Balance? We're nowhere near it! Lower Spending!

When you're in the situation pictured below, you take some boxes off the cart. You don't go get a bigger donkey!  Cutting spending is like removing some boxes, of course. Increasing taxes resembles getting a larger donkey, and also has a suspicious resemblance to getting more of our present government.

So the question is Balance? Taxing versus spending balance? We're so far from that, it makes a mockery of the word. While others debate 3 dollars of spending cuts for 1 dollar of tax increases, I think it should be somewhere above 10 dollars of spending cuts for each dollar of tax increases. That's if it's not all spending cuts, pure and simple. Government spending simply needs to be a smaller percentage of GDP. As Speaker Boehner's recent spending chart showed, spending is the problem, not taxation.

The problem with the taxation side is that we're taxed enough already. Yes, that spells TEA, as in TEA party. The meaning of the phrase "TEA party" has evolved quite a bit since it first emerged. It's had a lot of help in that evolution from people who neither like nor understand what it stands for.

By what measure are we taxed enough already? A good measure is whether the level at which entities in the economy are taxed, cause them to alter their behavior significantly to avoid taxes. Of course, rational economic actors will alter their behavior at any level of taxation, from a little to the truly crippling. That's the foundation of the saying "tax anything and you'll get less of it!" But above significant behavioral changes, markets get so distorted that people's wealth is reduced and overall economic performance suffers.

Back to balance. I'm with CNBC's Rick Santelli on balance. For another illustration see his videos using watermellons and a pea as props to illustrate how little Congress is dealing with the spending side of this "balance".  

Todd Akin, Republicans and Winning Elections

The Two Personalities of the Republican Party

The Todd Akin brouhaha brings into focus something I've thought about the Republican party for a long time. The Republican party is a mash-up of economic thought and socio-religious thought.

As you read this, recall those circular drawings you saw way back in about forth grade. You were studying the intersection of sets. There is the set of economic conservatives who vote Republican. And there is the set of social conservatives who vote Republican. The Republicans seem to assume at times that their voters are at the intersection of those sets. I don't assume that, and as I listen to peoples' commentary I suspect that most are outside the intersection of these sets.

That is, they vote Republican for economic reasons *or* because they are socially conservative. Often I think the social conservatives don't care about economic issues and the economically-minded or free-market voters stay Republican in spite of the socially conservative platform planks.

I worry about the limiting effect of the intersection of those sets. As I survey the American scene it appears to me that the set of social conservatives is shrinking. They may be hard-core and vocal, but small in numbers. And the rise of Hispanic voters may render them less important than otherwise.

What about those who are economically conservative and socially liberal, such as myself? We are sometimes called Libertarians. The only catch with voting Libertarian is that they don't have the juice to win - and a vote Libertarian is basically a split from a Republican candidate or issue that might win. 

Into all of this comes Todd Akin

The Republican assumption seems to be that it must have hard-core religious social conservatives in the tent (with Todd Akin suddenly excepted). I don't agree - instead, the whole fiasco is just another exhibit illustrating the wisdom of separating religion and state. I could mention Islam at this point, but I won't.

George W. Bush's strategy was brilliant at the time, I thought. He said a lot of nice things to keep social conservatives in the tent, but did very little in terms of trying to change policy. I liked it that way.

I believe that in America today, and given the ways it is trending, the closer Republicans move to a Libertarian-style platform the better they will do. That's because hard-core church attendance and socially conservative believers are declining in numbers. And young people who are not constrained by any such belief systems are increasing in numbers. And those same young people can no longer assume affluence will be theirs in middle age. They  hear the constant drumbeat in the media about the economy. Some of them will give economics systematic study, and come around to free-market thinking.

I'd celebrate if the entire abortion plank were dropped from the platform. To wit, if Todd Akin does not want an abortion, he does not have to get one. :-)

In my personal experience I've seen that a woman does not get an abortion lightly. That's even if that woman fights vehemently for the right for women to have them. It seems the right to have them is important, but theoretical, before a woman is pregnant. But when the fetus is hers, a lot of feelings, hormones, religious beliefs, fears, medical risks and facts, social concerns, and advice from loved ones suddenly come into her equation. And that's probably how it should be.

Markets Down Hard, Debt, and Obamanomics

I haven't written here in my blog in a long time. But I've been watching the economic scene. And as you might imagine I've been quite unhappy with our President, his administration, and the results of their economic policies. Here in California the effect is magnified and made even worse.

I see these factors holding back the U.S. economy:

• Debt
• The effects of some misguided corporate rescues
• Market and corporate uncertainty caused by government actions, discussions and personnel appointments
• Present and expected future avalanches of regulations
  

After U.S. markets closed today, after the 512-point Dow drop and 60-point S&P drop, I watched a clip of Obama in 2008 or 2009, in which he said the economy should be much better 3 years out, or his presidency will be a single term. Well, here we are, it seems. I'll soon hoist a martini to his single term.

The pundits' observations I thought most valuable were that the market's fall is not about the U.S. debt deal, but about Euro-zone debt worries, and the growing perception that the U.S. economy is not growing fast and may actually fall into a "double-dip" recession. We'll see what actually happens, but though I've searched and listened to truckloads of commentary, I don't see a catalyst for U.S. growth. Yes, there are some sectors that should grow, and yes, the middle classes may be growing in China and India. But in our present trade environment we can't take proper advantage of it.

Obama said one correct thing, as far as the basic concept. He said Congress should approve the 3 or 4 international trade agreements in its queue. Now the agreements are forgotten and Congress has flown out of town for a month. The trade agreements would be one small catalyst for growth.

Hedge fund manager Phil Falcone was interviewed today on CNBC, mostly about his LightSquared network. In it he said that innovation was the only way for the U.S. economy to get going and grow again. I agree with him.

And what stands in the way of that innovation, or would foster the economic growth we all want (well, everyone except a few Luddites of various stripes)? In short, Obamanomics stands in the way of the innovation Falcone mentioned. Instead, for growth we should be repealing the laws, throwing out, simplifying, and rationalizing the regulations, and basically undoing all we can of the four factors listed above.

As an aside, during the Reagan administration, he said that he would reduce government employees by a significant amount. One evening I was looking up at the federal office building in West Los Angeles and doubted anything would happen. A very few years later the building was 40 or 50% vacant, if I recall correctly. I was very happy to see that Reagan did what he said he would do. Today the size of government employment has grown past any nightmare Reagan ever had. It's time to slim down again. The regulations and other scribblings of the bureaucrats are not needed. In fact, they're harmful.

Again, the bottom line is "back to free markets" to create the growth and jobs we need.

T.E.A. Party Day

Hooray for the Tea party organizers. I'm going to my local Tea party today to see what happens.

The stimulus bills and associated pork may have been the catalysts for the Tea party movement. However the larger and longer term issue is the growth of government spending as a percentage of GDP. That is bad, on top of all the other reasons, because a dollar cycled through the government has a lower multiplier than a dollar kept circulating in the private sector. That subject is explored in detail in any good first- or second-year economics course.

For those that don't care about wealth, or want to lower it, the lower multiplier is not a problem. For the rest of us it's a key issue, even if it's not usually argued in those terms.

So I'm off to my local Tea party. Here's an article that surveys the Tea party phenomenon.
http://online.wsj.com/article/SB123975867505519363.html

What To Do About the Cap and Trade Idea?

What really should be done from a normal free-markets and American perspective? Forget it; it’s nothing but a big market distortion. People willingly buy goods and services that return utility to them – not the right to cause dis-utility to another unidentified and nebulous group. Only a small part of the population would pay into such a fund voluntarily. If they feel better contributing, great. If a Cap and Trade tax program is implemented as the Obama administration has proposed, the only logical place for the revenue is to fund forests and other plants that efficiently convert carbon dioxide back into oxygen. Imagine paying Brazilian rain-forest owners and farmers a fee to recycle carbon dioxide! But that’s not what our environmentalists or the Executive Branch are thinking. They want to use the funds to create further market distortions subsidizing their chosen energy technologies and groups.

What Should be Done About AIG Bonuses?

Absolutely nothing should be done about the bonuses paid to AIG employees, at least not legislatively. To understand why, please take out a calculator now and do this simple division. Enter 165, to represent the $165 million in bonus compensation. Divide that by 170,000 to represent the $170 billion in bailout money that AIG has received. Look at the result. Adjust your calculator's display to show 5 digits to the right of the decimal point if your calculator doesn't already show them. The number you'll see is 0.00097. What does this mean? It means that the bonus money is less than one one-thousandth of the bailout money going to AIG.

This money, on a percentage basis, is less then the rounding error in many calculations. While $165 million is a huge amount of money to most of us, it's just not meaningful in the scope of AIG's problems or it's bailout, or the problems in the banking system, the government or the economy.

So I watch with sadness and amuzement while the House rants and then passes a bill that is reckless on several levels. It's reckless on constitutional grounds. If the Senate and President pass and sign anything like it, it may get struck down on those grounds in the courts. It's reckless on business grounds because of the perceptions of recklessness, fickleness and inconsistancy it will create for businesspeople. Who'd want Congress as a business partner? And it's reckless on political grounds, if there is a backlash against things going further wrong due to this bill.

This week we seem to be moving past the AIG furor, and focusing on the Geithner plan. That's great. We should forget about the AIG bonus issue and hope the legislation lapses into irrelevancy.

Is getting the bad assets out of the banks the way to go?

Today Federal Reserve Bank of Boston President Eric Rosengren said about getting the bad assets off the banks' books that it is "desirable to move quickly". I believe even more strongly than that, that it is essential. And that the people and institutions responsible for helping the economy recover are making a strategic mistake if they don't move quickly on it. They may be working on this in the background, and may even be finding problems and making progress. If so, the mistake is then one of communication.

Rosengren's study of the Japanese banks experience points to getting the bad assets out as cucial.

Rosengren points out from almost an organizational studies point of view that while the bad assets are on a bank's books, management stays fixated on the losses and mistakes at the cost of not moving forward into new, good loans. And as a trader, I know that sitting around looking at losses is not helpful in finding and making the next profitable trade. Instead, one should analyze the bad trade, learn what can be learned, and forget about the pain of the loss and move forward.

Getting the bad assets out of the institutions is of course easier said than done. That doesn't affect at all whether doing so is crucial to recovery. As we see with the Citibank bailout effors to date, the sick assets essentially sicken the whole institution. I've listened to many commentators about this, especially over the last three months. And it seems to me that the smart ones are essentially in agreement that paths always lead back to the bad assets in the institutions and their value. Washington and others may want that fact to go away, but it won't.

Neither is the fact that the root cause of the creation of those bad assets was the government's driving the banks to make lousy loans they would not otherwise have made. But I've covered that particular point already in this blog.

Here's a list of issues I've seen regarding the bad assets. Specifically these assets are the CDO's containing subprime loans, and derivatives based on these and other troubled assets, including CDS's.

1) There are losses on derivatives created out of thin air. That is, not just derivatives based on CDO's that actually exist. For the best explanation I've seen of this, see the article "The End" in Portfolio magazine, Dec08/Jan09.

2) The question is how to value assets, and after determining what are they worth. Of course the simple answer is that they *should* be valued by price discovery in an open, regulated, undistorted market. Since that option is not available, some form of modeling must be used.

3) The "taxpayer" has an interest in this. Politicians of any skill at all learned quickly months ago to recite phrases like "protect the taxpayer", "make the investment back" for them, "protect their interest" and the like. Nice to consider, but our situation is so bad that there will just be costs. This situation seems to be worse than the savings and loan debacle, and its relatively successful bailouts. The models for valuing the assets become mechanisms for allocating the losses. Not pretty.

4) The FASB changed an accounting rule earlier in the crisis, known as "mark-to-market" and also "Fair Value Accounting". I feel I understand FASB's basic motivation to make the rule change. A huge theme in accounting is knowing the present value of everything, even things that won't be realized as a financial entry until the distant future. However, this rule change, accompanied by a lack of guidance at the time, did serious but quiet harm to banks and other institutions. This harm is not yet fully discovered. Over-the-counter, unregulated markets and the end of markets and price discovery at all combined with the rule to force banks losses. The get close to declaring the losses; they need the bailouts.

5) The "bad-bank" discussions are about creating containers for the toxic assets outside the instituions. If we had liquid markets for the assets, we wouldn't need the containers. Every few days there's a story about a firm that wants to buy some toxic assets, but learn that they can't. In a sense it's too dangerous to establish a price by selling assets to them. Go figure.

6) In the end, leaving the toxic assets in a fully public "bad bank" wouldn't be as bad as the government nationalizing banks, or almost so. Why? The government can boss the assets around all it wants to, and then sell them later. This will cause less long-term damage to markets and American free enterprise then the government bossing around banks, and creating long-term, heinous market distortions.

Short Course on Capitalist Economics vs. Socialism

When I hear the word “Socialist” connected to anything important my blood begins to boil. If it doesn’t for you, I invite you to read my article here. You may not agree with what I say. Or you may thank me later.

This Presidential election is truly important among all presidential elections, as some commentators have said. Joe Biden may be a good old-line Democrat, but Barack Obama is something quite different. You, me, and the rest of the electorate don’t know exactly how different, in my opinion, because Obama’s façade has been so carefully crafted and maintained.

Your vote, if you cast one, is important. Between these presidential candidates we’re making a more profound choice than usual, and we all have to live with the results.

The Republican campaign has trumpeted that Obama’s ideas, positions and associations seem like socialism. It hasn’t had much effect. The surprise to me has been how little effect it’s had. A key problem with this election is that many people, and possibly you, don’t know the fundamentals of why socialism is bad. Many people don’t seem to have the visceral reaction to it they used to. If one doesn’t know why capitalism and free markets are good for a society, it follows that one can’t fully appreciate how socialism is bad for it.

I’m taking on the task of attempting to explain why free markets are important. I apologize in advance for this article being longer than your typical op-ed piece.

Should we Pursue our Enlightened Self-Interest?

In economics, people acting in their “enlightened self-interest” is an important concept. It revolves around being a good citizen in the American Constitutional sense while pursuing economic goals in one’s own self-interest. A market-oriented economics professor can prove to you with numbers that everyone in a society benefits as people do this. And they benefit to a greater degree than under any other economic system.

But aren’t the rich taking from the poor? No, a capitalist economy is not a zero-sum game. Wealth is *created*. It may be intuitively nice to compare haves and have-nots and think “if only those poorer people could have some of what those richer people have”. The non-intuitive truth is that wealth taken from haves and given to have-nots will result in less wealth for everybody. Any rosy outcome will be temporary, followed by less wealth for everybody at some lag. Economics can show clearly why this is true and how it works.

The fact that a capitalist economy is not a zero-sum game is extremely important. To understand why, consider the opposite assertion for a moment. If a capitalist economy *is* a zero-sum game and there’s only a finite amount of wealth in an economy, than for poor people to have any more some will need to be removed from rich people, or the people in the middle. If there’s a finite amount of wealth in an economy, for rich people to get richer someone else has to get poorer. If there’s a finite amount of wealth in an economy, the equality of the outcome (meaning the wealth people have at a given moment) is skewed to become more important than the equality of opportunity – that is, the possibility that people may have more wealth in the future. Many policies, and virtually all of these are well-intentioned, are built on the fallacious assumption that the economy is a zero-sum game.

Where’s That Altruism as We Create Wealth?

In fact, wealth creation is a fundamental purpose of a society, if not of civilization in general. The elemental catch with the notion of “redistributing the wealth” is the incentives, or disincentives, created in that environment. The “richies” have less incentive to work and produce as the wealth is taken away, and the “poories” have less incentive to get out and work as wealth is given to them. Years ago we debated how welfare mothers would get *trapped* into not working at all, because if they did, they lost too much in the way of benefits. There are some ways to reduce the harm done; for those ideas I refer you to Milton Friedman.

Some on the Socialist side talk about the altruism involved in redistributing from rich to the poor. The catch is that most people don’t act all that altruistic most of the time. So the Socialists help things along with “enforced altruism”. In the end a society is pretty much left with just force to accomplish the wealth transfers.

Some economists looking the Microeconomics side of things say there’s really no human altruism at all; it’s just that the incentives people are operating under aren’t properly recognized. The altruism argument can continue – but the bottom line is that capitalism is aligned with human nature to a much greater degree than is Socialism. And it’s hugely more aligned with human nature than Socialism’s more extreme variant, Communism. That’s an essential reason why the capitalist system creates more wealth than the others.

An economically-minded walk through anthropology and history would show the same outlines. Which societies traded? Which societies developed technologies, arts, sciences, and advanced culturally in general? And what freedoms did at least some strata of those societies enjoy? Consider how the merchant classes “got away” from the aristocratic classes in the European Renaissance. They pretty much took economic power through a sort of generations-long accident.

Looking the other way, consider what happens when modern technology is used to control people and restrict freedoms. This can be done very effectively today, but when it is the wealth scenario isn’t pretty. For examples see North Korea, Russia, Venezuela, and some African countries. An old joke about the Soviet Russian economy is “We pretend to work, and they pretend to pay us.” The evolution of markets, or perhaps better called the market anarchy, after the Soviet Union fell is a separate study.

Politics was once known as “Political Economy” and for good reason. One of the government’s top responsibilities is to promote a good economy for the prosperity of its citizens. So we can say that good politics is, or should be, good economics.

For another view of wealth creation consider that American poor people are far richer than many people throughout history, and richer than most poor people throughout the rest of the world today. Why is that? Wealth creation. But that wealth isn’t ordained to continue forever. The “golden goose” of the free market economy must be cared for. For still another view consider Cuba, where poor people are far poorer. And most of the people are poor. In Cuba the disincentives to wealth creation are considerable, and in large part people are outright prevented from wealth-producing activities.

How is Wealth Created?

If someone has some money, they can do two interesting things with it. They can invest it or spend it on consumption. The uninteresting thing they can do with it is to hide it under the proverbial mattress.

If our person invests a dollar it becomes capital for investment. And that’s the main purpose of capital in a capitalist system. Capital is assembled, investments are made, and innovations result. The innovations and efficiency improvements that result from investments are the key to the creation of wealth.

I should note here that for many people the word capitalism is associated with greedy capitalist fat cats sitting in guilded mansions and hording money from the little guys. A capitalist may consume conspicuously. But to dwell on that is to miss the fundamental point. A capitalist invests capital in the hopes of creating wealth and therefore profitable returns or she won’t be a capitalist (with any capital) for long.

The key property that makes the whole process work is that the new wealth benefits not just the original capitalist but the entire society and economy. That is what the “supply-sider” economists are talking about. For a grossly simple example, companies made money inventing, improving, manufacturing and selling televisions. Everybody has benefited from televisions.

If our person spends a dollar economists can study where that dollar goes. As the dollar goes through various companies’ and people’s hands economists can calculate the rate of travel. They call it the velocity of money. Banks amplify the available money in the system through lending. Economists study banks and the effects their lending has on the money supply. The multiplier effects of the different paths that money can take through an economic system are studied.

If our person chooses to hide money under the mattress that has an economic effect too. It’s easy to see how the velocity of that money is slowed down. Also no new wealth is created, no consumption is enjoyed, and our person can sleep soundly on the mattress until she realizes that inflation has in time eroded the value of her money.

The institutional fear in the present credit crisis has caused banks and other players to do the corporate equivalent of hiding money under their mattresses. And we are observing the contractions in economic activity resulting from those choices. We’re also watching governments scramble to restore confidence so money and economies start moving again.

I’ve really just hinted at huge subject areas within the study of wealth creation. I can only urge you to study the subject, at least a little. Also I invite you to capture your own good ideas and try to make them real. You could create some wealth.

Capitalism provides the incentives and means to create wealth. This is as true for the guy with the idea at his kitchen table it is for the big company investing billions annually in R&D (Research and Development). If either of them or any other company comes up with a product people want, business expands and more people are hired to supply the product. Wealth is created and the virtuous cycle continues.

Capitalism and free markets know no boundaries of race, ethnicity, gender, sexual orientation, language, physical ability or any other human classification you can think of. It works like math and it works for everybody. The boundaries and impediments perceived by people are real, but they are not inherent properties of Capitalism. Therefore their remedies do not lie in tinkering with, or rather distorting, markets.

What’s a Free Market and How are Markets Distorted?

Capitalism is built on free markets. So to truly understand the Capitalism and Socialism discussion, one must understand the basics of a market, and free markets. I’m going to attempt a rudimentary discussion of markets with only text. But it’s better with pictures, or actually with graphs containing supply and demand curves. In college we used an edition of the Paul Samuelson economics book. He’s author of a monumental series of economics textbooks. Weighty tomes to be sure, but to me the “dismal science” of economics gets exciting when it’s applied. Have a look at a Samuelson economics text or any like it for loads of graphs like the ones I discuss here.

First, imagine a garden variety X-Y graph, with a downward-sloping left-to-right demand curve and an upward-sloping left-to-right supply curve. Your X-axis across the bottom is quantity, from zero up to “a lot”. Your Y-axis up the left side is price, from zero up to “a-lot”.

Why are the curves this way? If something is expensive people don’t want to buy very much of it. Quantity is low. If something is cheap, people will take a lot of that! Oh yeah! If something is free people will take it all. Self-interest is certainly visible there, but maybe not all that enlightened. On the other hand if something is very cheap suppliers can’t find a way to supply much of it. So the quantity supplied would be low at that price. But if the price is very high suppliers will be happy to supply it all day! Quantity is high.

In economics, the point where the two curves cross is what the free market will bear. And that’s the most efficient quantity of the product to be supplied and consumed. It’s also the most efficient price. In economics you’d learn all about what happens to quantities supplied and demanded when distortions are inflicted on a market.

During the spike in crude oil and gasoline prices, many commentators, including those who should have known better, said "demand has fallen". That was usually incorrect. When prices rose, the “quantity demanded” fell.

To understand the difference, return to our typical downward-sloping demand curve.
Again, the price rose and people bought less gasoline. Had demand fallen? No, because the demand curve has not moved. Had the price fallen back to where it started people would have bought just as much gas as before. The market was just at a different point on the demand curve then, where the price was higher and the quantity demanded was less.

A few weeks later, people had developed workarounds for the high gas prices. The demand curve had indeed moved, and therefore demand had really fallen. And now the markets are working on discovering new prices given that people have actually changed their preferences and behavior at a given price of gasoline.

So if you were to say "the quantity demanded fell" rather than "demand fell" earlier on that would have been economically correct, if not quite as short and clean a phrase. Why does this matter? Economists need to understand this stuff accurately to make good recommendations. Traders need to understand things accurately to have a chance at making profitable trades. I took you through it all so you’d have a feel for how markets are viewed.

What about a market distortion? Gasoline during the “oil shock” of the 1970s was a classic example. The price went up high, but in that instance the government decided to fix it. Price controls were mandated. The result was that people could buy the gas at the mandated price – if they could find it. Hence the infamous gas lines. Given where the supply curve then was, supplier’s decisions amounted to “well if we can only get that price, then we can only supply that much of it.” They weren’t trying to punish anybody, they were just interested in staying in business.

I’ll leave to you the reader the challenge of researching how to draw this type of market distortion on the graph. A hint is that you’ll see a disturbing gap between the quantity the buyers want and the suppliers supply at the given price. These shortages are painful and inefficient.

This time around with the gas price spike, the government had kind of learned its lesson and decided to forebear on capping the price of gasoline, to its credit. See, we lived through it and prices are coming down. A windfall profits tax on oil and gas producers would have been a whole different type of market distortion.

Market Distortion is a very timely subject as it applies to the credit crisis, sub-prime mortgage debacle and the housing price bubble and bust. For the best and most detailed account of this I refer you to the Thursday October 30 front page article in Investor’s Business Daily (IBD) entitled Why The Mortgage Crisis Happened.

Price Discovery and Where to Look for the Invisible Hand

As we look at markets we come the next key concept in economics, known as the “Invisible Hand”. This was introduced early on by Adam Smith, a very well-known economist in history. The Invisible Hand is just referring to people changing their behavior to react to the realities in the markets in which they participate. Why did a person or company decide to do this or that? The Invisible Hand guided them to do it.

The Invisible Hand guides people in making the most efficient decisions in their “enlightened self-interest” through the mechanism of free markets. The sum total result is the most efficient allocation of resources in the subject economy. That’s another way of saying the most wealth and the highest level of enjoyment, or total utility, for the people in the economy.

When a market is distorted, the player’s decisions in the market are distorted. Politicians sometimes seem to ask “Well can’t we just distort things a little bit? Can’t we just take a little tax or nudge things this way or that?” Sure we can. It’s done all the time. But every time it’s done the outcome is less than optimal, the player’s decisions around price and quantity are changed and the total wealth and “utility” enjoyed by the society are reduced. Don’t just take my word for it, let a market-minded economist prove it to you with numbers.

Free markets, the Invisible Hand, and people’s pursuit of their own Enlightened Self Interest depend on “price discovery”. How can you know what to do with something if you don’t know its price? Ask a person who has just sold a $10,000 piece of art at their garage sale for $10 and learned of their error about price discovery.

Price discovery is an essential outcome of trading and speculation. When the price is discovered it’s usually visible to all. In the recent credit crunch you’ve heard about Credit Default Swaps (CDS). These can be loosely described as insurance policies written against defaults on portfolios of loans. But they’re not traded on an exchange for all to see. They are privately traded “over the counter”. So it emerged in the crisis that the prices of these CDSs were not discoverable or visible. And since their total value was gigantic and owned by companies worldwide, fear set in on a massive scale and a lot of behavior was distorted, to go along with the markets.

Dynamic Analysis and International Trade

A mistake often made by our friends in government is that of static analysis. It’s essentially the assumption that a tax or some other distortion can be introduced into a market and no player will change their behavior. That is, customers will buy and suppliers will supply the same quantities as before. And everyone will stay just where they are, doing the same thing, and all be happy (well, I’m getting a little snide here.)

The governing entity is shocked to learn that the quantities change, markets are sometimes abandoned, industries die, or companies move to different states or offshore entirely. And the government’s revenue gain or intended outcome is quite different than projected in the analysis.

So dynamic analysis rather than static analysis would have been a better way to go. But sadly, governments at all levels get to learn this lesson over and over. Dynamic analysis is harder to do, but not impossible for good economists.

This brings us to international trade. Free trade versus protectionism is also an important subject of contention in this presidential election. The various devices of protectionism are all simply market distortions. And as such they reduce the overall efficiency and wealth creation of the participating countries. A discussion of international trade and countries’ “comparative advantage” is a bit out of scope here. I’ll just offer the by-now-unsurprising comment that you can ask your local free-market economist, who can prove to you with numbers that free trade really is better for overall wealth creation.

The only positive thing to be said for protections is that a grossly uneven trading relationship will have strains. That is, a completely free-trade country trading with a highly protectionist one will suffer some costs. Consider our trading relationship with China versus our trading relationship with Canada as examples. The take-away is that protections sometimes need to be ratcheted down with a partner, rather than unilaterally abandoned, for optimal results.

For more on these subjects I refer you to the Tuesday, October 28th editorial in Investor’s Business Daily (IBD) entitled Defining Problems With Socialism For The Post-Cold War Generation.

Please consider these points as you listen to what the candidates say, however inarticulately or intentionally distorted. I hope you’ve enjoyed at least a line or two in here. Thanks for reading.