Drug Sniffing Dogs in High School

An interesting thing happened in my town’s high school last year at this time and again this year.  The school system had the police enter the school with drug sniffing dogs.  The dogs sniffed out the kids’ lockers and roamed the halls (controlled by the K-9 officer, of course) sniffing around as students went from class to class.  In the few cases where the dogs reacted to scents, their lockers were opened and where drugs and paraphernalia were found, the kids were pulled out of class confronted by the police with the evidence.  I’m not sure how common a practice this is, but according to the superintendent of our schools, there is precedent for this activity.

I was a little surprised at how pissed some of the parents were over whole thing.  It’s hard to tell from the press in the local rags if it was a mass outcry or a few, highly vocal irritated parents.  The parents expressing concern and outrage generally feel that it was a violation of the kids’ civil rights and privacy.  Other concerns included safety (mostly centered on the presence of dogs) and the stress and embarrassment of being pulled out of class to be questioned.

I’m basically a Libertarian.  I don’t like people telling me what to do or not do or what is best for me.  I prefer to have the government touch as little as possible and have the lightest touch it can when it does have to get involved.  I’m not a strict constructionist, but I believe that the Constitution and Bill of Rights is the foundation of every good thing we all enjoy in our country.  That said, and always with a bias towards the spirit of the words, I think you need to be practical in the application of thesethings.  For that reason, I struggle with the reaction on the part of the parents.

Let’s tackle the easy issues first.  Safety – the dogs are highly trained, disciplined Labrador Retrievers bred and selected for brains, obedience, and temperment.  They are always under the direct control of a similarly trained K-9 officer.  There aren’t zero safety issues, but probably pretty damn close.  I think the safety issue is a red herring.  Stress and Embarrassment – I think this is more real.  It’s brutal enough being a teenager in a cliquey environment without being in the spotlight, especially for something bad.  I think this is a pretty short term impact, though, unless you actually do have drugs in your locker or on your person.  In this case, life will probably be tough for you (at least at home!) for a while.

The sticky wicket is the civil liberties issue.  I’m not a lawyer and I definitely don’t know all of the legal details involved, but I guess I see it like this – as long as the authorities followed accepted and established legal guidelines with respect to illegal search and seizure and probable cause, I don’t really have a problem with the whole thing.  The police weren’t profiling (a entirely different debate) and they weren’t being arbitrary.  If the dogs reacted to a locker or bag, it seems to me that the threshhold for probable cause has been met.  While the stuff in the lockers may be private property, the lockers themselves certainly are not.  They are owned by the BOE or the town.  I don’t equate cracking open a school locker based on reasonable evidence of illicit activity with grabbing a kid  randomly and forcing him to open his bag or admit the police to his bedroom for a search.  It think the facts of each instance are very different.  As a parent, I want my kids to be in a safe and drug free environment.  That is one of the few things I do expect from my government in their own spaces.  

Finally, there is the issue of whether or not minors have the same level of protection across the board for their rights.  I think this is very gray and I’m torn on this.  In the practical application of our laws, rights, and protections, it is clear that different standards apply to people based on their age and level of life assumed life experiences – voting, military service, driving, drinking, identity shielding for minors accused of a crime, the mentally ill or impaired, etc.  I think another important role of the the government, or its laws, is to help protect people who can’t protect themselves.  Is a 15 year old’s right to privacy more important than another student’s right to safety, especially when the judgements of both parties aren’t fully developed and the kid who isn’t into {pick your illicit activity} doesn’t have a choice as to his presence in the same environment as the offender?  I don’t know the answer to that, if there is one, but I guess I’d rather know what my child is up to and that he’s safe versus driving a civil liberties stake in the ground.

I’m interested to hear what everyone else thinks.

The Four Stages of Listening to the President’s Speech on Tax Fairness

Disbelief, Anger, Pity, and Disappointment.  I experienced them all in the first five minutes of the President’s speech.  Even though I knew what was coming, I almost couldn’t believe the words I was hearing pour forth from the President’s mouth.  I’ve never been more disappointed in a public official, and I come from a state that has had both a State Treasurer and a governor put in jail in the past decade.  I listened to half-truths, twisted logic, arbitrary value-judgments, and pontification that amounted to a declaration of class warfare.  His commentary belied a complete lack of knowledge of even the most fundamental economic principles.  He has completely bought into his own bullshit.  Mr. President, follow the advice of Chuck D. and don’t believe the hype.

 

He picked April 15, tax day, to explain to the country why his budget and prospective taxation policy is fair and just.  He told us that he was lowering the tax burden (not accurate).  He characterized the largest plan for redistribution of wealth as progressive.  He admonished the wealthiest people in the nation for not carrying their share of the load, making himself the arbiter of what is fair.  He told us that he was shifting the burden from victims to those who are responsible for the current economic situation (not accurate).  He drew a clear and distinct line between those who work for their wages and those who do not.  He told us that his was a blueprint for growth (not accurate).  He told us that he was reducing government expenditures and that his was a plan to move the budget deficit in the right direction (anyone with a calculator can figure out for themselves that this is not accurate).  He told us that much of the cost cutting had been identified and documented (not accurate).  He chastised a specific portion of the population for unfairly using loopholes to avoid their fiscal and societal obligation (not accurate).  He completely mischaracterized or ignored the true landscape of taxation and spending in this country.  He inaccurately described his crusade as a mandate from the electorate (absolutely not accurate).

 

The one true thing that he said was that he was lowering the tax burden for 95% of the country.  The problem is, this 95% pays a very small percentage of the overall income taxes collected.  He is, in fact, raising taxes in aggregate by shifting even more of the tax burden to a very small percentage of the overall population.  If tax receipts are going up in aggregate and 95% of payers are getting a tax cut, this means a huge increase in taxes for the 5%.  That is fair?  Everyone has a moral obligation to society. I believe that the more you have, the greater your obligation.  This is the foundation of progressive taxation, and the concept is well founded.  This obligation has moral and practical limits, though.

 

Let’s look at the distribution of the tax burden based on numbers provided by the Congressional Budget Office.  The top 10% of wage earners, making at least $92,400 per year, pay 72.4% of the nation’s income taxes.  Contrary to popular belief, the 2001 tax cuts “for the wealthy” increased this burden for the top 10% from 67.8% in 2001 to 72.8% in 2005.  In part, this is because tax cuts boosted the economy thereby increasing earnings.  Mostly, though, this was the result of a reduction in the lowest tax rate from 15% to 10% and an increase in the refundable child credit from $500 to $1,000.  This had the net effect of removing millions of people from the tax rolls completely.  Still think that the wealthy aren’t carrying enough water up the hill?  In 2001, those making less than $44,300, 60% of the country in number of taxpayers, paid 3.3% of the income tax.  In 2005, that percentage approached zero; less than 1%.  This group makes 26% of the nation’s income but pays less than 1% of the federal income tax collected.  In 2001, the bottom 40%, accounting for 43 million Americans making less than $30,500, paid no income tax at all and received checks (funded by those who do pay taxes) worth over $16 billion.  In 2005, this amount exceeded $33 billion.  By any definition, this is progressive and fair.

 

It’s not enough for the President, though.  He says it’s still not fair.  What’s the definition of fair?  Is 10% paying for 80% fair? What about 100%?  That doesn’t seem fair to me.  The President’s plan will result in a full 50% of Americans paying absolutely no income taxes.  This is unequivocally unfair.  I accept my obligation to my fellow countrymen.  I understand that when the tide lifts, I will benefit more than Johnny Lunchpail.  I’m willing to fund social and economic programs to help those in need, those who can’t help themselves, and even (grrr!) those who won’t help themselves.  But this, my friends, is bullshit.  The idea that the top 10% or the top 5% or the top 2% aren’t meeting their obligations is completely unsupportable.  Folks, the hard truth is that the wealthy already pay for everything, full stop.

 

In Monday’s WSJ (page A15), Ari Fleischer likened the current tax landscape to an inverted pyramid scheme.  With an upside-down pyramid supported only by its tip, the only way it can stay upright is by spinning fast enough or by broadening the tip.  The narrower the tip, the faster the pyramid needs to spin (economic growth).  The President’s redistribution of income is a narrowing the tip.  The mass being supported by the tip is increasing and the base supporting the mass is decreasing.  When the pyramid can’t spin fast enough, the pyramid falls over (economic retraction).  Fleischer goes on to propose changes to the tax code that involve everyone sharing some of the tax burden.  I don’t agree with that because I do believe in the societal obligation referred to previously, but the concept is interesting.

 

This problem is compounded by the fact that very little in the President’s spending and tax proposals promote long-term growth.  In fact, nearly everything he’s proposed increases friction in the economy and diverts resources from their first, best use to wherever he decides they should go.  Higher taxes increase friction and are not accretive.  This is beyond dispute.  Taxes and growth have a well established inverse correlation.  Forcing investment in technologies that aren’t economically viable without huge ongoing government subsidies isn’t growth.  Ignoring comparative advantage and imposing tax penalties to punish companies that look to outsource manufacturing resulting in lower consumer costs isn’t growth.

 

You cannot tax your way to prosperity, and even if you taxed everything at 100%, you still couldn’t pay the current governmental obligations, never mind the new ones (see In Defense of the Wealthy – The Economic Argument).  The proposed budget does not, in fact, reduce spending.  It is hugely accretive to the deficit and national debt.  I’ve seen figures presented by independent, non-partisan organizations of up to $2 trillion in additional expenditures.  The “savings” are primarily budgetary slight of hand of the same type perpetrated on the public by nearly every administration, both Republican and Democrat.  As an example, the huge savings purported by the plan to make health care administration electronic and paperless is complete fantasy.  Even the two McKinsey consultants who prepared the study on which the administration basis its savings admit that their results are based on unrealistic assumptions (there was a great article in the WSJ a few weeks ago on this which included substantial input from the authors of the study).  The savings being attributed to reduced military action have been similarly questioned by both sides of the aisle, as they assume savings from a future deployment level that was already reduced; phantom savings.  In fairness to the President, he is on the right track with some initiatives, such as working to make government, and specifically, military, spending and procurement more efficient. To stand in front of the American public and say that he’s already identified hundreds of billions of dollars of implementable savings is simply not true.

 

In the moral justification of his plan, he repeated the mantra of making the system work for working Americans.  The clear implication is that the 95% of Americans getting a tax break work and the other 5% don’t.  Even CNN picked up on this in their post-speech comments.  I don’t even know where to begin.  That statement grossly absurd and can only serve the purpose of pitting the 95% against the 5%.  I work like a dog.  All of the successful people I know work like dogs.  That doesn’t mean that people who aren’t rich are lazy…not at all.  Contrary to what some people believe, the central tenets of capitalism do not state that poor people are lazy or stupid.  I’ve painted houses, erected scaffolding, and worked for the highway crew.  All these jobs take hard work.  The key point, though, is that not all skill, knowledge, and effort have the same intrinsic value.  They are not all worth the same thing and don’t have the same scarcity.   I’ve addressed this in prior posts.  The idea that our President feels the need to draw a value judgment line in the sand on the relative worth of the efforts of the wealthy versus the middle class in support of his tax policy speaks volumes about the incredibly weak theoretical and empirical footing on which he’s standing.

 

What really chapped my ass was when he put that on that stern, scolding countenance and sanctimoniously chastised us for not meeting our moral obligations to the poor and working class; that we need to accept the tax increase as the manner in which we can recognize how fortunate we’ve been. The facts don’t support that AT ALL.  The fortunate are already paying up.  60% of the nation gets support at no cost to them, and that support is provided by the 10% of the population that he was dressing down.  Pretty ballsy.  I’d prefer that he thank me for my hard work and my check to the IRS every April and keep his opinions to himself.

 

To make matters worse, he goes on to accuse people of unfairly taking advantage of tax loopholes to reduce their personal tax burden and avoid their responsibility.  He must be talking about the lower tax rates on capital gains, deductions for mortgage interest, and deductions for charitable donations.  The lower rate for capital gains is a concept well founded and accepted.  It rewards people for putting their capital at risk to finance the growth and innovation from which everyone benefits.  It’s not some bullshit, shyster way for the greedy to lower their tax bill.  Real money is at risk.  Most investments don’t provide better than average risk adjusted returns.  If you want people to invest in the future instead of sticking the money in their mattress, you need to recognize that capital is a scarce resource.  This means that the after tax returns need to be compelling enough to warrant an individual’s capital, otherwise it makes no sense for them to put it at risk. 

 

The deductions for mortgage interest and charitable donations provide a strong incentive for people to purchase houses and help others.  Contrary to popular belief, after property taxes and interest paid on mortgages, real estate isn’t a particularly great investment.  There are much better risk adjusted places to put capital.  If people aren’t buying houses, then building activity and housing stock decreases, which will hurt the middle class and the poor disproportionately because rents will be driven up.   The common complaint from the left is that the wealthy get a bigger break from this deduction because they have bigger mortgages.  Of course they do, they pay all the taxes.  There getting back their own money.  And let’s not forget that at the highest income levels, they need to spend $3 to get a $1 benefit, so it’s not like it’s a money maker.  This activity supports building activity from which many trades (all middle class) benefit.  Just to make certain that the deduction isn’t regressive, the deduction is capped at interest paid on mortgages totaling less than $1MM.  In this fashion, a guy can’t shield his income by taking on a $30MM mortgage.

 

The flaws in the President’s arguments against the “charitable donation” loophole are basically the same.  The top earners get the biggest tax breaks with the charitable donation deduction because they 1) pay all the taxes and 2) have more money to donate.  Again, you get $1 of relief for every $3 donated (at the highest income levels).  Not a windfall and certainly not a tax cheating scheme.  If I have to donate $100k to save $30K in taxes and the charity has a $100k tax free with which to conduct good works, please explain to me how anyone has been fucked.  Again, there is a cap on how much of an individual’s income can be offset by charitable donations, so as to limit any regressive impact on taxes.

 

The point has been made that those in the highest brackets get more benefit for a dollar donated than someone in a lower bracket.  This is true.  If the last dollar is getting taxed at the highest rate, why shouldn’t the first dollar of credit for an activity deemed beneficial not also be treated at the same rate?  It’s all about the marginal dollar.  You can’t have it both ways.  You can’t tell me that a dollar is worth more in one capacity than another.  There is absolutely no framework for this that isn’t completely arbitrary.

 

The President also referred to the use of the tax code as a wedge at least twice in his speech.  He didn’t get specific but the implication was that the tax code is being used to incent actions that harm the middle class.  How can that be?  60% of the nation is immune from this “wedge” because they basically don’t pay any taxes (0.6% of the total in 2005), in aggregate.  Those who do pay taxes are incented to 1) buy homes that support construction and related trades, as well as support an assets class into which most people (particularly the middle class) have the majority of their net worth; 2) make charitable donations; and 3) put capital at risk financing growth and innovation.  Overwhelmingly, in a growing economy, job creation takes place at the middle class.   Once again, I don’t get it.

 

To add insult to injury, when someone dies, estate taxes will take anywhere from 30% to 100%+ of the deceased’s assets, depending on how much pre-probate tax planning has been done.  Estate taxes in excess of 50% are not uncommon.

 

The final bag-over-the-head punch-in-the-face was the reference to his “mandate” to take the country back on behalf of the middle class and those who work for a living.  Not only is this incorrect, but to the listener, it reinforces his view of the relative value of the nation’s various socio-economic classes.  I promised that my blog wouldn’t be a political arena filled with meaningless potshots, but in my opinion, it takes more than 53% of the popular vote to create a mandate; 47% of the voters didn’t agree with him.  That’s not overwhelming support.  The only mandate he received was to not be George W. Bush.  In the Land of the Blind, the One-Eyed Man is king.  Let’s not confuse that with a mandate to ignore some of the founding principles of our nation.  I also note that the 53% is pretty close to the 60% of the people in this country that pay only 0.6% of the taxes.  Probably coincident, but as someone once said, “When your policy is to rob Peter to pay Paul, you can generally count on Paul’s support”.

 

I am not opposed to cutting taxes for the middle class.  In fact, I support it completely.  What I do oppose is raising the taxes on the top 5% or 10% or whatever % it is that is already carrying the overwhelming majority of the burden with no attention paid to spending and the effectiveness of that spend.  I’m not arguing for a tax break for the highest earners.  They don’t need one.  They should, and do, shoulder more of the burden, but there are limits.  The President’s proposal isn’t fair by any objective measure (I only introduce the concept of fairness because the President keeps harping on it), it is not a sustainable policy (see any highly nation with a high tax burden, especially those towards the socialist end of the spectrum) and it will have long term repercussions.  2% to 5% of the wage earners cannot be expected to support the remainder when spending continues to increase.  As a minimum potential consequence, any disruption to the earning power of that sliver will begin to topple the pyramid.

 

We need to start calling bullshit when we hear from our leaders this kind of garbage.  There is a saying I love, “Don’t piss in my ear and then tell me that it’s raining”.  His plan isn’t about growth, long term job creation, innovation, maintaining our leadership position on the world stage, or building a stronger nation.  The math, the facts, and the history of the world’s economies simply do not support any of this.  Everything he does is based on his crusade to redistribute and equalize based on what he believes is fair.  People need to educate themselves about the economic realities of what is being proposed and fully understand the attendant tradeoffs.  Taxes are going up and they’re going up for the people that already shoulder most of the burden.  You may think that taxes need to increase because the proposed budget is necessary and good, but don’t believe that the middle and lower classes are suffering under an unfair tax regime becuase that is not true.

A Deeper Look Into the Desirability of Increased Regulation

Warning:  This is a long one.

 

I’m doing my least favorite thing in the world right now, which is flying.  To offset the six hours of anxiety I suffer on a cross-country trip, I’m a little wacked out on an anti-anxiety sedative that has effect of increasing the time it takes thoughts to get from my brain pan to my fingers by about 30%.  It also seems to be affecting my typing skills.  No matter.  I will rise to the challenge of better articulating why we should all be concerned about the reaction to the current economic crisis.  Such reaction, in and out of government circles, centers on comprehensive regulation of all financial services firms of any size (although larger firms will be subject to more rules).  The regulations proposed will be sweeping and touch nearly every aspect of the financial services world, from product development and product pricing, compensation, reporting standards, oversight standards (who reports to whom, and how), who can own what and how much of it…the list goes on.

 

In this post, I’ll attempt to address several good points brought up by others that have left comments on my prior post (Regulating Outcome).  I don’t have the complete list in front of me, but I think I can shoot from the hip and get pretty close.

 

First, I want to get a couple things out of the way.  One comment was from someone who said that what really chapped his ass was the attitude that all government employees are idiots and that they should get out of the way and let the “smart” people go to work on the problems.  I never said this.  I didn’t even imply this.  What I did say is that the government is probably not the right place to look for the Right answers.  This is a function of the backgrounds of the participants, the committee-like nature of every decision making process, the culture of government organizations, and the politicization of everything that the government touches. There are plenty of highly educated and very experienced people working in Washington on behalf of all of us, but very few have the skill and experience sets to understand and deal directly with what is going on right now in the economy.  This is especially true of our elected officials, right up to the top.  This isn’t a condemnation of our public servants; it’s a statement of fact supported by even the most cursory review of their backgrounds.  It’s not all about the people.  The system and its structure are rife with inefficiencies, conflicts, and perverse incentives.  I’ll make a distinction from those who serve on the local levels versus the state and Federal levels.  More detail on all this later.

 

Mea Culpa time:  senior business leaders in all industries, not just financial services, fucked up big time.  They ignored fundamental tenets of risk management and manageable growth.  What’s more, everyone could see what was coming.  Of course, no one knew exactly when it would happen, but on all measures, we were operating so far above the mean trendline that it had to snap back.  Remember this if you take nothing else out of what I write, “Everything regresses to the mean”.  The questions are, “How did this happen?”, “Who’s to blame?”, and “What can be done to mitigate this activity in the future?”.  In short, “Could regulation have prevented this and, if so, what type?”.  Maybe the most important question to be asked is, “Even if what they did was stupid, did they act rationally?”.

 

There was some malfeasance and unfair dealing, but that actually represents a very small percentage of the current goat rodeo.  Madoff, Stanford, Lay (Enron), Kowalski (Tyco) are truly bad dudes who burned off a lot of other people’s money, but in the greater scheme of things, the actual damage wasn’t nearly a large as the press they received.  It was truly bad activty and it needed to be addressed, but that’s not why we are where we are.  Also, let’s not forget that it takes complicity on both sides of a transaction to get it to work.  Complicity can take the form of active fraud or it can take the form of reduced due diligence and investigation on the part of the buyer.  More on this later, too.

 

The U.S. economy, really the world economy, is working off a bubble.  It’s a valuation bubble that started with residential housing, spread into commercial real estate, and ended up impacting company valuations late in the game.  Bubbles are nothing new:  tulips in Western Europe, the South Sea Company (South Sea Bubble), railroad stocks in the U.S., tech/internet companies in the late 1990s.  All of these bubbles enriched people as they grew and then suddenly popped when the market decided that the system contained too much poison.  The bubbles were painful as they unwound. 

 

What did all these bubbles have in common:  excessive and cheap liquidity, financing speculation to drive up prices to levels unsustainable by actual market supply/demand dynamics and intrinsic value.  There is a huge psychological component to bubbles, but they simply can’t exist without excessive and cheap financing.  In every case in history where a bubble has existed, the ability to borrow money cheaply and in great quantity has been central to the growth of that bubble.  The price of money is not allowed to float freely in response to supply and demand of currencies.  In fact, it is tightly controlled by the central banks; the Federal Reserve in the U.S.  For several administrations, our government, through its regulatory and controlling bodies, has actively managed interest rates down and  instituted a weak dollar strategy, thereby pumping trillions of dollars of excess liquidity into the economy.  Greenspan, in particular, was the architect of the Goldilocks Economy – attempting to manage liquidity so the economy neither got too hot nor too cold.  The key point here is that government intervention caused the excess liquidity that allowed the creation of a bubble.  This is past debate.  Almost no serious economist would suggest otherwise.  Greenspan himself publicly took responsibility for making mistakes trying to move the cost and availability of capital.

 

What was the focus of this increased liquidity and why?  Residential real estate became the prime outlet.  This was primarily due to the Community Reinvestment Act passed in the Carter administration (thanks Matt!) but accelerated in practice through the Clinton and Bush administrations (this isn’t a left/right thing…there is plenty of shit to cover both sides of the isle).  The goal was admirable although somewhat arbitrary.  The intent was to enable as many people as possible to own their own home.  The decision was made that universal home ownership should be the state of equilibrium.  This was affected by putting pressure on banks to write mortgage loans to borderline borrowers with interest rates lower than their credit histories would suggest in a completely free market.  The only way that banks were going to write this paper was if they had someone to which they could sell the aggregated mortgages (mortgage backed securities, or MBS).  The banks knew that these were not going to be good credits but they were prohibited from charging interest rates, fees, and down payments commensurate with the risks they were taking.  The government required Fannie Mae and Freddie Mac, the two largest purchasers of pooled mortgages and securities, to buy MBS backed by sub-prime loans.  A market is born.

 

This increased loan activity bubbled up the risk ladder and was applied to less risky borrowers but was provided on less stringent terms, such as 0% down, interest only (IO) loans with balloon payments, and so forth.  The banks were happy to write this business because the spread between their borrowing costs and their lending costs was very high (remember the artificially depressed interest rates as a result of a hyper-liquid market).  Not only were they being economically incented to write this business, the government was tracking the loans written to the worst credits and nudging banks that were falling behind.  Government intervention in the market created a set of incentives for all market participants, not just the bankers but the consumers of mortgages, that made it easier for them to ignore common sense and risk management principals.  Did we make mistakes?  Definitely.  Did we act rationally given the incentives?  Probably.  This is a clear case of rational behavior when the allure of the perverse incentives is greater than the negatives of doing the wrong thing because the honey is near term and the sting is abstract and longer term.  Should we have known better? In a perfect world, yes.  Welcome to the Law of Unintended Consequences.

 

The whole point of this is that the system is incredibly complex and there are literally billions of levers to pull.  There is absolutely no way for any one individual, or even a group of the smartest, most highly educated people in the world, to effectively make decisions for the entire market.  The Law of Unintended Consequences will always manifest itself, and the more complex the system, the more misguided the intervention and the worse the consequences will be.  Well meaning government intervention in the free market (with an admittedly admirable goal of broadening home ownership) is directly responsible for the mess we’re in now.  It’s not 100% responsible, but it played a major role.  Without the excess liquidity produced by the Fed and without it being directed by the government into a market that couldn’t rationally absorb the capital, the housing bubble wouldn’t have happened and we wouldn’t be here today.

 

Let’s look at other cases of well intentioned government regulation that didn’t work out as planned.  Sarbanes-Oxley is the major reason why the IPO market is a shadow of its former self.  The goal of increased transparency is important and one that is critical to efficient, self-correcting markets.  You know from prior posts that I put transparency at the top of the list of things we need to focus on to correct the system.  The ham-handed structure of this regulation added so much cost to being a public company that no private company wants to go public.  This has taken away a critical financing mechanism for growth of small, medium, and large businesses, and therefore growth of the economy (GDP, jobs, etc).   It has squelched much more value creation the cost of the Enron disaster, to which it was a reaction.

 

The mark to market requirement is another regulation that blew up in our face.  The theory is sound:  take the ability to manipulate investment valuations away from the investment managers so that there is more transparency and accuracy in reporting, especially for those companies with significant balance sheet risk.  I’ve had several people ask why this is a problem.  If the mark to market valuations are down, doesn’t that prove that they were being overvalued on balance sheets and isn’t it better to know that now versus later.  How can transparency be a bad thing?  Second thing first.  Transparency is never a bad thing in commerce.  In fact, it is paramount.  The problem is when the mark to market values do not reflect intrinsic value due to technical factors.  This is what is happening now and is the straw that broke the camel’s back (see the Regulating Outcome post).  The artificially depressed values of the securities in question don’t reflect the economic reality of the underlying assets, so the transparency is false.  There is also a fundamental duration mismatch between daily or quarterly mark to market values for long-term securities with 10+ year lives.  It’s just not a relevant valuation benchmark because no one would ever sell these securities at these values unless they absolutely had to (remember that the intrinsic value far exceeds the market value due to technical factors).  But institutions are being forced to sell these securities at these artificially depressed values because they no longer have enough capital reserves as set by the regulators because they are forced to mark long-term assets to daily marks.  This forced selling in a depressed market puts more downward technical pressure on the assets.  You can see that it’s a vicious cycle.  This is a very basic point and obvious to anyone in the investment management world.  Ivory Tower accountants and the SEC regulators (at the urging of the Senate and House finance sub-committees) set the mark to market mandates without any discussion with market participants.  If they had bothered to ask, they would have learned what a shit storm they were about to precipitate.

 

The Smoot-Hawley Tariff Act.  That was another piece of well thought out, constructive regulation.  1,028 economists signed a document decrying this Act before it was instituted.  The Senate, House, President, and all his advisors knew better.  The world markets reacted, as expected, by raising tariffs against the U.S., ushering in the Great Depression.  We ignore the market at our own peril.

 

Why is government regulation so consistently off the mark with its results when the government aims so carefully at its intended targets (many of which are worthy).  I point to three areas:  the decision making process, the culture of government, and the people.  Let’s start with the culture.  I said in a previous post that the people in the relevant governmental agencies don’t understand the game.  My friend Matt took issue with this, stating that they understand the game all too well.  I couldn’t disagree more.  {Please note that these comments apply most directly to the state and federal governments.  Local governments I’ve found to be pretty in tune with their constituency and much more sensitive to the budgeting issues because their budgets are so small.}  The culture of government is one of provision.  They decide who need or gets what and this is done in the absence of meaningful market feedback (the consumer, which is the ultimate regulator in a free market).  They pay for that provisioning decision through levying taxes.  It’s completely backwards.  They decide what the costs are going to be first and then take the revenues.  There is no profit and loss responsibility.  They only cut back when they are forced to do so.  It’s not a culture of growth, efficiency, and maximizing outcome.  Government employees get paid the same whether they are the best at what they do or the worst.  They do not live their professional lives in an environment where they lead by and respond to incentives, therefore, they don’t think through the long term impact of the decisions they make that get applied to a world that does.  It’s a completely different mindset when your personal gains and losses are absolutely disconnected from your effort and the outcome of your decisions.  They are products of their environment.  If you have spent any time in a large government agency (I’ve spent some time with my state’s insurance commission) you know what I mean.  That’s a problem when you start talking about heavy, pointed regulation in the free market.  The Law of Unintended Consequences will rear its ugly head.

 

What about the people?  Matt has argued that there are some incredibly smart people in government. He’s right.  He specifically mentioned the President’s economic advisors, many of which are some of the most highly respected, recognized people in economics.  These are also the same people that got us here by deciding how much money should be in the system, how much it should cost, and where it could serve the best purpose.  Alan Greenspan is one of the most highly respected economists in the world, and he, more than any other, is the architect of the excess liquidity that we’re working through now.  He has admitted this.  I don’t care how smart you are or how much experience you have, no one person, no group of 100 people, can accurately forecast future needs for any economic input.  The tools at the disposal of the Fed are way too blunt and the feedback loop on the decisions is too inaccurate and lags too long for the Fed to react appropriately, in terms of timing or scale.  What you end up with is a whipsawing effect that increases in frequency and amplitude until the market takes matters into its own hands, begins to self-correct, trending back towards the mean, and pukes out the poisons that have been introduced into its system.  Look at the last 10 years as support for this statement, as the market has tried to self-correct, only to be thwarted temporarily by government intervention in the money supply and active weakening of the dollar.

 

The President, his advisors, and the Fed are only one part of our governmental decision making system.  Congress, and specifically the finance committees and sub-committees, are equally is important (and complicit).  {These comments apply mostly to the Federal and state governments.  Local government, in my experience, is largely comprised of people that are doing double duty (their day job plus a committee) or people like Town Planners that have extensive education and training in a specific function.}  That fact is, most of our elected officials have zero background in economics, finance, or running a business.  Lawyers by far outweigh business people in the Capitol.  By and large these are not people that have had any responsibility for creating jobs, building a brand, creating a long-term strategic plan and tactically executing to that plan, building a business, managing employees, allocating scarce resources (mostly their own), or balancing the thousands of tradeoffs that come with running something real that actually creates something.  They’ve gone to good schools but are educated in abstract disciplines.  Most importantly, they lack significant real-world and hands-on experience. 

 

I’m a pretty smart kid with lots of education and experience in economics and finance, but you wouldn’t want me directing the planning and zoning for your town.  I may make decisions that seem sensible to me, but they will all be made in a vacuum, devoid of any experience or ability to forecast ramifications or repercussions.  I don’t understand why our town has put a moratorium on cul de sacs.  I think they’re safer and more desirable.  When I raised this point with our town’s planner, I learned that there are actually several good reasons why cul de sacs and dead ends are not at all desirable from a town planning perspective.  There is no substitute for experience and knowledge.  Most of our elected officials and many of our appointed officials don’t have any direct experience in or knowledge of finance and economics.

 

The definitely don’t understand the specifics of the instruments and activities they’re trying to regulate.  They don’t know a thing about collateralized debt obligations, mortgage backed securities, credit default swaps, capital reserves…the list goes on.  They don’t know how they work, why they can be valuable, or how they can be destructive.  They don’t understand how they’re valued or have any experience with the contracts.  They haven’t spent any time living daily with any one of these highly complex issues, never mind all of them.  How can they possibly effectively regulate them if they done know anything about them.  They have absolutely no knowledge base from which to issue the types of specific regulatory mandates that are currently on the table.  What information they do get is distilled by equally inexperienced aids that have neither the time nor expertise to provide detailed briefs.  You need to understand the pieces if you’re going to regulate the pieces.

 

I question whether many Senators or Representatives on either side of the aisle really understand the whole, never mind the pieces.  Did any of you see Barbara Boxer’s “interrogation” of Geithner a few weeks ago?  She embarrassed herself with questions and the misuse of terminology that weren’t even remotely related to the issue she was trying to address.  She asked Geither about “his CEO”.  When he looked at her like she had two heads and said he didn’t understand the question, she accused him of getting bogged down in the details.   She clearly has no knowledge of even the fundamentals of the banking system or the economy.  Her rambling is on You Tube.  Check it out.  Chris Dodd, Chairman of the Senate Committee on Banking, Housing, and Urban Affairs, is equally clueless.  Chris Murphy, a Representative from my home state and a friend of mine, is a 2^nd year law associate that did a very good job supplanting a senior representative from her seat two elections ago.  He knows absolutely nothing about the economy, finance, or running a business.  He’s smart, a good kid, and his heart is in the right place, but he doesn’t understand how anything works, he only knows where he wants everything to end up.  That is dangerous.

 

Matt also brought up the point that our officials as elected by the populace are the right people to make system-wide decisions, not business leaders who are self-interested and conflicted (my paraphrasing, mostly from memory; my apologies to Matt if I got this wrong in my Lorazapem induced haze).  Our elected representatives in all branches are horribly conflicted and wrestle with these conflicts at every turn.  The system strongly incents them to think short term and to respond to populist sentiment.  People want instant satisfaction.  In today’s environment, they want an instant solution to the economic woes.  People aren’t interested in a long-term solution when they’re not working and can’t feed their families.  Our elected officials are all too aware of this short term pressure.  They rely on votes to keep their jobs.  The have to get these votes every 2 to 6 years, depending on their position.  Representative Murphy complained in the Hartford Courant last year that his fundraising for the next election began almost immediately after the election he just won.  Fundraising means compromise.  Within the Capitol, they consolidate power by swapping support for programs and bills.  To compound the problem, each Senator and Representative represents a relatively small portion of the overall economy and population.  Even if they were perfectly aligned with the needs of their specific constituency (which they are not), they would not necessarily be aligned with what’s best for the economy or the population as a whole.  The political process almost guarantees that any policy that comes out of the sausage maker will result in inefficiency and unintended consequences.  Look at military contract disbursements, base closures, public works disbursement, and all of the other pork projects that both Republicans and Democrats argue over and tell me that they have the entire country’s best interests in mind.  They are concerned with keeping their positions through votes and bringing money into their districts or states, without regard to efficiency, effectiveness, or the impact on the whole.  I don’t blame them for this.  They are merely reacting to the incentives set in front of them.  I’d probably do the same if I was in their position.

 

Finally, does anyone really think that our state and federal elected officials represent the best this country has to offer?  They won a spending and marketing contest.  They didn’t progress through a meritocracy.  Obama is definitely not my guy, but frankly, McCain probably isn’t any more knowledgeable.  Don’t get me started on Palin.  While some appointees may have some relevant backgrounds, by and large they are political appointees and their position is the result of trading favors.  Me, I’ll put my faith in transparent, efficient, free markets supported by strong contracts and full disclosure.

 

This may sound like I’m anti-democracy.  Nothing could be further from the truth.  Each of the individual units in our system of government has conflicts and flaws.  Certainly, the individual participants do.  The Founding Fathers understood this, and this is the genius and strength of what they established.  The beauty of our system is that it, too, has mechanisms for self-regulation, checks and balances, and self-correction (over time).  No matter what ideology is in favor, the system smooths out the rough edges, again over time.  Someone once said that our system was created by geniuses to be run by idiots.  Instead of idiots, I substitute “people that think they know more than they really do”. 

A market economy is the ultimate form of democracy.  Everyone has a vote and it counts directly, as opposed to our representative system.  Unlike the representative system, the end user, the consumer, is directly involved real time and is the most powerful regulator (but this is only completely true in an environment of full disclosure and alignment of interests – see my closing comments).  How can you not trust the market but trust our government, which is a decidedly less pure form of democracy?  I find that position to be inconsistent.

 

What do you regulate and what limits do you set?  How do you arrive at those limits?  What are the possible consequences?  Can we live with them?  Are the regulations fine enough to fix the problem without unwanted impact?  What will the market do to get around these regs and what impact will that have?  What impact will these rules have on financial innovation, the cost of capital, or growth?  Any hard limits that are set will be arbitrary and not effective in a highly diverse and dynamic world economy.  All these things are interrelated.  Highly structured financial instruments serve a valuable purpose in reducing the cost of capital, which in turn finances growth and lower consumer costs.  Are we at risk of regulating these out of existence?  Some rhetoric would suggest so.  If you think things are bad now, wait until interest rates jump 5 points and become the new equilibrium point because there is no way to trade risk and arbitrage short and long term expectations.. 

 

Whenever a government, either through regulation, taxation, and spending, has diverted capital and resources to non-market choices, there has been long-term backlash.  The further away from the market path we go and the longer we force it to stay there, the more violent the purging we can expect.  The extreme deleveraging that has taken over the world economy is the market self-correcting despite the Fed’s best efforts.  It is purging the system of excess liquidity and it is forcing saving.  It is forcing valuations and consumption patterns back to the mean.  It is rebalancing the supply and demand of both goods and money.

 

Where does this leave us?  Clearly something has to change so that this won’t happen again.  Unbridled capitalism is unlikely to result in a good outcome.  This is Mercantilism, and history has shown that it is undesirable all the way around.  Clear ground rules and enforcement are critical.  The market needs to be put in a position to regulate itself and self-correct.  I believe that this is best done by establishing and enforcing strong guidelines for disclosure, transparency, alignment of interests, and contracts.  Sunshine is the best disinfectant.  If people aren’t fully informed about what they are buying, that’s a problem because risks can’t be accurately priced.  If people are fully informed and they misprice the risk, that’s ok and the cost of that mistake is an important component of individual decision making, market self-regulation, and correction.  This transparency extends to full disclosure of asset ownership and consolidation of this reporting so that cross-ownership can be metered and fully understood.  The market will price in the risks of this cross ownership and punish those institutions with higher costs of capital, forcing a real time disgorgement of the relevant assets.  Financial institutions can’t be allowed to act solely as agents, taking a fee on securities but with no requirement to keep some of the risk that they packaged up and sold to others.  If institutions are required to maintain balance sheet exposure to the securities they develop and sell, they will pay much more attention to the quality and risk profile of those assets.  Compensation, up and down the organization, should be tied to company performance.  Management having a meaningful ownership stake in their companies is an important incentive, but to truly align interests, they should be required to purchase shares at current market values with real cash instead of getting option grants at low prices that can be reset if the stock heads in the wrong direction.  These are all basic standards that our government can institute that will have a meaningful, long term positive impact on our economic system.  This approach will not have unintended consequences because we will not be trying to manipulate individual pieces in a highly complex system.  We need to set up the right incentives (and disincentives), not try to regulate outcome.  I believe this approach is our best chance of squelching unwanted behavior and mispriced risk taking while simultaneously increasing the efficiency of our economic system and rewarding smart risk taking and growth initiatives.

Second Hand First Hand Experience in Iraq

My good friend, Dan, just returned from a 12 month tour in Iraq.  Dan is a Commander in the Naval Reserve.  Prior to Iraq, he had responsibility for a salvage diving unit based in Newport, RI.  He spent several years in the regular Navy subsequent to his college graduation.  He has a great family with two young kids that need their dad around.

Two weeks prior to his call up from the Navy, Dan and I were skiing in New Hampshire and joking that as a Navy diver, he was probably the least likely guy in the military to be called into a desert war.  Wrong again Scott.  Dan has completed several advanced war programs and had successfully filled several management-level roles in the Navy.  This experience and skill is what put him in the DoD’s crosshairs.  He was billeted to a multi-national task force headquarterd at Victory Base in Baghdad.  His particular task force was focused solely on dealing with the IED threat that is the bane of the Allied forces in that theatre.

Dan’s day job is Senior V.P. in Morgan Stanley’s high net worth group.  He’s a broker for (generally) wealthy people.  For those of you that don’t know this business, as a broker, you’re basically an independent contractor.  The Mother Ship provides support, but you’re on your own when it comes to building your book of business and servicing your clients.  Being away from your business for a week on vacation is a pain in the ass.  Being away for a year with very limited contact is beyond impossible and potentially devastating.  His is a high touch, high maintainence  (sp?) business in the best of times.  His relationships are his prime business asset.

Dan could have claimed hardship due to the nature of his business.  He didn’t.  He stepped up without a second thought.  A mutual friend asked him why he didn’t file for a hardship exemption for the good of his family.  Dan’s reply was that this was his obligation as a Reserve officer and he always knew it was a possibility.  He felt it was his duty.  Nothing out of the ordinary for someone in the military, nothing special.  His duty.

Morgan Stanley also stepped up to the plate, big time.  I don’t want to get my buddy in trouble with MS by spilling the beans on his deal with them, but believe me when I tell you that it was WAY beyond what they were required to do.  It was an accomodation they made because 1) they recognized Dan’s duty to country; 2) they recognized their duty to Dan; and 3) they recognized that they needed to keep Dan happy to keep him loyal and productive post-tour.  They knew that he would never forget their actions in this inflection point in his life.  They knew that they needed to enrich a cog in the wheel if they wanted maximum long term effort from him.  This is a far cry from the mercantilist motivations that most ascribe to “big business”.  I digress…

Dan’s post-tour comments really made me feel good about us as a nation.  He told me that the Iraq’is have made tremendous progress over the past several years.  They are absolutely ready to take over for themselves and want to be responsible for their own destiny.  There have been some bumps along the way, but the Iraq’is truly appreciate our role. Progress is slow in many measurable things, but life is better for them now.  Everyone is safer.  Everyone has more say in their lives.  Violent activity is down.  It’s not perfect, but it’s trending in the right direction.  These facts are not being communicated to the American public and he doesn’t know why.

He told me about the success of his specific multi-national task force; many people from several different countries with different experience sets focused on solving a specific set of problems.  When our attention is focused on a specific goal, such as keeping young people from being blown up by roadside bombs, people seem to be able to put the bullshit aside and focus on bringing their knowledge and experience to bear on the key issues.  It’s not that hard…focus on the problem, focus on the facts, apply common sense and logic.  I think there are lessons here for us as we try to work through some of our domestic economic issues

The most encouraging thing that Dan said was that his opinion of this nation’s 20+ year olds was completely changed.  He was so impressed with the young people he dealt with directly and witnessed during his tour.  He was impressed by their absolute commitment, their dedication, their intelligence, their ability to take a completely shitty situation and turn it into progress.  He, like me, painted this group as a bunch of overindulged, slack-jawed fuck nuts more interested in building wannabe Fast and the Furious VW Jettas than capitalizing on the gifts they’ve been given.  After his tour, Dan feels very good about the leadership to be provided by the next generation. That’s very good to hear.

I can’t thank Dan and his colleagues in the military enough for the sacrifices they’ve made in the service of our country.  Agree or not with the war, you have to concede the effort and sacrifice made by those that serve.

Reading List

Just a quick one tonight as I decompress in front of Opening Day on ESPN.  Here are some books that I think everyone should take the time to read.  I guarantee that you won’t be disappointed or bored if you dive in.  Let me know what you think.

1.  The Fountainhead; Atlas Shrugged; We the Living – Ayn Rand  (must read for anyone; fiction; definitely long; compelling perspective on democracy and free markets from a woman who grew up in Russia and stole away to the U.S. as a young woman)

2.  Anything written by P.J. O’Rourke , especially Holidays in Hell and Modern Manners (incredible satire from a former liberal turned Republican; calls “bullshit” on everything no matter what side of the aisle it comes from; beyond funny)

3.  Anything by Kinky Friedman – too bizarre to describe; hilarious

4.  Washington’s Crossing – David Hackett Fischer (fantastically written narrative of the American Revolution)

5.  The Fabric of the Cosmos – Brian Greene (physics for dummies written by one of the world’s most foremost authorities on string theory; not as dorky or esoteric as it sounds;  actually really interesting)

6.  Flyboys – James Bradley (author of Flags of our Fathers; amazing and tragic true story of American bombers captured by the Japanese and tortured on the island of Chichi Jima; balanced perspective on the atrocities of the war from both the American and Japanese perspective)

7.  Sway – Ori and Rom Brafman (great, quick read on the psychological influences that derail rational decision making)

8.  Truman; Brave Companions; John Adams; 1776; Mornings on Horseback , The Great Bridge – David McCullough (one of the best writers of American history I’ve ever read; incredible narrative; turns everything into a compelling story; highly recommend Mornings on Horseback; read his complete works and you’ll have an incredible perspective on the history of our nation and the key players)

9.  Freakonomics – Steven Levitt (Humans are predictable animals that react to clear economic incentives; a world class economist dives into why people do the things they do;  quick read and very fun using atypical, real world examples)

10.  Battle Cry of Freedom – James McPherson (definitive one volume work on the Civil War)

11.  The Tragedy of American Compassion – Marvin Olasky (compassion or enabling dependence?)

12.  Merle’s Door – Ted Kerasote (for anyone who owns a dog and treats him like a person)

13.  Titan; House of Morgan; Alexander Hamilton – Ron Chernow (great biographies of three of the most important figures in our nation’s economic history – John D. Rockefeller, Julius Pierpont Morgan,and Alexander Hamilton)

14.  Never Surrender – Michael Dobbs (fictionalized account of Winston Churchill’s activities as he tries to combat Hitler’s invasion of Belgium and France)

15.  Band of Brothers; D-Day; The Wild Blue; Nothing Like it in the World; Eisenhower – Stephen Ambrose (same comments as David McCullough; makes everything so real and powerful; not just people but events, such as the building of the transcontinental railroad)

16. The Corp (series); Brotherhood of War (series); Men at War (series); Honor Bound (series) – W.E.B. Griffin (great stories, fun, historically accurate; fantastic characters; the best fiction military writer I’ve ever read)

17.  South – Sir Earnest Shackleton -(personal memoir of the man who led the first exploration to cross the Antarctic land mass; an incredible story of leadership and courage)

18.  Team of Rivals – Doris Kearns Goodwin (seminal work on the rise of Abraham Lincoln to the presidency and how he managed a cabinet of rivals for the office through the Civil War and the end of slavery; must read for all Americans)

19.  Howard Hughes – Donald Barlett/James Steele (fascinating biography of Americas most bizarre genius and businessman)

What I Believe

I thought that blogging would be cathartic. If I could provide some stuff that people hadn’t thought of before or maybe offer a different perspective for people to consider, so much the better.  In a short period of time, it has become an emotionally taxing labor of love.  I feel very strongly about the issues I’m addressing, and I work hard to be thoughtful about my comments.  Unfortunately, it’s in my nature for a project like this to consume me, and it has.  People like my new friend Matt offer very strong counter-perspective (is that a real word?).  He clearly thinks a lot about this stuff and gets right in the weeds with me.  I love it because we’re not slinging meaningless generalities at each other.  The conversation is premise/conclusion/support, which is how I was trained to think and write.  I find it refreshing and a big step up from the Coulters and Begalas of the world.  The downside is that I accept the challenge and it absorbs me.  I actually lay awake at night thinking about this shit (and I’m not sure that’s healthy).  To keep this project in proper perspective, every so often, I need to shift gears a bit .  Tonight I’m going to lay down an overview of me from 40,000 feet.  I thought it might be interesting to provide the 50 people that read this thing some perspective on me.  It’s completely self-indulgent, but it’s my page.  Don’t read on if you’re not interested.  Later this week, back to the real work when I address some of the points that Matt made in his reply to my last post.

I’m a fiscal conservative but much more liberal in my social views, and I don’t find that inconsistent.  I believe that conservatism has lost its way.  How can we espouse choice in the markets but eschew it when talking about personal or lifestyle decisions?  I’m pro choice, not only in the women’s rights sense but in every sense.  I believe that religion has no place in policy decisions.  I believe that if I don’t like something, I have the choice to ignore it, not participate in it, or turn it off, but I don’t have the choice to decide what other people should or should not be doing and try to legislate same.  As long as it doesn’t directly affect me, knock yourself out.  I think if God gave us something as precious and unique as the ability to reason and choose he’d be disappointed if we let it go to waste.  I think the Religious Right is dangerous on its own but I believe that it serves a counterweight function that is important in our societal framework.

I believe that most decisions are best made closest to home, and I believe this is what the Founding Fathers had in mind.  I’m an unrepentant capitalist and I believe that over the long haul, the free market will result in the best outcomes.  I believe the market self corrects, but not as quickly as most people would like.  I believe that the more we force resources from where they want to go to where we think they should go, the more frequent and deeper the cycles we’ll experience.  I believe that system is excellent but that people are flawed.  I believe that our greatest protections against abuse are absolute transparency and strong alignment of interests.  I also believe that we all need to take responsibility for our decisions.  I believe that if I take risks and they work out, I should be able to keep most of the rewards.  I believe that if I take a risk and it blows up in my face, as long as there was transparency in the transaction, I should take the hit.  I believe this concept is critical to the successful functioning of the market.  I believe that Moral Hazard  is responsible for a lot of the messes we find ourselves in.

I believe the government should ensure a framework that provides for equal opportunities for success but should also acknowledge that equal outcomes are not realistic or necessary.  I believe that not everything has the same intrinsic value and any system that ignores intrinsic value is seriously flawed.  Flipping burgers isn’t worth as much as teaching or healing the sick or financing the next Intel.

I believe that we all have a responsibility to society; a moral and real economic obligation.  If you can’t put something in the jar, you at least owe everyone else to work to the point where you’re not taking anything out.  If you’ve been fortunate enough to be successful, you need to acknowledge that you probably didn’t do it on your own.  I believe that the rich do have some obligation to support the poor, but I believe there are limits.  I believe in charity.  If you don’t have the money, donate your time.  If you do have the money and you don’t contribute to charity, shame on you.  I believe that the application of Bill Gates’ and Warren Buffet’s fortunes to charity will change the world.  I believe in compassion, but there is a fine line between compassion and engendering dependence.

I believe that it’s not a zero sum game.  Getting rich by making others poor is a short term strategy and always blows up in your face.  I believe that you if you want to build long term wealth, you need to enable those around you to increase their wealth; you need to add more to the system than you’re taking out.  I believe that this strategy multiplies individual efforts and accelerates the wealth building process for everyone.  True success, no matter how you measure it, isn’t a one man endeavor.  I believe that most people practice this but there are always a few assholes who still look to gain at others’ expense.  These high profile fuck-ups don’t do anyone any favors.

I believe that heavy handed regulation is counter productive long-term.  I believe that the government is not in a position, culturally or experientially, to effectively regulate private enterprise without severe and unintended consequences BUT I believe that the government is in the perfect position to set the standards for transparency and alignment of interests without “in the weeds” regulation. I believe government’s duty to establish a framework ensuring opportunity for all is paramount.  I believe this will result in the best outcomes.  I believe that heavily regulated economies and societies suffer from low growth, minimal innovation, and reduced individual and system wide wealth and happiness.  I believe that history supports this view.

I believe in a strong military.  I support the war on terror, but I don’t like being lied to in its justification.  I think the world is a better place without Saddam Hussein.  Although I understand the philosophical position, I think the practical implication of applying our Constitutional framework and standards to non-US citizens who want to do us harm weakens our efforts to ensure the safety of our people.  I think I’d rather have me and my family safe.  I’ll reconcile my position with Saint Peter when I die of old age instead of a terrorist attack.  Maybe I’m being selfish.  I believe this point of view offends a lot of people on the left side of the isle, but I’m afraid to die and I couldn’t live without my family, so I’m willing to get the Stink Eye from them on this one.  I think its naive to say that our war on terror has failed.  Say what you want about George W. Bush (he was a disappointment for me, too), but you can’t ignore the fact that there has been no terrorist attack on U.S. soil since September 2001 despite explicit threats and efforts.  I believe we have made a difference in Iraq and they are now ready to take over in our absence.  I believe that if you disagree with all these things, it doesn’t mean that you’re unpatriotic, only that we reach different conclusions after looking at the same facts.  I believe that’s healthy.  I’m glad I live in a place where I’m allowed to say that.  I think that anyone who has ever said “Love it or leave it” completely misses the point and should have their fucking head examined.  I do think that we need to put Kim Jong Il down for the dirt nap.  That nut is unsafe at any speed and his people are suffering greatly at his megalomaniacal hands.

I believe in God, but I can’t prove his existence and that is very hard for me to reconcile.  

I believe that education is the best long-term weapon we have to maximize outcomes for individuals.  I believe the existing education system is flawed and inefficient.  I’m concerned that math and science, strengths of ours since WW I, are being ignored because they’re “uncool”.  What could possibly be cooler than science?  I believe that we are losing ground.  I think we place too much emphasis on traditional college education and not enough on vocational training that lies somewhere between existing vocational training and college.  I believe that because of this structural and cultural bias, many people are not reaching their true potential.   I think that most colleges provide a wildly substandard experience, educationally.  I believe that the rubber meets the road with your performance when you’re given an opportunity.  I’ll take a hard worker with a state school education over an Ivy League grad any day of the week.  My actual experience in hiring bears this out.  I don’t care where you earned your degree, it doesn’t guarantee success.  You need to perform. Knowledge alone is worthless; applied knowledge is what counts.  That is where you separate yourself.  Harvard has the most Fortune 500 CEOs but it also has the most convicted white collar criminals.

I believe the current administration is sacrificing our future greatness and leadership for a near term outcome that mirrors the President’s view of what is fair.  I think that if this is what we want, we should at least go into it with our eyes open.  I don’t believe we are, and this concerns and saddens me.

Regulating Outcome

People are very pissed about what has happened in the global and domestic economy over the last six months, and rightly so.  The natural reaction is to assume that this is all the result of malfeasance, stupidity, ignoring the signs, greed, unbridled risk taking, and, in general, an absence of regulation.  Some of it is.  The thinking is that the market, and the people in it,are  not able to self-police; that if enough of the right rules had been put in place, none of this would have happened.  As governmental agencies make up and enforce the rules, the extension of this reasoning is that greater governmental intervention is needed to clean up the mess and make sure it doesn’t happen again.

I’d like to offer a different point of view for consideration.  I suggest that what we have here is, to a large degree, the direct result of government intervention and regulation.  There are clearly many things that market participants need to do better to damp out deep cycles, but I don’t believe that market regulation is either effective or conducive to long term growth and system-wide health.  I believe that we can do a better job by adhering to some fundamental principals of disclosure, alignment of interests, and risk management.  I go into a lot of detail because, frankly, if you don’t understand how the markets and investment structures work, you really can’t understand what’s going on.  Stick with me…it won’t be that bad.

Jack Welch famously said that if you can’t identify and admit to a problem than there is no way that you can fix it.  We need to get in the weeds and understand what happened to create the current environment.  Let’s start with a basic premise:  humans are simple animals that react fairly predictable to incentives and disincentives.  The logical conclusion is that by looking at the incentives that are in place, you can predict (or do a post-mortem on) behavior and outcomes.

The economy is deleveraging.  Although credit was slowing down starting in the second half of 2007, the first real bit of deleveraging happened quite rapidly from September to December of 2008.  This provided the initial shock that sent everything into a tailspin.  Triggered by the fear of increasing defaults on instruments supported by aggregated sub-prime mortgages, institutional investors decided that they held too much leverage in the form of leveraged loans, corporate debt, residential and commercial mortgage backed securities (RMBS and CMBS), collateralized loan and collateralized debt obligations (CLOs and CDO), and asset-backed securities (ABS).  All of this leverage was supported by exceptionally low interest rates.  Relative to equity, debt became an exceptionally cheap way to finance things and so everyone used more of it to buy stuff: houses, buildings, companies, basic goods and services.  This excess liquidity, in turn, drove up prices to historically excessive levels (availability of capital results in more demand which results in higher prices).  People were paying more for things than they were worth because they could.  They weren’t spending their own money, and as long as values continued upwards, everything was fine.  The problem is, trees don’t grow to the sky.  Everything reverts to the mean.

Where did this liquidity come from?  Why were interest rates so depressed?  The government.  Specifically, over the past several years, the Federal Reserve (the “Fed”), has artificially maintained low interest rates which has the effect of introducing liquidity into the economy.  It started in 2000 when the Fed Funds rate was knocked down to stimulate the economy.  As the economy began to pick up steam in mid-2003, the Fed looked to incrementally increase the Fed Funds rate to retard growth and stave off inflation.  The problem is that all of the tools at the Feds disposal are very blunt, have long lag times, and require a near perfect estimation of what’s going on if they are to be successful.  All of these things, especially the last point, make it very unrealistic for the Fed to effectively manage the economy through direct intervention.  In fact, just the opposite has happened and Greenspan has recently admitted as much.

Another piece of government intervention is central to what has happened.  Back in the Clinton Administration, the Community Reinvestment Act was passed.  A key part of this Act was the determination that home ownership is a specific goal that should be promoted as broadly as possible across the soci0-economic spectrum.  How best to promote home ownership?  Increase the availability of capital by making it cheaper and easier to get.  This was put into effect by mandating that both Freddie Mac and Fannie Mae purchase securities backed by marginal, or sub-prime, mortgages.  Without FMC and FNM as buyers, there are no sub-prime mortgage-backed securities (“MBS”).  No banks and lenders will write paper if they can’t securitize it and sell it off, which means no sub-prime loans.  The specific, and arbitrary, decision that home ownership by everyone is a desirable outcome (and by implication, the best outcome) led directly to the establishment and expansion of a sub-prime mortgage market.

Owning a home is one of my proudest accomplishments, but it is a privilege and not a right.  Nor is it necessarily the best possible outcome for all people.  Some people simply cannot afford a house nor should they be encouraged to financially stretch to achieve home ownership.  It is not a desirable outcome in and of itself.   Given that people get paid a fee to underwrite mortgages and then sell the mortgages off to someone else, what happened after the establishment of the sub prime market was painfully easy to predict:  lax underwriting standards, product innovations to make mortgages more affordable today by back-end loading costs and interest rates, and no money down.  To be sure, people took advantage of the programs on both sides; both lender and borrower.  There was unscrupulous behavior all the way around.  It all started though, with the government mandate that home ownership should be woven into the economic fabric as deeply as possible with the complicity of quasi-government institutions.

To bring this full circle, another piece of government regulation was the tripwire that touched off the whole cascade of events.  It’s an arcane piece of accounting regulation known as “mark to market”.  The concept is that financial institutions need to mark their investments to the most recent fair market value, which is very generally defined as the price that an independent third party is willing to pay to acquire an asset.  Makes sense, no?  For public equities, this is easy.  The price of a share of Exxon is there for all to see and it is a price set by the bidding of millions of shares per day (a “deep” market).  For more highly structured investments, such as mortgage backed securities, it’s a bit more difficult, bordering on rocket science.  The fundamental approach to valuation, though, is pretty simple. 

Mortgages are contracts that require fixed (typically) monthly payments of principal and interest.  MBSs are securities that aggregate thousands of mortgage contracts into pools and are entitled to the monthly payments.  Therefore, when you set up an MBS, you know exactly how much money you are entitled to each month until the last mortgage in the pool matures.  When you discount these known cash flows by the required rate of return, (which is as function of asset quality, interest rates, expected default and prepayment rates, etc.) you can calculate the intrinsic value of an MBS.  Its just math, and math that investment managers do in their sleep. 

The math is only one part of the pricing equation.  The other part is supply and demand.  Supply we have, so let’s focus on demand.  If you spend $500k to build a house and then put it on the market for $500k and it doesn’t sell, then the market value isn’t $500k.  If you sell it for $400k, the market value of the house is $400k even if it would cost you $500k in materials and labor to build the same house (its “intrinsic value”).  This is what happened beginning in October, 2007, in the structured securities markets.  A small number of sub-prime borrowers started to default on their loans.  Institutions began to panic, which was exacerbated by the amount of this paper they held on their balance sheets, and stopped buying at any price.  To make matters worse, they tried to dump their structured paper, for which there was also no buyers.  The market was flooded with assets that no one wanted to own.  The prices were driven down to ridiculously low levels, not because the intrinsic value had changed but because demand dried up.  This is a critical point.  Only 7% of all sub-prime mortgages are defaulting, but  MBSs are trading as if 2o+% are defaulting.  There is nothing wrong with the assets, the problem is with the pricing mechanism.

The discounted value of the actual, current cash flows is much higher than the trading prices.  Herein lies the problem with mark to market accounting of long term assets.  Financial institutions were forced to write down the value of these assets even though they were (and are) really worth much more.  Banks and insurance companies are required to hold reserves against their invested assets to provide a buffer against a run on the bank.  When the mark to market write downs occurred, the reserves fell below the required levels and these institutions were forced to hold more cash in reserve.  They didn’t plan for this level of cash drain but they couldn’t raise money in the equity and debt markets because the tailspin had already started.  The most ironic part of all this is that most of these banks, including Lehman, were actually generating cash flows from operations, but they had a severe liquidity crunch because of a regulatory accounting treatment.  Liabilities exceeded assets even though the businesses were making money.  Applying a daily or quarterly mark to market methodology to long-term assets is a huge mistake because it is a complete mismatch of investment horizons.

Why did so many institutions 1) write sub-prime paper or 2) buy so much paper backed by sub-prime assets that they were overexposed to a specific type of risk?  Excellent question!  Again, it comes back to incentives.  The institutions that write this structured paper and the investment banks that sell the paper get paid on a fee basis.  Essentially, they get paid on commission and have no exposure to the risk because they don’t own the paper themselves.  They have no skin in the game, no alignment of interests.  Banks, insurance companies, etc. loaded up on this paper because it was easy money.  The interests rates were high relative to other investment options and investment officers get paid based on the performance of the portfolios they manage.  There were strong incentives to take risk to maximize upside but no incentives in place to avoid excess risk. 

To complicate matters, while Institution A may not have owned much of their own paper, they owned a lot of the paper of other institutions, which in turned owned the paper issued by Institution A.  This created a complex web of cross ownership.  When one institution started to crap out, it immediately impacted everyone else because they all own each other’s issues.  Risk management did not take the cross ownership into account.  In my view, this was incredibly stupid and could have been avoided.

How do we avoid this in the future?  The market should demand the establishment of proper incentives and disincentives, increased transparency (particularly with respect to investment portfolios, off-balance sheet financing, and risk management metrics, including cross-ownership), and proper alignment of interests.  I think this last point is critical.  If people are required to eat their own cooking, they’ll pay a lot more attention to what goes into the dish.  Government does have some role here.  They need to roll back the mark to market accounting standards for certain types of assets, for instance.  They also can play a valuable role in reporting and transparency standards. 

What would be a disaster, though, is if they get involved with compensation, portfolio construction, or other mandates such as the Community Reinvestment Act that create artificial incentives for funneling capital to a sector that can’t reasonably absorb it.  The fact is, the people in government 1) don’t understand the game; 2) serve too many political masters; 3) don’t have the tools at their disposal to effectively manage the economy; 4) have perverse incentives of their own to contend with that make it near impossible for them to be objective; and 5) have demonstrated repeatedly that the Law of Unintended Consequences outweighs any benefit that their regulations may provide.  Everything in the economy the government has touched in the past 15 years had lead to directly to the current outcome.  I personally struggle to see how additional government intervention can make things better.

What Business is the Government Really In?

Fernsehtek asks in a earlier post what I think of the recently unveiled plans for the government to start purchasing and subsidizing the purchase of “toxic securities”.  This actually requires a pretty detailed response beginning with making sure that we understand why we are where we are.  I’ll try to be brief (not in my nature) now and piece together a more detailed, thoughtful response in the not-to-distant future.

Honestly, I’m torn on this one.  I desperately want the current situation to be over quickly because it’s shitty for everyone and it is giving our global neighbors the opportunity to (prematurely) pick over the carcass of our economic foundation.  On the other hand, I firmly believe that the government is in the worst position to intervene in the markets.  Furthermore, one of the central tenets of an efficient free market, and the primary regulator of risk and suboptimal behavior, is the idea that people and institutions are fully exposed to the downside of whatever choices they make.  This is a very important concept and its absence over the past several years is a primary factor in the current mess.

I think there are a couple problems with the program.  First, it’s introducing additional liquidity into the economy before its even gotten close to deleveraging.  This is mitigated a bit because it’s capital allocated to a very specific purpose, but the end result will be banks and other institutions have a bunch more liquidity.   That capital will need to go somewhere.  If it gets spent before we work our way through the overhang, we will have treated the symptom but not cured the disease.   In addition, when we cycle out of this downturn (and we always have, with our without any intervention by the Fed, Treasury, or Congress/the President), the excess liquidity will most likely lead to inflation (see any of the Latin American countries in the 80s or the Jimmy Carter years).  I’m of the mind that, as painful as it may be, we should take a page from Japan’s playbook and work our way through the devalued assets and the excess liquidity over time so that we can start from a stronger foundation.

There is also the issue of Moral Hazard.  Moral Hazard exists when incentives are in place to ignore risks in the quest for gains because the gains are concentrated but the costs of the risks are spread broadly.  If the banks, insurance companies, car companies, etc. are shielded from the consequences of their bad decisions and they can reasonably believe that this shielding is a constant, there is no incentive for them to manage risk.  If things work out, they get the honey.  If things blow up, everyone else gets the sting.

The real problem with the practical application of the above is that in the case of the banks and other owners of these securities, the sting is so unbelievably huge that even dispersed, it really hurts the individuals.  It’s aggregate effect also has really large impact on the overall economy.  This is where “too big to fail” comes in.

The one positive in all this is the government’s implicit acknowledgment that it needs the private sector, both its capital and its expertise, to fix the problems.  That’s progress in my book.

In Defense of the Wealthy – The Economic Argument

Thanks so much to everyone who took the time to read the last entry.  I especially appreciate those that took the time to offer some thoughtful commentary, either directly or through other channels.  My position is an unpopular one, and I know it.  Irrespective where the threshold is set for “wealthy”, this segment of the population represents a minortiy in terms of number but accounts for a much greater-than- pro rata share of the real wealth.  In the short term, anyone who isn’t in this group will benefit from a redistribution of wealth, and this has obvious popular appeal.  My primary objective is not to convince everyone that I’m right (although that would be nice!) but instead to get people to consider the issues a bit more deeply than “Wall Street and Big Business has put us here” or “the rich get richer and the poor get poorer”.  Things are a bit more complicated than that, and if we, as a nation, are going to make the right decisions, we need to make fact based decisions as opposed to turning everything into an emotional reaction.  This is how our President has said he is going to proceed.  Unfortunately, his intrinsic bias is towards making things “fair”, as he defines this term.  He is attempting to acheive very specific ends by managing the economy with blunt tools, and I fear that the unintended consequences will not only squelch these efforts but also lead to an overall reduction in wealth that will effect everyone.  Every decision is a trade-off and will have long and short-term ramifications.  The last thing we need now is shooting from the hip in an attempt to acheive some arbitrary (and highly personalized) notion of “fairness”.

So, 250 words into this diatribe, I finally begin to address the main topic.  I think there are some pretty clear reasons founded in economic theory and supported by historical empirical evidence that suggest that the current sentiments are flawed.  Let’s start with taxes.  My friend Rich made the comment that it’s about time that the middle class got a break (my paraphrasing).  I couldn’t agree more.  In fact, lower taxes across the board, both personal and corporate, will not only benefit each of us individually, but will also facilitate broad economic growth which we can all enjoy.  The historical evidence is fairly definitive on this point.  Lower taxes (or friction) leads to faster growth and generally higher overall tax receipts.  This has to do primarily with two things:  greater incentive for investment (capital, time, knowledge) and increased velocity of capital (the idea that every dollar introduced into the economy isn’t used just once but cycles many times).  Velocity is why the GDP is a multiple of the money supply.  Less friction means more investment and greater velocity.  This is the engine for growth.

The natural tension pulling against tax reduction is the desire or need to provide services and support.  The real value and effectiveness of these programs is inextricably intertwined with this discussion, but really deserves separate attention.  For the current purposes, let’s assume that all existing programs are neccesary and effective.  This is not my belief, but it represents a middle ground between slashing entitlements and increasing government support.  As stated previously, to a point, incrementally lower taxes generally result in increased tax receipts. 

Our government, though, has been operating at a deficit for a long time.  Here’s the dirty secret of our current system of entitlements and taxation:  the present value of the all the future liabilities of all the current federal government programs (social security, Medicare/Medicaid, and any other program which has a stated future obligation) exceeds the value of the entire capital stock of the United States.  This means that even if everything in the country was sold at fair market value (stocks, bonds, real estate, etc.), we couldn’t generate enough proceeds to cover the future obligations of our government, discounted for the time value of money, and pay them off today (remember, a dollar tommorow is worth less than a dollar today, so at a 5% discount rate, a $10 liability due 5 years hence could be paid off for $7.84 today).  The absolute dollar value of these obligations over time is a multiple of the present value, or the value at which they could be paid for today. This is a nerdy financial point, but it is hugely important.  The practical implication is that even if the government took everything we owned and taxed us at 100%, it couldn’t pay the bills.  We absolutely, positively cannot tax our way out of this situation.  Don’t take my word for it.  The CFA Digest published the results of a study done by a couple of finance and economics professors from which this reasoning springs.  I’ll try to track the study down and post the bibliography as an addendum to this post.  Winston Churchill said that trying to tax your way out of a recession is like standing in a bucket an trying to lift yourself up by the handle.  Pretty sharp for a boozebag womanizer.

That’s pretty fucking depressing.  The good news is that it is not hopeless.  What this analysis does not include is the value of hard work, innovation, and growth.  I believe that our only way out of this is to grow our way out.  It’s the only way the math can work.  We should be supporting policies that support investment and growth initiatives by and in the private sector.  We need to increase investment and the velocity of money to grow ourselve whole.  Taxes are the antithesis of this, even if 100% of the tax receipts are going to “growth initiatives”, which they are most certainly not.  Keynesian economic theory doesn’t work out in the real world.  It was discredited directly in the failure of the New Deal to stimlate the economy out of the Depression, and it was discredited indirectly with the success of diametrically opposed policies founded in classical economics (look back to the reduction in inflation and interest rates, GDP growth, and the pace of overall innovation from 1980 until the current crisis).  The government cannot spend its way to growth and prosperity.

Why not?  What’s the difference between private sector investment and public sector investment?  For starters, the government allocates money to projects that are alway politcally expedient but are seldom the first, highest use of capital.  Energy independence is a noble goal, but today, it is not realistic and it is economically inefficient.  It ignores the rules of comparative advantage and market pricing.  None of these alternative energy proposals can exist without significant government subsidies.  The need isn’t acute (yet), the cost of alternatives to the alternatives is too low, and the technology isn’t there (yet).  To force something that has a marginal cost higher than its marginal benefit ends up costing everyone money.  In addition, the perverse incentives set up by this messed up cost/benefit relationship all but ensure failure.  Finally, even if we concede that the benefit exceeds the cost, does anyone really believe that the government is the organization to most efficiently execute on this plan?  The result is a diversion of capital from a best, most efficient use that will facilitate growth to a use that will ultimately act as a drag on growth.  This type of activity takes us further away from where we need to be.

Before you go nuts, I’m not saying that we don’t need to develop alternative sources of energy.  I support the innovation of these technologies and acknowledge the eventual need.  Right now, though, it is a hugely suboptimal choice to increase taxes to force-fund this activity.  When the marginal benefit exceeds the marginal cost, through better technologies and the increased system-wide cost of the current energy sources, the market will dive in head first and efficiently make it happen, and it will do so while being accretive to the overall economy.  This is just one small example.

Let’s bring this back to my conclusion that we should think twice about sticking it to the rich to support these programs.  Not to be glib, but the wealthy already effectively pay for everything.  The top 1% of earners pay 25% of all personal income tax and the top 5% pay 40%, according to the Tax Policy Center.  The top 400 earners in 2006 paid an average of $45.2 million in taxes each, or 1.8% of all income taxes.  In addition, these people use basically zero government provided services above and beyond the stuff that everyone gets (defense, education , etc.). 

When you throw in corporate America, the Big Business whipping boy, the delta increases.  Exxon, the poster child for the anti-profit/anti-business crusade, will pay income taxes equivalent to the bottom 50% of all taxpayers, in aggregate.  You may love to hate them folks, but the fact is, you can’t live without them.  The very people that you vilify in their pursuit of financial gains provide nearly all the support for every social program that you hold so close to your hearts.  How much more of the burden can they be expected to shoulder?  At what point is can they reasonably be expected to say, “Fine.  If you’re going to tax the shit out of me, you can do it all yourself.  Good luck replacing my investment capital, my drive for innovation, my sacrifice”.  The reason most of them got rich in the first place is because they were able to do what the rest of us couldn’t or wouldn’t, which is provide those very things that increase the size of the pie for us all.

This isn’t some theoretical raving.  Let’s look at the initial settlers of our country to see how this works.  The initial settlements were founded on an ideal that, on the surface, made a lot of sense.  The idea was that things were bound to be difficult in the establishment of a new society from scratch, so the best chance for success was for everyone to provide support for everyone else.  They believed this system of mutual support would provide the strongest foundation.  Makes sense, no?  What actually happened was somewhat different.  Not everyone was willing or able to make equal contributions.  The idea that you had the support of the whole if you couldn’t support yourself made it easier not to live up to your end of the bargain.  It soon became apparent that a minority of the settlement’s population was providing a majority of the benefits (crops, livestock, infrastructure efforts).  In economics this is known as the Free Rider Problem.  The natural reaction of this minority was to reduce their efforts becuase they became sick of supporting everyone else.  No one wanted to support the free riders, but if they did anything at all, even if it was just enough to support themselves in the absence of friction (taxes, etc), most of it was diverted to the benefit of everyone else.  The result was that they almost all died becuase no one was doing anything.  Until they shifted to an “eat what you kill” model that is pretty close to what we have now, the prospects for our new nation were pretty grim.  Once they did, we were off to the races.

This getting too long and too pedantic.  What’s the punchline?  There are a lot of admirable goals in the administration’s plan.  In fact, I believe that everyone really wants the same things, and many of them are in the adminstration’s blueprint.  The question is, “What is the right way to acheive these ends?”.  I argue that it’s not by penalizing the rich going forward by increasing taxes.  This will squash investment, resource allocation, innovation, and growth.  To be sure, the rich will increase their wealth, and at a faster rate than the rest of us.  But everyone’s level of real wealth will go up as the economy grows.  Again, look to 1980 until the current situation to see how this has worked.  The wealthy should gain more.  They will be putting their capital and efforts at risk to make it happen.  We’ll play an important role, too, but not as important and with far less at stake.  We should get paid less for the growth.  Instead, let’s get back to a system that encourages prudent risk taking (with the attendant exposure to downside for excess risk taking), investment, innovation, increased opportunity sets for everyone, and the ability to reap the rewards of your actions (as well as suffering the consequences of your bad decisions).

In Defense of the Wealthy – The Philosophical Argument

Recently, the wealthy have been taking it on the chin like a Cuban welterweight.  Obama and his team made the affluent a target in his campaign from Day One.  The general public is outraged (as they should be) at large bonuses paid out by investment banks and other financial services firms that have received TARP and other bailout money; aka our tax money.  His rhetoric in support of his budget and spending plans is a message centered on what amounts to a moral crusade against the wealthy.  Don’t take my word for it.  Read the first several pages of his budget proposal, which amounts to a preamble justifying the most massive taking in the history of this nation.  Christ, just read the title of the thing.  He repeats the theme of moral obligations and fixing a broken social contract more than once.  There have been some excellent op-ed pieces in the Wall Street Journal on this very subject over the last 2 weeks.  I’m not breaking new ground here.  I’m not stating anything to which the President wouldn’t readily admit.  In fact, the President has been very forward about his goals.  He believes that he has the moral obligation and the mandate to redistribute wealth from the people that have it to the people that want it, or in some cases, need it.  This is a pretty low risk play for him politically.  While it involves a lot of money, it affects a relatively small percentage of the population, each member of which only has one vote.  When your policy is to rob Peter to pay Paul, you’ll probably have a lot of support from Paul.  I wish I thought that quote up, but some important historical figure said it a long time ago, although I can’t remember who right now.

When you boil down all of this rhetoric, it comes down to a philosophical argument and value judgement of what is “fair”.  The conclusion being made is that some significant portion of the wealth owned by the wealthy isn’t fair.  The premise is that 1) the haven’t earned it; 2) they earned it at someone else’s expense;  3) they have more than they need and the rest of us are entitled to it; or 4) some combination of 1, 2, & 3.  All of these arguments are horribly flawed.  

Reference is made continuously to the working class, the middle class, those who work for a living, Main Street (v. Wall Street), and it goes on ad infinitum.  The idea that because someone doesn’t turn a wrench, swing a hammer, or drive a truck they aren’t working or doing something important for the broader economy is one of the most fundamentally wrong ideas I have ever heard.  Senior managment running companies large and small, bankers (commercial or investment), investment managers, venture capitalists and buyout pros all provide hugely valuable services that EVERYONE benefits from in the form of growth, lower costs for consumer products, lower costs of borrowing, increased efficiency (lower costs), new ideas and development, building value for pension plans, and facilitating the flow of capital from those entities (individual and corporate) that have it to its highest best use.  This last point deserves fleshing out in a different rant because, in my view, it is the single most important activity in a market based capitalist system.  These people make huge personal sacrifices to do their jobs.  The hours are ridiculous (80-100 per week), the travel schedules are ridiculous (I have spent 20+ of 52 weeks on the road and I’m a piker relative to a lot of these guys), and the stress is beyond crushing.  These people are working hard.  They are steward of other people’s capital and lives, and this is a heavy burden that most take very seriously.

In the vast majority of cases these people are taking out a small fraction of the value that they’ve created for others.  Jack Welch is a perfect example.  He made more money than I can conceive of, but the value that he created at GE is measured in the hundreds of billions of dollars in the form of stock gains for GE shareholders (which is in every public pension plan, which is owned by the “real” workers, not just rich folk), new products that everyone benefits from, much lower costs on everything GE touches, and jobs.  God knows GE has done a lot of bad, too (Pittsfield, MA – Superfund site), but the positives far outstrip the negatives.  Jack has earned his dough.

The overwhelming majority of the wealthy didn’t get that way by breaking the law or fucking someone else out of their share.  There isn’t a Wealthy Guys Club where rich people sit around thinking about how screw Ordinary Man.  Most wealthy people got that way because they’re smart, they work hard, they sacrifice, and they don’t just take advantage of opportunities, they create opportunities to be successful.  Most importantly, they understand that it’s not a zero sum game – the idea that the only way I can get rich is by taking it away from someone else.  Instead, they know that creating opportunities for growth and success in their relevant universe is the best way for them to be successful.  Indeed, this is a fundamental underpinning of the American system as conceived and executed by our Founding Fathers.  Most rich people got that way because they added a lot to the jar and took out their fair share.

The idea that anyone can say how much is enough for anyone else again runs against the basic premise of the American system.  Your judgement on how much I need is not only arbitrary, it completely misses the point.  People only do things for the reward.  The reward doesn’t need to be money, it can be the love of your job or the feeling that charity gives you or recognition for a job well done or anything else to which you ascribe value, but if there isn’t honey at the end of the effort to crack open the beehive, than why would anyone endure the sting?  If someone is going to cap my personal wealth creation, and effectively devalue my contribution through increased taxes and wealth redistribution, what incentive do I have to keep pushing ahead?  Why would I put capital, reputation, effort, ideas, or anything else at risk if I don’t benefit?  If everyone else is going to benefit from my work but me, why should I bother doing more than tread water?  I only make more if I create more value.

A corollary of this thinking is that a dollar is worth more to the poor than the wealthy.  Again, this is an arbitrary value judgement.  Money is a measure of how the market values my time, effort, skills, intelligence, etc.  For me personally, there is nothing more valuable to me than my time.  Time at work is time away from my family and the things I’d really like to be doing if I didn’t have to pay the bills.  Don’t every tell me that my time isn’t worth as much to me as it is to someone else.  That’s just insulting.  Why would I sacrifice my time for everyone else’s benefit but not my own?  An interesting sidebar is the charitable activity supported by, no – driven by, the wealthy.  Most wealthy folks end up giving away a substantial portion of their wealth, and the wealthier they are, the more they give as a percentage of their net assets.  This is well documented (see Bill Gates, Warren Buffet, etc.).  I would argue that the wealthy more than uphold their end of the Social Contract, both in terms of wealth creation for everyone in their work related activities and their charitable activities (all of which are orders of magnitude more effective than any government program).

I’m not a dope.  I know that while the above is generally true, it doesn’t apply universally.  There are definitely some bad guys out there that have gotten very wealthy by doing the wrong things and porking everyone they could to get ahead:  Ken Lay, Bernie Madoff, the guy from Global Crossing (can’t remember his name right now) – the list is long.  The fact is, these people are a small minority of the people out there getting wealthy.  These are high profile cases and they resonate with the populace because their activities are so egregious they stick in peoples’ minds and become THE association with Big Business (a different topic that deserves attention), bankers, hedge fund managers, etc.  A good analog is the aviation industry.  Plane crashes almost never happen, and when they do it’s generally a catastrophe with lots of lives lost. The result is that these events stick in our minds.  It would be foolish to say that airline travel is unsafe because our impression is that planes crash a lot because that’s what we remember.

People are hurting right now.  Things are as bad as I’ve ever seen in my lifetime and hope to ever see.  People want answers and they want someone to be responsible.  The wealthy make an easy target.  Let’s be thoughtful about how we ascribe blame and before we decide whose “suffering the most”.  Idealogically, this “soak the rich” mentality makes no sense.  It also will have very specific economic ramifications to be addressed in the next entry.