Monday, October 6, 2008

The Republicrats will win the next U.S. election

The Republicrats are not an officially recognized party, yet for all intents and purposes, they might as well be. They represent, I believe, the symbiotic relationship between the Republicans and Democrats. In between the rhetorical maneuvers of “change” and displays of “patriotism”, lies a commonality that is evident to any impartial observer. This interaction would be quite comical if it were not for the fact that its consequence will prove grave for the entire nation. Sifting through the glib headlines and MSNBC/Fox News sound bites that have come to encompass the “issues”, the fact of the matter is that neither party proposes alternatives to treat the root causes of the problems that bedevil our nation. Hence the term Republicrats. I will take two issues to make my point.

The U.S. currently finds itself with a public debt of about $9.6 trillion; this does not even count the $5.4 trillion liability resulting from the de facto nationalization of Fannie Mae and Freddie Mac or tens of trillions in other unfounded government liabilities. Since the Reagan administration, Republicans have become intoxicated with spending. Hinging on their interpretation of supply-side economics, they believed that lowering taxes would increase government receipts (this is the famous Laffer Curve), thus giving them the ability to spend without little constraint. They have “reasoned correctly from this erroneous premise.” Democrats, on the other hand, have had an equally nefarious record. They will quickly point out and say, "hey, at least Bill Clinton reduce the budget deficit." Unfortunately, however, that's not entirely true. In fact, public debt increased during Clinton’s Presidency. According to Treasury Direct, an agency of the U.S. Bureau of Public Debt, Mr. Clinton’s administration added about $1.5 trillion public debt. Currently, our nation needs to borrow $2.5 billion dollars, primarily from foreign sources, on a daily basis to meet its bills. Making matters worst is the fact that the dollars backing the debt have been printed out of thin air—thanks to the U.S. Treasury Dept. and the Federal Reserve System. The excessive supply of dollars has not translated into higher prices in the U.S. because foreign governments have had an insatiable appetite to acquire them. If one assumes that the foreigners will always crave dollars, then the U.S. will continue to get a free ride. If one assumes the contrary, more unpalatable consequences are surely to come. Despite this ominous forecast, neither party has candidly addressed this issue. Instead they talk about more spending, giving more money away to other nations, and continuing to use government credit to bail out corporations.

On the foreign policy front, the theme repeats itself. Neither party has relinquished its imperial ambitions to embrace peaceful multilateral relations—an absolute must in order to foster international trade. Democrats offer “no imperialism without representation”; that is, a continued belligerent foreign policy, as long as there is world consensus. Republicans, well, it goes without saying that they are the party of “perpetual war for perpetual peace”. The U.S. Constitution gives authority to declare war only to Congress. Yet, hearing presumptive presidential and vice-presidential candidates these days one wouldn’t think that. In fact, rarely anyone mentions that Congress never declared war on Iraq; a resolution was passed but never a declaration. I can only come to the conclusion that continued breach of U.S. law will prevail. So as a net result, one party wants to take the U.S. citizen out to McDonalds while the other one proposes Berger King.

Wednesday, September 17, 2008

What is Seen and What is not Seen

John Kay, a Financial Times columnist, wrote the following article that in essence exemplifies the reality of the unseen consequences of financial regulation. Of course, in this environment where a calmed, tempered, and realistic assessment of our economy is replaced by ideological, fantastical, and sheer lunatic views Kay's argument may be lost or perhaps simply ignored. In the end, as one of my favorite analysts proclaims, "you don't get what you expect, you get what you deserve."


Taxpayers will fund another run on the casino

By John Kay

Published: September 16 2008 19:48 | Last updated: September 16 2008 19:48

Fannie Mae and Freddie Mac were probably the world’s most heavily supervised financial institutions, subject to a specialist agency, the Office of Federal Housing Enterprise Oversight. The office employed 236 people at the time of its last annual report. OFHEO did not fail because it was understaffed or not well informed about Fannie Mae’s activities, but because it lacked authority. The entire staff earned less in aggregate than Franklin Raines, the aggressive chief executive who masterminded Fannie’s expansion.

Like Martin Wolf, I yearn for a world in which regulators would moderate the inherent instability of the financial system. But my yearning is tempered by modest expectations of what regulation can achieve. Martin’s realism, which I share, acknowledges that public expectations are much higher and politicians will claim to respond to these expectations. But the politicians will fail. The next financial crisis will be different in origin and the rules that will be introduced to close the doors of today’s empty stables will prove irrelevant.

It is easy to assert that the solution to any market failure is better regulation. If regulators were all-knowing and all-powerful; if they were wiser than the chief executives but willing to do the job for a fraction of the remuneration awarded to such executives; if they understood what was happening in the dealing rooms of Citigroup, Merrill or Lehman better than Chuck Prince, Stan O’Neal, or Dick Fuld; then banking regulation could protect us against financial instability. But such a world does not exist. Market economies outperform planned economies not because business people are smarter than civil servants – sometimes they are, sometimes not. But no one has enough information or foresight to understand the changing environment, so the market’s messy processes of experiment and correction yield better results than a regulator’s analysis.

In an imperfect world, the simple rules that Martin seeks have unanticipated and counterproductive consequences, as with the reserve requirements imposed under the Basel agreements. Reserve ratios were transformed from an internal discipline of prudent management to an external burden to be evaded when possible. Because these rules distinguished different asset categories, they opened the doors to regulatory arbitrage, fuelling the explosion of securitisation, which is at the root of current problems. Capital requirements proved ineffective in preventing banking failures and as soon as crisis struck, they proved counterproductive, forcing banks to constrain good lending to meet regulatory obligations. The proposed solution – of course – is further refinement of the regulations – to legislate against structured investment vehicles, to supervise the categorisation imposed by rating agencies and to introduce counter-cyclical reserve requirements.

In our debate in London last week, Martin used a forceful metaphor to describe the impact of the development of financial conglomerates – a utility is attached to a casino. The utility is the payments system that enables individuals and non-financial companies to go about their everyday business confident that they can make and receive payments, and lend and borrow to finance normal transactions. That activity needs to be protected from the consequences of the booms and busts that are an inevitable concomitant of securities trading in volatile markets.

There are two routes to this result. One is to separate the utility from the casino. Narrow banking prevents conglomerate institutions from relying on the assets of their unsophisticated customers as collateral for their highly sophisticated trading. Another approach regulates the casino sufficiently to ensure that failure there cannot jeopardise the utility. This latter outcome is not feasible and to come close to achieving it would end financial innovation.

The industry will successfully resist both the ring-fencing of everyday banking and the meaningful regulation of trading operations. Martin and I both recognise that in the next crisis, as in this, the taxpayer will step in to fund the casino in order to protect the utility.

Tuesday, September 9, 2008

The FED & The U.S. Treasury Dept.

Occasionally, there is unvarnished and stark truth reported in newspapers about the very nature of the powers-that-be who claim to look out for the welfare of its citizens. I'm talking about the Federal Reserve System and its partner in crime...err, i mean the Treasury Dept.

Here is what the Financial Times said about our wonderful institutions, which in my opinion, they have it right. Pointing to the fact that private investors were reluctant to bail out Freddie Mac and Fannie Mae, the article claims that as a result the government had to play superman. Consequently, "the former investment banker [Hank Paulson] has in essence converted the Treasury into the US hedge fund of last resort (with the Federal Reserve as its prime broker)."

There you have it. Two sentences reveal the perverse aspect of institutions hailed as having saved the day. If anyone does not believes that, I have a bridge to sell them.

Saturday, August 30, 2008

So Much For Obama's Change

The Financial Times issued the following report. The moral of the story: money talks and hmmm walks.

Lawmakers ignore special interests clampdown

By Stephanie Kirchgaessner in Denver

Published: August 30 2008 03:42 | Last updated: August 30 2008 03:42

On his path to winning the Democratic nomination, Barack Obama swore that he would change Washington by stamping out the influence of special interests who buy access and favours from the political establishment.

But there was little evidence that change was on the way in Denver. Despite the passage of ethics rules in Congress last year designed to curb the influence of lobbyists and other donors, the Democratic National Convention was funded almost entirely by corporations that pumped tens of millions of dollars into the event, using a loophole in campaign finance rules.

In restaurants and hotels, lawmakers mingled with lobbyists and other donors just as they do in Washington, out of the view of the general public, and seemingly unconcerned by Mr Obama’s stance against lobbyists – he has banned them from donating or taking paid positions on his campaign. Among the dozens of parties were JPMorgan’s salute to women governors, the Recording Industry Association of America’s concert featuring Kanye West, and a brunch hosted by Billy Tauzin, a former congressman who is chief executive of PhRMA, the pharmaceutical lobby group.

As the California delegation headed to a party thrown by AT&T on Monday to cap off the first day of the Democratic convention, they were greeted with goodies. Though these days, even gift bags come with disclaimers.

“We have been advised by counsel that we may not offer complimentary gift bags to public officials,” read a sign on one table.

Another sign said public officials might have to skip the nibbles because of ethics rules. The telecommunications group, a big sponsor of the convention, hosted another party attended by Steny Hoyer, House majority leader, who in June helped craft legislation that protected AT&T from lawsuits related to its alleged participation in the Bush administration’s warrantless eavesdropping programme.

Lawmakers seen at a party hosted by Washington lobbyists Heather and Tony Podesta appeared visibly uncomfortable when asked what they thought about Mr Obama’s stance on lobbyists.

Carl Levin, the Michigan senator, shrugged and said he had not followed the lobbying debate. “They are old friends of mine,” he said of the Podestas.

“The rules are the rules. But sometimes the rules defy commonsense,” said Steve Israel, a Long Island congressman who also attended the brunch. “A PAC [political action committee] can give a $5,000 contribution and discuss that member’s vote, but a $12 lunch where you are talking about the Mets is against the rules.”

Congressman Paul Kanjorski said with a smile that it would be better not to talk about it. For proponents of campaign finance reform, even more problematic than the parties was the corporate sponsorship of the convention itself, and the special access big party donors were given to Mr Obama’s speech.

Experts say that every election cycle raises the cost of access. When President George W. Bush ran for office in 2000, individuals who bundled donations on his behalf were given special status if they raised $100,000 (€68,000, £55,000). Today, campaign finance experts say, bundlers are raising as much as $500,000.

In all, private donations exceeding $112m will pay for about 80 per cent of the combined convention costs in Denver and St Paul, according to a study by the Campaign Finance Institute.

“Both candidates have talked a big game about reducing the influence of special interests,” says Massie Ritsch of the Center for Responsive Politics, which tracks political donations. “But they don’t seem to have done much to rein in their political parties and the corporate subsidies underwriting the conventions that nominate them.”

Investing the Templeton Way - Book Review

Chapter 1

The chapter is primarily biographical, which details John Templeton's (JT) philosophy of value investing was an extension of his overall lifestyle. It demonstrates how his background influenced his outlook in life. His father a true capitalist who lost all his fortune truly betting everything he had accumulated in the commodities market. His mother, on the other hand, taught him to be curious, self-reliant, and instilled a sense of a greater mission in life through the Christian faith. He was a firm adherer to thrift, believing it was a cornerstone to securing one's well being.

Chapter 2

It details the basic premise from which Templeton believed was the way to obtain bargain stocks. The chapter can be nicely summarized by his observation that "bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell." While this principle may appear easy to exercise, in fact human nature turns contrary to it. The psychological factors that affect markets are stressed nicely. Readers may resort to Nicholas Taleb's book, The Black Swan, which extensively explains these anomalies that shape people and markets.

Chapter 3

It stressed the salutary aspects of considering the universe of stocks, including those emanating from foreign sources. Although not expressing a strict number of different assets, Templeton believed that diversifying "was a good way to protect you from yourself." He emphasized a "bottom-up" approach to foreign investing. That is, once a particular company or companies were identified, one would then assess the macroeconomic environment. I found this advise helpful because my approach is the opposite: review the macroeconomy, spot areas or industries that may be depressed and are poised for a comeback, and then seek good companies. Templeton gives the reader a good rule of thumb on what to focus in terms of foreign economies. He esteemed unfavorably places where government was profligate, operating rules onerous for business, and prevented individual creativity from taking root (e.g. Venezuela).

Chapter 4

It details the analysis JT used that led him to invest in Japan before everyone else. He benefited from the general perception of the extreme pessimism and ignorant views of the country held by the market during the 1950s and 1960s. His analysis revealed that stocks were extremely undervalued in comparison to U.S. stocks. The chapters goes in further details of what made JT an impeccable stock picker: he scrutinized his assumptions and made his own decisions--not based on the "wisdom of crowds." Moreover, he used quantitative measures (e.g. price no longer reflects estimated worth) in comparison to an alternative when to sell a stock. This led him to reduce his Japanese exposure in the early 1980s, just when everyone was beginning to inflate the bubble. But more importantly, this practice prevents an investor to be married to a particular investment.

Chapter 5

Occasionally JT was asked where the best investment prospects lied, he pointed that one should rather ask "where is the outlook most miserable" to find the most promising stocks. This chapter goes into greater detail explaining this philosophy by focusing on how JT concluded that U.S. stocks demonstrated good value, despite that it had been declared that "equities were dead" in the early 1980s. JT used various yardsticks of value to make decisions (e.g. P/E, PEG, P/BK, Enterprise value). But beyond simply calculating these metrics, he relied on his learned acumen to pick apart the assumptions underlying them. One should continually think outside the box because quantitative decision metrics will "eventually cease to work when everyone practices them in unison."

Chapter 6

The chapter gives us a glimpse into the innate irrationality that seems to grip the market more frequently than recognized. JT was able to profit mightily from rightly timing the NASDAQ crash. He noted that "the point of maximum optimism was reached when there were no more buyers left in the market, and the sellers were about to take control"--the opposite logic with respect to the point of maximum pessimism. Thus, JT shorted 84 stocks, each position worth $2.2 million, which ultimately netted about $90+ million in profits. JT gives us his shorting methodology: 1) control your losses, 2) remember rule #1. In order to control losses, establish a a price ceiling, which could be in terms of percentage change, for the stock before covering your position. Similarly, you must establish a point where you'll take profits.

Chapter 7

This chapter is an extension of the previous one. It details the mindset of the "bargain hunter" when dealing with market crisis. Irrespective of its nature and present sentiment, market drops are an ideal situation to take advantage because fear is pervasive. When other are alarmed and panic selling, you must maintain your composure and buy good stocks. After 9/11, JT bought a set of airline stocks that met a certain criteria (one-day price drop of 50%) because he understood that the government would bail-out those firms. Indeed, his expectation came into fruition, and thus was able to make a handsome return on his investment. The last two chapters underscore JT's keep ability of politics and economics that went beyond crunching number. As a result, he was well prepared to take advantage of market volatility.

Chapter 8

In this chapter we learn the analytical process JT exercised when investing in the South Korean economy. Following his disciplines of looking for great bargains in markets that were weighted under pessimism, South Korea was a perfect candidate after the effects of the Asian Crisis. As the book repeats numerously, simply investing in depressed markets without doing your homework is akin to speculating. We are furthered exposed in this chapter to JT's uncanny ability to assess his environment beyond number in such a way that leaves the reader wondering about his/her intelligence. "Bargain hunters who understand history...can appreciate the fact that these patterns repeat themselves over time, again, and again." Indeed, the operative word is "understand", something that very few individuals are capable--irrespective of their training and longevity.

Chapter 9

In this chapter we are encouraged to exercise good judgment to profit in assets outside our immediate purview. While JT was an excellent stock picker, he demonstrates his dexterity in fixed income assets. We are told of his advice of buying bonds prior to the technology stock market crashing. He reasoned that the fall in the market would adversely affect the economy by way of lesser consumption due to a negative wealth effect. JT understood that the Federal Reserve would come to rescue the economy by lowering interest rates. As a result, he undertook a carry trade (i.e. borrow in a cheaper currency and buy an asset denominated in another currency) buying zero-coupon bonds. When the FED lowered the interest rate, the value of the bonds purchased by JT increased in value. We are reminded to look at all assets and position yourself in such a manner so as to benefit your expected market environment.

Chapter 10

This chapter introduces the reader to JT's view on "the sleeping dragon", that is China. At first we are given an a cursory overview of modern Chinese history. Given that JT believes that China will continue to grow, it is a market that one needs to look quite thoroughly. As any country that is growing tremendously, there will be times when valuations will be above and beyond what a bargain hunter feels comfortable. By the early 1980s, JT understood that the Chinese would continue to open their economy, away from communist hold. Indeed, he noted, politically the country leaves much to be desired; but in terms of economic policy, JT thought that in comparison to the U.S. the Chinese has more freedom right now. We are reminded of the extreme pessimism principle for bargain hunter, i.e. mostly sellers are in the market. Only during that time, the best values will be found. As JT stated, "bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria."

Saturday, August 23, 2008

Panic of 1893: Another Example of Politicians Causing A Mess

"History doesn't repeat itself but it does rhyme." - Mark Twain

Indeed, looking back at the antecedents of the Panic of 1893 it seems as if we are reading in half measure the newspaper headlines over the last year. The economic hardship experienced during said depression was incomparable until then in the history of the United States. Politicians, who mascarade their ambitions for power in good intentions, were the progenitors of this economic mess.

During the 1880s, the U.S. economy was growing tremendously thanks in part to the economic shift from an agrarian to industrial society. The U.S. was becoming efficient in producing manufacturing goods that not only were sold locally but also were demanded internationally. The high economic growth and the coincidental increase in aggregate consumption led farmers to take on excessive debt to increase their productive capacity. In addition, the railroad industry had similarly overextended itself, as it believed demand would continue to expand from the people living west of the Mississippi. During this decade we witnessed something that today seems inconceivable: economic growth and deflation. Excessive debt in a deflationary environment, however, is a deadly combination for debt holders, because the value of money that is paid increases with time. Moreover, deflation meant that agricultural products became cheaper, thus producer's profit margins were squeezed. Nonetheless, for the industrialists (i.e. manufacturers) lower prices translated into a bonanza domestically and internationally resulting from greater demand for their products. During that time also, the U.S. (and the rest of the world in fact) operated under the gold standard, which meant that every dollar was backed gold. In other words, every dollar could be redeemed for that precious metal. This fixed exchange rate mechanism implied that monetary policy had limitations: money supply could not be manipulated by politicians without dire consequences. This is important to note because farmers (and other debt holders) wanted an inflationary monetary policy.

The government, seeking to please a voting block ahead of national interests, in 1890 passed the Sherman Silver Purchase Act, which required the federal government to purchase a fixed amount of silver with U.S. notes (i.e. dollars that were backed by gold). The net effect of this action caused the money supply to increase. Since gold had decrease in value relative to silver, widespread fear began to overtake the market that the U.S. would abandon the gold standard. Foreign and domestic holders of U.S. notes began to redeem them for gold. This generated a massive run on banks which ultimately led many to fail. The financial debacle spread to the real economy causing a number of bankruptcies. So the intentions of the government to help a special-interest group turned into a nightmare for everyone. It is estimated that during mid-to-late 1890s, unemployment ranged from about 11% to 18%. This anecdote makes us recognize that surely politicians will claim to exercise good judgment when using someone else's money to bailout others from the consequences of their actions. The notion that the 19th century was completely laissez fair does not hold under closer scrutiny. Today, nothing much has changed with respect to this aspect, as the U.S. federal government continues to want to manage economic expectations under the good stewardship banner. But as the old adage says, "the road to hell is paved with good intentions."

Wednesday, August 20, 2008

The Less You Read Newspapers and Watch TV, The Better Off You Are

That may seem counterintuitive, but in fact it is absolutely true. Fischer Black's seminal paper about market noise, written in the 1980s, gives a stellar explanation about this phenomenon (Journal of Finance, Vol 41, pgs 529-543). Noise represents large number of inconsequential events. This is contrasted with information, which relates to small number of significant events. People in general mistake one for the other, and thus make decisions that can ultimately lead to disastrous consequences--or alternatively to serendipitous results. Therefore "noise is what makes our observations imperfect. It keeps us from knowing the expected return of a stock or keeps us from knowing what, if anything, we can do to make things better." In this day and age, what will separate the relative success of one person from another will be predicated on the quality of information, not noise disguised as information. If you have ever walked in a securities trading floor, you will notice impressive databases that provide instantaneous information; much of it, however is simply noise. Traders undoubtedly will make buy and sell decisions supported by what they abstracted from these databases. This is the foundation that supports the view that daily stock price movements embody a voting mechanism. That is, market participants will buy/sell a stock as if casting a vote on the perceived price for a given amount of information (which is really noise).

I equate "noise" to the unfortunate human activity of gossip: There's a lot of it going around, but few of it deserves worthy consideration. However, people generally treat all gossip as credible information and act accordingly based on it. For the average person, irrespective of his or her condition (i.e. wealthy or poor), distinguishing noise and information can be a daunting task. As a result they will tend to gravitate to the "path of least resistance"; that is, to take whatever flashes in a screen from a "reputable" entity as reliable, without actually checking its veracity. Newspapers and television are primary culprits of disseminating it to the general public; so it is best for individuals to stay away from them as much as possible. I believe it is noise the fire that starts euphoric sentiments in the market. In other words, panic selling or ecstatic buying has its roots in discernment from this misinterpreted data. As a result, we become someone, as John Locke said, "reasoning correctly from erroneous premises." This analysis not only applies to stock markets but also to a wide array of human activity.

Monday, August 18, 2008

Why Central Economic Planning Fails

First let me define what i mean by central economic planning: It is a committee of people that is far removed from the actual place of economic activity and are trying to dictate the affairs thereof. For example, a bureaucrat in Washington D.C. decides the appropriate amount of federal money Billings, Montana necessitates to improve its roads (who would know better but the residents of said location); or for the Federal Reserve System to identify the exact interest rate that will equilibrate providers of money with users of money. In order to adequately ascertain the exact amount needed in both cases, the policymakers would need an excessive amount of information extracted from the market. This means that they would have to turn to everyone participating (and even those that do not) in the economy. Even if such information could be obtain (which is impossible) they would still have difficulty collecting it in real time. Even if that impossibility might conceivably be possible they would still be exposed to the vagaries and volatility of individual sentiments. The data, thus, would be quite chaotic.

This is at the heart of what the 1974 Nobel Laureate in Economics, Frederich Hayek, explained in his excellent work, "The Use of Knowledge in Society." We live in an age where scientific knowledge dominates policymaking and assume that this is all to it. But "there is beyond question a body of very important but unorganized knowledge which cannot be possibly call scientific in the sense of knowledge of general rules: the knowledge of the particular circumstance of time and place." In other words, individual transactions will be predicated on the assumption that one has unique information over the other, and thus not reveal it. That is, you are not going to show your edge to your competitor. In order to accept Hayek's view, which i share, one must renounce to all central economic planning because it will ultimately fail. Communism failed because its systems could not capture all data for appropriate decision making. In fact, communism did something that is difficult to accomplish: the value of a final product was less than the sum of the value of its inputs. Socialism fails for the same reason. You may ask, "what about Europe? Socialism seems to work there." The reason it has held up over there is that Europeans get a tremendous defense subsidy from the U.S. Being an empire, the U.S. has taken (whether it likes it or not) on the defense cost of European nations. It has done this since the end of WWII.

But to regress to our main point, policymakers do not consider "the knowledge of the particular circumstance of time and place" because (i think) it requires of them a genuine act of introspection about the consequences of their actions and to consider that they may have the whole thing wrong. This requires them to be humble--hardly a trait of politicians and their subservient bands. But more importantly, acceptance of this knowledge also requires rejection of positivism (see the end of my previous post). Many financial and economic assumptions would immediately come into question, such as the efficient market hypothesis, rational expectations, and Keynesian economics, to name a few. By no means i'm implying we should throw "the bathwater with the baby," but simply to recognize the danger to blindly accepting mathematical or empirical results without critical thinking. The former is no substitute for the latter. In spite of this axiom, we live in a world that believes empiricism is sacred. As long as this continues, there will always be market crashes, country crises, and (in our lifetime) world-wide economic chaos when our monetary system fails. "There is something fundamentally wrong," wrote Hayek, when our analysis does not consider "the unavoidable imperfection of man's knowledge and the consequent need for a process by which knowledge is constantly communicated and acquired." This continues to be true today.

Friday, August 15, 2008

Happiness Is In The Eye Of The Beholder

There has been a lot of debate about the economics of happiness. In other words, how much is income related to a person's happiness. A seminal study done by Richard Easterlin in the mid- 1970s revealed (correctly in my mind) that income is a poor indicator of someone's happiness. This became known as the Easterlin Paradox. That is, more income does not necessarily generate more happiness. This meant that achieving a high GDP growth, long view by politicians and economists as the appropriate gauge for welfare, will not guarantee satisfaction in a nation's citizens--which can only mean that there are other non-monetary factors at play. Most economists agree (me included) that income growth causes well-being to increase, but up to a certain imputed point. That is, the utility of money exhibits the form, in mathematical parlance, of a concave function.

However, earlier this year another study by Betsey Stevenson and Justin Wolfers professed the opposite conclusion: more income equals to more happiness. The authors claim that better information gathering sources and enhanced econometric techniques available today in comparison to Easterlin's time heightens the credibility of their results. Yet, a closer inspection of their study reveals that their findings are not what they're cracked up to be. First, the method of data gatherings is primarily surveys (so was Mr. Easterlin's study), which always run the risk of people not being completely honest. Second, unless the same people that Mr. Easterlin's study targeted were interviewed for the recent study--which they were not--the results will be suspect. I'm not saying they are wrong; i'm merely saying there is a doubt about their validity or better they should be taken with a grain of salt.

Third and most importantly, there is evidence that contradicts the authors' results. They mention that Japan's experience "does not undermine the claim that there is a clear link between economic growth and happiness." This conclusion was in contrast to what Easterlin had found in the same country. The authors, however, never mentioned that Japan has the highest suicide rate among developed nations. Furthermore, in Britain, which in particular the authors do not consider, there are nearly as many people who are medically unable to work because of depression or stress than people unemployed. In my view, these evidences severely dent the authors' entire claim.

That said, this debate has deeper roots. It is the idea that through econometrics one can fully assess those aspects of humanity that are impossible to quantify. The current study of finance and economics rests on the idea of positivism, that is "the purpose of science is to stick to what we can observe and measure." If happiness exists, then it must be quantified; if it cannot, then its existence is dubious. This is why it is taught in Econ 101 that we study "positive" economics , that is how things are; in contrast to "normative" economics, which emphasizes the way things ought to be. This means that any ideas about morality are taken out the analysis. It is interesting to note that Adam Smith, before writing The Wealth of Nations, laid out his morality foundation in his less-known work, The Theory of Moral Sentiments. This last work has fallen in the memory hole of modern economists. Happiness exits and money is not the way to measure it. I doubt there will ever be a good proxy to gauge it.

Wednesday, August 13, 2008

Crowd Mentality: A Look Into Finance and Politics

To truly understand modern politics, investing, or financial risk management one must also understand the characteristics of the crowd mentality. Very few, if any, scholarship on this subject is part of a standard undergraduate or graduate business, economics, or international affairs curriculum--at least based on my experience. This kind of study has been primarily ensconced to the fields of psychology, albeit there have been small inroads being made over the last decade by way of the nascent behavioral economics/finance field. Crowds in and of themselves are not a necessarily a bad thing; rather what is important to note is their motive and objective in achieving a particular objective. People can form crowds to perform a benign service for their local community or can be amassed to undertake the most scandalous actions. I will focus, however, on the aspects of crowds in general.

Nature of Crowd Mentality

The very nature of crowds is one of uncertainty. Their collective wisdom resembles those of animals in the wild: at moments serene but at other times sheer madness can be evident. Perhaps this is what John Maynard Keynes referred to when he made his proclamation that the market was inhabited with "animal spirits." People en masse display a level of intelligence significantly below than the average individual. In fact, crowds can only understand very simple, catch-phrased words like "war on terror," "fighting for democracy", or "real estate prices always go up" without critically analyzing their inherent contradiction. Thus crowds do not exhibit an ability to be thoughtful, but always eradicate those things that stand in the way of what they have already imagined. The very fact that crowds are extremely gullible by words and images, given their lack of mental capacity to reason, they are susceptible to leaders or self-proclaimed experts who will control them to achieve a particular end. Leaders who understand this are able to puppeteer the people by connecting seemingly separate events as cogent evidence of what the crowds already believes.

The moment this happens the leader(s) has the people at his disposal to do whatever he/she desires. For example, during the technology stock market bubble many people believed they were going to get rich because they had bought the next Microsoft, yet no one bothered to understand that most of those businesses were inadequate. "Experts" hailed the "new economy." Initially everyone followed the crowd; prices rose. When irregularities emerged that in fact those business plans were inadequate, stocks were sold. Everyone followed the crowd; stocks fell and the market declined. In its heyday, no news could temper the rosy scenery painted by the market gurus. But in the downturn, positive news could not prevent almost everyone heading for the exits at the same times, thus prices fell through the floor.

Psychological Analysis

Gustave Le Bon, the great French psychologist, described crowds this way: "A crowd thinks in images, and the image itself immediately calls up a series of other images, having no logical connection with the first. We can easily conceive this state by thinking of the fantastic succession of ideas to which we are sometimes led by calling up in our minds any fact. Our reason shows us the incoherence there is in these images, but a crowd is almost blind to this truth, and confuses with the real event what the deforming action of its imagination has superimposed thereon. A crowd scarcely distinguishes between the subjective and the objective. It accepts as real the images evoked in its mind, though they often have only a very distant relation with the observed fact (The Crowd, pgs. 24-25).

A recent article in the Financial Times about the presumptive presidential candidate Barack Obama gives further life to our analysis. In fact, Mr. Obama's current campaign is fascinating to watch. It resembles the dotcom boom/bust or the current real estate housing market experiences, in that glaring contradictions do not appear to molest market participants. Although it appears that his aura of invincibility may be wearing off. The FT article reports in part Mr. Obama's recent strategic European trip to impress upon voters at home of his abilities to maintain foreign support of U.S. activities, despite his non-existent international experience. What is worthwhile to note is a comment made by a former adviser to ex-President Clinton and to the 2000 Presidential campaign of Al Gore, who said the following: "What the last two weeks have shown is that Brack Obama is looking increasingly presidential which was, of course, the whole point of the trip and of yesterday's economic summit...It doesn't matter what else a voter thinks about a candidate, if they cannot imagine you as commander-in-chief then you will not become president. Last week's trip helps voters to imagine Obama in that role."

So there you have it, for those looking in from the outside the view is clear. The same analysis can be applied to most politicians, including John McCain. As someone I read once said, to paraphrase, either you're a contrarian or you're eventually a victim. I prefer the former.

Monday, August 11, 2008

The Dollar and The Federal Reserve: A Love Myth

"Dishonest scales are an abomination to the Lord, but a just weight is His delight," says a Biblical Proverb. But beyond just being a mere proverb, this principle is a vital pillar in any sound monetary system. Weaken the pillar and an entire economy is put at risk. Yet despite the aforementioned aphorism, time and time again "credible" and astute individuals come to the fore in defense of the Federal Reserve System (FED). Few truly recognize that it actually represents a balance that distorts prices, and hence a tremendous liability to our nation and to our liberty.

Several weeks ago a letter was co-written in the Financial Times by James Livingston, a history professor from my undergraduate university and by Marc Chandler, the head of currency strategy at a global bank. The letter clearly propagates myths and perceptions of the Fed and passing them as truths. I will take one excerpt that at best represents misinformation and at worst is grotesque historical revisionism. But before i do, let me provide a brief overview of Fed.

Federal Reserve System

Most people may not know that up until 1913 the U.S. did not have a central bank. Several institutions prior to 1913 had been created, but never in the form of the FED; however, all were dissolved because of their unconstitutionality. The FED is made up of 12 regional banks, which in turn are owned by private banks. As you can imagine, there's nothing federal about the FED; technically it is a private organization. In fact, several court cases, most notably Lewis vs. U.S.A., have affirmed that the FED is "privately owned and locally controlled operations." Through the federal funds rate, the FED (via the Federal Open Market Committee) affect monetary policy mainly in three different ways: 1) open market operations where bonds are sold/bought to decrease/increase the money supply, 2) adjust banks' reserve requirement, and 3) adjust the interest rate changed for emergency loans to banks (discount window lending). Although its domain is deposit-taking banks, the FED has begun assisting investment banks (i.e. non-depository institutions) for the first time since the 1930s.

The official mandate of the FED, as dictated by section 2A of the Federal Reserve Act is "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

Historical Revisionism

According to the Financial Times letter,

"the establishment of the Federal Reserve in 1913 was a huge contribution to democracy and it was overwhelmingly supported by finance capital at the time as necessary means of crisis management. Thereafter the market could not appear as an abstract externality driven by laws no one could manipulate, or even understand. Human intentionality, and thus democracy, was amplified as a result."

Although not a topic of this post, Mr. Livingston and Mr. Chandler appear to disregard the dubious origins of the FED. Also, they disregard that a scant 16 after its creation, the U.S. experienced its worst economic recession in its history. By their standards and definition of democracy, the years prior to 1913 must have been stagnant. They fail to realize that the most prosperous economic times the U.S. has experienced were in the years the FED did not exist. In fact, the growth rate of output (see Table 1) between 1870-1913 was about 4.42%, but only 3.14% between 1913-1972. It appears that the way the co-writers define democracy is by how much the hands of the government can manipulate economic activity. Make no mistake, despite the fact that the FED is a private agency, it is still subservient to the government. It is amazing that professed experts can make such a statement without recognizing that it is the same underlying reasoning why communists desire to influence an economy.

Let us see for a moment how wonderful "human intentionality was amplified." In order to test their theory, we will choose the FED's mandate of stable prices. When the U.S. had the gold standard every dollar was backed by the valuable metal; inflation was virtually non-existent. When the FED was created 1 ounce of gold was worth $20.67, by 1934 the ounce of gold was worth $35 (notice how gold prices historically had been stable). In 1971, the dollar abandoned the gold standard and since then we have seen the astronomical rise of the commodity, reaching a current price of about $900 per ounce. This represents a loss in value of the dollar of about 97% since 1913. The loss in value has been transmitted in the form of inflation; in fact during the gold standard lower prices were the norm. Whether people are willing to recognize it, inflation is a tax that falls heavily in the middle and lower classes. Economists call this government benefit seignorage; that is, those that print money are the first one to use it at a higher value. Once that money enters the economy and reaches the hands of its citizens it is worth less (inflation) than when it was first printed. This is the norm nowadays not only in the U.S. but all over the world. In other words, what we have achieved a massive "dishonest scale."

Friday, August 8, 2008

Competing Views On The Business Cycle

At a recent BIS Conference, Edmund Phelps, the 2006 winner of the Nobel Prize in Economics, delivered a speech on the topic of monetary policy. He outlined the difficulties encountered by monetary policymakers in trying to contain the economic troubles given the level of complexity (or dynamism) of advanced economies. Certainly there is no shortage of opinions trying to explain the genesis of the credit crisis engulfing the financial industry. These opinions, more or less, are based on understanding the root causes of the business cycle. While Mr. Phelps' speech was very good, i thought, it did not go far enough in explaining the root of economic imbalance. Granted, that was not the theme of his talk, but the views one holds about about how the business cycle operates will certainly influence the reception of the speech; thus the inclusion of such topic should have been a priority. I trust this post may shed a bit of light in this matter.

To begin to understand the root cause of the economic cycle one must understand the critical function that entrepreneurs play in an economy, especially under the influence of external factors. There are various schools of thought that try to explain this cycle. Yet, none but one satisfactorily explains why such high level of erroneous decision-making from people who are paid to forecast future business activity correctly is clustered around a particular period of time. Think about it: people make business projections, make investments based on those projections, and at a point in time there is a massive failure in their ability to forecast. Some number of businesses will always fail, there's no dispute on that argument; but it's peculiar that a lot of individuals who are good at forecasting suddenly loose that ability at the same time. Most popular theories miss this point entirely.

Brief Review of Business Cycle Theories

There are two broad camps where economists generally fall, although they are not all inclusive. Classical economists basically view the business cycle as a natural consequence to any production or spending dislocation. Because they are firm adherents to Adam Smith's invisible-hand, this dislocation would not be expected to be prolonged and it should fixed itself through market forces. Classicals do not explain in detail the rampant unemployment experienced in recessions, although some economists have made several propositions. Over the last 20 years, Classicals have expanded their theory to explain the why production and spending contract and point to productivity shocks (see Real Business Cycle Theory)--that is, as i like to say, anything that makes life easier. They were adamantly against government intervention. The other camp, headed by the ideas of John Keynes (aka Keynesians) claim that slack in private demand cause the business cycle: less demand, less businesses, less jobs, and well, less of everything we deem good. Since they believe that prices and wages are fixed in the short term, the only way to smooth out the cycle is through government spending. Keynesians are not concern about the sources of money of the government or how it gets to spend it. So, for example, if the U.S. government borrows from abroad to spend at home, Keynesian theory has no problem at all with that.

The Great Depression was certainly a turning point in U.S. economic history. Classicals expected the economic downturn to be short-lived, and when it did not turn out that way they lost credibility. Enter in the picture Mr. Keynes' The General Theory of Employment, Interest and Money published in 1936. A mathematician turned economist, Keynes' publication intentionally, it seems, created an idea that there was a scientific approach to social engineering by a central authority. The title of his book is a parallel to Albert Eistein's The Special and General Theory, where the latter expounded about the theory of relativity. Politicians, always looking for ways to increase their power, fell in love with Keynes' theory. Indeed, they took on Mr. Keynes proposition in full measure and beyond. It was until Milton Friedman came along to dispel the myth of Keynesianism. In short, Friedman (along with Edmund Phelps) stated that once market participants knew ahead of time what the government would do, people's expectations would automatically change, thereby leaving a particular economic situation unchanged. What mattered, therefore, was unexpected changes. The U.S. experience in the 1970's, a decade of rampant inflation and economic stagnation in light of government intervention, in my view, effectively nullified Keynesianism.

Monetarists, which is the school of thought that Milton Friedman belongs, insist that the business cycle in essence results from unstable money supply growth. Ask a monetarist the origin of any problem in the world and he/she will most likely answer you, "it's the money supply." While i agree with the free-market principles of monetarists, they have no problem accepting that the most important price of an economy--the interest rate, which is the price of money--is centrally-planned.

Another Business Cycle Perspective

The business cycle theory i am about to propose most likely you will not find it in any popular economics textbook nor will you hear about it much in mainstream academia. In fact, the more I learn about this theory, the more am convinced it is the most appropriate one to consider in the present day we live. Formally proposed by Ludwig von Mises, this "Austrian-school" economic theory is the only one that encamps an economy's capital structure as a pillar in understanding business cycles. In fact, base on his theory, Mises publicly declared, at the height of the 1920s boom, as a result of the Fed's intervention in the economy a severe economic recession would eventually ensue. Indeed, his prediction was realized. Succinctly, it states that when money creation is at full force, thus lowering interest rates below that which would exist in the absence of intervention, projects that would not have taken place become unrealistically profitable. The profitability illusion is destroyed, though not suddenly, once money creation ceases. Realizing they have been duped because of fictitious expected demand that resulted from too much printed money, entrepreneurs cut prices and production, thus causing an economic contraction. This is why financial institutions feel the first pinch, and why capital-intensive production falls more than consumer goods-related industries.

Consider the current U.S. experience. From 2001 to mid-year 2004, the Federal Reserve had a very loose monetary policy. This was the catalyst that fueled the housing, derivatives, and in part the commodities boom. From mid-2004 until early 2006, the FED changed its stance to a more tight policy. Once the FED initiated this policy, it was a matter of time before problems in the economy would surface. I realized in 2005 that our economy would suffer some serious setbacks; when that would happened, though, i had no idea. I expect production to continue to worsen and, given the weak balance sheet of the average U.S. citizen and the government, the horizon looks bleak.

As Ben Bernanke has acknowledged, the FED created the conditions of the Great Depression. Even though most economist focus on what the FED did after the stock market crashed in 1929, it is the excessive supply of money during most of the decade that goes unnoticed. This is why any economist who understands Mises theory could foresee the troubles ahead.

Thursday, August 7, 2008

Supply-Side Economics Bamboozle

Politicians are an interesting crop of individuals. Unlike the average person whom from day to day tries to do what is best for him and his family, the politician is trying to figure out a way how to get an advantage over everyone else irrespective of the unforeseen consequences. In other words, he is trying to find the proverbial free lunch. A free lunch is defined, according to John Black's Dictionary of Economics, as "a policy or combination of policies which produces advantages without any offsetting disadvantage." Another way to say this is to exclaim that eating a cheeseburger frequently at McDonalds will have no effect on a person's weight. Of course, this is an obvious example of a free lunch. But there are less obvious ones, which have the appearance of holiness but are anything but that. I am referring to the an economic thought that goes under the name of supply-side economics, which rose to preeminence during the Reagan years, has been followed by Bush II, and is intended to be used by the presidential candidate John McCain. Few (including myself) questioned whether supply-side economists had actually any thought at all. One thing is clear though, while all of us make a fool of ourselves occasionally, some hold out longer than others.

Supply-side Economics

Supply-side economics is rooted in the belief that a reduction in the marginal tax rates will cause the supply of labor to increase because of higher disposable income--that is, income after taxes. Now, the increase in labor supply will have the effect of expanding the output (GDP) capabilities of a nation. In technical terms, this is refer to as full-employment output (aka natural real GDP), the maximum output that can be produced when labor supply equals labor demand for a given capital stock and production function. No one disagreed with this assertion.

Since people always tend to save a portion of their income, supply-siders went even further to proclaim that the lower marginal tax rates would have a significant positive contribution to productivity (output per unit of input) and saving. This in turn would cause tax receipts to increase. Are you scratching your head? Yep. That's what their theory expressed.

During the Regan administration indeed the tax rate declined, beginning with the Economic Recovery Tax Act of 1981 and then with the 1986's Tax Reform Act ; but the salutary effects of the policies envisioned by their creators fell far from short. Empirical evidence demonstrates that labor supply and productivity grew more slowly in comparison to the years of Carter administration (source: Robert Gordon, Macroeconomics, pg. 348).

The Punch Line

But here is the clincher for one of greatest Ponzi schemes, in my view, in the modern history of the U.S. economy: the infamous Laffer Curve. Attributed to Dr. Arthur Laffer, who supposedly drew it on a napkin over a meal in a Washington restaurant, this curve demonstrates the parabolic relationship between tax receipts and tax rates. In other words, one can lower taxes and increase government receipts. Make no mistake, i support all tax cuts. What the economic theory did for politicians of the Reagan kind, who publicly endorsed a small government but in reality left much to be desired, was to legitimized its ambitious spending spree.

"You mean to tell me that we can reduce taxes and spend more?" one can still hear Reagan ask Dr. Laffer. Supply-siders turned Republicans, who traditionally shunned fiscal deficits, into embracing persistent deficit spending. In other words, they concocted a Keynesian world with a small government moniker: Truly a free lunch! In fact, government debt has increased from $1 trillion when Reagan began his presidency to the current figure of about $9.5 trillion! Over the last 25+ years, the U.S. Federal government has been behaving like the average U.S. citizen over the last 6 years: spending away to prosperity. Democrats will quickly point out and say, "hey, at least Bill Clinton reduce the budget deficit." Unfortunately, however, that's not entirely true. Although i won't go in much detail in this post, the figure Clinton reported to the public was not what actually was booked. In fact, the Clinton administration recorded a deficit almost every year he was in office.

Wednesday, August 6, 2008


It has been brought to my attention that there is html code showing in the postings' body. Although I don't see it on my end, I'm trying to find the problem. I deleted & re-posted the messages, but the problem still seems to be there. My apologies until the error is fixed.

Anatomy of a Financial Crisis

A former U.S. regulator was quoted in a recent article in the Financial Times saying, “if you had said a year ago that America could suffer a banking crisis on the scale of Japan, people would have laughed.” Of course, that “laughable” kind of (honest) rhetoric during the peak of the prosperity bubble was unwelcome and shunned. Just a bit over a year ago, one of the most incompetent CEOs to ever have managed a corporation was still claiming that better times were still on the horizon. Yet, at that time no one wanted to hear that such prosperity was an illusion, a castle made of sand. Wall Street had come to believe that human fallibility, along with the notion of risk, no longer existed. If a Jeremiah would have stood up to explain the imprudence of the “originate and distribute” banking model—i.e. extend credit to anyone then pass it on to a greater fool (for a commission)—that person would soon have been banished from eyesight or paid no mind.

But what is interesting about the FT article is the (I assume) rhetorical question posed by the Bank of International Settlements (BIS): “How could problems with subprime mortgages, being such a small sector of global financial markets, provoke such dislocation?” The BIS is “an international organisation which fosters international monetary and financial cooperation and serves as a bank for central banks.” Surely if anyone in the world knows the answer to that question, it is the BIS. But I doubt their attempt to propose a reason for the financial upheaval gets to the root of the problem. As far as I know, all central banks (and by extension the BIS) promote and endorse the current monetary arrangements, which is the source of our troubles. As I mentioned in my last post concerning unrealistic assumptions, central bankers operates under the premise that our fiat monetary system is sacred. Nothing can be further from the truth.

Undoubtedly, financial institutions deserver their fair share of the blame. However, despite the recent statement of innocence by Mr. Alan Greenspan, Anna Schwartz, a distinguished economist, aptly commented that the Central Bank’s policy from 2003 to mid-year 2004 “was too accommodative. [Interest] rates of 1 per cent were bound to encourage all kinds of risky behavior.” A rational market participant encountered with the option to use funds at a rate less than the inflation rate will almost always borrow to consume or invest. In short, this is exactly what transpired after 2001: excessive money creation (another way to say “lower interest rates”), led to below-market interest rates, leading to all sort of ill-advised behavior (i.e. moral hazard). The way it worked is as follows. When printed money enters a bank, part of the deposit gets multiplied as it moves along the banking system by way of loans. This is what’s called the multiplier effect. For example, bank A gets money from the central bank and will extend credit to one of its customers (say, to buy a house), that customer will make payment to bank B’s customer by depositing it in his/her account. Since Bank B (all banks in fact) has to keep a fraction of all deposits at hand (in the U.S. this equals to 10%), the remaining amount (90%) of the funds is lent to another customer (who maybe wants to buy a house too). This process is repeated over and over. As you can note, from a one time injection of printed money, more is created out of nothing when portions of it move from bank to banks.

What I have just explained is referred to as the fractional reserve banking system. Bankers love this model because it’s a free lunch: they get to use money (created out of thin air) and earn interest on it. Note that banks did nothing to get this money, but rather it was given to them by the central bank. The trouble with this banking system is that if a majority of a bank’s customers decides all at once to withdraw their deposits, the bank will immediately become insolvent because it does not have the sufficient cash to honor the liabilities. This is what recently happened to a major California bank.

Cuts Deeper

But our analysis of the financial crisis does not end there. The loans extended by the banks were bundled in off-balance sheet companies (aka special purpose vehicles), which then issued securities from them to be sold to investors. Some investors then repackaged those securities into other newly created special purpose vehicles of their own, and subsequently issued more securities that were sold to other investors. This process was repeated several times, each occasion generating toxic products with names like CDOs, CPDO, and others that few knew really what they were. At the same time, investors (e.g. hedge funds, private equity, etc) leveraged their exposure in these instruments by borrowing from other financial institutions, some of which were the same ones who created the aforementioned abstruse products. A lot of money was made along the way, of course. Human nature being what it is, everyone eagerly chased yield and became greedy. Recognizing the incestuous relationships these companies maintained, the system was bound to collapse at the slight notice of trouble.

Most mainstream economists are blind to the fact that every financial crisis and economic bust since the Industrial Revolution has been the result of excessive money creation. In our age, the finger is pointed to the Federal Reserve System. Contrary to what you read in most economic textbooks or in newspapers, central planning, which is what the Federal Reserve is, does not work in a dynamic economy: It always leads to a decline in living standards. In fact, the U.S. experienced its greatest economic expansion without the assistance of a central authority dictating monetary schemes.

So, to answer the original question posed by the BIS, anyone who believes they are getting a free lunch (fiat money) will always do foolish things. The 2003-2007 economic boom was nothing short of sheer fraud. Some people understand that printing money out of thin air is never a good thing. If anyone doesn’t understand why it is so, simply google Zimbabwe, you will find your answer there. So long as the current system is in place we will continue to experience these kinds of debacles: The financial crisis is merely the consequences of the severe capital dislocation experienced during the false economic boom.

More on this to come on future postings….

Don't Take Economics at Face Value

**This article was written and published in my school’s (Columbia University) student-run newspaper earlier this year. However, I originally wrote this in the fall of 2007—before it was evident that the financial sector was coming apart at the seams.

What is the likely scenario when someone lends money to another who has a history of not repaying? Well, the answer is not as obvious as you may think. If you are a normal human being, i.e. your cognitive faculties are in good order, then you would probably say the most likely scenario is that the person will not pay back. But if one asks a mathematician working at any popular hedge fund or at a rating agency, for example, then the answer depends on the manipulation of a few numbers and opaque formulas. Therefore, the “real” answer—like beauty—is in the eye of the beholder. Milton Friedman once said, to paraphrase, who cares about assumptions if your prediction is right? I add a corollary, if one’s results are right today, they won’t necessarily be right tomorrow. So on that note, I want to discuss two major assumptions that support some theories of finance and economics—disciplines that are near and dear to me. These assumptions have been discredited by common sense or history, but have been recycled and presented as new approaches. But mean regression is not only confined to statistics; it also applies to the acceptance of defunct assumptions. So-called experts that glorify them tend to exude a strand of hubris in their abilities to predict and to utilize methods that quite frankly invade the territory of faith, rather than to present a realistic observation of our surroundings.

Let me expose one such article of faith that is not much talked about but is of a monumental crux to the disciplines: homo economicus—a being that is rational, self-interested, and omniscient. This unique homo sapien, lauded in textbooks and in the classrooms of most of academia, is present everywhere but in real life. But he exists, say the experts. Take their word for it. Homo economicus is capable to instantaneously calculate all available information, consider alternatives, and discount activities that have not occurred yet. The complexities and ambiguities of life are reduced to a few variables, disguised under bell-shape curves or non-parametric estimations. He is then boxed in a static, two-dimensional graph that in part endeavors to depict in futility the unknowable uncertainty (or “unknown unknowns,” as the former Sage of the War Department—as I like to call him—Donald Rumsfeld, once uttered). We “now know”, however, that homo economicus might not be as rational as expected. For instance, he is able to maintain contradictory beliefs without hesitation, hold on to losing positions longer than he should, react differently depending upon how the “facts” are framed, and is plagued by numerous cognitive biases unbeknownst to him. One of the most renowned economists to ever live, Alfred Marshall, declared in 1890 that economics relates to the “study of mankind in the ordinary business of life.” Despite the insurmountable evidence confirming this observation, homo economicus is still on the loose—mankind is far from perfect and from obtaining complete knowledge and foresight.

The other assumption implicitly accepted relates to our fiat monetary system (i.e. value by decree)—as if it has existed since time immemorial. Money is fundamental to all economies because it is supposed to function as a storage of wealth for people. Without a sound monetary system the division of labor becomes severely strained. Today the pieces of colored paper (called money) issued by almost all nations derive their value from government magic: a law dictates how much something is worth. The U.S. Dollar, for instance, is supported by the “full faith and credit of the United States.” Some will quickly point and say, “wait a minute, it has to do with supply and demand.” Supply and demand intersect to yield a price not a value—there is a difference. It is incredible that this type of faith-based conjecture (fiat currency) is allowed to pervade as scientific and inerrant. Like an alcoholic at an open bar, that person is likely to have too much liquor. The same logic applies to governments that can wantonly print paper money: It creates distortion in the process of capital allocation. Looking at the annals of worthless money history, it can be noted that long-term purchasing power of all fiat paper is zero.

Assumptions are crucial. Without accurate accounting and recognition of them, decision-making becomes an obfuscated process. Wrong judgments are reached. Wrong decisions are made.

Introduction: Get Ready...Set...Go!

“I know nothing except the fact of my ignorance.”
Socrates, from Diogenes Laertius, Lives of Eminent Philosophers

I begin this modest experiment of plunging into the Blogosphere recognizing the ineptitude of my abilities to fully grasp all there is to know. As Socrates implied, if anyone lacks anything less than perfect knowledge, one is ignorant. Often we believe all knowledge is that which we can put under a test tube, apply the scientific method, and obtain a particular conclusion. Yet, there is unseen and unidentified knowledge that will always be ignored when expounding events happening around us. This is, I believe, at the heart of what Socrates was trying to get at: Irrespective of what we do to connect cause and effect or correlation and causation, the fact of the matter is that ultimately we may have the whole thing wrong. Is this a weakness on my part? On the contrary it is my strength—just like it was Socrates’ strength. How can that be? I have reduced the probability of becoming an individual, as John Locke exclaimed, “reasoning correctly from erroneous premises.”

Having said that, Socrates also proclaimed another universal truth: “The unexamined life is not worth living.” I reckon that this examination starts within us first, followed by our immediate surroundings, then extending further out as possible. Socrates’ statements may appear at first glance contradictory, but in fact they are not. We are exhorted to examine the unexamined, to take heed of our beliefs and perceptions and put them through the fire. If they stand the test, then we may have something meaningful. Ultimately, the life we live is evidence of what we hold dear. Our nature is one where it takes an extraordinary amount of energy to deconstruct what previously has been constructed—either by our own accord or exerted to us by exogenous forces—in our minds. We come to accept that evidence of absence is synonymous with absence of evidence, when in fact their repercussions are worlds apart.

I chose to name this blog uncommon insight and wisdom simply to recognize that my viewpoints may not be in line with what is generally accepted. In all frankness, I don’t take anything at face value—even in the areas of my personal life. I am an amateur skeptical empiricist—to borrow a phrase from Nassim Taleb. That is, someone who is “open-minded, skeptical, and empirical.” In other words, someone who does not easily accept things that have been packaged for mass consumption (e.g. war on terror, Obama/McCain, house prices always go up, etc). This will become quite apparent as you read my future missives.

Having expressed my caveat emptor, the objective of this project is to give commentary through the eyes of an economist on current issues that I feel are pertinent, mainly in the political and economics spectrum; although from time to time I may delve into issues that do not fit this mold. My methodology will be to try to peek behind the curtains and question (and maybe explain) what is happening. Personally, this blog is a beginning of a learning experience, which only God knows where it will lead. I welcome comments (not synonymous with ad hominems), as I am a firm believer that, as The Bible states, “the way of a fool is right in his own eyes: but he that hearkeneth unto counsel is wise.”

I conclude this introduction sharing with you the best lesson I received while in college. My professor back then (at that time we were at the zenith of the dotcom stock market stupidity) admonished us to be very careful to put into practice or take as given the words of so-called experts. I was still wet behind the ears then, thinking you can solve the world problems as if you would solve a quadratic equation. But as I grew older (and after the dotcom market crashed), the value of this simple advice made my entire undergraduate education certainly worth it. Given the predilection in our age for thirty-second sound bites and seeing an exponential growth of people who are experts in their own opinion, you can ignore the advice at your own peril.