The true hallmarks of a society which consumes too much would never present themselves as shocking economic contraction except for the most severe cases. The problem of over consumption is an opportunity cost as opposed to economic contraction (which in theory would be hard to pinpoint on over consumption alone). In a society which over consumes, current resources are allocated mainly to depreciating assets. For example, in an over consuming society too many t-shirts are made while science research languishes. The use of resources to build more t-shirt factories lead to a society that creates too many quickly depreciating assets while long term growth suffers from underinvestment in research. The society could easily collapse after the current depreciating resources quickly become consumed and no further output is able to support a growing population. The fact is, however, that this would be hard to pinpoint as an over consumption problem because you would have to know that the investment into science research would have made the world better off than producing t-shirts. In this example it may be easy to conclude that t-shirts are less useful than science research, but what about the case of food?

For those who claim America consumes too much and saves too little, the only facts that can be used to make this claim is that in dollar terms the average american saves very little of their income and purchase a lot of items with debt. This argument does seem to be supported by the outwards appearance of things, people do purchase most of their consumable items with debt and seem to save little. The problem is, this does not necessary mean that the solution is to consume less and save more. Currently, many feel that the housing market should have less owners of homes. Many discuss that people should not be allowed to take out large sums of credit card debt. The average consumer worried about their future income consumes less on debt and saves equity to service their outstanding current debt bills. All of these are logical reaction to a situation where people consume too much and save too little.

The problem is, the resolutions that people are discussing today will not result in more research or better economic conditions. It is not that there aren’t enough houses to satisfy demand, or that there is a shortage of t-shirts or food in America. The problem is that individuals can only consume these items at current prices using debt. Meanwhile, if Americans saved more the extra savings may result in larger funds invested into the banking system as individuals lend their money to banks for a small savings account return, but this extra savings will not necessarily be used for future economic prosperity. Extra savings will likely be held by the banks to meet their concerns for servicing their debt payments. Over consumption is not a problem for a society where many resources exist, and the consumer is unable to consume on current income.

It is possible that we might have avoided the current economic downtown if more resources were allocated to research and less to t-shirts. It is possible that the current contraction has been fueled by depreciating resources that were incorrectly priced for years.  However, it will probably be impossible for us to know for sure if that was the case, and our current sentiment that the solution is to consume less and save more may prolong and deepen the current crisis due to the shut down of a lot of production, the loss of jobs, and the decline of prices leading to a vicious circle.

The real solution to the problem is figuring out a way to allow the current economy to function with its vast creation of resources and opportunity for investment, while decreasing the debt burden needed for so many individuals to transact in society. Already we do this by flooding the system with cheaper dollars so that debt services can pay back their debts with less valuable dollars, but the re-pricing of items to counteract inflation partially offsets this. Items are becoming cheaper in dollar terms, however, the debt burdens themselves are still very high and many individuals have no way to earn dollars to pay back outstanding debt obligations. Meanwhile as individuals consume less, fewer people can earn dollars to payback outstanding debt, and their only option will be to default on this debt. Over-time it will just remain to see who can and cannot pay back their obligations.

Unfortunately the solution to the current economic crisis is much harder than saving more and consuming less. We will still have to come to a point where individuals earn enough equity to transact in society. Pricing may continue to readjust, but if you earn 0 dollars its hard for prices to adjust enough to continue economic growth. The real solution will come in the form of higher earnings/equity for a large portion of society. One quick way to solve this problem may be to allow for a one-time debt forgiveness. As odd as this may sounds, it would quicken the recovery as individuals now may go back to consuming on equity earnings as opposed to saving for debt servicing. It would allow for the long and slow process of debt defaulting to occur quicker and lead to a quicker economic recovery. Finally, as a one-time event, the moral hazard problem would be less than our continual bailouts of institutions or consumers. People would not foolish borrow without the expectation to payback as it would be explicit that this forgiveness would not occur again. However odd this solution may seem, it may be much more tenable than a slow default process or the printing of money to make debt burdens less expensive in real terms.

For most, an economy is perfect because it allows many participants the ability to interact with each other, share information, and allocate resources to the most productive portions of society. The common view is that the market creates the best of all possible worlds since it aligns its goal (the most production) with its structure (allow individuals to maximize their production given their inputs). It is because of this view, that we typically think of any problems in a capitalist society as self-correcting in the long-run. Abstractly, how could any system which has a goal of maximizing utility fail at that if it freely allows all participants to follow their natural tendency of maximizing their own utility.

The problem arises, typically, in the interaction of the participants and how those individuals can influence the system to maximize their utility at the expense of others. In this way, the system begins to decrease utility as the marginal benefit of one individual given one unit of resource is less than another. In a perfect market this is thought not to happen since the pricing element helps to equate the utility of each participant and allows those that value resources higher, to buy at a higher price. One reason why this does occur is that for the market to function all individuals need the ability to trade otherwise they have no way to participate.

Each participant has available two resource types to trade—capital or labor. Similarly, each individual has two types of things in which they own—consumption units and investment units (for later consumption). In capitalism, typically individuals first trade themselves for resources and then as they save those resources, are able to transact with resources in order to allow the current resources to grow over time. The growth of an economy is typically thought to occur from one major factor—science/technology.

As technology and science develop, the amount of resources that capital creates is larger. For each investment unit put into the system, more units come out and general prosperity occurs. These developments mean that capital begins to earn higher and higher returns and thus causes a subset of society to gain even more resources out from their investment in. Capital begins to become consolidated as a the more resources an individual has the more they are to take a chance (higher risk) on any new venture which may create more units out than are initially put in.

Over time, with some individuals having a large amount of capital, there are two investment decisions they can choose—one is to consumer and the other is to invest. Consumption naturally declines the value and existence over time as the capital is used, while investment grows value creating more objects from the inputs. Meanwhile the propensity to consume of any one individual is typically capped since there are only so many units of an item that can be consumed. While this may push up the price of some individual units (luxury items) quite high, it typically does not create more items since the consumption of the individual is somewhat rationally capped (how many units of corn, housing, jewels can one consume at one time). Similarly the value to society as a whole of high priced units such as jewels and yachts is less due to the fact that these objects are non-productive and becoming increasingly consolidated. Without transaction these units have a lower probability of being augmented.

In choosing then to invest a large amount of the capital saved, the individual must transact with others in order to gain resources from them (since in capitalism resources are a zero-sum game—each resources you own cannot be owned by another individual). As consolidation of resources occurs, the individual investor gains more physical capital and now must endeavor to capture the human capital within the market. This occurs mainly because the capital owner has already acquired the physical resources of another and must now move to capture the one resources it cannot fully own (at least not currently)—the individual.

In terms of an example, I may for years transact with you to gain possession of your items either in bartering the physical item or gaining the monetary value of your item. After awhile, some individuals have gained more from the items they have transacted and some individuals have gained less. I may take the piece of wood you give me and build a house that yields me more resources while you may take a piece of corn from me and consumer it leading the degradation of the unit. Naturally over time, some people win and other lose, and as some people gain more resources to transact they have a greater probability of winning as opposed to losing since they have more units in the game. This is what causes capital to become consolidated amongst fewer hands.

For the losers, they continue to lose their current capital as the units they own become degraded or destroyed. At the end of it, they are left with only one last thing to transact with, themselves. The winners have only one last incentive towards transacting with the losers, that is to gain any possible future resources the losers may have earned by transacting themselves. For the winners, there exists only two ways to transact with the losers in order to gain more resources, one is to employ them to augment the current capital, and the other is to lend the losers money in an attempt to contractually obligate the losers into giving their future revenue streams to the winners (if those streams are ever to occur).

This system continues to occur unimpeded because each participant is maximizing their own utility without regards to the utility of the whole system. Each new resource unit is worth less to the individual who has a ton of them, than it is worth to the individual who has none. Each person maximizes to the best of their ability their outcomes given their inputs.

As capital replaces labor as the augmenter of capital (since technology allows for capital to create more capital without the aid of labor), the society moves towards less investment in labor and more investment into capital since it is more productive. Over time, capital owners lose their need to transact with labor as labor has less potential for future resource gain as capital replaces labor in its function to augment capital. Many resources created for the benefit of many now are “less productive” because they represent consumption units which the majority of labor have nothing to transact with anymore since they have been replaced.

In this way, the best of all possible worlds is lost since the system itself no longer affirms the maximization of societal utility, but rather the maximization of individual utility. This may very well be the reason that more advanced economies have lower birthrates since the consolidation of capital within the free market system only allows for fewer individuals being able to transact and exist.

This may be a naturally better world since we cannot assume that lower populations are a bad thing. However, it does bring up one problem, it is incredibly hard to say how much better (worse) or society may be for the contribution (lack of contributions) of one individual. What if Einstein’s parents chose not to have children? Until capital is able to fully function as a human would, the natural loss of population that occurs as society consolidates wealth can actually be very detrimental. But without knowing what other worlds were possible, we may always be stuck seeing this as the best of all possible worlds.

Similarly, the problems we see currently of wealth consolidation, large debt burdens, and market failure can be traced fundamentally back to the problem outlined above. As labor becomes replaced by capital, more people own less in equity and most contractually obligate themselves to others through debt. The capital owners have so much capital that their diligence and risk aversion decline and capital is more foolishly allocated towards riskier investments in the hope to gain more potential returns (since in investing we always think that higher risk means higher returns when we really should be saying that higher risk means we should require higher returns). As time goes on, and the future resource gains of those who contractually obligated themselves with debt declines, individuals begin to default on their debt causing the investors to realize they allowed the wrong people to borrow at cheaper rates and investors begin to balk at transacting due to their current resource loss. The most problematic factor of the whole situation is that it is not due to some exogenous factor that will hopefully go away and allow a perfectly functioning system to progress. This problem is endemic to the system and involves a rethinking of how capitalism operates in order to insure that society does not destroy utility as opposed to creating it.

            As the previous post described, there are a few reasons that account for the current economic crisis. One reason, the growing wealth disparity in the US, is one which deserves a bit more attention than it has already gotten. While wealth disparity may not be wrong from the views of a capitalist economy, it may be the root of many problems we experience today. One thought I have found myself wondering more often is whether we really should be looking towards a private market for capital investment. While it is important that capital be allocated to those parts of the economy which will use it best, I wonder if its truly necessary that this capital be privately owned and therefore the returns to capital being privately held. It is this privatized system of capital that may be one of the largest reasons for wealth disparity.

            In the American system, we always want inducement for investment. It creates a reason for individuals to save and allows these savings to go towards future economic prosperity. However, if I am Warren Buffett with a large amount of capital, I really don’t just have an inducement to save for future prosperity, but a necessity to save since outright consumption of that capital would be useless. In this case, the capital owners allocate their large stores of wealth into the public markets to find ways in which to grow this capital. At the same time, capital investors require larger and larger returns for riskier investments. For science research (biotech for example), the researching venture must pay out a large return to initial capital investors eating away much of the return for the actual augmenter of that capital. At the same time many science ventures are completely unable to receive investments from these capital owners since they will never be profitable within a ten year period or so. This has caused a large distortion in the American labor market moving many individuals out of careers in the sciences even though it is science research which ultimately creates the most amount of economic prosperity for society.

            This large amount of capital being invested by the wealthy owners of capital may explain some of the reason why we had too much money seeking too few investments. In this case, investors become less vigilant. If I only have 100 dollars savings from which to invest I will be much more vigilant with say 40 dollars of that investment, but if I have 100,000 to invest I am probably less concerned over a 40 or even 400 dollar investment. At the same time, with only 100 dollars I am much more risk averse to investing that money in a start-up biotech firm, but the individuals with 100,000 would probably have no problem taking 100 dollars to invest in a risky venture thinking that if they lost all of that investment it still would only represent less than 1% of their funds. At the same time, the biotech start-up having a large pay-off from a successful drug can yield many times the initial investment creating even more wealth for the individual with 100,000. These examples give a very simplistic view of how wealth dispersion can cause markets to be less vigilant and for society to see a larger dispersion of wealth as the system continues.

            The question that I wonder about at this point is, is it really necessary that individuals own capital that they use to invest in. It is certainly a radical proposition and would sound quite socialist if not communist to suggest that capital not be completely privately owned, but it is still something to give some consideration to. Certainly there should be rewards for the creation of economic wealth in our society, but should those rewards go to someone who merely gives capital to another person to develop, or to the individual who actually develops that capital into something. In this case, I’d argue that it is the scientist or thinker who should be capturing the economic rewards of their technological gains, not the capital owner. At the same time, economic returns for an individual would seem foolish to be in the billions. Take Microsoft for example, their productivity gains for society have resulted in a capital owner (Bill Gates in this case) being able to capture the economic returns for his technology. While I do not argue that Bill Gates does not deserve this as a mastermind entrepreneur or that he has used his money in foolish or wrong manners, I just wonder really of what use over 30 billion dollars is for any individual. At the same time his advancement has probably resulted in the loss of many jobs and the replacement of labor with capital across many industries.

            In a radical way, I think it may be more advantageous for the government to have a very large progressive tax allowing for a majority of the capital gains of any one individual to be captured by the public, and then this capital be reallocated back to private markets through a finance industry similar to the one we have today.  In this case, the rewards for superior capital allocation would go to the traders deciding the best places for capital to be allocated. At the same time, companies would be encouraged to allow for a larger portion of their earnings going to labor. In this case, it would allow individuals to work and be paid more in line with the cost of living whereas today many individuals continue to lose their jobs and wages are not rising in terms that are commensurate with the cost of living. This may be a subsidization of labor, but at some point it becomes necessary to subsidize labor (more on this later). This system would allow for individuals to apply themselves and make large returns (in the millions not billions) for their endeavors in science and technological innovation, but would not see a large portion of returns being captured by capital owners. Is it important that a man have a huge store of wealth or that he make that wealth into economic prosperity?

            It is true that this system may cause society subsidizing labor which may cause more individuals to become “lazy”, but a little thought into this supports the idea that there are actually greater returns for individuals who apply themselves in the sciences. Hopefully we would begin to see individuals work more towards researching and less towards law, finance, and medicine. For the other workers in society, a little thought would give way to us realizing that it is necessary to begin subsidizing labor in our society. Currently labor in the US is being replaced by both capital (in the form of machines and technology) and overseas labor. These two factors are economically good for society, but we see lots of opposition for them because it is showing that at some point labor is not worth anything. Think towards the future where society has created advancements in AI and robotics that allow for a massive portion of the labor force to be replaced. In our capitalist system, we have this idea that all this labor would then go and re-tool themselves as scientist or something which can’t be replaced, but this theory is foolish. There are clear limitations biologically for people such that not everyone would be fit for a new job in this new society. In this case, we have massive unemployment with the returns of the robotics and AI going to the capital owners of these machines and away from labor. Essentially there would be a set of Microsoft-like firms which see huge profits and huge returns at the expense of massive amounts of labor which becomes replaced by these machines. It may seem like a far off idea, but it may even be the reason today why wealth dispersion becomes a larger problem.

            This system would be a radical change from what we have been bred to believe. Capitalism resonates very strongly with our internal goals of advancement, however the system itself may not be the most ideal for society today. The way in which our society has developed leads us towards a future in which we may see a whole new form of feudalism and unrest. Where wealth is consolidated amongst fewer and fewer hands and a massive portion of the population finds themselves near poverty. I certainly hope this is not the case, but it may involve changes to our perception of capitalism and the optimal form of economy.

            Over the past few months, we have seen a radical worsening of the economy. As the government continues to support banks in a hope to revive the lending market, the major US automakers are close to failing themselves. They now look to Washington to bail them out, labeling themselves as “too big to fail.” In this case, the automakers may have a more direct point than the banks seeing as they employ a large amount of individuals in the middle portion of America. Along with this, the ceasing of the credit markets have shown us just how leveraged the economy truly was. While banks struggle to stay solvent, many homeowners see the value of their housing decline rapidly. As companies begin to scale back their operations, unemployment has begun to rise rapidly, and consumer demand begins to fall. All these factors beg the question, How did we get here?

            The question of how did we get here is not easily answered and highly subjective. One factor was certainly the amount of leverage across society, but this is not unusual nor necessarily a bad thing. Typically leverage allows individuals to purchase today what they wouldn’t be able to for awhile. A house, for example, is purchased with debt today with future earnings being pledged typically as payment for the debt. Now certainly part of the problem was individuals purchasing houses with the idea that their price inflation would allow for then to sell in a couple years and make a profit, and when housing prices stopped climbing it created a large problem for these short term buyers. However, housing prices (along with company valuations and college education) moved much higher than seemed reasonable during the past few years. The reason for this, the same leverage that typically allows for individuals to responsibly pledge future earnings for the purchase of something today. These housing market often is a bidding market where in many cases the buyers ability to pay determines the sellers price. This works similarly for the purchase of companies, the price of the company gets set competitively mainly by how much the bidders can find to purchase the company with. In this case the cost of debt became a large determinant for the price of these assets.

            In this case, our typical fed policy, the setting of the feds fund rate, had a terrible consequence. While the fed used its typical tool to help provide liquidity for the market during times when the economy began to decline, it was causing a huge rise in the prices of these assets. When the base rate of the economy was lowered with providing a large amount of liquidity in the market, it began to lower the cost of borrowing, and consequently raise the value of these assets in a bidding market. This was the first facet that created the current market problems. The decline of this base rate provided a large amount of liquidity into the market at cheap rates, which gave bidders in the housing and LBO market a larger amount of cheaper capital to bid on these assets. While the Fed watched the CPI and other indicators of general inflation, it failed to recognize the inflation in these markets since we typically do not discuss “inflation” of housing prices or company valuation. This inflation, however, became a large portion of “wealth” in our society and was in many cases tied to our economic prosperity in the past 7 or so years. This was the first and more direct factor which created the seeds of this current crisis.

            The second factor, has been an ongoing problem and works similarly to the Fed’s fund rate in how it helped spur this crisis. This problem, which has been mentioned before by many different sources, is the wealth disparity which continues to this day. In America, our capitalist system has allowed for a consolidation of wealth in the upper tier. A majority of this wealth, since it is unnecessary for consumptions, is funneled back into the public markets as investment. This allowed for a huge amount of liquidity available for investment into the debt markets which were already bolstered by the Fed’s policy to cut rates. For example, the collateralized mortgage market was a pass-through created to allow for more liquidity in the home loan market. Public markets allowed for a simple mortgage loan to be packaged with other loans, statistically analyzed, and then financially restructured to meet the risk criteria of a broad range of investors. This allowed for a large amount of those invested funds from the top tier of America to be reinvested as loans for the middle to lower class in order that we could bolster demand in the housing market, and achieve the American Dream of home ownership. This also allows for a large amount of investment into hedge funds and private equity firms which offered attractive returns funded by the large amount of debt funds from the over saturated debt markets.

            The reasons for the wealth dispersion rely mainly on the way returns are allocated in society. Since we have been staunchly capitalist from the start, returns to capital (that is money invested in companies from capital owners) have always been highly attractive in order to spur investment. At the same time factors have continued to decrease returns to labor. Offshoring, immigrant labor, and technological innovation, have moved the returns earned in society towards the capital owners which often times are unfortunately the more wealthier individuals who have invested their large amounts of wealth back into the market. In economic theory, as labor earns lower returns, it should have less funds by which to demand products in society and so prices should decline. That is why often times offshoring and technological innovation are seen as creating economic wealth. They lower costs and allow for lower pricing for the general consumer. However, the larger returns to the capital owners have allowed for larger investments in debt. Essentially the lower to mid tier wage earners are being offered less equity earnings in terms of wages and jobs, and being supplied with the availability of debt in order to purchase items that would otherwise be out of their range. We have allowed for economic growth solely in terms of leveraging out the future “potential” earnings of the lower to mid tier wage earners. In this case, all possible future earnings have been captured by the upper tier in the form of debt (like mortgages and credit card debt).

            None of this was malicious or even wrong, it was just the way in which we viewed society and economics. Debt was great, it allowed for individuals to acquire today what they could never dream of without saving for decades. Fed policy was intelligent, insuring that markets had enough liquidity in order to operate efficiently. Many of those who earned fortunes were those capitalist who supplied our economies with the ability to grow and innovate. This was all fine as long as the system continued to operate, but the second things began to falter, the house of cards crumbled. We have now seen just how precariously the system was and how isolated failure could lead to system-wide collapse. 

            As is ever present in the news, the financial markets are in disarray. The excesses of the last couple of years have led us so far on the up-cycle, that a huge downward spiral is bringing is far below what should be rational asset pricing. One of the most interesting trends in financial markets is that instead of decreasing volatility and managing economic risk, markets have begun to experience extreme volatility. Its not that this was unforeseeable, but few thought that such a rapid and extreme movement downwards for the financial markets would be experienced. Inevitably, there will be a large amount of after the fact commentary. Many will call this socialist or communist steps to manage the economy and markets, but in reality the situation is much more complicated.

            One of the components to this crisis has been noted by a few sources – Monetary policy. In the US, the central bank has allowed frothy rising markets to move upwards regardless of their over valuing of assets and over leveraging of institutions. At the same time, in order to buttress the subsequent decline due to these excesses, the Fed has moved in to support these institutions as letting them become insolvent would cause extreme consequences for the markets. This protection from defaulting has created the infamous “moral hazard” problem—as the Fed moves into to save banks, it is implicitly saying that they will be there when the worst of situations occur. Ironically, in doing so the Fed protects the creditors to this institutions (in order to keep it solvent), but wipes out the equity owners. To me, that seems like a huge incentive for debt over equity.

            Regardless, something which is absolutely necessary is to begin to segregate institutions so that when failures occur in one segment, the others can still operate in order to preserve the markets. These institutions perform the function of “market-maker” as well as counterparty to many other trades. That is why they are termed “too big to fail” because their going out of business causing many problems for the markets that they make. These companies (like airlines, public transportation) have built in protection because their service is too fundamental to allow them to fail. It is almost funny that most people now discuss that investment banks cannot support themselves and must merge with a commercial bank. There are few synergies to combining those businesses and many restrictions mean that investment banks cannot be financed by the commercial side. Essentially all this does is lower their cost to borrow due to the characteristics of the larger commercial bank. This is one thing the fed has done right—there should not be extra incentive to become tied to a commercial bank in order to have access to the fed window or get lower borrowing rates. Creating super institutions will just mean that they will be ever more “too big to fail” and they will have even less incentive to make proper investing decisions with their finances thus creating even worse problems for the market.

            The problem now is that the government now has to make sweeping and substantial steps to make sure that the financial markets do not collapse. This type of reform will be the most substantial problem that America will face in the coming years. The Feds actions have been unpredictable and will cause even more uncertainty in the market. At the same time, in order to make sure that they do not suffer as large of a moral hazard problem, stringent and sometimes arbitrary demands will be made of the remaining institutions. Liquidity and leverage requirements will certainly be made, however, the problem is not just the capitalization of banks, but rather how our economy has moved with regards to debt.

            I have gone on in other posts to discuss the interesting facets of how debt is handled in the economy, but interestingly enough its often not discussed in the mainstream. This is not just about the cliché arguments that Americans have too much debt, but that debt has been a largely misunderstood form of funding for most people. We have moved towards believing that the more debt the better especially due to the tax deductibility of interest for housing and companies. Asset pricing continues to become skewed due to this move away from rational and fundamental valuation towards financial valuations where asset value is predicated largely on the buyers ability to pay. For instance housing saw a huge shoot up in value for two reasons, one was the availability of large amounts of cheap debt, the other was a circular raise in home prices as demand was high. This created a self reinforcing cycle where it was ok to pay substantially more for a house than what was reasonable because it was going to rise even more in value. The same occurred for PE shops performing LBOs and infrastructure funds buying land assets.

            It is this shift in our economy which created this downturn and it will remain to be seen how we handle it. Right now our solution is to move in fast, support the economy to reduce the downturn, and move us towards “economic growth” again. However, without a shift in the way the financial industry operates along with the way our government interacts with the financial industry, this problem will arise again in the next 1-2 years. Markets are incredibly short sighted and once debt is really cheap and there is large interest from buyers, they will be happy enough to create a new frothy market. Perhaps the next big trend will be infrastructure funds that haven’t been hit as hard as other PE funds and with the lowering of debt rates will find more and more attractive opportunities for levering up assets and doing what they can to purchase new ones.

It is hard to say “what is to be done” because this is an unprecedented situation. Right now the fed will have to move in to protect the economy from a the worst case scenario, a new Great Depression. Following this situation, it will be important to take a look at what were the prime causes and think through a way to make sure that the financial industry is set up in a way that will lessen the volatility of cycles, not magnify it.

NON-PROFIT CAPITALISM
Sep 11th 2008

An initial public offering with a difference

“WE RUN a business here–but instead of selling cars or candy to kids,
we’re selling hope and leadership,” says Nancy Lublin, the chief
executive of Do Something, a non-profit group which promotes
volunteerism by teenagers. On September 17th she is launching an
initial public offering (IPO) to raise the $8m needed to double Do
Something’s activities by 2011, by which time it plans to be engaging
with around 21m of America’s 32m teenagers.

 The IPO prospectus, put together by Do Something’s board of chief
executives and technology entrepreneurs, contains the usual market
data, a description of the 15-year-old organisation’s activities, an
overview of the competitive landscape and bold claims about its
qualities (“Do Something is also one of the most efficient
organisations in the United States”), all designed to convince
investors that it can achieve its ambitious goals. The only thing that
stops it from being a typical IPO prospectus is the absence of any
pledge to make a profit. On the contrary, the opening boilerplate
explains that “units offered in conjunction with this prospectus
represent a perpetual interest in Do Something; this interest is
strictly philanthropic, with no provision for cash returns at any time.”

 This imitation of the for-profit IPO process may seem gimmicky, but in
fact it is part of a new trend to improve how non-profits are financed,
so that they can escape the obsession with short-term fund-raising that
is pervasive in the charitable world. With money in the bank to finance
the next three years’ operations, Ms Lublin and her team will be free
to focus on reaching Do Something’s goals.

Other non-profits have done something similar, including Teach for
America, which puts recent college graduates into needy schools, and
College Summit, which aims to increase the number of poor children
going to college. VolunteerMatch[1], a sort of eBay for volunteers, is
in the process of raising $10m. George Overholser of Nonprofit Finance
Fund, one of the pioneers of this trend, reckons that around $200m of
“philanthropic equity” has been raised by non-profits in the past few
years, and another $100m is sought.

 Do “investors” get anything for their money? Do Something promises “a
significant social return on investment”, quarterly performance updates
and a conference call with management. But none of these recent
philanthropic IPOs actually gives investors voting rights, unlike
during the boom in “joint-stock philanthropy” in 18th-century England.
Back then, social entrepreneurs such as Thomas Coram, who started the
Foundling Hospital in London, were fired when they failed to perform.
Still, Ms Lublin says that if her new shareholders ever ask her to step
down, she will go.

I’ve copied the whole text here so that later the link wont get cut and I will lose this article. I am sure other funds have sought market-like funding sources, but this article describes exactly what would be entailed by taking non-profit firms to market. All that is required is that the market participants do their diligence on the firms which is motivated by the donators goals to maximize societal welfare. As long as firms are increasingly transparent, follow similar guidelines for reporting their results, and show clear motivation towards their goals, this would be an extremely worthwhile endeavor. Likewise, the government should create special tax consideration for investors in these firms with the stipulation that the firms do not pay a profit. In this case, charitable donations will still receive tax advantage under this market system.

Hopefully, this will expand our consideration of how a market operates and what kind of endeavors can be publicly funded in an open market. As I’ve noted before, science foundations should actively seek market funding through IPOs and the like under the same specification that they are not for-profit endeavors, but rather look to maximize societal welfare. Part of what has killed science research (specifically biotech research) has been the requirement from market to turn a profit as soon as possible. Along with this, student loans for college should likewise be funded this was more so than they are already. Investment in student education is paramount and should not be constrained due to the way in which we finance education currently (that is largely through debt).

            The disappearance of the middle class is a commonly cited and discussed phenomena. It is almost banal and commonplace in today’s society. Many of the previous posts discuss this and similarly many economists discuss the end of America with the loss of the middle class. It would be almost redundant to discuss the typical topics that appear in the classroom—the increasing returns to capital, the decreasing returns to typical service jobs, the correlations between both capital and technologically advanced workers, the perpetuation of wealth, etc. One topic, however, that I have not seen discussed at length is the possibility of a feedback mechanism in the economy causing a self-reinforcing cycle (in our case a negative one). This may explain why the process may become both accelerating and destructive.

            What I mean by a self reinforcing cycle is one in which wealth diverges and due to changes in the income profiles of many Americans, wealth diverges some more. For instance, in our current economic downturn, the biggest losers will be the middle-class retailers whether that be retail, housing, consumables, etc. To see how this might occur, it is important to analyze the specifics of recession in the economy. In the current downturn the most worrisome sign has been the inability of business to borrow debt in the open market while having their current debt become more and more expensive. This loss in income and financing causes companies to have to find places to free up costs, which given the ease at which labor is fired and hired, is primarily found in cutting jobs. Even if physical capital is being liquidated, most of the time that physical capital will have individuals assigned to it who will lose their jobs as well. It is hard to think of ways in which a company frees up finances that does not involve cutting jobs.

            This is the beginning of our downturn, not much to be worried about, however, if the markets rebounds and demand is high companies will have every incentive in the long term to hire back and perhaps expand. The larger problem is consumer demand which has now been reduced by the amount of jobs lost. This would not be worrisome unless the problem is systemic and continued pull backs further weaken the market. Often times, there is also multiplier effects that further exacerbate the problem. The pull back in debt markets may feed into consumer markets which lead to contraction in purchases. Productivity gains may help a company to still produce a large amount of products despite the loss of labor, which substitutes labor (a purchaser) with capital (a purchase). These factors can continue to motivate the cycle of further cuts leading to further loss of demand.

            The interesting thing is that it could very well develop a completely new trend in society—a two tier society. Similar to an aristocracy, this new society would feature a few large capital owners and many poorer individuals. This is an extreme and laughable analogy, but it may prove to be not too exaggerated. What may be different about this new two-tier society is the ease by which we can accept it. As the middle class dissolves, the standards of the lower class begin to raise as individuals find themselves not destitute, but certainly not having much purchasing power. Large, low cost retailers will benefit immensely as disposable incomes drop. These retailers will continue to cut costs in order to compete for an increasing market which trades a larger portion of wealth away for consumables. Individuals find themselves worse off each year, but due to their basic needs being met, they are far from a serf class. Minimal ownership does not phase the individual and surviving paycheck to paycheck becomes a normal affair. The richer individuals continue to purchase conspicuously further increasing asset ownership and then loaning assets, land, and money out to the rest of society in search of as high a return as possible.

            The winners in this society are the small but still sizable percentage of society in which own large proportions of capital. The services they request become higher and higher priced, the goods they buy become unthinkably expensive, and they purchase their progeny the rights to a successful future. They diminish their political risk through cheap and available funds to anyone looking for them (at a price). At the same time, their mentality on “fair and equitable” treatment begins to justify their point of view towards society. Earning a living as they have becomes virtuous, and sharing it becomes wasteful. As they seek to maximize returns on margin, each seeks to squeeze out every extra available fund from society and each other, causing further consolidation of the winners and incredible losses for the loser.

            This certainly is hyperbole, and almost seems ludicrous and paranoid. Society affords many programs for the poor, progression taxation, estate taxes, state subsidized education, medication and other services. Certainly before we ever got to the point where it was truly a two-tiered society we’d make the appropriate changes to help stability and create opportunity for everyone. Those who were poor would have their voice heard and legislatures would never allow any such system to become that out of control. Besides, free markets benefit everyone increasing the size of the pie and allowing for decreasing costs for everyone.

            The problem is not that we’d condone this type of society, but that we’d conditional ourselves to condone it. Many of the points commented on above are not too far from how we conduct ourselves currently. It is problematic given that after a century of explosive development we could move backwards as a race. While for the first time being physically able to support a majority of the population of the Earth in basic needs, we fail to do so due to a system that we created. Instead of providing the food that’s available, we ask individuals what they did to deserve it. Instead of supporting others to develop themselves and their economies, we move towards cheaper and cheaper labor in order to improve margins for the owners of companies but not for the purchasers of goods. One thing is certain, it will be interesting to see how far it goes before a breaking point is reached.

            In economic theory, labor is often analyzed from two perspectives. The first is how corporations decide the right amount and type of labor to invest in. The second is how individuals decide to make their choices in terms of employment. For most of economic history, these have been quite adequate for analyzing the result of different economic outcomes. Often decisions have been made from these perspectives in order to maximize economic output. There is, however, a third perspective that is often not discussed within the labor context—disparity of wealth.

            Certainly there is a lot of discussion on disparity of wealth; usually in terms of the amount of danger it poses to a society. In societies where wealth disparity is extremely high, there are a lot of problems in terms of security, health, and welfare. In human history, disparity often is a result of under developed societies that become more equal as economies develop. There are some arguments that the Kusnetz curve (an economic principle in which societies become more unequal as they develop and then more equal after development) might have a continuation that shows disparity increasing beyond development. While no industrialized nation has yet to see disparity become an extreme problem, it does seem to be occurring in today’s society.

            One reason for this disparity is the way in which payments to labor have decreased while payments to capital have increased. This may involve a complete rethinking about the way in which labor is rewarded. Typically a society should allocate to labor its marginal productivity – that is labor should be paid in accordance to what it makes. This, however, has become problematic as the payments to capital have become higher and higher as labor has been seen as either obsolete or easily replaceable. While it is hard to ask the question “What wage should labor be paid?”. There’s a clear problem that will occur not just for those who aren’t being paid, but also for those who are trying to sell their products. Beyond a certain point, goods pricing will have to decrease, but this may only occur after much economic hardship. Keynes often argued that the wage paid to labor should be uniquely analyzed since it is that wage that will funnel back into the economy. If wages continued to be decreased for a vast proportion of society, then there could be a economic freeze-up that will cause a lot of problems.

            In some cases, this almost hints at socialism (the kind that has often been adopted in many European countries). I am not advocating a move towards this, but only looking to a solution for wage disparities. In this case, as resources are naturally allocated to capital owners and away from labor, the government steps in to mitigate this disparity. While providing for basic services like education and healthcare, there is still ample upside gain for those who decide to push themselves harder in order to earn higher returns from their intellectual capital. It is often hard to ask companies to subsidize their labor through higher wages and setting a wage (above a minimum wage) would clearly limit the economic possibilities companies have and thus limit economic gains. At the same time, extreme gains as earned in America often are destabilizing instead of creating prosperity for society. 

Every day in the news, there’s more discussion about oil and the price of gasoline. With the upcoming election, there will certainly be lots of campaigning and discussion around this issue. The usual rhetoric of wealth distribution and trickle down economics begin making their rounds. Obama would have a taxation of the oil companies and then reallocate these funds to decrease the price of oil for poorer Americans. McCain opposes this taxation stating that this will hinder investment going forward in Oil and Gas exploration and drilling. Unfortunately, both of these plans are dangerously foolish.

The real issue here is oil and energy. Oil, and more broadly hydrocarbons, will remain the most influential and also detrimental factor for the world. Hydrocarbons still provide the majority of energy needs in the world today. Renewables have not found a viable option for storing energy and thus have remained only a small portion of energy production (except for dams, very few renewable sources comprise a portion of energy in the US). One of the greatest challenges humanity will face, besides global warming, will be how to move energy away from hydrocarbons and towards other sources.

Obama’s plan for taxing oil companies and using that money to lessen the price at the pump is at best foolish and at worst dangerous. Taxing profits of large oil companies certainly would not be in anyway viable. In many cases, oil companies will in some way pass this tax on to the consumer. McCain is correct in that this will hinder investment and in the long run increase the price of energy. With the lower profitability, companies will either pass the tax onto the consumer or lower their cost basis. Either way, the end result will be a future rise in the price of gasoline as money that would have been used for investment would be in the short run allocated to consumers by a lowering of the price of gasoline at the pump. More dangerous would be the subsidizing of a very influential commodity in the economy. By artificially depressing the price of gasoline, these taxes would hinder investment into other areas (such as renewable) by causing demand for gasoline to rise. As the general public is satisfied with gasoline, the demand for other forms of transportation and renewables technology will decline.

In some ways, it seems only natural that while the rest of the US suffers high gas prices, oil companies should not be making exorbitant profits. The fact, however, is that profits represent the spread between a firms inputs and their outputs. While commodity markets do not operate in the same way that a manufacturing market might, the general business concept is to turn your costs into higher revenues. Companies as economic agents fulfill this role surprisingly well. Mostly, a group of individuals could never be as efficient as a market—often times individuals destroy value in the market. If we were to take profits from oil companies and give them to the general American public, we would be artificially hindering investment and development in this market.

These economic agents help society quickly and safely adjust to the environment. The rise in the price of oil has helped a lot of competitors to oil develop other technologies to compete. However, given that this is a market for addicts (no one can operate without oil), there are many reasons why government intervention may be necessary. In many cases, oil companies can sell oil for whatever price since people need it to travel. At the same time, it is detrimental to divert resources into the renewables as these companies will often lose money on renewable forms of energy. The government should make a concerted and strong step towards encouraging renewable energy through research and development. At the same time, oil companies should begin pursuing diversification into other markets. Many mining companies will purchase mines containing different metals in order to insulate the company from shocks in commodity pricing. Oil will always be in demand, but going forward the prices will continue to rise and often squeeze the margins at refineries. Many oil producers would do well to begin diversifying their revenue streams while helping to develop a better market for energy.

            Right now we are in one of the worst times for financial institutions. A perfect storm has come about leading to a precarious situation for most banks and investment firms. While much has been said about the sub-prime market and the precipitous rise in interest rates, little is remembered of one of the first events that marked the beginning of the end—the Structured investment vehicles. The CDO and CLO markets also saw downturns at about this time.

            Structured investments were one of the biggest sources of debt financing. These items were modeled after the mortgage backed securities and were an extension of financial theory that had moved its way through the markets over time. Mortgages were one of the first extensions of an academic view that all investment opportunities could be analyzed as a risk vrs. Reward prospect. In this case for the debt issuers, the goal was to minimize risk with respects to a fixed reward. The long standing idea was that these debt obligations could be packaged together into a larger group of which pieces of that group could be sold. While I might not be able to give my neighbor 500,000 dollars loan for his house, I could own a piece of his mortgage and 30 other guys that fit his profile.

            Interestingly enough, many people didn’t mind being far removed from the actuality of their investment and liked the ability to easily understand the analytics of what they owned. At the same time, the glut of liquidity in the markets caused people to be less risk averse and offer more supply for some of the riskiest securities. The problem, however, came with the amount of abstraction done concerning the mortgages. While banks and sellers of mortgages had an obligation to pass through the important information concerning the mortgages, they increasingly had less incentive to insure that the little information they did give out was accurate.

            One thing that is interesting is how the debt markets here diverged strongly from the equity markets. While these two markets have different outlooks and security, the changes taking place between the two accentuate why the SIVs and debt markets would see a huge change. It would seem incredibly odd for banks to try this with equities. In this case, they would package together these “stock portfolios” that grouped together a certain set of companies with similar risk profiles. While this might sound like a mutual fund, it differs in one key aspect—similarity of risk. While a mutual fund will spread themselves amongst a set of stocks with different risk profiles, SIVs and debt markets would create smaller portfolios of similar profiles which meant that diversification was not really occurring. At the same time, the debt portfolios had less oversight into what they actually owned, while stock portfolios will pay close attention to the items within the portfolio.

            The important thing is where things will go into the future. The SIVs and debt markets are an important source of liquidity for businesses. While debt was too freely given before, it is now unrealistically hard to get. SIVs typically were using short term payments to cover more long term investments which was probably a poor choice in terms of liquidity since they would have to pay back money far in advance of making it back on the investments they would have to sell. While financial engineering has helped us to understand that all securities are similar in key respects such as risk and return, they have often blinded us to the reality that truly good investment comes from the intangibles. If we only analyzed companies as cash in/cash out vehicles with differing volatilities of earnings, it would be hard to determine which ones held true value. While debt is more secure than equity, it does not mean that diligence is not as important for the investor. Sometimes we underestimate a person or companies willingness to file bankruptcy.