. Meanwhile, fear has swept away any sense of logic in the pricing of securities and the perverse effects of tax laws and various mutual fund regulations can only serve to further distort the market picture. This isn’t to say that there aren’t true issues with the economy. Rather, people turn to leaders in times of challenge. The Bush administration has gone on permanent holiday and Obama is reluctant to fill the gap. One is left to hope that the market can simply take care of itself.

Written by caseyayers

21 November, 2008 at 9:44 am

Steve Jobs, Auto Industry Savior?

with 5 comments

Marketwatch has an interesting column that follows up on a point made by a different interesting column written a few days ago by Tom Friedman. At the tail end of his article, he said:

Lastly, somebody ought to call Steve Jobs, who doesn’t need to be bribed to do innovation, and ask him if he’d like to do national service and run a car company for a year. I’d bet it wouldn’t take him much longer than that to come up with the G.M. iCar.

The question is, could The Steve save the US auto industry? The unionized workforce is a major bump in the road, so to speak. Part of what makes Apple so successful is its cutthroat culture. Called a “Stevetatorship” by more than one, the UAW would balk at any attempt to as tightly extract every ounce of effort from each employee.

Further, it seems like many of the Big Three’s designers and engineers are simply stuck in the past and not always willing to make the next big leap. Another important key to Apple’s success is its almost gleeful abandon at the prospect of leaving old ideas and technologies on the side of the road. Consider the switches from the old OS 9 architecture to OS X, from Carbon to Cocoa or, the most high-profile of these sea changes, their complete shift from PowerPC to Intel in less than two years. The last one in particular is incredible. Here was a situation where both the software and the hardware saw major changes across a variety of products in a very short period of time, and it was accomplished with the least pain of any comparable transition by other manufacturers by far. Compare this huge shift in architectures to simply trying to upgrade to Vista from Windows XP and tell me which operation was handled with greater care.

Concept Chevy VoltThis flexibility comes with a price, of course. As mentioned above, Apple is definitely a fast-paced company and has not shied from a tough decision since Jobs retook control. It is this mental agility and confidence in quality that has been Apple’s formula for great success since the launch of the first iMac. This level of innovation does exist within the bowels of the large American auto manufacturers; their presence is made most clear at industry trade shows when sleek and sophisticated concept vehicles are put on display. But, for one reason or another, this potential seems always dragged back to Earth. Just consider the differences between the original Chevy Volt concept vehicle compared to its production counterpart, even now at least a year or more away. What was once a beacon of great imagination has become just another Malibu after the first 45 miles of electric-only power.Volt Production

It’s not just the vehicles that need fixing, though. The whole fuel architecture must be changed in order to make any real progress from an environmental standpoint. The chief problem with electric vehicles is their relatively short range and long recharging times. The solution is to have battery-swap programs in place at refueling stations across the country. Simply putting a new battery into the vehicle should be no more painful than refilling a gas tank is now, and if the architecture is laid out efficiently then it does not need to entail a massive new line of expenses for the end user.

Finally, improving the driving experience is key. Americans continue to shy away from compact vehicles even in the face of high (but continually decreasing, at the moment) fuel prices because they like the luxuries afforded by larger vehicles. US auto makers must make the features onboard the most innovative and highly-sought after in the market. This, as Apple well knows, is a difficult and continuous proposition, because the competition will simply lift the best ideas and put them on next year’s model.

The magic isn’t in Steve Jobs, the person. The magic is in “Steve Jobs”, the mentality. “Fixing” the domestic auto makers doesn’t mean converting all of their factories wholesale into subcompact production lines, because this is not what the market demands. Prices must fall, yes, but more importantly, quality must rise. Because as Apple knows, this may not be the recipe to market domination, but because people will pay a premium for a clearly superior product- an American product, whatever that means today*- it is the recipe for recovering and roaring profits.

*-It’s important to remember that many vehicles from Japanese automakers are made today in American factories, mostly located in the South, where open shops ensure that the ludicrous arrangements devised by unions will not exist.

Written by caseyayers

14 November, 2008 at 2:51 pm

Re-Writing the Rules

leave a comment »

From today’s Politico Arena question: “The economy: How big a stimulus? How wide a rescue?”

It depends on what indicators take priority. If the goal is to make stock market values rise quickly, then an immediate reduction of the capital gains tax to 0% would do wonders to bring buyers back into the market. However, because these would be speculators looking to take advantage of a limited-time tax break, this could simply be another shot in the arm that leads to an even deeper hangover recession a few years down the line.

If instead we agree that we’re in the midst of a broad reallocation of resources across the board (which is a recession’s part to play in free markets), then we can choose two routes. Either we allow the recession to take its course, lasting longer than we would probably like but resulting in a more efficient economy in the long run, or we make decisions at the governmental level about what priorities America most values. For example, how important is General Motors to this country? If we as a people decide that it is worth saving due to national pride or some other metric, then that is well within our reach.

Map of the US Interstate System

The key is that whatever decisions are made, they should be made with a larger sense of strategy. It’s maybe a bit distasteful but okay in the long run to run up a deficit in the present if it leads to strong returns in the future. Some people call this overspending; others call it speculative investment. It seems clear that government interventionism is here to stay for now. So be it: put the unemployed to work on green energy projects and on building this country’s infrastructure for the 21st century. Imagine what this country would be like had similar expenditures not been made the 1940s and 1950s. We can use this as an opportunity to set the ground rules for future economic growth.

Written by caseyayers

7 November, 2008 at 2:42 pm

He Has Them Where He Wants Them

leave a comment »

John McCain wasn’t kidding when he made that statement. The reality is that his campaign faces such certain doom that it would seem Obama has already been the president for several months. McCain is a specialist in rising like a phoenix at the least likely (and last possible) moment, and this is the perfect opportunity for his greatest performance. The elements are in place for such a stunning reversal of fortune to occur. This isn’t to say that it’s likely, just that it’s possible, which is in and of itself a feat given how far the conventional wisdom has gone to write him off at this point.

Two things must happen for McCain to pull out a squeaker. First, note that a stunning fourteen percent of voters remain persuadable at this late hour, only four days until the general election. You have to love the incredulosity of the Associated Press report that claims, “a stubborn wedge of people…somehow, are still making up their minds about who should be president.” After all, what could keep them away from Obama? It all comes down to money. When the economy looks a little bad, I believe that voters tend toward a more liberal philosophy to “fix it”. Yet when faced with a market selloff like the one hopefully just behind us, more of an every-man-for-himself mindset begins to set in. Given this newfound personal insulationism in the face of dwindling retirement accounts, voters are becoming more wary of what they perceive as the Obama threat of raising taxes. They feel they simply can’t afford to give up one more dime. The Obama campaign’s fuzziness on the high-end number for their redistributive tax credit doesn’t help because it leaves the middle-class receptive to McCain’s argument that their tax hikes will creep down the line, leaving tax credits only for those that barely pay taxes to begin with.

Secondly, the almost absolute assumption of Barack Obama’s inauguration on January 20, 2009 could potentially depress turnout on election day. Even though excitement seems high for the Obama ticket, if too many of his supporters figure that he will win by such a landslide that their vote is not required, we may see a stunning reversal from arguably accurate poll numbers to actual numbers at the poll. That, however, assumes strong turnout for McCain, which is a problem. But if enough undecideds swing toward the more conservative choice and enough Obama supporters simiply write off victory as inarguable, John McCain may yet find a way to pull off what would be, perhaps, the greatest upset in the history of the presidency.

Written by caseyayers

31 October, 2008 at 10:16 am

Why Oil Is Tanking

leave a comment »

It’s all about what I call Illusory Perceived Demand. At least that’s what the run-up was all about. The reality is that oil is much closer to its true price. Part of the reason that it has fallen is also attributable to the dollar, which has been remarkably strong given the Treasury’s efforts to completely discredit it as a legitimate currency as of late. But we’ll talk about the incredible inflationary cycle that we’re about to undergo another time.

For now, let’s focus on oil, which was fallen as of today to under $70/barrel, from a high of around $150 as recently as this summer. In the past month alone, the value of crude has fallen by more than thirty percent. So why is oil falling so quickly?

It’s easy to blame the Hedgies, day-traders and speculators, and to say that because they have now been forced out of the market, prices are swiftly falling back to “real” values. But speculators did not cause this, or at least not the type of speculator you have in mind. Rather, actual consumers of oil, the type that purchase these contracts on futures markets, drove up the prices in a bit of a panic. Speculation-in-earnest, not greedy speculation, is the issue here.

The mentality on the futures market has been, until recently, that a massive, amorphous being called CHINA would absorb each and every drop of oil in the world unless Western companies could thwart them by consistently raising the stakes. Because “China” would pay almost anything to continue its stunning growth trend fueled largely by oil, American companies perceived that there was a massive and unquenchable demand afoot that forced them to pay ever-higher premiums to receive the oil they needed to operate. So they accepted rapidly rising oil prices as a geopolitical absolute, and continued to suck down as much of the stuff as they could possibly afford (to the economics student, right up to where marginal cost equals marginal revenue, most especially in the airline industry).

But the reality that is now prevailing in the commodities market is that China is not, indeed, insatiable. Furthermore, their economic system, although difficult for many to understand, doesn’t result in an unlimited supply of wealth with which to buy energy. Further still, their growth is not a phenomenon that will continue to gain speed no matter what. Just as America and Europe are undergoing a recessionary period at this point thanks to the recent liquidity crisis, China is facing a rocky road. Perhaps China is even worse off than America, for instance, since China is so dependent upon Western consumption to maintain its level of growth.

So the boggart has been put back in the armoire, and appropriately so: by enough people standing up to declare the current situation to be ridiculous. The market is soaked in oil, with new production coming out of every spigot at this point. Even the largest nightmares are eventually wiped away as the rational thinkers in the market begin to wake up and question exactly what makes oil almost thrice as valuable as it was just a couple years ago. China is, in fact, a normal player on the world stage, following the same rules of consumption that the rest of us follow. And oil is not in such dire low supply as to be gone within a decade. Even worse for the naysayers, watching oil prices fly so high resulted in many new fields and techniques being discussed anew for where additional oil may reside but be too expensive presently to drill out.

This isn’t to say “Drill Here Drill Now” is the end-all solution to long-term energy needs for this country or the world. Gas will not be, though, obsolete by this time next year. The decision to move to new sources of energy en masse will be made either politically, where citizens decide that they prefer short-term economic inefficiencies for purposes of national security or environmental wellfare, or it will be made economically, when oil supplies truly are outstripped by demand in the long-run.

Unfortunately, the huge run-up and present crash of oil prices is not that dissimilar from the scenario we’ll see when all of this unabsorbed liquidity catches up with the markets. The idea that credit is unavailable is almost absurd. Rather, bankers are claiming that the liquidity flowing out of the fire hydrants is poisoned. When the market quits thrashing about in hysterics and sets to the task of absorbing these funds, they will find money laying about in true excess. This will lead to massive inflation, unless the Fed can perfectly thread a needle that’s almost impossible to read. But we’ll cover that later.

Written by caseyayers

22 October, 2008 at 3:38 pm