Not So Dismal

Making Economics a Little Easier to Understand

Archive for December 2008

If It’s Too Good to Be True…

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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.

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Written by caseyayers

15 December, 2008 at 11:02 am

Of Pianos and Cars

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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