When a Dollar is not a Dollar

We often think a dollar is a dollar. This concept gets us into trouble when we try to understand the economy or economic troubles. If we instead think of two different dollars, financial issues become clear and even Stagflation can be understood. I'll call the first of these two dollars Consumer Dollars to represent money used to pay workers and to purchase consumer goods. It is money that circulates quickly and has a very high velocity. These are the dollars most of us think of when we think of dollars. The second I'll call “Investment Dollars” and represent money used for long term investment purposes. This is money held as stocks, bonds, loans, etc. It has a low velocity. 

Adam Smith, perhaps unwittingly, referred to this when discussing bank notes. He explains the effective difference between “fixed capital” and “circulating capital”. He opposed small bank notes believing that money should only be borrowed in order to procure materials necessary to produce goods. He believed borrowing money to purchase consumption goods was so insane no person or government would ever do it.

Recession and Inflation

Inflation occurs when too much money chases too few goods. The normal response to this is to constrict the money supply by printing fewer dollars or raising interest rates. Recessions occur when too many people are trying to horde too few dollars. The normal response here is to print more money or lower interest rates. When either of these become severe, as in the US in the 70s and in Japan in the 90s, the solutions must become more drastic. They remain the same solution, but become politically more difficult as the remedy becomes more and more drastic. However, these measures only work on the right problem and because there are still many who, for political or ideological reasons, dismiss Keynes, the most effective methods are often vehemently opposed. 

Regardless of the method used to combat recession and inflation, in this context, inflation and recessions are consumer dollar problems.

Booms and Busts

To differentiate Fiscal problems from consumption problems, I will refer to booms and busts as the fiscal equivalents of inflation and recession. A boom is too many investment dollars chasing too few investment opportunities. A bust is too many people trying to horde too many investment dollars. Keep in mind that this behavior can occur regardless of what is happening on the consumption side. Though, this is often clouded with statements like “Wall street is nervous about the new consumer confidence numbers coming out today.”

The solution to a boom is usually pretty simple, but politically almost impossible. Who wants to be the one who ended the party. Unfortunately, not ending the party will result in a horrible hangover. This hangover is much more expensive to fix than stopping the party. I will delve deeper into this in my next post.

Stagflation

So, how does this explain stagflation? In the 70s, we had rising inflation and rising unemployment. Remember that inflation is too many dollars chasing too few goods. The solutions to inflation almost always focus on the too many dollars part. This is what the policy of the 70s did. However, the rising unemployment should have pointed to too few goods as the real culprit, and the fiscal policy of the 70s is also the policy needed to end a boom party. The problem here is there was no party to end. Instead we had a little bit of a headache. When interest rates rose, investment dollars disappeared.

If a factory owner wants to make more money, and demand is high, he can expand production or raise the price. If he raises the price too much another entrepreneur will think “Hmmm, I could make a killing too if I made that.” So he goes to the bank and borrows some money. More likely he would go to an investor, but for reasons I won't go into, the end result is the same and the bank makes things much clearer. Now, if he borrows at 5%, he obviously needs to make more than that to pay his loan back, so if we assume the normal profit rate is 5%, then he needs to sell his goods with a 10% mark up to cover these costs. 

If banks raise the interest rate to 18%, as happened in the 70s, the prospective factory owner would require a 23% markup to cover these costs. The original factory owner can also charge 23% even though his costs are only the 5% normal profit rate. The 18% his competitor must pay becomes, to him, all pure profit. At some point consumers will cease buying the good and those who borrowed the money to fund a factory will go under first. But, unless something significant changes, like a massive recession or a sudden availability of cheap investment dollars, the situation will remain where it is. 

When the Fed turned its policy against consumer dollars instead of in favor of investment dollars, it also hurt the real problem of the economy which was supply and not demand. This has been taken up as the neo-con mantra of economics. However, the trickle down crowd has learned the wrong lesson from this supply crisis. Just as a sudden influx of dollars can un-stick a recession, supply side policies can un-stick a bust. But, an influx of dollars is not an appropriate long term solution to a robust economy any more than trickle down economics is a long term solution. 

This does not completely explain stagflation, how it started, how it ended, and what should have been done. I hope, however, this makes understanding the debate much clearer and helps illuminate the insanity of some “analyses”, especially given our current situation. I wanted to explain how I am thinking about the macro economy before I delved into my understanding of our current mess. 

Living Life Behind The Power Curve

I wrote this a while ago and shared it with friends. I think it's worth saving some place.

You are flying the final leg down to the runway and you realize you're too low. You add power and pull back, but you're still going down. Give it full power and you're barely holding altitude. What's going on? This is called flying behind the power curve. This phenomenon happens because there is so much drag on the airplane it can't climb no matter how much power is added. The trick is to push the nose down, get some speed, and gently begin the climb again.

How often do we do the same thing in our life? We are so focused on climbing and we give it everything we've got, but we still aren't climbing or worse, we're going down. This is living life behind the power curve. All we need to do is back off, get our mind and body into a healthier condition and we can climb almost without effort if we so choose, or glide along where we know our position is our choice, not our limitation. This all seems so simple until faced with a real situation. Imagine we are in the airplane again and in front of us is a row of trees, power lines, or buildings. It takes an awful lot of faith, training, or both to be willing to point the plane straight at disaster in the hopes of recovering later.

When will the plane begin to climb again? Could I make it if I keep doing what I'm doing? Looking back at our own lives, the trees become bills, power lines are credit card payments, and buildings represent a mortgage. Can we risk easing off in our attempts to climb with those looming threats?

We often know we cannot continue as we are, but are afraid of what happens if we stop. If I don't deliver this project on time, will I get passed over for a raise I badly need? Will I get fired or laid off? If I ease off now I know I will crash and I do seem to be climbing ever so slightly. So we continue like this and just barely miss the trees. We look out in front of us and are relieved to see there are no more immediate obstacles. Now is the time to nose down and get out of this situation, right? Of course not. We cleared the trees meaning this must obviously be working for us. In fact, things are going so well, I'm going to fly over to the other side of the mountains; and so we buy a new car or take a vacation on our credit cards or buy the latest new gotta have gadget or learn to fly.

Sir Gwain and the green light

The wind whipping by, cold then hot then cold again, goose bumps marching steadily down my back, chest tight with cold, fear and exhilaration scuffling for control. I’m riding a motorcycle through the streets of Hyderabad. Effortlessly, years of riding manipulate my body forcing it to do the right thing though my mind is still struggling to remember what to do. Almost two years of auto rickshaws and trying to cross the street here has prepared me for this. Years of riding in the US has also helped.

I’ve always ridden with the assumption that everyone on the road is out to get me, and here they really are. This was the most free I’ve felt in India since becoming comfortable taking autos. I could have ridden all night.

When I decided to get a motorcycle I told myself simple, I’ll ride very conservatively. Not weave through traffic, not pass in oncoming lanes, and cross intersections cautiously. That lasted the first hour. I feel as comfortable riding here as home. The rules are different, but the game is the same. Somebody will cut you off. They will pull out in front of you. They will stop suddenly, same as at home. But here it’s at 60 kph not 60 mph.

The light barely works, the horn doesn’t, the turn signals don’t, there’s a strange rattle from the front end and the brakes are drum, not disk. And, I love it!

It’s like my first car, a symbol of freedom. It will always be in my heart a magnificent bike. Years from now it will become more powerful, bigger, better, and more beautiful with every telling of the story. For now, it is my Llamrei.

Thumbs Out, Thumbs In – Off With Their Thumbs!

The wealthy, powerful, and connected sit on high watching the masses struggle and fight in the arena. They place their wagers on the outcome as simple people strive for nothing more than a life of food, water, and shelter. The betting becomes intense as the outcome becomes more and more certain. All wagers shift to the obvious winner and as the house has predicted this years ago, it is only too happy to oblige. The fight slows. The fighters worn out. The outcome becomes questionable. The gamblers begin to panic as the fighters refuse to give a satisfying outcome. The house suspends all bets and the gamblers cry out in fury! This is not fair! We are ruined! The drones did not behave correctly! It is our right to exact justice!

The wealthy retire to their private jets and sky boxes to await the just decision of the referee. As the masses have failed the gentleman gamblers, let the masses pay the losses!

Career Change

“I've contacted and registered with the U.S. consulate in Chennai so they are keeping an eye on me. I have a legal team giving me advice, and I have a safe-house. What more could a guy want?” And so I closed my e-mail to my friends back home. I was scared and I needed to reach out to somebody. Nobody in India wanted to have anything to do with me. I could not go into the office, I could not hang out with friends, and every time I saw a black Mitsubishi I looked for safe places to run. I was living in hiding from extremely powerful and possibly unstable people.
The crime I was being hunted down for was the crime of quiting a job and moving to another company. Quiting isn't really exactly what happened, but that was the intent.
I don't know where to start. I began at the beginning and it was not far enough back. I started in the middle and nothing made sense, so I'll start at the end. I have removed all names as a precaution.
My co-worker asked me to meet with him after work on Wednesday. We went to a bar where he talked about his divorce, toasted women, our past accomplishments, the health of the team, and in short everything he could think of to toast. I drank very little because I was very suspicious and knew what was coming.
We talked about problems at the company and how my lack of understanding of the way things work in India made a bad situation worse. The problem was an Indian guy with a Napoleon complex destroying every project he touched and since he was close to the CEO, I had to try to get things done despite him on an incredibly tight deadline. I was tired of all this and had decided to leave the company for a competitor, but had not yet given notice.
We talked about how my stepping away from the problem would help solve it and how my ability to design at the drop of a hat was my most valuable asset. We drank to that and several other things. By this time it was getting late and my co-worker was very drunk. We ordered a few more bottles and toasted a few more things when my co-worker finally dropped the expected line. "Here are your tickets home. Get some distance from the problem and we will have you work from Seattle."
I looked him straight in the eye and said "I'm not getting on that plane." The rug had been pulled out from under him. He was obviously not expecting this. This was not the way the plan was supposed to go. I had an interview at my new company the next day and he had found out about it. 
"I have been predicting this move for three weeks. That's why I moved my things out of the guest house. I checked my itinerary this afternoon and saw it was changed."
He was angry. He said it had now become personal. I would never take the programmers with me to my new company.
And that's when the trouble started.
They came to the guest house and confiscated my computer first thing in the morning. They took every computer in the guest house. They kicked me out onto the streets and asked for my phone. I told them if they wanted my phone they would have to call the police. I called all my friends and arranged places to stay and rides to my interview. I managed to get through the day and found refuge with very dear friends.
Once they had my phone, they began making fake calls and sms messages. They created a fake e-mail account to lure people into thinking it is me. Everyone here was worried that it was just the beginning. The movie guys are very tight with the Mob and they were very concerned. I was getting a little unnerved myself.
I had no job, no return ticket, I feared my safety, and was living in hiding. I wished I had taken the job in Colorado.
Things got a whole lot worse before they got better. Fearing for his wifes safety, my friend had to ask me to leave their apartment. My new company put me up in a serviced apartment, think long term hotel, until things calm down. They gave me a phone and a laptop to get in touch with everyone
The CEO of my old company told the CEO of my new company, that they would be filing criminal charges against me for stealing source code and trying to sell it. My former CEO is closely related to the Chief Minister of Andrha Pradesh. That's the state Hyderabad is in. My new company offered to cover all legal fees and keep me on the payroll and furnish me with living expense money and an apartment. I had the option to go home now, or to stay till it all settled down.
If I left, my old CEO would file charges and I would never be able to come back to India again. They assume my fleeing is an admission of guilt and since I don't have to be convicted, it will be enough to keep me out. That had a very high likely hood of happening. If I stayed, and he pressed charges, my passport could be confiscated and I might be stuck here 3-5 years while I clear my name. I decided to stay at least 2 weeks so there is no indication that I would flee and when that threat proves baseless, I can go home for a much needed rest and to collect my thoughts.
I didn't want to do something that has life long implications. I guess either way is, but the odds are very much against those guys going through with it. Also, the owner of my new company is the other family's arch nemesis. So I have a dragon against me and one for me. It's also partly why they helped me. They have been fighting since the beginning of last century.
I have not really been able to write about all this. Friends will recognize that this is mostly a compilation of old e-mails. I still can't write about it. It may seem surprising, but it is the most frightened I have been in my life. I still look over my shoulder and feel sick when I see a black Mitsubishi.

Understanding The Meltdown

The more I read about explanations for why we are in a financial crisis, the more I realize Occam was right. But in this case the simplest explanation is not how do we understand the problem, but rather where are we looking. We blame bankers for making illogical loans and gambling trillions of dollars. We blame middle America for wanting to own a home. We blame deregulation for allowing financial institutions to put the national economy at risk. Finally, we blame the overseers for not overseeing. All of those explanations are only symptoms of a very simple and fundamental flaw in our economy and, indeed, our entire national understanding of economics.

Let me walk through a simple thought experiment:

Imagine there are ten people and each has $100. This creates a society with $1000 worth of currency. One is given the exclusive privilege to lend money at a fraction of what he actually has. So, five of the people decide to borrow $1000 each in order to build a home. We now have $6000 in our society. The borrowers agree to pay back $1200 at the end of the year, but since they are not banks they must return the money in real dollars, not as bank credits. All five cannot repay the loans because it would require there to be more money in existence than actually exists. Even if, through the “invisible hand” of the market each of the five could get back all the credits outstanding and pay them back to the bank, the return would be short $500. These five must somehow get the remaining $500 that society has and turn that over to the bank as well.

But! I can already hear the objection. The bank would be issuing other loans and so there would be more currency out there than just the $6000. The five would have built something of value and so could borrow again with that newly built value.

In our world, in order to pay the original loan, the first five sell the houses to the other five for $1100 who take loans from the bank. Since the bank now has a supposed $5000 in loans it can cover these loans and even buy a house itself without any money. They make enough profit to borrow again and build themselves a home. Now the original five borrow $1000 to build homes. We now have $10400 in circulation. But, it must all be paid back to the bank. In fact more has to be repaid than exists in the world and so can never be repaid. So, the bank starts taking homes and can't sell them because either someone has a home or cannot borrow to get a home. 

This is the scenario we find ourselves in. But really, this just goes back to who is wrong? Is it the system? The borrower? The Bank?

Well, here is where we start looking elsewhere for the problem. As long as the system keeps expanding and the amount of money keeps increasing, we have no problem. As long as the population increases and technology increases we have no problem. And, as long we always have demand for that new production, we have no problem.

But, we have a problem. In our world there is a pretty straight connection between the money borrowed and the value of the product now owned. In other words, there is no profit takers. The bank makes money by its unique ability to create new currency and to hold dominance over that currency. Each builder makes a profit, but it largely goes back to the bank for more loans. And as long as this cycle continues, the system works fine.

Now before I am accused of being anti-profit, the point here is not pro or anti, rather it is to be considered.

In this world of ours, one of the ten becomes an entrepreneur Through some mechanism he ends up with a little more money or credit than his other citizens and he builds a factory with borrowed money and the other eight work for him. They get paid for building value and he gets profit for his (and here you will have to insert your own justification as I have not yet concluded in my own mind what he is exactly contributing. So insert any economics 101 regurgitation here as that will suffice for these purposes). The entrepreneur issues stocks and the workers buy some and the owner gets the rest and his factory is worth $10000 based on his workers buying shares with money they borrow based on loans from the increased value of their house and generous contributions in the form of 401k and option plans. The system actually continues to function. The workers work, and repay loans. The factory owner gets his profits, and repays his loans. Everything stays in balance.

Now I have really taxed the patience of the reader. I promised a simple explanation for what has happened and all I have done is given a long winded thought experiment justifying the status quo. I am almost to the point and I apologize it takes this long. I want to cover as many initial objections as possible before revealing the point. I hope that I have created a world that all can agree is a reasonable simplification of our economy at work. True, we have only one bank, one factory, and everybody works at the same place and we haven't even discussed the issues of monopolies, unionizing, taxes, government enforcement, oversight, banking regulations, pollution, raw materials, etc. All these are extraneous to the conversation and if we simply agree those issues are balanced by other forces in a larger, more complicated market, then we can continue the experiment.

For some reason, whether it be the forces we have not included or some unforeseen new opportunity such as expanded trading opportunities, our Entrepreneur begins accumulating wealth at a higher rate than he had before. This upsets the societal balance. The money must come from somewhere. Let's say he discovers he can make due with one less worker because he has optimized his operation. There is now an unemployed worker who is skilled at the job required. So, our entrepreneur cuts wages. After all, if they don't like it, the out of work worker will gladly take the job for less money. Unemployed or under-employed, the workers begin defaulting on loans. The entrepreneur and the banker begins accumulating the wealth in our fictitious village. The workers attempt to offer solutions to the two powerful men such as renegotiated loans and the banker and entrepreneur agree. The wages are cut further and the loans extended longer. At each stage, the workers ask for new terms and they are given. At each stage the accumulation of wealth increases deepening the already difficult economic situation. Finally, the two own all the real cash and there is none left to repay outstanding loans. The fictitious money collapses under its own devaluation. The banker finds himself once worth $10400 now worth only $500. The entrepreneur is in a similar situation. He has only $500 left and nobody will buy his products. The economy has collapsed and the two can only think back to when they were so rich.

The problem we face today is nothing more or less than proof trickle down economics does not work. All it does is concentrate the currency into the hands of a few people who leverage that currency into larger quantities of fictitious money whether they be stocks or mortgages. This money then, as Gresham's Law points out, drives out the good money where it is horded or moved overseas to purchase oil or finance federal debt. Since these institutions are not bound to take this fictitious money as legal currency, and in fact are forbidden, the bad money must be converted to good money in order to pay off another instrument of bad money, the mortgage. This transaction debases the bad money further and begins a downward spiral. Though the value of the fictitious money held by the bank is diminishing through this policy, the obligation of the borrower remains the same. His increasingly valuable real currency must be exchanged for a decreasingly valuable debt. The result is hording by the banks of the valuable real currency and an expulsion of the bad and decreasingly valuable fictitious money.

How can I make a statement as bold as this is proof trickle down economics does not work? Because we have seen an increasing accumulation of wealth and an increasing burden of debt to everyone but the wealthy. If money truly did trickle down, we would see the distribution of wealth remain relatively consistent and the economy rising evenly across all income levels. What we have seen instead is a greater and greater concentration of wealth resulting in a Gini coefficient at its highest since the great depression. This wealth is then leveraged into fictitious money and is considered to be at parity with real currency. And indeed, if one were to sell 100 shares of Microsoft, you would get parity. You would get what the market says it is worth. However, if Bill Gates sold all of his shares in Microsoft, he would not get parity, but rather some fraction of the current assumed worth. If everybody tried to sell Microsoft, the stock would be worthless and the parity percent would be zero.

Our assumptions that fictitious money and real currency have equal parity misdirects our economic efforts. For example, we point to the GDP and say, “Look at our prosperity!” But, this prosperity is largely fictitious money. As we pass legislation increasing the dominance of fictitious money through low capital gains taxes and IRA plans, we in turn devalue the fictitious money. Our parity percent becomes lower and lower with each increase of fictitious valuation. When we turn our economy from real goods and services to the management and creation of fictitious money, we balance our economy delicately on the pinnacle of a house of cards. Each move in this direction decreases the parity percent and the difference between our true worth and our perceived worth becomes increasingly larger until it can no longer be sustained and it all comes crashing down.