As far as I am aware there are only four legal ways to become seriously rich in a short period of time: to inherit or marry into money, to hit a lottery or sales jackpot, to become the CEO of a large public company or investment fund in the USA or to leverage one’s way into wealth. Out of the four, only leverage is not fundamentally determined by destiny or luck.
Not surprisingly, this explains why, throughout history, leverage never ceased to fascinate people as a kind of “Aladdin's lamp” for immense wealth. In fact, the history of financial innovation is little more than a continual re-invention of some form of leverage. Leverage or gearing is the percentage of external financing and it is often measured as the ratio of capital to debt or as the ratio of total debt to total assets.
Indeed, credit is an essential element of market capitalism. It allows those with entrepreneurial spirit to invest beyond their own capital and gives those without such spirit the chance to share in the success of entrepreneurship. This means that passive investors must accept a lower return to make it worthwhile for entrepreneurs to take the added risk.
The case to make debt-financed investments applies equally to families and governments. So, in a closed economy this might create an impossible situation where everyone wants to be a net borrower, leaving the central bank as the only net lender by creating the money necessary to fulfill the demand for debt. In such a system those in charge of dispensing credit have an extraordinary power over the fate of the borrowers.
In practice market economies rarely reach this extreme situation for three main reasons. First, many people cannot or do not bother to search for investment opportunities with returns well above the risk free rate of return. In particular, families and governments are often in this situation. Second, many do not have the collateral required by lenders or do not fulfill the requirements to access non-recourse finance. Finally, leverage is a double-edged sword and not all can or know how to cope with the risks of debt-financing.
To understand that there is a thin line between fortune and misery in the use of leverage, imagine that one can invest up to four times the value of his capital to achieve an expected return of 25%. If he succeeds his return will be 100%. But what if instead of an appreciation of 25% there is a loss of 25%? He would be completely wiped out.
The fact that the likelihood of a 25% loss is very small is not enough comfort because it will happen one day. And, if one keeps reinvesting all his proceeds, he will lose all his previous gains. Any roulette player knows this, but people often tend to forget it. Especially when prices have been going always in the same direction, as happened recently in the real estate market (many people had never observed a fall in housing prices).
So is it true that leverage, like death, in the end will always finish by catching us on the wrong side of the bet? Not necessarily, provided that we do not re-leverage all our gains, do not exceed a prudent level of leverage and manage it correctly (for instance by not carrying leveraged positions over-night).
To be prudent one needs to answer the important question of whether there is an optimal level of leverage and what are its determinants. Unfortunately, neither in theory nor in practice can we find an answer to this question.
First, different assets have different levels of volatility (for instance in the last 10 years, intra-day, the Dollar never fell by more than 4.8% in the Euro/Dollar market while in the stock market the shares of Microsoft never fell by more than 12%). Second, in itself, leverage changes the optimal composition of investment portfolios. Thirdly, because the optimal level of leverage may be above what lenders consider safe and lenders are often prone to stampede behavior creating wild fluctuations in what they judge as safe or not.
But, most importantly, at the theoretical level we find ourselves in a difficult position. This is true, even after ignoring the wild fluctuations in banker’s lending limits while considering only the spreads (or mark-ups) they charge to compensate for risk. Theoretically the optimal level can be defined as the level of leverage that maximizes the difference between the returns achieved with debt finance and those obtained without any leverage. The problem lies in the fact that the two curves depicting the marginal efficiency of capital cannot be derived separately.
In the absence of estimates for the optimal level of leverage, prudence dictates that one should err on the down side by keeping a reasonable margin below the level of debt capacity acceptable to lenders. This can be easily defined in relation to margin requirements or the present value of future free cash-flows. With this proviso and knowledge of the nature of debt-financing, investors may be able to turn a potential foe into a friend.
Monday, 25 July 2011
Sunday, 24 July 2011
Marx and Friedman Were Wrong About the Suicidal Nature of Capitalism
The suicidal nature of capitalism has been predicted by several authors, both supporters and enemies of capitalism. By suicidal we mean a process through which capitalism would weave its own destruction.
Among the most influential theories we found Karl Marx’s surplus value theory of capital accumulation, Schumpeter’s claim that the success of capitalism would lead to a form of corporatism fostering values hostile to capitalism, especially among intellectuals, Milton Friedman’s theory on the suicidal nature of capitalists and Solzhenitsyn's attack on the commercialized nature of Western culture. In this post we will examine why Marx’s and Friedman’s predictions are wrong.
Marx’s prediction derives from his theory of capital accumulation presented in Chapter XXV of his book The Capital. In a nutshell Marx breaks down capital into fixed costs (the value of fixed capital) and variable costs (the sum of wages) and assumes that as the accumulation of capital proceeds the ratio between the two would increase resulting in a growing number of unemployed (the so-called industrial army reserve). This system would implode through over-production, over-population and misery.
It is easy to see why his model is wrong. First, not all technical progress is labor saving (on the contrary). Second, his Malthusian assumption of an ever growing population is wrong because fertility rates diminish with increasing incomes. Finally, and most importantly, he failed to see that workers would become capitalist and now hold a large part of a nation’s capital through pension funds and personal holdings. This was his most clamorous failure. Instead of his prediction that we would all become proletarians we all became capitalists. His motto “workers of the world unite” should have been “capitalists of the world unite”.
Friedman’s theory on the doom of capitalism was given in a Lecture at the Cato Institute entitled “The Suicidal Impulse of the Business Community”. His main contention was that when faced with policy issues business people tend to be very short-sighted. This leads them to seek government protection for their own industry, to favor public education which tends to be socialist-oriented, to lobby for the transformation of anti-trust laws into regulatory controls and to give more political contributions to nonprofit left wing organizations (three times more) than to non-profit right wing institutions.
He admits that he has not a good explanation for this suicidal behavior but advances three possible reasons. These include the presumption among business people that everyone is an expert in economics, the Schumpeterian argument that within large organizations people develop essentially bureaucratic-socialist attitudes and that there is a general propensity to look out for government action as an all-purpose cure for every ill. He dismisses the first two and retains the last.
By doing so, Friedman makes four mistakes. First, he ignores that like everybody else, given the chance, business people will be free riders on Government money. Second, payments to left wing organizations are made as insurance or protection against those from where they see more danger. Third, he fails to make a distinction between the different types of capitalism (managerial capitalism, state capitalism and market capitalism). Finally, as Adam Smith noted long ago, capitalists and conservatives are not necessarily the great defenders of capitalism. The true defenders of capitalism are consumers and investors without a controlling stake in their companies.
It is one of the great ironies of history that the capitalistic economic system, the greatest wealth creation machine ever invented, has so many enemies and critics among its beneficiaries (ranging from the church, government, academia to the business community). Yet, the supreme proof of its superiority is the fact that despite so many enemies and without an army of supporters it has nevertheless conquered the world.
Among the most influential theories we found Karl Marx’s surplus value theory of capital accumulation, Schumpeter’s claim that the success of capitalism would lead to a form of corporatism fostering values hostile to capitalism, especially among intellectuals, Milton Friedman’s theory on the suicidal nature of capitalists and Solzhenitsyn's attack on the commercialized nature of Western culture. In this post we will examine why Marx’s and Friedman’s predictions are wrong.
Marx’s prediction derives from his theory of capital accumulation presented in Chapter XXV of his book The Capital. In a nutshell Marx breaks down capital into fixed costs (the value of fixed capital) and variable costs (the sum of wages) and assumes that as the accumulation of capital proceeds the ratio between the two would increase resulting in a growing number of unemployed (the so-called industrial army reserve). This system would implode through over-production, over-population and misery.
It is easy to see why his model is wrong. First, not all technical progress is labor saving (on the contrary). Second, his Malthusian assumption of an ever growing population is wrong because fertility rates diminish with increasing incomes. Finally, and most importantly, he failed to see that workers would become capitalist and now hold a large part of a nation’s capital through pension funds and personal holdings. This was his most clamorous failure. Instead of his prediction that we would all become proletarians we all became capitalists. His motto “workers of the world unite” should have been “capitalists of the world unite”.
Friedman’s theory on the doom of capitalism was given in a Lecture at the Cato Institute entitled “The Suicidal Impulse of the Business Community”. His main contention was that when faced with policy issues business people tend to be very short-sighted. This leads them to seek government protection for their own industry, to favor public education which tends to be socialist-oriented, to lobby for the transformation of anti-trust laws into regulatory controls and to give more political contributions to nonprofit left wing organizations (three times more) than to non-profit right wing institutions.
He admits that he has not a good explanation for this suicidal behavior but advances three possible reasons. These include the presumption among business people that everyone is an expert in economics, the Schumpeterian argument that within large organizations people develop essentially bureaucratic-socialist attitudes and that there is a general propensity to look out for government action as an all-purpose cure for every ill. He dismisses the first two and retains the last.
By doing so, Friedman makes four mistakes. First, he ignores that like everybody else, given the chance, business people will be free riders on Government money. Second, payments to left wing organizations are made as insurance or protection against those from where they see more danger. Third, he fails to make a distinction between the different types of capitalism (managerial capitalism, state capitalism and market capitalism). Finally, as Adam Smith noted long ago, capitalists and conservatives are not necessarily the great defenders of capitalism. The true defenders of capitalism are consumers and investors without a controlling stake in their companies.
It is one of the great ironies of history that the capitalistic economic system, the greatest wealth creation machine ever invented, has so many enemies and critics among its beneficiaries (ranging from the church, government, academia to the business community). Yet, the supreme proof of its superiority is the fact that despite so many enemies and without an army of supporters it has nevertheless conquered the world.
Saturday, 23 July 2011
Financial Investment – Art, Science or Gambling?
In principle, everything we buy can be treated as an investment and therefore to a large extent investment is like breathing, something that everybody knows about. However when dealing in financial assets we should avoid the traditional statement that investment is the commitment of funds with the hope of gain, or a process of buying and selling securities with a view to get the greatest possible return, or, more plainly, the art of buying low and selling high.
This is so because the services provided by financial assets (money, securities, contracts or hybrids) include the protection and transfer of wealth, the facilitation of partial ownership and the provision of liquidity. That is the utility we derive from them depends primarily not on its material use but on rotating our exposure to them so that we may profit from distributions and changes in their market value (mostly in secondary markets).
Thus, we define financial investment as “a process of rotation between financial exposures which at the time of our choosing will allow us to attain the highest possible net liquidation value above that achievable without rotation and risk”. This means that at any given moment in time we may compare the valuation of our holdings in long, short and hedged positions in financial instruments with the valuation of such portfolio in a previous date.
The success of exposure rotation is the result of skill and luck. The skills required depend on the investment approach chosen (day-trading, event-trading or portfolio management) as well as on the strategies pursued. The net returns achieved may be amplified or reduced through taxation and leverage which also require specific skills.
Like in many activities the skills are both innate and nurtured through practice and education. Thus skills must necessarily be a combination of art, science and gambling. And, specific strategies and instruments require different combinations. For instance, investing in derivatives is closer to gambling while investment in fixed-income securities is more reliant on science.
In terms of science we could look at investment as an optimization problem defined as the maximization of total return over a given time horizon subject to a number of risk constraints. However, because of the uncertain nature of the investment outcomes, this mathematical formulation of investment is not feasible.
Alternatively we may look at investing as a form of gambling. To draw analogies with gambling we must distinguish games that combine luck and skill, like poker and football, from those that are purely games of chance like the roulette or the lottery. This distinction is fundamental because investment can clearly be considered as a game of the first kind, a game that mixes skills with luck but not a game based on pure luck or randomness.
Finally, we may define the investment activity as an art, an art not only in buying and selling but an art in forecasting prices and in undertaking calculated risks. What distinguishes science from art is not the degree of science and technique used in a particular activity but rather the creative and aesthetic nature of the activity. This is crucial to spot short-lived market imperfections and in this regard some view investment as a craft while others consider it to be the last liberal art.
Our preference goes to classify investment as a liberal art, defined as an activity based on worldly wisdom achieved by developing mental models enabling investors to extract knowledge acquired through multidisciplinary approaches (including the traditional disciplines of accounting, economics and finance, but also physics, biology, philosophy, psychology and literature). To a large extent, such an art form must be developed on an individual basis and as a self-satisfying activity.
Unfortunately not everyone can be an artist. However, the beauty of market capitalism is that not all investors need to pursue the art of investment. They may outsource it to honest professional investors.
This is so because the services provided by financial assets (money, securities, contracts or hybrids) include the protection and transfer of wealth, the facilitation of partial ownership and the provision of liquidity. That is the utility we derive from them depends primarily not on its material use but on rotating our exposure to them so that we may profit from distributions and changes in their market value (mostly in secondary markets).
Thus, we define financial investment as “a process of rotation between financial exposures which at the time of our choosing will allow us to attain the highest possible net liquidation value above that achievable without rotation and risk”. This means that at any given moment in time we may compare the valuation of our holdings in long, short and hedged positions in financial instruments with the valuation of such portfolio in a previous date.
The success of exposure rotation is the result of skill and luck. The skills required depend on the investment approach chosen (day-trading, event-trading or portfolio management) as well as on the strategies pursued. The net returns achieved may be amplified or reduced through taxation and leverage which also require specific skills.
Like in many activities the skills are both innate and nurtured through practice and education. Thus skills must necessarily be a combination of art, science and gambling. And, specific strategies and instruments require different combinations. For instance, investing in derivatives is closer to gambling while investment in fixed-income securities is more reliant on science.
In terms of science we could look at investment as an optimization problem defined as the maximization of total return over a given time horizon subject to a number of risk constraints. However, because of the uncertain nature of the investment outcomes, this mathematical formulation of investment is not feasible.
Alternatively we may look at investing as a form of gambling. To draw analogies with gambling we must distinguish games that combine luck and skill, like poker and football, from those that are purely games of chance like the roulette or the lottery. This distinction is fundamental because investment can clearly be considered as a game of the first kind, a game that mixes skills with luck but not a game based on pure luck or randomness.
Finally, we may define the investment activity as an art, an art not only in buying and selling but an art in forecasting prices and in undertaking calculated risks. What distinguishes science from art is not the degree of science and technique used in a particular activity but rather the creative and aesthetic nature of the activity. This is crucial to spot short-lived market imperfections and in this regard some view investment as a craft while others consider it to be the last liberal art.
Our preference goes to classify investment as a liberal art, defined as an activity based on worldly wisdom achieved by developing mental models enabling investors to extract knowledge acquired through multidisciplinary approaches (including the traditional disciplines of accounting, economics and finance, but also physics, biology, philosophy, psychology and literature). To a large extent, such an art form must be developed on an individual basis and as a self-satisfying activity.
Unfortunately not everyone can be an artist. However, the beauty of market capitalism is that not all investors need to pursue the art of investment. They may outsource it to honest professional investors.
Friday, 22 July 2011
Bond swap plan is for Greece and Greece only, but it won’t be enough.
The FT just published a few details of the bond swap agreement in the new bailout for Greece. The swap agreement is only for Greece, and “All other euro countries solemnly reaffirm their inflexible determination to honour fully their own individual sovereign signature”.
The only interesting feature of the agreement is the voluntary exchange of bonds maturing before 2019 by 15 and 30 year bonds, paying 5.9 and 6.8%, as a compensation for the banks accepting a 21% “haircut” on the value of the existing bonds. IIF, the Banker’s designer of the plan, estimates a participation rate of 90%.
The Greek government will have to use the new funding to buy European AAA bonds to post as collateral for the new bonds. The cover ratio was not specified, but if it is close to one the “haircut” will be meaningless. Even at 50% and with a take up rate of 90% the effect of the effective haircut would be only “9.45%”.
As been amply demonstrated in last few years the Greek problem is not one of liquidity but of solvency. We and many other observers have estimated that to get out of insolvency Greece needs a debt pardon of about 50%.
All the other measures announced to support Greece are not enough to fill the gap between these 50% and the expected “haircut” of 9.45%. So, it is only a matter of time before Greece needs another bailout, probably as early as 2013.
The only interesting feature of the agreement is the voluntary exchange of bonds maturing before 2019 by 15 and 30 year bonds, paying 5.9 and 6.8%, as a compensation for the banks accepting a 21% “haircut” on the value of the existing bonds. IIF, the Banker’s designer of the plan, estimates a participation rate of 90%.
The Greek government will have to use the new funding to buy European AAA bonds to post as collateral for the new bonds. The cover ratio was not specified, but if it is close to one the “haircut” will be meaningless. Even at 50% and with a take up rate of 90% the effect of the effective haircut would be only “9.45%”.
As been amply demonstrated in last few years the Greek problem is not one of liquidity but of solvency. We and many other observers have estimated that to get out of insolvency Greece needs a debt pardon of about 50%.
All the other measures announced to support Greece are not enough to fill the gap between these 50% and the expected “haircut” of 9.45%. So, it is only a matter of time before Greece needs another bailout, probably as early as 2013.
Thursday, 21 July 2011
Taxation and Moral Values – the Case of Conspicuous Consumption
Everywhere, politicians advocate public policies to foster virtues (e.g. philanthropy) and discourage vices (e.g. smoking) through both the revenue and the spending side of the budget. However, they frequently treat them differently by failing to measure separately the costs of tax breaks and surcharges applied to achieve such policies.
Free markets do not require neutrality in the rates of taxation on property, income and consumption. Indeed, they should not be neutral in relation to the taxation of consumption for the satisfaction of basic needs (food, healthcare, etc.) and the taxation of luxuries and conspicuous consumption. Fiscal neutrality is often defined as in the FT Lexicon: “when the impact of taxes and of government spending cancel each other out, with demand neither boosted nor curbed”. Others add the requisite that it does not cause distortions. Besides, to some extent, the use of taxation for policy purposes goes against the principle of budget unity, and the repudiation of earmarking specific revenues for given expenditures.
However, in general, when it comes to differentiating between different classes of conspicuous consumption there is a strong case to advocate the rule of fiscal neutrality. We will exemplify with a choice between spending on impressionist masters and trophy wives, because the first may have some cultural value while the second may be morally degrading.
Imagine for example an ostentatious billionaire who is considering spending 50 million on a master’s painting or in marriage to a super-model under a pre-nuptial agreement that grants her the same amount if the marriage lasts three years. Since he is neither an art lover nor is he in love with his trophy wife both types of investment are morally questionable.
Yet, most countries will treat differently the two investments when he decides to file for divorce or sell the painting. Assuming that he cannot earn transfer fees on his wife and makes a capital gain in the painting, some tax codes will give him a tax credit on his divorce settlement and charge capital gains in the sale of the painting. As a result, he will be rewarded in the most degrading investment and will be punished in the cultural investment. This is exactly the opposite of the proclaimed objective of encouraging virtue and discouraging vice.
Not only is the taxation of virtues and vices difficult on practical grounds. For instance, it is impossible to distinguish between a genuine and a convenience marriage. But it is also impossible to make a distinction between capital gains and losses on ethical grounds. Therefore, taxation should be kept away from policies based on moral judgments. Its concerns should be based mostly in a fair sharing of the funding and the minimization of the government revenue collection costs.
You do not need to agree with James Buchanan and other libertarians that a moral order is preferable to moral anarchy and moral communities because it only requires a minimal intervention of the Government. Simple common sense tells us that governments are not apt to judge on the basis of moral merits, without becoming an easy prey of vocal interest groups.
Free markets do not require neutrality in the rates of taxation on property, income and consumption. Indeed, they should not be neutral in relation to the taxation of consumption for the satisfaction of basic needs (food, healthcare, etc.) and the taxation of luxuries and conspicuous consumption. Fiscal neutrality is often defined as in the FT Lexicon: “when the impact of taxes and of government spending cancel each other out, with demand neither boosted nor curbed”. Others add the requisite that it does not cause distortions. Besides, to some extent, the use of taxation for policy purposes goes against the principle of budget unity, and the repudiation of earmarking specific revenues for given expenditures.
However, in general, when it comes to differentiating between different classes of conspicuous consumption there is a strong case to advocate the rule of fiscal neutrality. We will exemplify with a choice between spending on impressionist masters and trophy wives, because the first may have some cultural value while the second may be morally degrading.
Imagine for example an ostentatious billionaire who is considering spending 50 million on a master’s painting or in marriage to a super-model under a pre-nuptial agreement that grants her the same amount if the marriage lasts three years. Since he is neither an art lover nor is he in love with his trophy wife both types of investment are morally questionable.
Yet, most countries will treat differently the two investments when he decides to file for divorce or sell the painting. Assuming that he cannot earn transfer fees on his wife and makes a capital gain in the painting, some tax codes will give him a tax credit on his divorce settlement and charge capital gains in the sale of the painting. As a result, he will be rewarded in the most degrading investment and will be punished in the cultural investment. This is exactly the opposite of the proclaimed objective of encouraging virtue and discouraging vice.
Not only is the taxation of virtues and vices difficult on practical grounds. For instance, it is impossible to distinguish between a genuine and a convenience marriage. But it is also impossible to make a distinction between capital gains and losses on ethical grounds. Therefore, taxation should be kept away from policies based on moral judgments. Its concerns should be based mostly in a fair sharing of the funding and the minimization of the government revenue collection costs.
You do not need to agree with James Buchanan and other libertarians that a moral order is preferable to moral anarchy and moral communities because it only requires a minimal intervention of the Government. Simple common sense tells us that governments are not apt to judge on the basis of moral merits, without becoming an easy prey of vocal interest groups.
Wednesday, 20 July 2011
Capitalism, What Capitalism?
In most countries wealth is created under various economic systems. An economic system is defined by a set of rules defining the relationship between interacting economic agents. For instance, in a feudal system the relationship between the landlords and their subjects was based on serfdom. Similarly the relation between the state and its citizens is exerted through coercion.
By contrast in voluntary and capitalist sectors the relationships between economic agents are defined freely through contractual arrangements. The first is based on bundling resources, risks and benefits while capitalism is based on unbundling them. In a capitalist system capitalists own the resources and profits but take the risks, while guaranteeing a contractual wage paid to workers. Both systems require the right to private property and its protection but only capitalism requires that most transactions between different agents be carried out through free and competitive markets.
The study of wealth predates the emergence of capitalistic systems but the modern economic science has its foundations in Adam Smith’s book on the Wealth of Nations. His book does not use the words capitalism or capitalist (curiously, the word capitalism had been used since 1633 but it was only popularized in the mid 19th century by the Marxist opponents of capitalism). Instead, the book is centered in showing why competition through competitive markets is the most efficient way of allocating resources and producing wealth. Since the capitalist system is the only system dependent on market competition it follows that, apart from a short experiment with communism, the history of modern economics and capitalism are inextricably intertwined.
Yet, the statisticians who have been developing the system of national accounts since the 1930s have never attempted to report the wealth contributed by each economic system – state, voluntary and capitalist. Instead they give us a breakdown of employment and GDP by sectors of activity and type of organization (e.g. households, government, financial and non-financial firms). Thus, when one wants to measure the contribution of the agents working in the capitalistic sector the task becomes almost impossible.
This is so because the so-called for-profit sector includes many types of capitalism. Moreover, the exchanges between for-profit firms and the other two sectors (state and voluntary) have reached a large volume of transactions which are not always executed on a competitive basis. Often such activities create a sector called grey-capitalism.
The various types of capitalism must be defined on the basis of their reliance on free and competitive markets. The purest form of capitalism is called market capitalism and it includes all self-employed and investor-controlled firms which are basically price-takers trading in free and atomistic markets. Other types of capitalism include the regulated industries, oligopolies, and management-controlled firms that operate under various not-fully-competitive systems, namely: managerial capitalism, crony capitalism, socialist state capitalism, corporatist state capitalism or social market capitalism.
Since economic theory has only proved the supremacy of pure competitive systems, any departures from such systems should be accepted only as a second best option justifiable solely by market failures and externalities. However, in the absence of entirely free markets, competition between the various types of capitalism does not ensure that the winner in terms of market share will be market capitalism. Indeed, quite the opposite may happen.
So, paradoxically, a rising share of market capitalism can only be achieved by regulating the growth of the other not-for-profit and capitalistic sectors. The rationale for such regulation is that the maximum collective welfare can be only achieved by a growing sector of market capitalism. That is, true capitalism ≡ market capitalism!
By contrast in voluntary and capitalist sectors the relationships between economic agents are defined freely through contractual arrangements. The first is based on bundling resources, risks and benefits while capitalism is based on unbundling them. In a capitalist system capitalists own the resources and profits but take the risks, while guaranteeing a contractual wage paid to workers. Both systems require the right to private property and its protection but only capitalism requires that most transactions between different agents be carried out through free and competitive markets.
The study of wealth predates the emergence of capitalistic systems but the modern economic science has its foundations in Adam Smith’s book on the Wealth of Nations. His book does not use the words capitalism or capitalist (curiously, the word capitalism had been used since 1633 but it was only popularized in the mid 19th century by the Marxist opponents of capitalism). Instead, the book is centered in showing why competition through competitive markets is the most efficient way of allocating resources and producing wealth. Since the capitalist system is the only system dependent on market competition it follows that, apart from a short experiment with communism, the history of modern economics and capitalism are inextricably intertwined.
Yet, the statisticians who have been developing the system of national accounts since the 1930s have never attempted to report the wealth contributed by each economic system – state, voluntary and capitalist. Instead they give us a breakdown of employment and GDP by sectors of activity and type of organization (e.g. households, government, financial and non-financial firms). Thus, when one wants to measure the contribution of the agents working in the capitalistic sector the task becomes almost impossible.
This is so because the so-called for-profit sector includes many types of capitalism. Moreover, the exchanges between for-profit firms and the other two sectors (state and voluntary) have reached a large volume of transactions which are not always executed on a competitive basis. Often such activities create a sector called grey-capitalism.
The various types of capitalism must be defined on the basis of their reliance on free and competitive markets. The purest form of capitalism is called market capitalism and it includes all self-employed and investor-controlled firms which are basically price-takers trading in free and atomistic markets. Other types of capitalism include the regulated industries, oligopolies, and management-controlled firms that operate under various not-fully-competitive systems, namely: managerial capitalism, crony capitalism, socialist state capitalism, corporatist state capitalism or social market capitalism.
Since economic theory has only proved the supremacy of pure competitive systems, any departures from such systems should be accepted only as a second best option justifiable solely by market failures and externalities. However, in the absence of entirely free markets, competition between the various types of capitalism does not ensure that the winner in terms of market share will be market capitalism. Indeed, quite the opposite may happen.
So, paradoxically, a rising share of market capitalism can only be achieved by regulating the growth of the other not-for-profit and capitalistic sectors. The rationale for such regulation is that the maximum collective welfare can be only achieved by a growing sector of market capitalism. That is, true capitalism ≡ market capitalism!
Monday, 18 July 2011
Subsidy Madness: The New Energy Policy of Germany
Free money is everywhere and every time a sure way to waste money in the most ludicrous ways.
Often this is only pathetic without causing serious damage to the economy. For instance when Brussels pays you to keep your pony paddock or when you no longer need even to pretend to grow olives; you simply have to show that you have title to the land and that you are keeping it in good nick, olives or no olives.
French farmers used to be the champions when it came to exploit the madness of government subsidies, but they are now being surpassed by the German producers of the so-called renewable energy (mostly wind and solar power).
Some years ago Germany established by law a ‘feed-in tariff,’ which obligated private utilities to buy renewable electricity from private producers at prices up to seven times higher than the market price and make their ratepayers pay for it (other countries like Portugal followed with similar measures). Some years after the German government imposed a moratorium on building nuclear power plants (one of the cheapest producers of electricity, see the table below) and ordered the existing ones – which produced 25 percent of the country’s electricity – decommissioned by the year 2021. The annual cost of this madness costs German taxpayers more than 17 billion Euros, this is an amount equivalent to more than 10% of the entire European Union annual budget).
To understand why this is economic madness you just need to consider this example. Imagine that a firm has two power plants, one powered by wind and the other by oil. The first has fixed costs of 40 cents per Kwh and zero variable costs. The second has 10 cents in fixed costs and 5 cents in variable costs. In a free market firms would build a second fuel-powered plant and decommission the wind-powered plant. But this not so as long as the government pays them a subsidy or lets them charge a tariff high enough to make the wind-power profitable. Now the firm’s optimal mix in terms of the two technologies will depend on the vagaries of the government policy not on the economics of the most efficient technology.
Unfortunately the madness of this policy is not an exclusive of the rich Germans. The debt-laden Portuguese responded to the recent rise in imported energy prices by switching to a similar energy policy and they have even overtaken Germany. Portugal now gets 53% of its electricity from renewable sources. The bad news is that it costs them 3 or 4 times more than conventional sources (at their current high level). Not a rational move, is it?
Often this is only pathetic without causing serious damage to the economy. For instance when Brussels pays you to keep your pony paddock or when you no longer need even to pretend to grow olives; you simply have to show that you have title to the land and that you are keeping it in good nick, olives or no olives.
French farmers used to be the champions when it came to exploit the madness of government subsidies, but they are now being surpassed by the German producers of the so-called renewable energy (mostly wind and solar power).
Some years ago Germany established by law a ‘feed-in tariff,’ which obligated private utilities to buy renewable electricity from private producers at prices up to seven times higher than the market price and make their ratepayers pay for it (other countries like Portugal followed with similar measures). Some years after the German government imposed a moratorium on building nuclear power plants (one of the cheapest producers of electricity, see the table below) and ordered the existing ones – which produced 25 percent of the country’s electricity – decommissioned by the year 2021. The annual cost of this madness costs German taxpayers more than 17 billion Euros, this is an amount equivalent to more than 10% of the entire European Union annual budget).
To understand why this is economic madness you just need to consider this example. Imagine that a firm has two power plants, one powered by wind and the other by oil. The first has fixed costs of 40 cents per Kwh and zero variable costs. The second has 10 cents in fixed costs and 5 cents in variable costs. In a free market firms would build a second fuel-powered plant and decommission the wind-powered plant. But this not so as long as the government pays them a subsidy or lets them charge a tariff high enough to make the wind-power profitable. Now the firm’s optimal mix in terms of the two technologies will depend on the vagaries of the government policy not on the economics of the most efficient technology.
Unfortunately the madness of this policy is not an exclusive of the rich Germans. The debt-laden Portuguese responded to the recent rise in imported energy prices by switching to a similar energy policy and they have even overtaken Germany. Portugal now gets 53% of its electricity from renewable sources. The bad news is that it costs them 3 or 4 times more than conventional sources (at their current high level). Not a rational move, is it?
Tuesday, 12 July 2011
Means vs. Ends: Hedonism and Happiness
Our blog is mostly about reflections on the means to achieve human happiness. Still, from time to time, we need to keep sight of what are the end pursuits of humankind. Often, these are not easily distinguishable from the means like when we pursue a long but healthy live or when we need to trade immediate pain for future pleasures.
The later is often discussed when pursuing a hedonist approach to achieve happiness. A hedonist is defined as “someone who strives to maximize net pleasure (pleasure minus pain)”. This definition is vulnerable to the usual caveats of defining inter-temporal maximization in an environment of life uncertainty and volatile preferences. Equally important is the trade-off between individual and group satisfaction (family, social, national, etc.), sometimes called utilitarianism.
Constrained maximization is not only complex but also a poor guide for action when inter-temporal choice is involved. Despite the fact that at the unconscious level we seem to be wired in a hedonistic way to seek pleasure and avoid pain at the conscious level the science of the brain has not yet uncovered ways to explain masochist or depressive behaviors and similar deviations. Consequently a simplistic taking up of hedonism would lead us to sacrifice the future for the present.
Yet, despite its limitations, hedonism can also help us to tackle the eternal human despair over life expectancy. Almost 2000 years ago, when Seneca wrote his essay “On the Shortness of Life”, life expectancy was about one third of what it is now in developed countries. Nevertheless we continue to suffer over the same issue. Should medical science find ways to treble it again our descendents will still despair over the same issue and so on until eternity? Like Seneca, in the end we all conclude that life is never too short if we do not waste most of it. By living a full life we mean enjoying both the immediate sensorial pleasures as well as the pleasure obtained from friendship and idealistic conscious pursuits, whether metaphysical or not.
In conclusion, a mild and responsible pursuit of hedonism when complemented by love and enlightened virtues is an essential means to achieve human happiness.
The later is often discussed when pursuing a hedonist approach to achieve happiness. A hedonist is defined as “someone who strives to maximize net pleasure (pleasure minus pain)”. This definition is vulnerable to the usual caveats of defining inter-temporal maximization in an environment of life uncertainty and volatile preferences. Equally important is the trade-off between individual and group satisfaction (family, social, national, etc.), sometimes called utilitarianism.
Constrained maximization is not only complex but also a poor guide for action when inter-temporal choice is involved. Despite the fact that at the unconscious level we seem to be wired in a hedonistic way to seek pleasure and avoid pain at the conscious level the science of the brain has not yet uncovered ways to explain masochist or depressive behaviors and similar deviations. Consequently a simplistic taking up of hedonism would lead us to sacrifice the future for the present.
Yet, despite its limitations, hedonism can also help us to tackle the eternal human despair over life expectancy. Almost 2000 years ago, when Seneca wrote his essay “On the Shortness of Life”, life expectancy was about one third of what it is now in developed countries. Nevertheless we continue to suffer over the same issue. Should medical science find ways to treble it again our descendents will still despair over the same issue and so on until eternity? Like Seneca, in the end we all conclude that life is never too short if we do not waste most of it. By living a full life we mean enjoying both the immediate sensorial pleasures as well as the pleasure obtained from friendship and idealistic conscious pursuits, whether metaphysical or not.
In conclusion, a mild and responsible pursuit of hedonism when complemented by love and enlightened virtues is an essential means to achieve human happiness.
Friday, 1 July 2011
Grow or Fail!?
The FT published recently some comments by James Murdoch claiming that News Corporation – the world’s largest media conglomerate – is not big enough. The reason, he argues, is that “When you actually look at the competitive set in an all-media market place, where you have monolithic brands, from Google and Apple etc, to the big [telecoms incumbents] Telefónica, Deutsche Telekom, Verizon – all the characters on a playing field or a terrain that has essentially collapsed – there are much, much bigger beasts than a News Corporation, or a Time Warner”.
So, he means that because the whole media sector (from production to distribution) is going through a technological revolution we are in for a “winner-takes-all competition”. I do not think so!
Interestingly enough the founders of News Corp, Google and Apple still control their companies and are not considered as part of the managerial capitalism sector, which thrives on rent-seeking behavior secured through oligopoly and regulatory protection. So, he is probably just voicing the usual kids whine about “that boys’ toy is bigger than mine” so dear to CEOs of managerial controlled firms.
There is however a case to consider whether the new technologies are promoting a mitigated from of winner-takes-all, the so called long-tail business model. In this model (with a long history in music and book publishing) the top sellers take about 80/90% of the total revenue while the remaining millions of producers have to fight for the residual 10/20% of revenues.
Whether this will be exacerbated or attenuated will depend not only on technology but also on the profit maximization choices of the leading companies. Should those “running the pipes” and the viewing devices – the telecoms and IT companies (e.g. Verizon and Apple) – be allowed to build oligopolistic positions based on competition for subscribers by offering “”all-you-can-eat” contents and devices for free, and then some producers and content aggregators (e.g. News Corp) would become almost entirely dependent on an oligopolistic advertising aggregator (e.g. Google). Under this scenario, it is not unreasonable to expect that content aggregators would also need to build oligopolistic positions.
Thus the fundamental question is whether atomized content producers and end-consumers would be well served by a supply chain (from aggregators to device manufacturers) that would be mostly oligopolistic. I do not think that they would benefit from such an end-game. Here is where economists and regulators should focus their attention. Our first impression is that some size limits should be considered before we get into “too big to fail” situations, regardless of whether they are managerial or entrepreneurial run firms.
These limits should be designed in a way similar to those that we advocate for the managerial sector in general. Not based on some old fashioned ideas like the percentages of ownership and national content.
Only a leading sector of market capitalism can protect the entire capitalist system as one of the main pillars of happiness for humankind.
So, he means that because the whole media sector (from production to distribution) is going through a technological revolution we are in for a “winner-takes-all competition”. I do not think so!
Interestingly enough the founders of News Corp, Google and Apple still control their companies and are not considered as part of the managerial capitalism sector, which thrives on rent-seeking behavior secured through oligopoly and regulatory protection. So, he is probably just voicing the usual kids whine about “that boys’ toy is bigger than mine” so dear to CEOs of managerial controlled firms.
There is however a case to consider whether the new technologies are promoting a mitigated from of winner-takes-all, the so called long-tail business model. In this model (with a long history in music and book publishing) the top sellers take about 80/90% of the total revenue while the remaining millions of producers have to fight for the residual 10/20% of revenues.
Whether this will be exacerbated or attenuated will depend not only on technology but also on the profit maximization choices of the leading companies. Should those “running the pipes” and the viewing devices – the telecoms and IT companies (e.g. Verizon and Apple) – be allowed to build oligopolistic positions based on competition for subscribers by offering “”all-you-can-eat” contents and devices for free, and then some producers and content aggregators (e.g. News Corp) would become almost entirely dependent on an oligopolistic advertising aggregator (e.g. Google). Under this scenario, it is not unreasonable to expect that content aggregators would also need to build oligopolistic positions.
Thus the fundamental question is whether atomized content producers and end-consumers would be well served by a supply chain (from aggregators to device manufacturers) that would be mostly oligopolistic. I do not think that they would benefit from such an end-game. Here is where economists and regulators should focus their attention. Our first impression is that some size limits should be considered before we get into “too big to fail” situations, regardless of whether they are managerial or entrepreneurial run firms.
These limits should be designed in a way similar to those that we advocate for the managerial sector in general. Not based on some old fashioned ideas like the percentages of ownership and national content.
Only a leading sector of market capitalism can protect the entire capitalist system as one of the main pillars of happiness for humankind.
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