Sunday, October 11, 2009

The Great Recession and other fun games you can play with family and friends

There is allot of confusion out there about the present state of the economy. I thought I would clarify for those who are late in joining our little game.

The avowed purpose of the federal reserve bank is to create stability and predictability in the relationship between unemployment and inflation in the national economy. Thus for some time prior to our present downturn we experienced about 2-3% inflation and about 4-6% unemployment. A seemingly ideal balance. The means of controlling inflation is to set target interest rates such as the federal funds rate and the discount rate. If interest rates are high inflation is reduced as money stops flowing into the economy (a very crude explanation, I know). If on the other hand interest rates are low inflation grows high as capital rushes into new investments and buys up fundamentally scare assets, land, labor etc. By setting these targets they don't "control" national rates but instead influence them.

Unemployment is then controlled by the interest rates in a very keynesian model. If money is abundant investors will be more likely to make aggressive or risky decisions because even if my new business only makes a return on investment of 5%, if I can get the money at 3% I just made 2% on however many billions of dollars I invested (borrowed). If on the other hand interest rates are set to 7% I would have lost 2%, thus with higher interest rates businesses and individuals are less likely to take risks that "might" result in a return of lower levels. Thus the interest rates determine the rate of unemployment since risk taking is exactly what creates new businesses and new jobs, as well as maintaining old ones.

A simple system at is essence, yes? (and I must say a simple minded explanation, my apologies) The trouble lies in the fact that the ability of the federal reserve to balance unemployment and inflation is controlled by gatekeepers. Only certain organizations have the power and ability to borrow money from the federal government at these targeted interest rates. And the only way in which that borrowing is reflected in the national economy is if those organizations in turn invest that money in some meaningful way inside the national economy that can influence inflation and unemployment. In our present case these organizations are borrowing that money and not investing it. Even though the federal reserve has lowered interest rates to 0%, a theoretically infinite incentive to invest in any opportunity that can return any benefit, WHY?!

Two reasons, and this is where we get to the gist of the matter.

One, the banks are still in such risky financial position that they are borrowing money at incredibly low rates in order to stabilize their current liquidity positions, they are in essence hoarding cash to the effect of hundreds of billions and in fact trillions of dollars.

Two, there is nothing in the national economy worth investing in.......

Does the thought make you shudder? Banks and investors who have billions of dollars of cash hoarded up are not interested in any investment whatsoever. Why? This brings us to our lesson in fundamental economics and finance for the day. Whether or not they should invest is determined by whether the present cost of an asset/investment is outweighed by the future returns they can expect (discounted for the risk that those returns will not occur).

Those returns take two forms.

Earnings: If I own a share of IBM and the company earns money and pays me a dividend that is earnings, an investment can expect some kind of earnings over time and theoretically into perpetuity.

Appreciation: If on the other hand I own a share of IBM and rather than paying me a dividend they reinvest the money into new factories, land, patents, employees my asset has gained in fundamental value. My share is de facto worth more, it has appreciated.

So the fact that interest rates are at effectively 0% and inflation is not occuring (in fact we have had deflation) indicates that those with the power to invest believe that the combination of appreciation and earnings from ANY POSSIBLE INVESTMENTS will not exceed 0%.

What does this mean? Two things, one unlikely and another quite likely.

One, that there is no way to earn money, this is quite unlikely, people still need to produce products and by definition then there will be a financial incentive for those who can efficiently and proficiently outperform competitors in the manufacture and provision of goods and services.

Two, that every single investment is overpriced. What this means is complicated. At 0% cost of capital, at first glance, it would appear that something could not be overpriced, but this ignores the element of risk. A business that returns for me every year 1% on my million dollar investment is a great purchase if I can get my million dollars at 0%. Unless of course the business goes bankrupt and I lose the million in the next say.... (for simplicity) 100 years. The element of risk determines that I have to make far more money than just a slight margin over my cost of capital to account for the chance that the business/investment may fail. Why then would the investments/assets not automatically reprice themselves to match the market cost of risk by lowering the purchasing price of the investment. Get ready for the punchline.

BECAUSE THIS MEANS A MASSIVE REDISTRIBUTION OF WEALTH. Are you scared yet? Do you understand what I mean? What this means is that your dad and my dad bought IBM for $20, they thought it had appreciated to $50 and that that was what it was worth. To sell it now for $20 or $10 or $25 seems unreasonable, they would rather just not sell. They will hold it believing that things will change. This the simplest and least illustrative example I could use. Also the least efficacious, lets try something that will hit closer to "home". There are houses for sale all over the country, on every street. Why do you say for sale? why not sold? Think of all those banks with their billions of dollars. People thought that what they were buying was worth more than what it is. They are unwilling to sell at the price that an investor is willing to buy at.

This is true across the market for every asset and investment. They thought they were rich, but they were mistaken. The only ones rich are those in possession of what is in demand. Thus in this case, the rich ones are the young workers who can provide the resources and products that those who have the "assets" right now want to exchange them for. But the "wealthy" do not want to trade what they worked their whole life for in exchange for less than they thought it worth. So the houses sit on the markets. The stock prices remain high. And the banks sit back running equation after equation, disagreeing within themselves when the risk of future investments is outweighed by the return they can expect. For that matter what is the quantification of either?

What does all of this mean to you? THE ECONOMY WILL NOT AND CANNOT RECOVER UNTIL THE WEALTH IS REDISTRIBUTED. Because the way to reduce unemployment (CHAIN -> increase buying power, reduce the burden on government, lower the tax rates, further incentivise investment, raise the price of goods, create inflation) is to inject capital into the markets. And the only way that that is going to happen is if we can reduce the price of the investments such that the returns of those investments discounted for their riskiness outweighs their cost.

CAVEAT: This ignores the discussion of whether we could instead reduce the riskiness of those investments and thus affect the worthiness of purchasing them. This is done because I do not believe that it would have the required effect. There are enough investments of sufficiently stable nature available in the economy that the problem is not excessive risk aversion but rather far more excessive price/ supply in-elasticity. Although right now we are feeling the affects of both.

Tune in later for more fun with economic collapses, courtesy of theoretical nonsense.


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Theoretical Nonsense said...

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