Posted by AlexMerced on 06/30/10

Regulating Enterprise
by Alex Merced

Time and time again we hear in the news that we need stronger regulation on Oil, Housing, and Banking to prevent all the problems we've seen over the last few years. Today, I'd like to make the argument that the problems with all three of these sectors has everything to do with government intervention in the market and that the best regulation would be the natural regulation of natural risk in the markets. In the name of populism much of this natural risk has been removed from these enterprises in the name of "promoting business", "job creation", and "economic growth".

The initial problem with this rhetoric is that growth is always good, so rushing growth or artificial growth must be good too. For example, if I want to bulk up quicker I could begin to take steroids, although while that is growth it's not sustainable since I haven't built the discipline and lifestyle needed to maintain that bulk, so I become dependent on the steroids to maintain it.

So let's take a look at three types of natural risk that effect the entrepreneur when they are making the decision to enter an enterprise, and on how to run the enterprise. We'll see that these policies remove the aforementioned risks and like steroids prevent the kind of discipline needed to create sustainable businesses and growth.

Risk # 1 - The Ability to Raise Capital

Arguably, if an entrepreneur can't raise the money then he may never start the enterprise at all. Why would raising capital be difficult? This could be for a variety of reasons that all have to deal with he viability of the business and if potential investors/lenders see a demand for product/service, are the potential liabilities addressed, are the margins too thin, is it profitable in the short term? If government were to intervene to make capital easier to raise for such enterprises, it's easy to see how more of them would exist despite these typical investor concerns.

Oil - Oil is a very difficult business without government aid, because investors aren't typically very optimistic about the chances of finding oil when doing exploratory drilling. So to encourage investment into oil in the 60's and 70's tax shelters were created for oil investment in the form of Direct Participation Programs, and during a time of 70% tax rates one can see how a tax haven can be quite a benefit, you'd actually profit from the tax savings alone. So capital was being sucked into oil cause of the tax benefits, not cause of the merit of the enterprise... actually you'd lose money if they found oil cause it'd create a paper gain which you'd pay taxes on. So the capital raising issue was now done away with for Oil drilling at the expense of driving capital away from technology, medicine, alternative fuels that would've meant that the BP spill might've never happened cause the oil rig would've never been there since we would have divested from oil long ago.

Banking - Banks can be a risky proposition with tight margins. The problems being if the bank takes too much risk then depositors begin to take money out to move it to a safer bank, which would cause a bank run since banks don't have enough money to cover all their deposits in the FRACTIONAL RESERVE banking system we have now. On the other hand, if they practice safer banking practices and keep their depositors then their margins are very low and the growth of the company is low which is not what investors want to hear. So if we could prevent investors from worrying about risk that the banks taking, then the bank take on the risk necessary to get all the investment they need, so FDIC/SIPC are born. By creating a mandatory deposit insurance depositors feel at ease and become less concerned with moving their deposits, allowing banks with those deposits to get bigger and bigger by taking on more risk, while making hard and near impossible for newer banks to compete for those deposits without taking more risk as well.

Housing - Houses are a great investment but a house can take a long time to turn over, especially these days. If you factor in all the maintenance costs it can require a lot of upfront capital and not much in return in the mean time. Countless institutions were created to encourage investment in housing:

- Fannie and Freddie were created to buy mortgages from banks, so banks could keep making more and more mortgages which solves the demand/turnover issue that made investment in development weary.

- Housing which by all means is a capital good doesn't get taxes as a capital gain when sold for a profit, maximizing it's after-tax return versus stocks or bonds which are more liquid.

- REITS which are just real estate company shares get special Subchapter M tax treatment getting the same tax exemptions that mutual funds get.

- Mortgage Tax Credit

- Tax Shelters like the ones created for oil were created for housing, which actually allowed you invest non-recourse loans (loans in which they CAN'T garnish your wages or repossess your assets if you don't pay)

... a lot lot more...

Risk # 2 - Liabilities

Liability is a huge issue to any investor or entrepreneur, the more likely the chances of being sued or a disaster occurring that would incur lots of liabilities the less appetizing the reward becomes versus the risk. So if the liabilities aren't mitigated through government intervention, needless to say a lot of these risks would drive entrepreneurs and investors to more safe sustainable ventures where they can make a similar return. Even if the if they do decide to go into the enterprise, liability will keep the entrepreneur disciplined or else lose his hard work and more.

Oil - Everyone has heard about the liability cap set on Oil companies, on top of it you had tax incentives to drill farther off shore then drilling on shore (less royalties needed to be paid the father out you drilled) which combined makes the risk/reward calculation on drilling offshore a no brainer.

Banking - Once again you had very huge liability in the case that a risky investment didn't pan out, or if depositors suddenly began withdrawing money despite the the cover of FDIC. To prevent the liability of these scenarios the Federal Reserve was created as the lender of last resort, originally created in 1913 to address problems from severe branching regulations in the early 1900's. So with FDIC and keeping depositors feeling safe and the Federal Reserve coming to the rescue when excessive risk catches up with the banks... owning a bank is great idea, especially since it's the bankers who are the entry point of new highly powered money.

Housing - The major liability in investing in housing is well... not being able to sell the house or the person you lend to not making their mortgage payments. Fannie and Freddie combined with loose monetary policy from the fed really fed the demand so that these houses were more liquid and that mortgages could be affordable to the least qualified of borrowers. If you don't have to worry about these factors well... then why not invest in housing.

Risk #3 - Attracting Talent

In order to grow a large and ever growing enterprise one must attract the talent to do so. The problem if your business isn't very sustainable cause of excessive liabilities or low margins then compensation becomes difficult to afford for good talent. Also, the best talent seeks to be somewhere that the job seems safe and secure so if you decide to run a high risk business this may detract talent cause the risk of unemployment becomes to penalizing and the cost of private unemployment insurance would lower your wages you'd make more paying a much smaller premium for a safer company. In this Free Market environment the best talent would gravitate towards sustainable enterprise unless government reduces the risk of working for risky unsustainable enterprise.

For All Industries - Government Mandated Unemployment insurances creates non-variable cost for working for anyone, so it doesn't matter how safe the job is the payment into unemployment is the same, so then you might as well work for the high risk taking high salary company. Worse comes to worse you will not get a fraction of a larger salary for the next 6 months, so you get rewards for taking the riskier job since you benefits key into what you made before becoming unemployed.

Conclusion

If the government makes it easier for capital to gravitate towards riskier business, makes it easier to take more risk without incurring large liabilities, and allows these firms to easily make grabs at all the greatest talent around the globe... what do you expect to happen? Overpriced Housing, Overleveraged Banks, Oil Spills

Greed is not alone powerful enough to cause these kinds of problems, but with the helping hand of government big business can have all the roadblocks removed from becoming... "too big to fail" or better put "too big to succeed"

Posted by AlexMerced on 07/17/10

The Difference Between Inflation and Increasing Price Levels
by Alex Merced

One of the biggest debates right now is the inflation versus deflation debate, and much of this debate hinges on the events in consumer goods prices, but can inflation occur even if prices drop? Can prices go up even if inflation hasn't occurred? Yes, and to understand this you need to have a proper definition of inflation As your baseline.

Inflation - Inflation is an increase in the money supply, not the mere act of rising price levels. The Money supply can increase and prices react in all sorts of ways across different sectors of the economy, no matter how they react the fundamental relationship between the demand for goods and the supply of money has changed and it will have it's effects on the economy.

Hyperinflation - Hyperinflation has more nuanced definition, it's not just merely that prices are increasing at super speeds, but that the faith in the money as a medium of exchange has broken. A good money requires people to believe that if they accept it that they can in turn use to trade with someone else, cause the seller usually has no interest in the money itself other than for trading. Although if the supply of money is expected to grow at large rates for the foreseeable future less people will accept the money due to the fear of the loss of purchasing power from the growing supply. If people have believe that the money in itself is stable measure of value they have no reason to stop using no matter what happens to prices due to innovation gains or natural increases in demands.

Cause of Hyperinflation in a Fiat World - So in a sense hyperinflation occurs when people lose faith in the money, not when prices are allowed to merely rise. In todays Fiat money world, if a governments budget gets larger than it's tax base it must participate in deficit spending. If the government can borrow domestically or from other countries the effect on the supply of money is minimal, but if it cannot find the demand for it's debt from willing lenders then it's central bank will create the demand by increasing the money supply, although this punishes the original domestic and foreign lenders by giving their investment purchasing power risk.

Because of this risk, those lenders in future financing will decide to lend less if not at all meaning the central bank will have to further increase the money supply at even larger quantities. Once a governments budget gets to the point that the only way of financing is through these liquidity injections with no end in sight, less people will begin willing to sell their foreign currency for the domestic currency, meaning foreign goods will begin rise in price dramatically. So as the world begins to lose faith in the domestic currency, the amount of the currency needed to exchange for goods cause of the wavering faith in the currency will see it's hyper inflationary crash. Thus it's crisis of faith in a currency, not a crisis in consumer good prices.

Price Increase and Decreases - While increased in the money supply (inflation) will have upward pressure on prices and a decrease in the money supply (deflation) prices can still go down and up in either environment for a variety of different reasons. Prices of technology go down in an inflationary environment cause of innovation in technology allowing to make the same good at lower prices, although inflation can erase much the nominal drop in price. Another you may see a drop in prices is a drop in demand which may be for a variety of reasons such as better alternatives, credit crunches, and more. Prices can increase in a deflationary environment cause demand for new goods is large, or special programs make credit available for certain goods such as housing or college tuition. Although all these price and increases/decreases would affect the consumer price index (CPI) although they have no fundamental bearing on weather the money itself is a stable medium of exchange. So essentially programs like fannie, freddie, and sallie may help create price bubbles it's really the money supply increases from the central bank that will lead to the destruction of the currency.


So how do I assess todays environment? - Well take the true monetary definition of inflation/deflation one must ask which one are we in? It really depend on which measure of the money supply you use, if you use the numbers like M1,M2, M3 which go beyond the base bank reserves and measure the circulating credit then it would appear as we've been spinning towards deflation. Since there's less credit available there is essentially less money available meaning demand will be limited causing price drops which clearly have been seen in goods such as clothing and other luxuries, although this doesn't really paint a picture of what's going on when the government finances it's budget.

If you take a look at the monetary base (bank reserves/dollars), this number has exploded has doubled and tripled at certain points. When the central bank injects liquidity to help finance the governments budget, the entry point is the monetary base and while credit hasn't been created on top of this base yet, it's still a sign to lenders of the future risk of their investments in US Treasuries (government debt). With many of the politically difficult to remove expenditures of the government budget, deficits seem to be perpetual and the amount of willing lenders has decreased to the point where the central bank is the largest holder of that debt. So while you may not see runaway prices increases you are seeing the faith in the dollar as stable medium of exchange eroding with only the fact that it's the reserve currency of the world, which is something that will take some time for the rest of the world to divest from, but it won't take forever.


Bottom Line: While credit contraction will have downward pressure on consumer prices, the increasing monetary base in order finance a growing government deficit will erode the faith in the currency to cause the inevitable hyperinflation. 

Posted by AlexMerced on 04/21/10

The Effects of Public Policy on Private Activity
by Alex Merced

One of the problems of people who advocate for a growing role of government is that they operate in a mindset of unlimited resources, or that a growth in government has little to no effect on their current resources. The reality is that the economy has a static and generally decreasing amount of resources, so when the economy is being productive innovations will help us use less of these resources to accomplish our day to day tasks. This is the benefit of a free market or private activity, the innovations that allow the shrinking pie to be spread even further.

For these innovations one needs investment, capital, and ideas. Capital gravitates towards ideas, cause good ideas will serve as a magnet for even more capital, but again there is a limited amount of capital to gravitate towards these ideas. So essentially, to survive in a world of growing scarcity you need innovation which needs investment which is maximized by freeing up capital for investment.

So where does the government fit in on all of this?

Since there is limited resources not all of society will get fair slice of the pie, or even slice at all. Overtime though this percentage should shrink as innovations will free up these resources travel to more and more people in a variety of ways. Although people generally grow impatient for this to happen and will call for programs to watch for the welfare for those who are unable to get a piece of the pie. Although these programs themselves must take resources from this pie/economy to watch for the currently small amount of people outside of it.

The government has two ways to move resources from one place to another:

1. Government can tax the people and redistribute those resources to the outsiders, although the people are taxed this means the people have less resources to invest or consume, and since the potential consumption of a potential innovation is diminished the amount people are willing to invest in it is reduced.

2. Government can borrow the money but there is limited amount of loanable funds, so if the government borrows these funds then they can't be borrowed to invest in innovations also hampering the innovation process. Even worse, to pay this debt with interest the government must tax later resulting in the effect previously mentioned. So borrowing has a worse effect than taxation since it reduces current lending and future consumption.

The result:

In the end, after taking these resources out of the economy, the economy has less resources to support the population that it was able to support before (it's productive capacity has been reduced) and now even more people fall outside of the economy creating a demand for growth in the social programs previously established. The growth in demand will increase the size of these programs and increase the size of resources that must be taken out of the economy creating a cycle that drives more and more resources into these "public" programs and away from private production.

So while the public sector has gotten larger and larger, the world has survived in spite of this cause the innovation that has occured has minimized the impact of this resource drain. Innovation is the key to battling scarcity and in this case you want resources free to gravitate towards ideas meaning the public sector must be dismantled.

Posted by AlexMerced on 04/19/10

The Illusion of a "Standard" of Life
by Alex Merced

Government constantly uses the concept of a "standard" of life in justifying it's policies in the name of improving this standard. Can there really be a standard, this is only possible if you believe in objective values and that certain things all people will value the same cause of some sort of  intrinsic worth. The reality is every experience, good, service, etc. is subjectively valued so even if you standardized the resources available (which we know an unsustainable practice) you still have varying levels of quality of the life individuals from how they value their own lives. Individuals will all subjectively value those identical resources differently and subjectively value the experiences they get from them differently as well.

There is no way to standarized how people value goods and services, and there is not accurate way to measure these valuations much less aggregate them. The quality of someones life can be vary to low or high whether someone is rich, poor, or in whatever condition they are in it's realtive to their preferences and understanding of the world around them. With all this in mind, it's impossible to construct any policy that can truly create real value other than pushing arbritary numbers higher. On top of it, these numbers (statistics) don't quite capture the resources wasted now, or the resources that'll be lacking tomrrow cause of the artificial upward pressure put on these numbers by government. (such as GDP, College Enrollments, Construction Projects)

The only way for someone to improve the quality of their life isn't to push some imaginary floor of quality but to free a persons autonomy to pursue the things they value and prefer as long as it doesn't interfere with anyone elses ability to do the same in a direct manner (indirectly, every action can arguably affect everyone). So policy shouldn't be geared to improving a standard life that can't truly be measured but to pursue the liberty for individuals to try to find happiness.

I've seen poor and rich be misrable, and I've seen them both be joyous, and no government can replace the journey that is the one to fulfillment, self-discovery, and happiness.

Posted 04/20/10 MichaelBarry Sebring, FL

The only valid "standard of living" is that which is required to sustain life as a state distinguished from death. It is the objective of the statist society to reduce the wealth of all those whom it intends to impoverish as close to this level as possible. If a mistake is made and some one dies, so what?

Posted by AlexMerced on 04/16/10

I constantly speak about the dangers of inflation (increase in the money supply), and inflationary pressures of a growing government. Inflation destroys our purchasing power, causes malinvestment, and encourages risker investing. Inflation is primarily on my mind cause it's more imminent, government is naturally incentivised to inflate, so inflation and it's danger are practical concern although some take this to mean deflation (a decrease in the money supply) is the desired alternative.

They paint this utopian image that in a world of deflation that purchasing power increases, savings will increase meaning more capital for investment and it'll breed a more prudent and moral society. In reality, deflation or any manipulation of the money supply will cause distortions in the economic calculation of market participants, just in different ways.

With deflation artificially increasing the value of money, and what is the story whenever we artificially the price of any good? When prices are fixed above the market price less people will be willing to consume that good so you end up with a surplus. This would be the result of a deflationary environment that even though savings will be available for lending for projects, lenders will not want to pay the higher price of money and will choose not to lend it. So now you have underutilization of resources, and while I would prefer under spending than over spending this is still not ideal.

So does this mean a constant money supply is wanted, not neccessarily because of the downward price level adjustments that will constantly occur to a fixed supply. The only solution to the money supply issue is have a supply free from human influence, meaning no FIAT or paper money. In a world with a commodity backed money, the supply will fluctuate based the demand for the money for industrial use and new money mined through labor.

It's in this world, absent from taxation, regulation, and FIAT money can individuals begin to more accuratly begin economic calculation.