Why the Stock Market is so Good when the Economy is so Bad

Posted by PITHOCRATES - March 31st, 2014

Economics 101

No One is going to get Rich by Buying and Selling only one Share of Stock

It takes money to make money.  I’m sure we all heard that before.  If you want to ‘flip’ a house you need money for a down payment to get a mortgage first.  If you want to start a business you need to save up some money first.  Or borrow it from a family member.  And if you want to get rich by playing the stock market you need money.  A lot of money.  Because you only make money by selling stocks.  And before you can sell them you have to buy them.

Stock prices may go up and down a lot.  But over a period of time the average stock price may only increase a little bit.  So if you bought one share of stock at, say, $35 and sold it later at, say, $37.50 that’s a gain of 7.14%.  Which is pretty impressive.  Just try to earn that with a savings account at a bank.  Of course, you only made a whopping $2.50.  So no one is going to get rich by buying and selling only one share of stock.

However, if you bought 10,000 shares of a stock at $35/share and then sold it later at $37.50 that’s a whole other story.  Your initial stock purchase will cost you $350,000.  And that stock will sell for $375,000 at $37.50/share.  Giving you a gain of $25,000.  Let’s say you make 6 buys and sells in a year like this with the same money.  You buy some stock, hold it a month or so and then sell it.  Then you use that money to buy some more stock, hold it for a month or so and then sell it.  Assuming you replicate the same 7.14% stock gain through all of these transactions the total gain will come to $150,000.  And if you used no more than your original investment of $350,000 during that year that $350,000 will have given you a return on investment of 42.9%.  This is why the rich get richer.  Because they have the money to make money.  Of course, if stock prices move the other way investors can have losses as big as these gains.

Rich Investors benefit most from the Fed’s Quantitative Easing that gives us Near-Zero Interest Rates

Rich investors can make an even higher return on investment by borrowing from a brokerage house.  He or she can open a margin account.  Deposit something of value in it (money, stocks, option, etc.) and use that value as collateral.  This isn’t exactly how it works but it will serve as an illustration.  In our example an investor could open a margin account with a value of $175,000.  So instead of spending $350,000 the investor can borrow $175,000 from the broker and add it to his or her $175,000.  Bringing the total stock investment to $350,000.  Earning that $25,000 by risking half of the previous amount.  Bringing the return on investment to 116.7%.  But these big returns come with even bigger risks.  For if your stock loses value it can make your losses as big as those gains.

Some investors borrow money entirely to make money.  Such as carry trades.  Where an investor will borrow a currency from a low-interest rate country to invest in the currency of a higher-interest rate country.  For example, they could borrow a foreign currency at a near zero interest rate (like the Japanese yen).  Convert that money into U.S. dollars.  And then use that money to buy an American treasury bond paying, say, 2%.  So they basically borrow money for free to invest.  Making a return on investment without using any of his or her money.  However, these carry trades can be very risky.  For if the yen gains value against the U.S. dollar the investor will have to pay back more yen than they borrowed.  Wiping out any gain they made.  Perhaps even turning that gain into a loss.  And a small swing in the exchange rate can create a huge loss.

So there is big money to make in the stock market.  Making money with money.  And investors can make even more money when they borrow money.  Making money with other people’s money.  Something rich investors like doing.  Something rich investors can do because they are rich.  For having money means you don’t have to use your money to make money.  Because having money gives you collateral.  The ability to use other people’s money.  At very attractive interest rates.  In fact, it’s these rich investors that benefit most from the Fed’s quantitative easing that is giving us near-zero interest rates.

People on Wall Street are having the Time of their Lives during the Obama Administration

We are in the worst economic recovery since that following the Great Depression.  Yet the stock market is doing very well.  Investors are making a lot of money.  At a time when businesses are not hiring.  The labor force participation rate has fallen to levels not seen since the Seventies.  People can’t find full-time jobs.  Some are working a part-time job because that’s all they can find.  Some are working 2 part-time jobs.  Or more.  Others have just given up trying to find a full-time job.  People the Bureau of Labor Statistics (BLS) no longer counts when calculating the unemployment rate.

This is the only reason why the unemployment rate has fallen.  If you add the number of people who have left the labor force since President Obama took office to the number the BLS reports as unemployed it would bring the unemployment rate up to 13.7% ((10,459,000 + 10,854,000)/155,724,000) at the end of February.  So the economy is still horrible.  No secret to those struggling in it.  And the median family who has seen their income fall.  So why is the stock market doing so well when businesses are not?  When profitable businesses operations typically drive the stock market?  For when businesses do well they grow and hire more people.  But businesses aren’t growing and hiring more people.  So if it’s not profitable businesses operations raising stock prices what is?  Just how are the rich getting richer when the economy as a whole is stuck in the worst economic recovery since that following the Great Depression?

Because of near zero interest rates.  The Fed has lowered interest rates to near zero to purportedly stimulate the economy.  Which it hasn’t.  When they could lower interest rates no more they started their quantitative easing.  Printing money to buy bonds on the open market.  Flooding the economy with cheap money.  But people aren’t borrowing it.  Because the employment picture is so poor that they just aren’t spending money.  Either because they don’t have a job.  Only have a part time job.  Or are terrified they may lose their job.  And if they do lose their job the last thing they want when unemployed is a lot of debt they can’t service.  And then there’s Obamacare.  Forcing people to buy costly insurance.  Leaving them less to spend on other things.  And increasing the cost of doing business.  Another reason not to hire people.

So the economy is going nowhere.  And because of the bad economy businesses have no intentions of spending or expanding.  So they don’t need any of that cheap money.  So where is it going?  Wall Street.  The only people who are borrowing and spending money.  They’re taking that super cheap money and they’re using it to buy and sell stocks.  They’re buying and selling like never before.  Making huge profits.  Thanks to other people’s money.  This is what is raising stock prices.  Not profitable businesses operations.  But investors bidding up stock prices with borrowed money.  The people on Wall Street are having the time of their lives during the Obama administration.  Because the Obama administration’s policies favor the rich on Wall Street.  Whose only worry these days is if the Fed stops printing money.  Which will raise interest rates.  And end the drunken orgy on Wall Street.  Which is why whenever it appears the Fed will taper (i.e., print less money each month) their quantitative easing because the economy is ‘showing signs of improvement’ investors panic and start selling.  In a rush to lock in their earnings before the stock prices they inflated come crashing down to reality.  For without that ‘free’ money from the Fed the orgy of buying will come to an end.  And no one wants to be the one holding on to those inflated stocks when the bubble bursts.  When there will be no more buyers.  At least, when there will be no more buyers willing to buy at those inflated stock prices.  Which is why investors today hate good economic news.  For there is nothing worse for an investor in the Obama economy than a good economy.

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The Austrian School of Economics

Posted by PITHOCRATES - March 3rd, 2014

Economics 101

(Originally published February 27th, 2012)

Because of the Unpredictable Human Element in all Economic Exchanges the Austrian School is more Laissez-Faire

Name some of the great inventions economists gave us.  The computer?  The Internet?  The cell phone?  The car?  The jumbo jet?  Television?  Air conditioning?  The automatic dishwasher?  No.  Amazingly, economists did not invent any of these brilliant inventions.  And economists didn’t predict any of these inventions.  Not a one.  Despite how brilliant they are.  Well, brilliant by their standard.  In their particular field.  For economists really aren’t that smart.  Their ‘expertise’ is in the realm of the social sciences.  The faux sciences where people try to quantify the unquantifiable.  Using mathematical equations to explain and predict human behavior.  Which is what economists do.  Especially Keynesian economists.  Who think they are smarter than people.  And markets.

But there is a school of economic thought that doesn’t believe we can quantify human activity.  The Austrian school.  Where Austrian economics began.  In Vienna.  Where the great Austrian economists gathered.  Carl Menger.  Ludwig von Mises.  And Friedrich Hayek.  To name a few.  Who understood that economics is the sum total of millions of people making individual human decisions.  Human being key.  And why we can’t reduce economics down to a set of mathematical equations.  Because you can’t quantify human behavior.  Contrary to what the Keynesians believe.  Which is why these two schools are at odds with each other.  With people even donning the personas of Keynes and Hayek to engage in economic debate.

Keynesian economics is more mainstream than the Austrian school.  Because it calls for the government to interfere with market forces.  To manipulate them.  To make markets produce different results from those they would have if left alone.  Something governments love to do.  Especially if it calls for taxing and spending.  Which Keynesian economics highly encourage.  To fix market ‘failures’.  And recessions.  By contrast, because of the unpredictable human element in all economic exchanges, the Austrian school is more laissez-faire.  They believe more in the separation of the government from things economic.  Economic exchanges are best left to the invisible hand.  What Adam Smith called the sum total of the millions of human decisions made by millions of people.  Who are maximizing their own economic well being.  And when we do we maximize the economic well being of the economy as a whole.  For the Austrian economist does not believe he or she is smarter than people.  Or markets.  Which is why an economist never gave us any brilliant invention.  Nor did their equations predict any inventor inventing a great invention.  And why economists have day jobs.  For if they were as brilliant and prophetic as they claim to be they could see into the future and know which stocks to buy to get rich so they could give up their day jobs.  When they’re able to do that we should start listening to them.  But not before.

Low Interest Rates cause Malinvestment and Speculation which puts Banks in Danger of Financial Collapse

Keynesian economics really took off with central banking.  And fractional reserve banking.  Monetary tools to control the money supply.  That in the Keynesian world was supposed to end business cycles and recessions as we knew them.  The Austrian school argues that using these monetary tools only distorts the business cycle.  And makes recessions worse.  Here’s how it works.  The central bank lowers interest rates by increasing the money supply (via open market transactions, lowering reserve requirements in fractional reserve banking or by printing money).  Lower interest rates encourage people to borrow money to buy houses, cars, kitchen appliances, home theater systems, etc.  This new economic activity encourages businesses to hire new workers to meet the new demand.  Ergo, recession over.  Simple math, right?  Only there’s a bit of a problem.  Some of our worst recessions have come during the era of Keynesian economics.  Including the worst recession of all time.  The Great Depression.  Which proves the Austrian point that the use of Keynesian policies to end recessions only makes recessions worse.  (Economists debate the causes of the Great Depression to this day.  Understanding the causes is not the point here.  The point is that it happened.  When recessions were supposed to be a thing of the past when using Keynesian policies.)

The problem is that these are not real economic expansions.  They’re artificial ones.  Created by cheap credit.  Which the central bank creates by forcing interest rates below actual market interest rates.  Which causes a whole host of problems.  In particular corrupting the banking system.  Banks offer interest rates to encourage people to save their money for future use (like retirement) instead of spending it in the here and now.  This is where savings (or investment capital) come from.  Banks pay depositors interest on their deposits.  And then loan out this money to others who need investment capital to start businesses.  To expand businesses.  To buy businesses.  Whatever.  They borrow money to invest so they can expand economic activity.  And make more profits.

But investment capital from savings is different from investment capital from an expansion of the money supply.  Because businesses will act as if the trend has shifted from consumption (spending now) to investment (spending later).  So they borrow to expand operations.  All because of the false signal of the artificially low interest rates.  They borrow money.  Over-invest.  And make bad investments.  Even speculate.  What Austrians call malinvestments.  But there was no shift from consumption to investment.  Savings haven’t increased.  In fact, with all those new loans on the books the banks see a shift in the other direction.  Because they have loaned out more money while the savings rate of their depositors did not change.  Which produced on their books a reduction in the net savings rate.  Leaving them more dangerously leveraged than before the credit expansion.  Also, those lower interest rates also decrease the interest rate on savings accounts.  Discouraging people from saving their money.  Which further reduces the savings rate of depositors.  Finally, those lower interest rates reduce the income stream on their loans.  Leaving them even more dangerously leveraged.  Putting them at risk of financial collapse should many of their loans go bad.

Keynesian Economics is more about Power whereas the Austrian School is more about Economics

These artificially low interest rates fuel malinvestment and speculation.  Cheap credit has everyone, flush with borrowed funds, bidding up prices (real estate, construction, machinery, raw material, etc.).  This alters the natural order of things.  The automatic pricing mechanism of the free market.  And reallocates resources to these higher prices.  Away from where the market would have otherwise directed them.  Creating great shortages and high prices in some areas.  And great surpluses of stuff no one wants to buy at any price in other areas.  Sort of like those Soviet stores full of stuff no one wanted to buy while people stood in lines for hours to buy toilet paper and soap.  (But not quite that bad.)  Then comes the day when all those investments don’t produce any returns.  Which leaves these businesses, investors and speculators with a lot of debt with no income stream to pay for it.  They drove up prices.  Created great asset bubbles.  Overbuilt their capacity.  Bought assets at such high prices that they’ll never realize a gain from them.  They know what’s coming next.  And in some darkened office someone pours a glass of scotch and murmurs, “My God, what have we done?”

The central bank may try to delay this day of reckoning.  By keeping interest rates low.  But that only allows asset bubbles to get bigger.  Making the inevitable correction more painful.  But eventually the central bank has to step in and raise interest rates.  Because all of that ‘bidding up of prices’ finally makes its way down to the consumer level.  And sparks off some nasty inflation.  So rates go up.  Credit becomes more expensive.  Often leaving businesses and speculators to try and refinance bad debt at higher rates.  Debt that has no income stream to pay for it.  Either forcing business to cut costs elsewhere.  Or file bankruptcy.  Which ripples through the banking system.  Causing a lot of those highly leveraged banks to fail with them.  Thus making the resulting recession far more painful and more long-lasting than necessary.  Thanks to Keynesian economics.  At least, according to the Austrian school.  And much of the last century of history.

The Austrian school believes the market should determine interest rates.  Not central bankers.  They’re not big fans of fractional reserve banking, either.  Which only empowers central bankers to cause all of their mischief.  Which is why Keynesians don’t like Austrians.  Because Keynesians, and politicians, like that power.  For they believe that they are smarter than the people making economic exchanges.  Smarter than the market.  And they just love having control over all of that money.  Which comes in pretty handy when playing politics.  Which is ultimately the goal of Keynesian economics.  Whereas the Austrian school is more about economics.

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Businesses and Jobs tend to move from Countries with High Regulatory Costs to ones with Low Regulatory Costs

Posted by PITHOCRATES - February 23rd, 2014

Week in Review

A business is an investment.  Business owners invest capital and labor to make money.  Just like people buy government bonds to make money.  Of course, investing in government bonds is safe but it doesn’t create any jobs.  So we prefer when investors invest in a business.  Because a business will create jobs.

So where would investors prefer to risk their money?   That depends on the expected return on investment.  Historically there was always more money to be made in a business.  But higher regulatory costs have reduced that return on investment.  Leading a lot of investors to turn to government bonds.  Or to move their businesses to another country.  One with a less costly regulatory environment (see The rich world needs to cut red tape to encourage business posted 2/22/2014 on The Economist).

Singapore has come out on top as the least burdensome for the past eight years (see chart 3), whereas many EU countries are bumping along near the bottom. Of the 148 countries surveyed in 2013, Spain was ranked 125th, France 130th, Portugal 132nd, Greece 144th and Italy 146th.

Americans who complain about the Obama administration’s unhelpfulness towards business will also note ruefully that over the past seven years their country has slipped from 23rd to 80th place…

Broadly speaking, in recent years emerging markets seem to have been cutting their red tape whereas the rich world has been strengthening its regulatory regime…

But not all labour laws are equally useful. In much of Europe the problem is that regulations designed to protect existing workers from unfair dismissal often make employers reluctant to take on new ones. One international executive recounts the tale of a French worker who had been with his employer for just three years but was entitled to five years’ compensation for dismissal. “We wouldn’t put anyone in France if we can possibly avoid it,” the executive said…

The danger is that, once European companies come to expand capacity again, they may do so outside the euro zone, where employment contracts are more flexible and wages and social costs are lower…

The EU not only has inflexible labour markets and high costs; it has slower growth prospects than most emerging markets. That will tempt many businesses to move elsewhere. “Western Europe is at a severe disadvantage because of the costs when you have to restructure your operations,” says Martin Sorrell, the boss of WPP. By contrast, Singapore has a low tax rate, a light regulatory regime and an enviable location at the heart of Asia. Sir Martin thinks some multinationals will eventually move their headquarters to the city-state.

The best way to protect workers is with a robust economy.  Not regulations.  If you lower the tax burden and regulatory costs the return on investment on businesses will soar past the return on investment from government bonds.  And investors would put their money into businesses to make more money.  This is how you help workers get better pay and benefits.  You create such economic activity that there are more jobs than people to fill them.  Forcing employers to offer higher wages and better benefits.  The way it was when the United States became the number one economy in the world.  Not the way it is currently in the EU.  Or the United States.  Where the Great Recession lingers on.  Thanks to an anti-business economic climate.  And the mother of all costly regulatory policies.  Obamacare.

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FT202: “You can’t indulge selfishness, narcissism and hedonism and expect the young to give up their life of consumption and gratification.” —Old Pithy

Posted by PITHOCRATES - December 27th, 2013

Fundamental Truth

The Generation that won World War II Sacrificed and Saved for the Future

The generation that lived through the Great Depression and World War II were a hardy people.  They knew a thing or two about sacrifice.  And going without.  For their wants often went unfulfilled.  And they were a skinny people.  As there was not a lot of food to eat.  First because of the Great Depression.  When people could barely afford to stay alive.  And then World War II.  Where the government rationed almost everything for the war effort.

So they spent little.  Saved what they could.  Got used to not having what they wanted.  And always worked hard for a better future.  Sound familiar?  No.  Of course not.  No one’s like this today.  That hardy generation survived the Great Depression and won World War II.  Making the world safe for democracy to flourish.  Their free market capitalism made a prosperous world of plenty.  So their children would never have to live in a world they had lived in.  As it turned out, though, that was a mistake.

Their children were not like their parents.  These baby boomers were not as hardy as their parents were.  While they struggled and went without the baby boomers didn’t.  The baby boomers became the Me Generation.  Because it was all about them.  They rejected the hard work and sacrifice of their parents.  And didn’t save for a better tomorrow.  No.  For them it was all about the here and now.

The Me Generation rebelled against their Parents and became Anti-Parents

The Me Generation didn’t save like their parents.  They spent.  Changing the economy forever.  From one made strong and healthy driven by private savings that banks converted into investment capital.  To a Keynesian one.  Where Keynesian economists viewed savings as economic leaks from the economy.  No.  Spending was better.  Consumption was better than saving.  Besides, what did we have to save for anymore with the Federal Reserve printing money?  And the government paying our way for us in retirement?

The Me Generation was only too happy to help transform the government from one of savings and investment to one of consumptionand gratification.  And they lived Life in the Fast Lane (by Joe Walsh, Glenn Frey and Don Henley, recorded by the Eagles in 1976 on the studio album Hotel California).   “Everything all of the time.”  And when that wasn’t enough there was cocaine to fill the remaining emptiness.  “There were lines on the mirror, lines on her face.”  Sometimes the drug use became so intense it interfered with another past time of the Me Generation.  Sex.  “He was too tired to make it, she was too tired to fight about it.”

So while their parents won the Second World War they were partying and getting high and having as much casual sex as their excessive drug use allowed.  And because of it the Seventies gave us a new drug in the Eighties.  Crack.  And a war on drugs.  As well as AIDS.  Thank you, Me Generation.  For rebelling against your parents and becoming anti-parents.  Destroying our past culture and traditions.  And our religion.  Just so you can have “everything all of the time.”  Right now.  Without ever waiting to gratify an urge or desire.

Obamacare will Fail because the Young won’t give up their Life of Consumption and Gratification

The counterculture (i.e., the anti-parents) movement then entered academia.  Took over the curriculum in our public schools.  And our colleges and universities.  Where they taught our kids that everything their parents told them was wrong.  That they are destroying the environment.  That American imperialism is the greatest threat to world peace.  That the Founding Fathers were rich white slave owners who wrote the Constitution to further their greed.  That free market capitalism is cruel, callous and unfair.  While government is kind, feeling and fair.

The Me Generation learned something valuable as they entered academia.  And government.  That there are a lot of young people who vote.  And because many of them grew up already rebelling against their parents they pushed these people closer to them.  The anti-parents.  Helping them to hold on to political power.  So they appealed to all the things young people want.  Such as sex.  By providing free birth control and access to abortion.  They attack Christianity and tell their students there is nothing wrong with their life of consumption and gratification.  And, of course, they favor decriminalizing drugs.  And are making great headway in that area with marijuana.  I mean, kids just love the Democrats.  For they indulge their every want and desire.  Without parenting them to sacrifice and save for their future.  Like their insufferable parents.

So our young have never been defined more by selfishness, narcissism and hedonism.  Always living for the moment.  Without a care in the world for the future.  Making even the Me Generation seem selfless.  Who lived in relative anonymity in their narcissistic world.  Unlike today’s youth.  Who can’t survive without Instagram, Twitter and Facebook.   And must share every iota of their existence with the entire world.  Because it’s all about them.  The world revolves around them and the pursuit of their life of consumption and gratification.  So it is rather ironic that the very thing that keeps Democrats in power—indulging in the youth voters’ selfishness, narcissism and hedonism—could deal such a threatening blow to their power.  For Obamacare to work they need these young voters to be more like their parents and less like the people they are.  Thanks to the Democrat indoctrination in our public schools, colleges and universities.  To sacrifice some of their wants and desires to help their parent’s generation.  To consume less.  So the people they rebelled against can have free medical care.

This is why Obamacare (the Affordable Care Act) will fail.  The young and healthy do not want to give up their life of consumption and gratification.  Which means they’re not buying health insurance.  Only the old and sick are.  Because they need health care.  While the young and healthy don’t.  So they are not going to buy costly health insurance policies that they feel they will never use.  Instead they’ll pay the lower-cost fine.  So they can continue to live their life of consumption and gratification.  That the Democrats told them all their life was what they should do.  Not to save for the future.  Or sacrifice.  For their parents.  Their community.  Or their God.  So the Affordable Care Act will fail.  Because you can’t indulge selfishness, narcissism and hedonism and expect the young to give up their life of consumption and gratification.

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Panic of 1907, Federal Reserve Act and Depression of 1920

Posted by PITHOCRATES - December 17th, 2013

History 101

In 1907 the Heinze Brothers thought Investors were Shorting the Stock of their United Copper Company

Buying and selling stocks is one way to get rich.  Typically by buying low and selling high.  But you can also get rich if the stock price falls.  How you ask?  By short-selling the stock.  You borrow shares of a stock that you think will fall in price.  You sell them at the current price.  Then when the stock price falls you buy the same number of shares you borrowed at the lower price.  And use these to return the shares you borrowed.  You subtract the price you pay to buy the cheaper shares from the proceeds of selling the costlier shares for your profit.  And if the price difference/number of shares is great enough you can get rich.

In 1907 the Heinze brothers thought investors were shorting the stock of their United Copper Company.  So they tried to turn the tables on them and get rich.  They already owned a lot of the stock.  They then went on a buying spree with the intention of raising the price of the stock.  If they successfully cornered the market on United Copper Company stock then the investors shorting the stock would have no choice but to buy from them to repay their borrowed shares.  Causing the short sellers to incur a great loss.  While reaping a huge profit for themselves.

Well, that was the plan.  But it didn’t quite go as planned.  For they did not control as much of the stock as they thought they did.  So when the short-sellers had to buy new shares to replace their borrowed shares they could buy them elsewhere.  And did.  When other investors saw they weren’t going to get rich on the cornering scheme the price of the stock plummeted.  For the stock was only worth that inflated price if the short-sellers had to buy it at the price the Heinze brothers dictated.  When the cornering scheme failed the stock they paid so much to corner was worth nowhere near what they paid for it.  And they took a huge financial loss.  But it got worse.

The Panic of 1907 led to the Federal Reserve Act of 1913

After getting rich in the copper business in Montana they moved east to New York City.  And entered the world of high finance.  And owned part of 6 national banks, 10 state banks, 5 trusts (kind of like a bank) and 4 insurance companies.  When the cornering scheme failed the Heinze brothers lost a lot of money.  Which spooked people with money in their banks and trusts.  As these helped finance their scheme.  So the people rushed to their banks and pulled their money out.  Causing a panic.  First their banks.  Then their trusts.  Including the Knickerbocker Trust Company.  Which collapsed.  As the contagion spread to other banks the banking system was in risk of collapsing.  Causing a stock market crash.  Resulting in the Panic of 1907.

Thankfully, a rich guy, J.P. Morgan, stepped in and saved the banking system.  By using his own money.  And getting other rich guys to use theirs.  To restore liquidity in the banking system.  To avoid another liquidity crisis like this Congress passed the Federal Reserve Act (1913).  Giving America a central bank.  And the progressives the tool to take over the American economy.  Monetary policy.  By tinkering with interest rates.  And breaking away from the classical economic policies of the past that made America the number one economic power in the world.  Built on a foundation of thrift, savings, investment, free trade, the gold standard, etc.  Where people saved for the future.  The greater their savings the more investment capital there was.  And the lower interest rates were.

The Federal Reserve (the Fed) changed all of that.  By printing money to keep interest rates artificially low.  Giving us boom and bust cycles as people over invest and over build because of cheap credit.  Leading to bubbles (the boom) in asset prices that painful recessions (the bust) correct.  Instead of the genuine growth that we got when our savings determined interest rates.  Where there is no over-investing or over-building.  Because the limited investment capital did not permit it.  Guaranteeing the efficient flows of capital to generate real economic activity.

Warren Harding’s Tax Cuts ignited Economic Activity and gave us the Modern World

Thanks to the Fed there was a great monetary expansion to fund World War I.  The Fed cut the reserve requirements in half for banks.  Meaning they could loan more of their deposits.  And they did.  Thanks to fractional reserve banking these banks then furthered the monetary expansion.  And the Fed kept the discount rate low to let banks borrow even more money to lend.  The credit expansion was vast.  Creating a huge bubble in asset prices.  Creating a lot of bad investments.  Or malinvestments.  Economist Ludwig von Mises had a nice analogy to explain this.  Imagine a builder constructing a house only he doesn’t realize he doesn’t have enough materials to finish the job.  The longer it takes for the builder to realize this the more time and resources he will waste.  For it will be less costly to abandon the project before he starts than waiting until he’s built as much as he can only to discover he will be unable to sell the house.  And without selling the house the builder will be unable to recover any of his expenses.  Giving him a loss on his investment.

The bigger those bubbles get the farther those artificially high prices have to fall.  And they will fall sooner or later.  And fall they did in 1920.  Giving us the Depression of 1920.  And it was bad.  Unemployment rose to 12%.  And GDP fell by 17%.  Interestingly, though, this depression was not a great depression.  Why?  Because the progressives were out of power.  Instead of the usual Keynesian solution to a recession Warren Harding (and then Calvin Coolidge after Harding died in office) did the opposite.  There was no stimulus deficit-spending.  There was no playing with interest rates.  Instead, Harding cut government spending.  Nearly in half.  And he cut tax rates.  These actions led to a reduction of the national debt (that’s DEBT—not deficit) by one third.  And ignited economic activity.  Ushering in the modern world (automobiles, electric power, radio, telephone, aviation, motion pictures, etc.).  Building the modern world generated real economic activity.  Not a credit-driven bubble.  Giving us one of the greatest economic expansions of all time.  The Roaring Twenties.  Ending the Depression of 1920 in only 18 months.  Without any Fed action or Keynesian stimulus spending.

By contrast FDR used almost every Keynesian tool available to him to end the Great Depression.  But his massive New Deal spending simply failed to end it.  After a decade or so of trying.  Proving that government spending cannot spend an economy out of recession.  But cuts in government spending and cuts in tax rates can.  Which is why the Great Recession lingers on still.  Some 6 years after the collapse of one of the greatest housing bubbles ever.  Created by one of the greatest credit expansions ever.  For President Obama is a Keynesian.  And Keynesian policies only lead to boom-bust cycles.  Not real economic growth.  The kind we got from classical economic policies.  Built on a foundation of thrift, savings, investment, free trade, the gold standard, etc.  The economic policies that made America the number economic power in the world.

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China’s Continuing Credit Expansion is Starting to Worry the IMF

Posted by PITHOCRATES - September 15th, 2013

Week in Review

As the U.S. fiscal year draws to a close the Republicans and Democrats are digging in their heels over the upcoming debt ceiling debate.  The Republicans want to cut spending and taxes to rein in out-of-control spending.  So they don’t have to keep borrowing money.  Running up the national debt.  The Democrats, on the other hand, say, “Who cares about the debt?  We’ll be dead and buried when the nation collapses under the weight of this mammoth debt load.  As long as we get what we want why should we care about future generations?”  At least, that’s what their actions say.

A lot of leading economists on the left, Keynesians economists, see no problem in running up the debt.  Print that money, they say.  Keep that expansion growing.  What could possibly go wrong?  Especially when the federal government has the power to print money?  Just look at what the Japanese did in the Eighties.  And what the Chinese are doing now (see As the West Faltered, China’s Growth Was Fueled by Debt by Christina Larson posted 9/12/2013 on Bloomberg Businessweek).

As demand for Chinese exports diminished in the wake of the financial meltdown, the Chinese economy kept humming at more than 9 percent annual gross domestic product growth each year from 2008 to 2011. The trick? “A huge monetary expansion and lending boom,” says Patrick Chovanec, chief strategist at Silvercrest Asset Management and a former professor at Tsinghua University’s School of Economics and Management in Beijing. With bank lending restrictions loosened in late 2008, “Total debt accelerated from 148 percent to 205 percent of GDP over 2008-12,” according to a May 2013 report from research firm CLSA Asia-Pacific Markets. When Beijing tried to rein in the banks beginning in late 2010, shadow banking—lending outside the formal sector—exploded. Today “China is addicted to debt to fuel growth,” according to the CLSA report, with the economy hampered by “high debt and huge excess capacity with only 60 percent utilization.”

The Beijing-based firm J. Capital Research dubbed 2012 the “Year of the (White) Elephant” in a report detailing some of China’s questionable infrastructure build-out. To take one example, 70 percent of the country’s airports lose money, yet more are being built in small and remote cities. At the shiny new Karamay Airport in far western Xinjiang province, there are four check-in counters serving two flights daily. Local governments have splurged on “new towns” and “special zones,” many of which have already fallen into disrepair. The $5 million Changchun Zhenzhuxi Park, intended as a scenic area, is now a large public garbage dump, as the local landscaping bureau never agreed to provide maintenance. Near the southern city of Hangzhou, a forlorn replica of the Eiffel Tower overlooks a faux Paris—the ersatz arrondissement attracted hardly any residents, and local media have dubbed it a ghost town.

“In China, you often hear people say they’re building for the future,” explains Chovanec. “But if you build something and it’s empty for 20 years, does that make any sense? By that point, it may already be falling apart.”

The classic Keynesian argument for economic stimulus is the one about paying people to dig a ditch.  Then paying them to fill in the ditch they just dug.  The ditch itself having no economic value.  But the people digging it and filling it in do.  For they will take their earnings and spend it in the economy.  But the fallacy of this argument is that money given to the ditch-diggers and the fillers-in could have been spent on something else that does have economic value.  Money that was pulled out of the private sector economy via taxation.  Or money that was borrowed adding to the national debt.  And increasing the interest expense of the nation.  Which negates any stimulus.

If that money was invested to expand a business that was struggling to keep up with demand that money would have created a return on investment.  That would last long after the people who built the expansion spent their wages.  This is why Keynesian stimulus doesn’t work.  It is at best temporary.  While the long-term costs are not.  It’s like getting a 30-year loan to by a new car.  If you finance $35,000 over 5 years at a 4.5% annual interest rate your car payment will be $652.51 and the total interest you’ll pay will be $4,018.95.  That’s $39,018.95 ($35,000 + 4,018.95) of other stuff you won’t be able to buy because of buying this car.  If you extend that loan to 30 years your car payment will fall to $177.34.  But you will be paying that for 30 years.  Perhaps 20-25 years longer than you will actually use that car.  Worse, the total interest expense will be $23,620.24 over those 30 years.  That’s $58,620.24 ($35,000 + 23,620.24) of stuff you won’t be able to buy because of buying this car.  Increasing the total cost of that car by 50.2%.

This is why Keynesian stimulus does not work.  Building stuff just to build stuff even when that stuff isn’t needed will have long-term costs beyond any stimulus it provides.  And when you have a “high debt and huge excess capacity with only 60 percent utilization” bad things will be coming (see IMF WARNS: China Is Taking Ever Greater Risks And Putting The Financial System In Danger by Ambrose Evans-Pritchard, The Telegraph, posted 9/13/2013 on Business Insider).

The International Monetary Fund has warned that China is taking ever greater risks as surging credit endangers the financial system, and called for far-reaching reforms to wean the economy off excess investment…

The country has relied on loan growth to keep the economy firing on all cylinders but the law of diminishing returns has set in, with the each yuan of extra debt yielding just 0.20 yuan of economic growth, compared with 0.85 five years ago. Credit of all types has risen from $9 trillion to $23 trillion in five years, pushing the total to 200pc of GDP, much higher than in emerging market peers…

China’s investment rate is the world’s highest at almost 50pc of GDP, an effect largely caused by the structure of the state behemoths that gobble up credit. This has led to massive over-capacity and wastage.

“Existing distortions direct the flow of credit toward local governments and state-owned enterprises rather to households, perpetuating high investment, misallocation of resources, and low private consumption. A broad package of reforms is needed,” said the IMF.

Just like the miracle of Japan Inc. couldn’t last neither will China Inc. last.  Japan Inc. put Japan into a deflationary spiral in the Nineties that hasn’t quite yet ended.  Chances are that China’s deflationary spiral will be worse.  Which is what happens after every Keynesian credit expansion.  And the greater the credit expansion the more painful the contraction.  And with half of all Chinese spending being government spending financed by printing money the Chinese contraction promises to be a spectacular one.  And with them being a primary holder of US treasury debt their problems will ricochet through the world economy.  Hence the IMF warning.

Bad things are coming thanks to Keynesian economics.  Governments should have learned by now.  As Keynesian economics turned a recession into the Great Depression.  It gave us stagflation and misery in the Seventies.  It gave the Japanese their Lost Decade (though that decade actually was closer 2-3 decades).  It caused Greece’s economic collapse.  The Eurozone crisis.  And gave the U.S. record deficits and debt under President Obama.

The history is replete with examples of Keynesian failures.  But governments refuse to learn these lessons of history.  Why?  Because Keynesian economics empowers the growth of Big Government.  Something free market capitalism just won’t do.  Which is why communists (China), socialists (the European social democracies) and liberal Democrats (in the United States) all embrace Keynesian economics and relentlessly attack free market capitalism as corrupt and unfair.  Despite people enjoying the greatest liberty and economic prosperity under free market capitalism (Great Britain, the United States, Canada, Australia, Hong Kong, Taiwan, South Korea, etc.).  While suffering the most oppression and poverty under communism and socialism (Nazi Germany, the Soviet Union, the communist countries behind the Iron Curtain in Eastern Europe, the People’s Republic of China under Mao, North Korea, Cuba, etc.).

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Post Office, Telegraph, Telephone, Cell Phones, Texting, Technology, Productivity, Savings, Investment, Japan Inc. and Eurozone Crisis

Posted by PITHOCRATES - August 13th, 2013

History 101

(Originally published August 28th, 2012)

Ben Franklin’s Post Office struggles to Stay Relevant in a World where Technology offers a Better Alternative

Once upon a time people stayed in touch with each other by mailing letters to each other.  Benjamin Franklin helped make this possible when he was America’s first Postmaster General of the United States.  And it’s in large part due to his Post Office that the American Revolutionary War became a united stand against Great Britain.  As news of what happened in Massachusetts spread throughout the colonies via Franklin’s Post Office.

In America Samuel Morse created a faster way to communicate.  (While others created this technology independently elsewhere.)  Through ‘dots’ and ‘dashes’ sent over a telegraph wire.  Speeding up communications from days to seconds.  It was fast.  But you needed people who understood Morse code.  Those dots and dashes that represented letters.  At both ends of that telegraph wire.  So the telegraph was a bit too complicated for the family home.  Who still relied on the Post Office to stay in touch

Then along came a guy by the name of Alexander Graham Bell.  Who gave us a telephone in the house.  Which gave people the speed of the telegraph.  But with the simplicity of having a conversation.  Bringing many a teenage girl into the kitchen in the evenings to talk to her friends.  Until she got her own telephone in her bedroom.  Then came cell phones.  Email.  Smartphones.  And Texting.   Communication had become so instantaneous today that no one writes letters anymore.  And Ben Franklin’s Post Office struggles to stay relevant in a world where technology offers a better alternative.

As Keynesian Monetary Policy played a Larger Role in Japan Personal Savings Fell

These technological advances happened because people saved money that allowed entrepreneurs, investors and businesses to borrow it.  They borrowed money and invested it into their businesses.  To bring their ideas to the market place.  And the more they invested the more they advanced technology.  Allowing them to create more incredible things.  And to make them more efficiently.  Thus giving us a variety of new things at low prices.  Thanks to innovation.  Risk-taking entrepreneurs.  And people’s savings.  Which give us an advanced economy.  High productivity.  And growing GDP.

Following World War II Japan rebuilt her industry and became an advanced economy.  As the U.S. auto industry faltered during the Seventies they left the door open for Japan.  Who entered.  In a big way.  They built cars so well that one day they would sell more of them than General Motors.  Which is incredible considering the B-29 bomber.  That laid waste to Japanese industry during World War II.  So how did they recover so fast?  A high savings rate.  During the Seventies the Japanese people saved over 15% of their income with it peaking in the mid-Seventies close to 25%.

This high savings rate provided enormous amounts of investment capital.  Which the Japanese used not only to rebuild their industry but to increase their productivity.  Producing one of the world’s greatest export economies.  The ‘Made in Japan’ label became increasingly common in the United States.  And the world.  Their economic clot grew in the Eighties.  They began buying U.S. properties.  Americans feared they would one day become a wholly owned subsidiary of some Japanese corporation.  Then government intervened.  With their Keynesian economics.  This booming economic juggernaut became Japan Inc.  But as Keynesian monetary policy played a larger role personal savings fell.  During the Eighties they fell below 15%.  And they would continue to fall.  As did her economic activity.  When monetary credit replaced personal savings for investment capital it only created large asset bubbles.  Which popped in the Nineties.  Giving the Japanese their Lost Decade.  A painful deflationary decade as asset prices returned to market prices.

Because the Germans have been so Responsible in their Economic Policies only they can Save the Eurozone

As the world reels from the fallout of the Great Recession the US, UK and Japan share a lot in common.  Depressed economies.  Deficit spending.  High debt.  And a low savings rate.  Two countries in the European Union suffer similar economic problems.  With one notable exception.  They have a higher savings rate.  Those two countries are France and Germany.  Two of the strongest countries in the Eurozone.  And the two that are expected to bail out the Eurozone.

Savings Rate

While the French and the Germans are saving their money the Japanese have lost their way when it comes to saving.  Their savings rate plummeted following their Lost Decade.  As Keynesian economics sat in the driver seat.  Replacing personal savings with cheap state credit.  Much like it has in the US and the UK.  Nations with weak economies and low savings rates.  While the French and the Germans are keeping the Euro alive.  Especially the Germans.  Who are much less Keynesian in their economics.  And prefer a more Benjamin Franklin frugality when it comes to cheap state credit.  As well as state spending.  Who are trying to impose some austerity on the spendthrifts in the Eurozone.  Which the spendthrifts resent.  But they need money.  And the most responsible country in the Eurozone has it.  And there is a reason they have it.  Because their economic policies have been proven to be the best policies.

And others agree.  In fact there are some who want the German taxpayer to save the Euro by taking on the debt of the more irresponsible members in the Eurozone.  Because they have been so responsible in their economic policies they’re the only ones who can.  But if the Germans are the strongest economy shouldn’t others adopt their policies?  Instead of Germany enabling further irresponsible government spending by transferring the debt of the spendthrifts to the German taxpayer?  I think the German taxpayer would agree.  As would Benjamin Franklin.  Who said, “Industry, Perseverance, & Frugality, make Fortune yield.”  Which worked in early America.  In Japan before Japan Inc.  And is currently working in Germany.  It’s only when state spending becomes less frugal that states have sovereign debt crises.  Or subprime mortgage crisis.  Or Lost Decades.

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Celestial Navigation, Insurance and the Joint Stock Company

Posted by PITHOCRATES - July 10th, 2013

Technology 101

(Originally published November 30th, 2011)

Despite Precise Celestial Navigation a lot of Ships and Valuable Cargoes still got Lost at Sea

Open sea navigation was once very perilous.  It took a long time before ships ventured from sight of the shoreline.  And a lot of technology.  Boats used to go the long way across the Mediterranean Sea.  Because being in open water at night without any visible landmarks was very dangerous.  So they hugged the coastline.  Adding days to every voyage.  And more danger.  Because the longer at sea the greater the risk there was of sinking.  Especially when you were skirting the rock-infested shallows of the shoreline.

The Sumerians charted the stars.  The Greeks continued this work, producing charts that could tell you what latitude (north/south position) you were at by looking at the stars and planets.  By measuring the angle of the stars and planets above the horizon.  The Arabs created one of the first tools to measure these angles.  The kamal.  Knowing this angle you could do a little math and look at a pre-calculated table of values.  And get your latitude.  Better instruments followed.  The cross-staff.  The astrolabe.   And then the sextant.  The gold standard of angle measuring until the advent of Global Positioning Satellites (GPS).  Calculating longitude (east/west position) was a bit more complicated.  Because the earth rotated.  Which required some more skillful measuring and more calculations.  And/or a reliable and accurate clock.  To adjust your results by the time of day.  As the time as well as the stars moved from east to west as the planet rotated.

The Chinese developed the magnetic compass.  A helmsman steered his ship by the compass.  The navigator checked the angles of celestial bodies (sun, moon, stars and planets), checked time and the ship’s speed to fix the ship’s position.  By determining latitude and longitude.  The navigator fed course headings and course corrections to the helmsman.  Armed with these skills, tools, celestial charts and tables, the navigator could do a little math and navigate a ship across a vast ocean day or night to any port in the world.  Transporting valuable cargoes safely and timely across the globe.  Pretty impressive for the time.  But despite this precise celestial navigation, a lot of ships still got lost at sea.  As well as their valuable cargoes.

The Joint-Stock Company and Insurance Reduced the High Risks of Transoceanic Shipping

No matter how well a navigator could fix a ship’s position there were some things he just couldn’t do.  Such as avoid an uncharted reef.  Prevent a mutiny.  Fend off pirates.  Fend off enemy warships.  Make storms go away.  Or even see through dense fog.  Simply put being on a small wooden ship in the middle of an ocean was very dangerous.  Which poised quite the problem for early global trade.

It was a huge investment to put a ship to sea.  It took another huge investment to fill a ship with valuable cargo.  And if that ship didn’t make it back to sell that cargo it was very bad news for the investor.  A lost ship could financially ruin them.  So not only could you get rich in this new global trade you could become impoverished.  Which made rich people reluctant to finance this early trade.  Because it was so risky.  Two things helped to reduce this risk to manageable levels.  Insurance.  And the joint-stock company.

A group of investors could buy stock into a company that was going to make numerous voyages on various ships.  In exchange for a share of the profits from this trade each investor paid a share of its cost.  Thus the joint-stock company spread the risk to multiple investors, reducing the risk to any one person.  So one lost ship would not cause financial ruin to any one investor.  Thus encouraging investment into this lucrative new trade of transoceanic shipping.  And with the advent of insurance, shippers could insure each voyage for a small affordable fee.  By collecting this small fee on every voyage the insurer could pay for the few ships and cargoes lost at sea.  Not the investors.  Thus further encouraging investment into this very risky endeavor.

Celestial Navigation, Insurance and the Joint-Stock Company made Transoceanic Shipping Possible

The smartphone you can’t live without today most likely came to you via a large container ship from a port across some ocean.  It made a long and perilous voyage to get to you.  Which wouldn’t have been possible without celestial navigation, insurance and the joint-stock company.  The things that made transoceanic shipping possible.  Most of which are still in use today.  As they were when brave mariners took to the open seas in those small wooden ships of yesteryear.

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Thales of Miletus, Olive Oil, Tulip Mania of 1636 and the Chicago Board Options Exchange

Posted by PITHOCRATES - April 30th, 2013

History 101

Thales of Miletus was able to Predict a Bumper Crop of Olives

Italian restaurants will have a bottle of olive oil on the table.  The more authentic restaurants.  That give you a taste of old Italy.  Where they give you bread to munch on while you wait for your food.  We pour a little olive oil on a plate.  And dip our bread in it.  And enjoy that Mediterranean flavor.  Something that some of us may believe the Olive Garden brought to the dining experience.  But olive oil actually predates the Olive Garden.  We probably started eating olives for the first time around the 8th millennium BC.  When our Neolithic ancestors were still using stone tools.  Someplace in ancient Greece.

Olive trees grew all around the Mediterranean Sea.  And the Mediterranean people probably started using olive oil around the 4th millennium BC.   That’s 4000 BC.  Awhile ago.  We began to produce olive oil commercially somewhere around 2500 BC.  And began trading this luxury good.  We ate it.  Used it in religious rituals.  In medicines.  And fuel for oil lamps.  Among other uses.  As demand grew we planted more trees.  And brought in large harvests at the end of the growing season.  And took the olives to the olive presses.  And waited for our turn.  To pay the pressman to press our olives into oil.  And during a good growing season you could find yourself waiting quite awhile.

But who has time to wait?  If only we could figure out some way to avoid that long line.  Well, as it turned out, if you were smart you could.  As Thales of Miletus did.  A Greek astronomer, philosopher and mathematician.  As well as a pretty good weather forecaster.  For he was able to predict a bumper crop of olives one year because of favorable weather.  Which would make those olive presses busy at the harvest.  So he went to the olive press owners and reserved time on their presses for a nominal down payment.  So when the harvest came in he would be at the front of the line.  If he was wrong about his forecast he would give up his nominal deposit.  And walk away.  As the press owners didn’t care whose olives they were pressing they were glad to take his money for this right to buy press time later.  They had nothing to lose.  And when Thales prediction proved true and there was a bumper crop of olives those options to buy time on those presses became very valuable.  Those anxious to get their olives into the presses were glad to pay him for those options.  To buy his right to be first to buy press time.  Which he did.  Getting quite wealthy in the process.  As well as proving a point.  Rational thinking had real value.  They could use philosophy to make life better.

As Tulip Prices continued their Meteoric Rise the Speculators entered the Market to Get Rich Quick

And the option was born.  You can use them to speculate about the price of something in the future to make a lot of money.  And you can use them for hedging risk.  Such as farmers do.  They enter contracts with people to sell their crops at a set price.  Which protects the farmer if there is a bumper crop and prices fall.  Those who didn’t enter an options contract will only get the market price for their crops.  And have an unprofitable season.  While those with options contracts will be able to sell their crops above the market price.  And have a profitable season.  But if there are droughts that reduce the harvest prices will rise.  Which protects the buyer.  As he is able to buy below the market price.  At the price in the options contract.  While those buyers without options contracts will have to pay the higher market price.  Thus entering a contract hedges risk for both buyer and seller.  One party may do better than the other if there is a large swing in price.  But neither party will suffer a bad loss.  So whatever happens in that growing season they will be around for the following growing season.  But the speculators, on the other hand, can suffer great losses.

Tulips were big in the 17th century.  The affluent adorned their homes with these beautiful flowers.  And they soon became a sign of affluence.  Today people go to the affluent shops on Rodeo Drive and buy the latest in high fashion to show off their wealth.  In the 17th century they planted tulips.  People were impressed with what they saw.  And soon had to have these wonderful flowers themselves.  Causing a great surge in demand for tulips.  Which tulip growers rushed in to meet.  But the supply couldn’t keep up with the demand.  So tulip prices soared.  Soon, growers (sellers) and wholesalers (buyers) start entering options contracts to hedge their risks in the volatile tulip market.  As tulip prices continued their meteoric rise the speculators entered the market to get rich quick.  This speculation grew into such a frenzy that people would even mortgage their homes to raise money to buy tulip options.  Waiting for the big payday when they could exercise those options.  And buy tulips at one price.  Then resell them at a higher price.  A much higher price.  The demand for options grew so great that an options market opened.  And people bought and sold tulip options.

All good things must come to an end, though.  As must speculative bubbles.  And that happened in the Netherlands in 1637.  For there comes a time where buyers simply refuse to buy anymore tulips at those high prices.  And when they stopped buying people with vast amounts of tulips to sell began to panic.  And started lowering their price.  As other sellers started doing.  When interest in buying tulips fell supply began to exceed demand.  Sending the tulip price into a freefall.  With falling tulip prices no one was buying options contracts.  Because the market price was falling so fast that it would fall below the price in those options contracts.  And when they did ‘fall out of the money’ those options contracts became worthless.  And all that money the speculators poured into the options market was lost.  People lost everything.  Even their homes.  Sending the Dutch economy into a nasty recession.

With the Advent of the Internet it’s Never been Easier to Buy and Sell Options

Stock options were a way to get rich quick.  And what made them so attractive to speculators was leverage.  A small investment could turn into great riches.  But that leverage worked both ways.  And it could take that small investment and turn it into a great loss.  Should the price move in the wrong direction and fall when you have a contract obligating you to buy at a higher price.  And with the tulip mania of 1636 investors were getting a little gun-shy of options in general.  Causing the volume of options trading to fall in London.  Concerned of the speculative nature of options London made options trading illegal in 1733.  A ban that remained until 1860.

Russell Sage inaugurated options trading in the United States in 1872.  These were over the counter (OTC).  There was no central stock exchange.  Or standardized options format.  Which made the trading difficult to say the least.  Brokers placed ads in financial journals for their respective buyers and sellers.  And waited.  For someone to read the ad.  And call.  Then haggled over the price a bit.  Signed a contract.  And then waited until the expiration date of the option.  Or placed another ad in some financial journal.  To find someone else to buy the option.

Then things started changing in 1935.  The SEC granted a license to the Chicago Board of Trade (CBOT) as a national securities exchange.  And in 1968, CBOT finally did something with that license.  They created the Chicago Board Options Exchange (CBOE).  Which standardized and organized options trading.  One Nobel Prize later to Fischer Black and Myron Scholes for their “The Pricing of Options and Corporate Liabilities” we had a ‘scientific’ way for valuing stock options.  And with the advent of the Internet it’s never been easier to buy and sell options.  Allowing some to hedge risks easily.  While others live dangerously.  And speculate.  Trying to score big.  Before they lose everything trying to get rich quick.

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Off-Budget Social Security Surplus

Posted by PITHOCRATES - February 18th, 2013

Economics 101

Because we have Limited Income we Prioritize our Expenses

We all want more than we can afford.  We may want to drive a brand new Lincoln MKT but can only afford a used Focus.  So we drive a used Focus.  We may want to live on the beach in Southern California but can only afford a 2-bedroom apartment in Pasadena.  So we live in a 2-bedroom apartment in Pasadena.  We may want to dine on filet mignon and champagne every night but can only afford Hamburger Helper and a store-brand soda.  So we dine on Hamburger Helper and store-brand soda.

In life we have to make choices.  And live within our means.  So we budget our money. We list all our income.  And all of our expenses.  Breaking down the expenses in order of importance.  Rent is more important than cable television.  The electric bill is more important than stopping at Starbucks every morning for a Venti Caramel Macchiato.  The gas bill is more important than unlimited texting.  Because we have limited income we prioritize our expenses.  Those most important we budget to pay first.  Those less important we enjoy when we have some disposable income left over.  After paying everything that is more important first.

This is responsible living.  Which a lot of people do.  Live responsibly.  While some don’t.  And use credit cards to buy things they can’t afford.  Or they do a little work on the side ‘under the table’ for some extra spending cash.  Money they don’t report as income so they don’t have to pay income taxes on it.  Because like Billy Joel said you can pay Uncle Sam for the overtime.  Or not.  And a lot of people choose not.  Interestingly, a lot who do are die-hard Democrats who want to raise tax rates on the rich.  But when it comes to their hard-earned money they want to hide it from Uncle Sam.  But I digress.

Social Security Taxes are Dedicated for One Thing—Social Security Benefits

We can call money we earn on the side off-budget money.  We don’t add this money to our household budget.  It’s special money to spend on things we enjoy.  For if a husband does some plumbing work on the side his wife may want to use that money to pay down a credit card balance.  Or spend it on new window treatments.  While he may have other ideas for that money.  Maybe some new fishing equipment.  Or a new power tool.  Or maybe using it to go tailgating with the boys.  That money could buy a lot of food to barbecue.  And a lot of beer.  Things that are a lot of fun.  While paying down a credit card balance is not.  Just as window treatments are not.

So by keeping this money off-budget he can use it for what he originally intended it for.  Him having fun.  Keeping the money off the family budget prevents anyone from using those targeted funds for some other unintended purpose.  Preventing out of control spending growth on other less important things.  He is actually doing the family a favor by hiding this money.  Or so he rationalizes.  Because hiding it prevents his family from spending too much money.  For let’s face it if you have that additional money you’re going to budget it on something.  You may even commit to some long-term spending obligation.  Like buying a new Lincoln MKT.  Which will be a problem if the husband throws out his back doing all of those side jobs and goes on disability.

Another example of off-budget money is Social Security.  Specifically, the Social Security surplus.  Contrary to the government calling it a retirement investment it is not an investment.  The government collects Social Security tax revenue.  And pays Social Security benefits from that tax revenue.  What’s left over is the Social Security surplus.  (Until it becomes the Social Security deficit.)  And they put it into the Social Security Trust Fund.  Outside of the regular budget.  So they can’t spend it on other things.  And any budget negotiations won’t affect it.  For employers and employees pay into Social Security.  And this is the money we get back in benefits.  Those benefits are not budget items paid from all the other taxes the government collects.  That pay for things from defense spending to food stamps.  No.  Social Security taxes are dedicated for one thing.  Social Security benefits.  Which is why they moved it off-budget.

If the Deficit is Consistently Understated there will be no Money to Redeem the Securities in the Social Security Trust Fund

But that doesn’t stop the government from spending that money.  Just like so many unions have underfunded pension plans so, too, government can’t resist the allure of a great big pile of money.  Because it’s just sitting there.  Not being spent.  Something that just pains a politician to no end.  Unspent money.  But because it’s off-budget they just can’t spend it.  They have to borrow it first.  So the money goes into the Social Security Trust Fund.  They then remove the money from Social Security Trust Fund.  And leave behind an IOU.  Treasury securities.  Backed by the full faith and credit of the United States.

So even though that money is dedicated for Social Security benefits and is strictly hands-off for other spending the government spends it on other things.  And it works out pretty well for the government.  Not only do they get a little extra money to spend it helps conceal the extent of their other spending.  For this off-budget money decreases the budget deficit.  Caused by all of that on-budget spending.  That far exceeds their ability to pay for it.  To illustrate that see the following table.  This is a very simplified fictional federal budget.  We have tax receipts.  And federal outlays.  Broken down into two general categories.  Guns and butter.  That’s defense spending.  And everything else.  Note how if they leave the Social Security surplus alone (without) there is a deficit of 47%.  But if they borrow that money (with) it reduces the deficit to 10%.

Social Security Surplus Off-Budget

When they talk about the budget deficit it includes the Social Security surplus.  That money is dedicated for one thing.  Social Security benefits.  They’re not suppose to use it for anything else.  So they shouldn’t count this revenue in the budget that pays for everything else.  When they do they understate the true budget deficit.  Worse, the money in the Social Security Trust Fund does not earn a return on investment.  Like with a 401(k).  Yes, there are Treasury securities in the trust fund.  But a government that is consistently understating their true deficit will never have the money to redeem those securities.  So they will do the only thing they can.  Print money.  Which is what they mean by the full faith and credit of the United States.  Print money.  Causing inflation.  And raising prices.  Making that meager Social Security benefit buy less.  Not to mention that Social Security itself will soon be insolvent.  Thanks to the growth in all of that other spending.  That is growing so great that they continually need to raid the Social Security Trust Fund to pay for it.

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