"That government is best which governs least" - Henry David Thoreau
There are some who believe that true free markets need no assist from rules, regulators, or governments at all. Certainly, eBay has proven to be a big success with very little help from the formal organs of government. But eBay itself acts as a formidable regulator, removing members who misbehave, and eBay has incorporated strong feedback mechanisms to allow members to police each other through eBay's ratings system.
For nearly all other markets, the state plays an important role in making the market work. It prevents domination by coercion. It enforces contracts, and persecutes fraud. And in most cases, it also regulates markets in an effort to promote fairness and trust, and frequently to advance public policy aims. A huge amount of our legal code is devoted to laying down the law on how business can do business. Employment law, the Uniform Commercial Code, the bulk of environmental regulation, and an alphabet soup of Commissions (ICC, SEC, FCC, CTFC, FDIC, etc.) are devoted to telling commercial enterprises how they can go to market.
Government policy is usually drafted by legislators with good intentions and no practical experience. As we all know, the road to hell is paved with good intentions. Commercial legislation results in all kinds of unintended consequences. "Cash for Clunkers" resulted in panicked shopping, model shortages of popular replacement cars, a sudden loss of inventory in the used car market (raising prices for those shoppers), and perhaps little actual stimulus as many buyers merely moved planned purchases up, rather than injecting new money into the car sales market.
One of the most common consequences of regulating markets is a perverse phenomenom known as "regulatory capture". The industry under regulation has a far greater interest in the details of the rules than others, and does all it can to influence the result. Industry representatives rightly point out that they have far greater expertise than the lawmakers or bureaucrats, and industry uses its greater knowledge to argue for change. Pressure is exerted to get people with industry experience on the commission. Such people are likely to have contacts in the regulated industry, and have some sympathy for their concerns. Gradually, the commission evolves to mirror the industry it regulates, rather than policing it.
Does this mean the regulators, now "captured", give industry free reign? Actually, no. Industry almost always fights new rules. But once they lose the fight, they frequently find the rules give them a useful advantage. Rules take time to master, and a rule-bound industry is more difficult for new entrants to penetrate. It's been said that there are only six men in all of New York City who have the knowledge and connections to get a building permit out of the city's bureaucracy. One of those six men is Donald Trump, and it is this skill of his (not his business acumen nor his eye for a good opportunity) that made him a multi-millionare. In fact, when The Donald invests outside of NYC, his investments usually go south.
The markets that work best are those that have a large number of participants. Here is another secret to the success of eBay. It may have the largest pool of buyers and sellers in the world. Barriers to entry give unwonted market power to those who manage to scale them, raising the costs for everyone else.
This is a message that our legislators and bureaucrats rarely hear and almost never figure out on their own. As a result, regulation quickly becomes over-regulation, and those players who master the rules turn their market advantage into extra profits for themselves and extra costs for everyone else. Regulatory capture is a parasite, and one that seems to be growing.
Friday, September 25, 2009
Tuesday, September 15, 2009
The Business of Banking
Borrow at 3% interest, lend at 6% interest, and be on the golf course by 3pm - Anonymous
The latest recession has been described as more serious than previous recessions because it's a financial recession. It's caused by and centered on the financial sector of our economy, and thus more serious than previous recessions based on oil embargoes or dot com bubbles. But what exactly is "the financial sector"? What role does it play in our economy?
Financial institutions (primarily banks, but also other entities such as brokerages and insurance companies) differ from other enterprises because they are in the money business. Mostly, they are in the business of "other people's money". They receive deposits, premiums, investment capital or some such from those who have a current surplus of cash. These people (or creditors) could be retirees with a saved nest egg. They could be a pension fund receiving contributions but not yet needing to pay the pensions. They could be mutual funds making investments. Most of them have a future need for the cash, but they don't have an immediate need. So they deposit their money in a financial institution, either as savings or as investment.
The receiving institution doesn't usually keep the money. Instead, they find a party with a need (or opportunity) that requires cash today. This could be a corporation wanting to build a new factory, a producer wishing to shoot a new film, or you wanting to buy a house or car, but not having the purchase price in cash. It could be your government running a deficit. These people (or debtors) borrow the money with a promise to repay, with interest.
So finance companies match investment capital with investment opportunities. As such, they are vital to nearly every other sector of the economy, particularly consumers and government, who represent the majority of outstanding debt.
Being important, and close to the money, means that financing is usually quite profitable. And so it has proven in the past 20 years, with the financial sector growing from 5% of our economy to 15%, and representing some 40% of corporate profits in 2006.
So what happened in 2007 and 2008? Well, one important aspect of finance is risk. Not all debtors pay you back. The riskier the debtor, the more interest you need to charge to cover that risk. If you don't charge enough, and too many default, you lose money. And worse, it's not your money. It's other people's money, those creditors who deposited or invested their surplus capital with you. Just because your debtor left you high and dry doesn't mean you don't owe back the money to your depositors. If you misprice risk, suddenly you becaume a defaulting debtor yourself.
During the frenzy of globalization in the last 10 years, China and other export-oriented economies ran a trade surplus. They sold more than they bought overseas, and found themselves with a mountain of cash. Much of the cash was returned to America as investment capital. But there were only so many good investment opportunities. The rate of return on many investments fell.
One sector, thinking itself clever, saw a chance to channel some of this cash their way. By 2005, residential real estate was seeing a strong boom start to tail off. Homes were getting too expensive for ordinary people to qualify for ordinary mortages. Real estate brokers "solved" this problem with a host of new types of mortgage. Sub-prime loans, teaser rates, liar loans and so on made otherwise disqualified buyers suddenly eligible. Admittedly, these buyers were riskier than the traditional type, but that was handled by charging these people higher rates. Besides, even if the buyer defaulted, the mortgage was secured by the home. Home prices in the USA hadn't fallen on a national scale since the Great Depression. So what risk was there? But, just in case, these loans were bundled with ordinary ones and sold in packages. The idea was that the typical loans would compensate for the risky ones. Since these bundles included high interest mortgages, their rate of return was higher than average, and everyone wanted some.These bundled loans were then sold by the billions to nearly every major financial institution in the world.
Then the real estate market, artificially inflated by this cash infusion, rose to unsustainable levels. It turned out that many of the new buyers couldn't afford their mortgages, especially after the teaser rates ended. Some mortgage payments doubled, and the overstretched buyers walked away. Forclosures began, and the market fell.
Now the logic of bundling took on a vicious reversal. Rather than the typical loans compensating for the risky ones, the risky ones poisoned the typical loans. The bundles became "toxic". No one wanted them on their balance sheets, but no one would buy them. Markets panicked, investors withdrew their money, and banks collapsed.
Banking by its very nature is unstable. Banks borrow money for six months, and loan it out for 30 years. The added stress of toxic assets undermined many of the most famous names in American capitalism. We understand the fall. But have we discovered how to rise again, and learned the lesson to prevent another collapse?
The latest recession has been described as more serious than previous recessions because it's a financial recession. It's caused by and centered on the financial sector of our economy, and thus more serious than previous recessions based on oil embargoes or dot com bubbles. But what exactly is "the financial sector"? What role does it play in our economy?
Financial institutions (primarily banks, but also other entities such as brokerages and insurance companies) differ from other enterprises because they are in the money business. Mostly, they are in the business of "other people's money". They receive deposits, premiums, investment capital or some such from those who have a current surplus of cash. These people (or creditors) could be retirees with a saved nest egg. They could be a pension fund receiving contributions but not yet needing to pay the pensions. They could be mutual funds making investments. Most of them have a future need for the cash, but they don't have an immediate need. So they deposit their money in a financial institution, either as savings or as investment.
The receiving institution doesn't usually keep the money. Instead, they find a party with a need (or opportunity) that requires cash today. This could be a corporation wanting to build a new factory, a producer wishing to shoot a new film, or you wanting to buy a house or car, but not having the purchase price in cash. It could be your government running a deficit. These people (or debtors) borrow the money with a promise to repay, with interest.
So finance companies match investment capital with investment opportunities. As such, they are vital to nearly every other sector of the economy, particularly consumers and government, who represent the majority of outstanding debt.
Being important, and close to the money, means that financing is usually quite profitable. And so it has proven in the past 20 years, with the financial sector growing from 5% of our economy to 15%, and representing some 40% of corporate profits in 2006.
So what happened in 2007 and 2008? Well, one important aspect of finance is risk. Not all debtors pay you back. The riskier the debtor, the more interest you need to charge to cover that risk. If you don't charge enough, and too many default, you lose money. And worse, it's not your money. It's other people's money, those creditors who deposited or invested their surplus capital with you. Just because your debtor left you high and dry doesn't mean you don't owe back the money to your depositors. If you misprice risk, suddenly you becaume a defaulting debtor yourself.
During the frenzy of globalization in the last 10 years, China and other export-oriented economies ran a trade surplus. They sold more than they bought overseas, and found themselves with a mountain of cash. Much of the cash was returned to America as investment capital. But there were only so many good investment opportunities. The rate of return on many investments fell.
One sector, thinking itself clever, saw a chance to channel some of this cash their way. By 2005, residential real estate was seeing a strong boom start to tail off. Homes were getting too expensive for ordinary people to qualify for ordinary mortages. Real estate brokers "solved" this problem with a host of new types of mortgage. Sub-prime loans, teaser rates, liar loans and so on made otherwise disqualified buyers suddenly eligible. Admittedly, these buyers were riskier than the traditional type, but that was handled by charging these people higher rates. Besides, even if the buyer defaulted, the mortgage was secured by the home. Home prices in the USA hadn't fallen on a national scale since the Great Depression. So what risk was there? But, just in case, these loans were bundled with ordinary ones and sold in packages. The idea was that the typical loans would compensate for the risky ones. Since these bundles included high interest mortgages, their rate of return was higher than average, and everyone wanted some.These bundled loans were then sold by the billions to nearly every major financial institution in the world.
Then the real estate market, artificially inflated by this cash infusion, rose to unsustainable levels. It turned out that many of the new buyers couldn't afford their mortgages, especially after the teaser rates ended. Some mortgage payments doubled, and the overstretched buyers walked away. Forclosures began, and the market fell.
Now the logic of bundling took on a vicious reversal. Rather than the typical loans compensating for the risky ones, the risky ones poisoned the typical loans. The bundles became "toxic". No one wanted them on their balance sheets, but no one would buy them. Markets panicked, investors withdrew their money, and banks collapsed.
Banking by its very nature is unstable. Banks borrow money for six months, and loan it out for 30 years. The added stress of toxic assets undermined many of the most famous names in American capitalism. We understand the fall. But have we discovered how to rise again, and learned the lesson to prevent another collapse?
Thursday, September 3, 2009
The Purpose of Profits
Property is theft! -Pierre-Joseph Proudhon
Great wealth has always sparked deep resentment among some of those who lack it. For a few it's envy; they don't see wealth as immoral, they just wish they were the ones who possessed. For others it's fear; history is full of examples of the very wealthy using their money for unfair advantage or illegitimate power.
This kind of resentment is petty and harmless. But there is another kind of anger over wealth, particularly wealth earned via investments and profits. There are many who find the whole pursuit of profit to be fundamentally immoral and beyond salvation. Money is the root of all evil. Man's higher calling lies elsewhere. There is greater merit to the "service" professions; teaching, nursing, social work, etc. Private business is inherently selfish, if not positively evil. Corporations epitomize how the pursuit of profit ruins your soul.
At this point, I'd like to ask "What ARE profits?". Fundamentally, profits aren't just money. They are two things; information and rewards.
To make a profit, you must do many things. You must find a demand or a market that can be served better than it is today. You must invest in developing some process that meets the demand. You must wait, living less well than you otherwise could, while the process is developed and your wealth is tied up. And you must endure the anxiety that your scheme will fail, your time will be wasted and your investment money will be gone forever.
Many investments come to nothing. Thomas Edison famously tried 10,000 different filaments before he discovered that tungsten made a successful light bulb. Risk averse investors don't try invention; instead they buy government debt, or put their money in mutual funds, or buy securities on the stock exchange. These people don't usually lose their investments, but they also don't get the spectacular return that Edison, or Bill Gates, or Sam Walton received when they took those big risks.
Today, the cost of developing a new jetliner or cancer drug runs to the tens of billions. Who should provide that money? The fall of the Soviet Union was, in large part, the result of the fact that massive government investment can't match the flexibility, innovation and entrepreneurial spirit of millions of retail investors.
Profits tell us whose innovation was a success. With this information, future investment is given a guide or direction. And the rewards for successful investment give the incentive to future investors to also risk their savings on innovation. If there is no chance of reward, what incentive is there to invest?
So why do some people scorn profits and corporations (which are, ultimately, vehicles to allow multiple people to invest in a common enterprise)? Why the resentment?
First, let's take a look at which people evince such a resentment to profits and corporations. Usually, the angry crowd isn't made up of poor people. Most poor see the rich as a role model, not an adversary. Many poor desperately save so they can own their own business, or perhaps put their hopes in their children by working extra hours so their children can remain in school and begin the path to a better life. No, the angry crowd usually includes fairly well-educated people. Ministers, teachers, professors, government clerks, lawyers, journalists, professional politicians and the like. These people see themselves equal to the wealthy in terms of talent and schooling. They feel they should also be equal in material prosperity. They followed the rules, got their degrees or diplomas, but they can't afford the European sedans or European vacations that their investment banker classmates buy so freely. They feel cheated. What did they do wrong?
Mostly, they didn't take risks. They didn't sacrifice to build up enough savings to have their own working capital to start a business, or they didn't invest "sweat equity" in their garage or dorm room tinkering to invent the next Apple or Google. Or they didn't accept a career that involved years of stressful graduate school (medicine) or high-pressure, 14 hour days (investment banking). I don't blame them. I want to enjoy life, and my passion isn't in invention or analyzing spreadsheets to midnight. But there are those who do make those sacrifices. Let us recognize them, and allow them their reward.
And let's face it. We all benefit, too. The inspiration and hard work of the innovative and entrepreneurial classes is what makes our nation the most dynamic economy on the planet. China's mandarin class never gave them any edge in commerce or science. It's the combination of excellent education with the "animal spirits" of drive and ambition that have made our nation such an economic powerhouse. We forget that at our peril.
Great wealth has always sparked deep resentment among some of those who lack it. For a few it's envy; they don't see wealth as immoral, they just wish they were the ones who possessed. For others it's fear; history is full of examples of the very wealthy using their money for unfair advantage or illegitimate power.
This kind of resentment is petty and harmless. But there is another kind of anger over wealth, particularly wealth earned via investments and profits. There are many who find the whole pursuit of profit to be fundamentally immoral and beyond salvation. Money is the root of all evil. Man's higher calling lies elsewhere. There is greater merit to the "service" professions; teaching, nursing, social work, etc. Private business is inherently selfish, if not positively evil. Corporations epitomize how the pursuit of profit ruins your soul.
At this point, I'd like to ask "What ARE profits?". Fundamentally, profits aren't just money. They are two things; information and rewards.
To make a profit, you must do many things. You must find a demand or a market that can be served better than it is today. You must invest in developing some process that meets the demand. You must wait, living less well than you otherwise could, while the process is developed and your wealth is tied up. And you must endure the anxiety that your scheme will fail, your time will be wasted and your investment money will be gone forever.
Many investments come to nothing. Thomas Edison famously tried 10,000 different filaments before he discovered that tungsten made a successful light bulb. Risk averse investors don't try invention; instead they buy government debt, or put their money in mutual funds, or buy securities on the stock exchange. These people don't usually lose their investments, but they also don't get the spectacular return that Edison, or Bill Gates, or Sam Walton received when they took those big risks.
Today, the cost of developing a new jetliner or cancer drug runs to the tens of billions. Who should provide that money? The fall of the Soviet Union was, in large part, the result of the fact that massive government investment can't match the flexibility, innovation and entrepreneurial spirit of millions of retail investors.
Profits tell us whose innovation was a success. With this information, future investment is given a guide or direction. And the rewards for successful investment give the incentive to future investors to also risk their savings on innovation. If there is no chance of reward, what incentive is there to invest?
So why do some people scorn profits and corporations (which are, ultimately, vehicles to allow multiple people to invest in a common enterprise)? Why the resentment?
First, let's take a look at which people evince such a resentment to profits and corporations. Usually, the angry crowd isn't made up of poor people. Most poor see the rich as a role model, not an adversary. Many poor desperately save so they can own their own business, or perhaps put their hopes in their children by working extra hours so their children can remain in school and begin the path to a better life. No, the angry crowd usually includes fairly well-educated people. Ministers, teachers, professors, government clerks, lawyers, journalists, professional politicians and the like. These people see themselves equal to the wealthy in terms of talent and schooling. They feel they should also be equal in material prosperity. They followed the rules, got their degrees or diplomas, but they can't afford the European sedans or European vacations that their investment banker classmates buy so freely. They feel cheated. What did they do wrong?
Mostly, they didn't take risks. They didn't sacrifice to build up enough savings to have their own working capital to start a business, or they didn't invest "sweat equity" in their garage or dorm room tinkering to invent the next Apple or Google. Or they didn't accept a career that involved years of stressful graduate school (medicine) or high-pressure, 14 hour days (investment banking). I don't blame them. I want to enjoy life, and my passion isn't in invention or analyzing spreadsheets to midnight. But there are those who do make those sacrifices. Let us recognize them, and allow them their reward.
And let's face it. We all benefit, too. The inspiration and hard work of the innovative and entrepreneurial classes is what makes our nation the most dynamic economy on the planet. China's mandarin class never gave them any edge in commerce or science. It's the combination of excellent education with the "animal spirits" of drive and ambition that have made our nation such an economic powerhouse. We forget that at our peril.
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