Monday, December 7, 2009

On Gold Standard and Fixed Money Supply Theory

Many Libertarian economist (mostly from Austrian School of thought) believe that government/central bank interference in market is coercive and detrimental. According to them the booms and busts are created by the Central banks which artificially controls money supply by manipulating interest rate and "quantitative easing". Many advocate a gold standard or a "fixed money supply" would bring harmony in markets and protect it from going to extremes (booms and panics). In this post, I want to discuss the consequences of fixed money supply and its impact on market equilibrium.

The consensus among economists is that increase in money supply leads to inflation. In deflationary period, money supply is increased as a remedy to protect economy from going into recessions. Similarly, decrease in money supply leads to deflation and is often used as a tool to control inflation and slow-down the growth of economy. The effective relationship between money supply and commodity prices can be derived by a supply-demand curve. However there is another dimension to it and that is the population growth. This was already discussed in the post (Inflation: A Necessary Evil? ).

The necessary condition for a healthy economy is to have growth for the simple fact that human population grows over time and need to have increase in production to keep up with the demand. In a fixed money supply scenario, increase in production to fulfill growing population-needs causes deflation. There were actually times in late 19th century when deflation was a norm because of constrained money-supply. A fixed money supply would cause prices to fall over time given a positive population growth-rate. The consequence of this deflation will be that people would be more interested in holding cash instead of investing it because the value of currency grows over time (and prices of commodities go down). The result of this decreased investment is high unemployment, falling production in near term. This in turn results in shortage of goods and lead to rising commodity prices. The rising commodity prices will then cause the currency to lose value causing inflation. This inflation in turn will lead to increased investment. This increased investment leads to increase in production and in due course of time causes drop in commodity prices. Thus the economy swings between inflation and deflation cycles (i.e. booms and busts). The duration of these booms and busts is not a week or month but it stretches over a longer duration during which things get over done. The whole cycle gets erratic with prices sharply shooting up and going down as the perception of market participant changes. There will be much more wastage because of abandonment of production-resources during deflationary period. The unemployment rate will fluctuate wildly and will cause a lot of economic instability. That is a fixed money supply would cause more frequent and more extreme economic cycles. This is in complete contradiction to what Libertarian economist portray.

Lastly, if we look back at history, booms and panics in stock market were much more frequent and of much bigger magnitude than in modern times (Pre-Federal Reserve Act period). This is something which all libertarian economists hide in their literature. The fact of the matter is in capitalism where people allocate resources depending on prevailing perception the occurrence of booms and busts is inevitable. Those who blame central banks for this should ponder more over fixed money supply system.

Thursday, November 12, 2009

How the Rich Get Richer?

It is a well known fact that in a capitalistic society rich get richer and the gap between the rich and poor keeps growing. While the overall standard of life might improve due to human innovations, the gap between rich and the poor continues to grow with time. The current recession has once again proved this point. “The wealthiest 10 percent of Americans — those making more than $138,000 each year — earned 11.4 times the roughly $12,000 made by those living near or below the poverty line in 2008, according to newly released census figures. That ratio was an increase from 11.2 in 2007 and the previous high of 11.22 in 2003.” (Read more here). Philosopher Adam Smith has summarized the phenomenon as: "The problem with fiat money is that it rewards the minority that can handle money, but fools the generation that has worked and saved money"

In this post, I want to explain this with an analogy. The analogy of capitalism is like a water tank with an outlet near its top (say at 75% of its height). This tank is elastic which means its base area can be expanded or shrunk. For a given volume of water, If we shrink the area of tank the water level rises whereas if we expand its area the water level falls.
The water tank in this analogy is the rich-capitalist class. The common man derives his income from the outlet which is located near the top of the tank. In other words, common man receives the excess-capital which the higher class is willing to invest for Job creation. The amount of capital available for investment is not dependent on the total volume of water available in the elastic-tank but on the water-level of the tank. This means the excess-capital is not dependent on the hard-cash like dollar-bills (or notes) but the market-value of the existing investment. The water that comes in the tank is the revenue from production and services. For a healthy business environment the water inflow has to be greater than the outflow (as most of the businesses are profitable).
Now, the interesting thing to note here is how the whole boom/bust sequence actually make the rich richer whereas common person ends up getting poor (at least after taking into account the inflation).
During the boom period (like late 1990s), the area of the tank shrinks and the water level rises. This higher water level means more water coming out of outlet (i.e. more jobs, more income, more returns on their nominal investment for common man). Note here that the actual volume of water might have increased in the tank (due to actual growth in production and innovation) but the increase in water-level is much more due to shrinking of tank’s area than by increase in water volume. That is to say that the amount of capital available for investment during the boom period is not because of actual increase in book-value but because of anticipation of higher returns and the perception of favorable business-conditions. This can be seen in the high price-to-earnings (PE) ratio of stocks and the low yields-values of bonds.
The increase in water level means more water getting dispensed from the outlet which means more jobs and higher salaries for common people. A common person, for what he is, does not grasp the entire picture and starts to make allowances which he cannot afford during normal times. The real-estate boom of 2004-2005 is a classic example where the crowd got deceived by the low unemployment rate and higher wages and started buying houses on Interest-Only loans or ARMS.
Increased outflow and profitability leads to higher inflow in tank which leads to actual increase of water-VOLUME in the tank. That is to say the appearance of increased prosperity will lead the crowd to spend more which in turn helps capitalist to increase their real wealth due to increase in production and consumption. Thus during the boom-period the rich folks benefit from the increased spending of the whole society. Because of rapid rise in water-level of the tank due to shrinking base-area (i.e. perception) as well as due to real increase in water volume due to increased inflow (i.e. real increase in wealth), the height of outlet increases. For examples if it was at 75% of tank’s height before boom-time, it goes to 80% during boom-time. This rise in outlet level is necessary to increase the amount of profits made by the capitalists. This means the increased company earnings does not linearly translate into increase in salary/compensation of workers. For example Microsoft's net worth has grown from $6/share in 1990 to $59/share in December 1999 (approx. 10 times increase), however this did not lead to a 10 times growth in income of a normal software engineer.
Of course, the boom has to end somewhere and it generally starts with an external event which shakes the belief that prosperity cannot continue forever (i.e. water level in the tank cannot grow forever). The first effect of this change in perception is that the tank starts to expand in area which means the water level which has gone up due to shrinking of tank area (during boom-time) starts to retrace and go lower as the tank-size increases. This means the capitalists who have enormous wealth on paper starts to see it going down as the changed perception causes the stock prices to go down and yields to go higher. This decrease in water level means less water coming out of outlet. This means the common man who was receiving high wages and bonuses starts to realize the sudden decline in his income. He suddenly realizes the allowances that he made for himself during the boom time are no longer affordable. The effect is worse as the level of outlet during the boom-period has increased (as we mentioned earlier from 75% to 80%). This decreased prosperity of common man leads to a "real" decrease in wealth of capitalists due to falling retail sales and profit margins. The level of water begins to fall not only due to increase in tank area (i.e. perception) but also because of decreased inflow (i.e. actual wealth reduction). This can be seen in lower earnings per share (EPS) as well as low PE ratios of stocks during recessions.
The starvation of common man due to decreased capital investment causes the government to come into action. It has to do "something" to assuage the sufferings. The central bank (which is not completely independent of Federal govt., as mentioned in Federal-Reserve act) starts to lower interest rates and adds more liquidity into market. This is like putting more water in the tank by an external source. Fear about the business condition keeps growing. The area of tank continues to expand and Central bank keeps pouring water into it to bring up the water level in order to feed the thirsty crowd. Note how every govt. intervention HAS to go through the water-tank otherwise it will be labeled as communism! (i.e. the system is designed in such a way that the well-being of common man is completely dependent on the prosperity of capitalists).
Ultimately huge monitory easing leads to disappearance of fear and arrival of hope. Confidence develops and begins to increase with government assistance. This means the growth in tank area stops and the water level begins to increase (i.e. the beginning of next boom cycle). In the worst case the water tank keeps expanding and might even develop cracks leading to depression. If the cracks are not mended even by govt. intervention, it might lead to a systemic failure (which was almost the case in October 2009 when Lehman failed and AIG was on the verge of failing).

In this whole episode, the volume of the tank has increase enormously which is to say the rich have gotten even richer. The common man ultimately gets his income from the same old outlet at may be a slightly higher rate. The ratio of water available in the tank to what is dispensed rises substantially compared to what it was in the previous boom/bust cycle which means the ratio of wealth held by rich and poor keeps growing!

Wednesday, March 11, 2009

The Arrogance of Capitalism Vs The Peril of Common Person

As I write this post, the government of USA has pledged about $780 Billion US Dollars (USD) for stimulating the economy. Treasury secretary Timothy Geithner is asking congress to approve about a Trillion USD for bank rescue. Add to this amount 1 trillion that Ben Bernanke (Federal Reserve chairman) is planning to use for TALF and for buying other housing related debts. Government has already approved $700 billion for TARP funds. When you add all this (along with the unemployment benefits for 4 million unemployed), the total comes to a staggering 4 trillion dollar. (The Mere repetition of the word ‘Trillion’ in news might devalue the US dollar!).

If we analyze President Obama’s promising spending plan carefully, it is not as promising as he advocates. There is a lot of criticism from Republican aisle that we all hear in the news. To cut short the rant, I would say the spending plan will not bear any fruit for next 2 years at least. The infrastructure projects do not start overnight. This defeats the very purpose for which the ‘stimulus’ was designed. Apart from this, most of the planned projects are not even critically useful and at least to me it seems like spending for the sake of it.

The bank bailout money is an indirect way of putting toxic assets on Govt.’s balance sheet. I am not advocating that banks should be left alone to deal with this, but there is no use of stuffing money in a feared entity either. With so much money at hand, banks have failed to lend due to their own fears. Stuffing money in bank at this time is like asking a scared child to go in dark. The interest spreads are skyrocketing despite the easy availability of money. In Ludwig Von Mises's words: “As the confidence wanes, the entrepreneurial component of Gross Market Interest spikes to a great height”. It is like a man who escaped from bunch of robbers, he will view every other man with suspicion. The bailout is like asking such a man to be friendly with strangers and lend them money with confidence.

Bernanke’s plan is more sensible than the other two. The problem however is that he realized it a lot later than he should have. He approached the problem with traditional monetary tool like: lowering feds funds rate, putting money in the banking system etc. After seeing them fail (and frankly too late) he realized that the need of the hour is for the Govt. agencies to be more direct in dealing with consumer lending and main-street businesses. Fed will now back securities for consumer and small businesses. It even plans to target securitized loans for larger manufacturing businesses. But all this has come after a year of economic downturn when fear has completely taken over the financial system.

The arrogance of Capitalism lies in failure to acknowledge the fact that sometimes govt. has to take charge of financial sector directly. The current crisis would not have turned out this way if the lawmakers (specially the Conservative Republicans and Libertarians wing) have not considered Capitalism to be a divine system. If the govt. started to directly act as a lender to consumer, things would have been a lot better. This idea may seem eerie (if not ludicrous) to many people in US who are raised with the notion that Capitalism is a sacred system and any govt. interference tantamount to heresy. So much so that any reference to nationalization is viewed as a threat to US itself.

The following things would have happened if Feds started lending directly:

1) It would have eased the credit market.
2) The private sector would have felt challenged in not lending and would have participated alongside the Federal Reserve. The relationship between the two would have been that of comperation (i.e. competition + cooperation).
3) A number of jobs would have been created and many job losses would have stopped. Jobs creation would be due to govt. acquiring people who could interface with the borrowers and participate in consumer lending. Banking sector was the most to suffer during this downturn and many jobs would have been preserved if Feds decided to act boldly. The private sector would not have laid-off so many people due to lack of capital, waning demand (due to economic worries).

I feel that govt. is so altruistic towards Capitalism that they can let the economy collapse and common man suffer. Thosaunds of jobs are being lost everyday, people are losing home but the officials don't want to concede the deficiency in the system.

Let me add, the cost for this logical action would have been far less than 4 trillion USD.

Tuesday, March 3, 2009

Investment Bibliography

I strongly believe that one should be well equipped with knowledge in order to operate successfully in financial markets. If these books look too much to you, my humble advise is to stay away from self-investment (/Gambling) and handover your money to someone who is well-educated.
· Trader Vic: Methods of a Wall street Master ------------------- Victor Sperandeo
· Trader Vic-II Principle of Professional Speculation ------------- Victor Sperandeo
· Trading for a Living ----------------------------------------------- Alexander Elder
· Extraordinary Popular Delusions & the Madness of Crowds --- Charles Mackay
· Jesse Livermore How To Trade in Stocks ----------------------- Richard Smitten
· Reminiscences of Stock Operator -------------------------------- Edwin Lefevre
· Battle for Investment Survival ------------------------------------ Gerald Loeb
· Lessons from Greatest Stock Traders of All time --------------- John Boik
· How I made 2,000,000 in the Stock Market ---------------------- Nicholas Darvas
· How to Make Money in Stock Market ------------------------------ William o' Neal
· Japanese Candlestick Charting Techniques ----------------------- Steve Nison
· One Up on Wall street ----------------------------------------------- Peter Lynch
· Bernard Baruch: The Adventure of Wall street Legend ---------- James Grant
· Alchemy of Finances ------------------------------------------------- George Soros
· Soros on Soros -------------------------------------------------------- George Soros
· The New Paradigm for Financial Markets ------------------------- George Soros
· How I Trade and Invest in Stocks and Bonds --------------------- Wyckoff, Richard
· Stock Market Techniques - Number One -------------------------- Wyckoff, Richard
· Stock Market Techniques - Number Two -------------------------- Wyckoff, Richard
· Wall Street Ventures and Adventures Through 40 Years --------- Wyckoff, Richard
· Tools and Tactics of Master Trader ------------------------------ O. Velez and G. Capra

Saturday, February 21, 2009

On Speculation

Over a long time, I have rarely met people who are mentally immune from financial markets (especially the stock market). It has become a routine thing for many middle class professionals to try their luck in stocks. After few hits and misses and a significant magnitude of loss he gets scared and tells everyone how bad the stock market is! The listener thinks the narrator is inept and he can do a much better job than him but ultimately suffers a similar fate. It has become a story of every household of how someone they know have lost money in stock market yet the fresh crop is always ready for mowing.

The "green outsider" (as Jesse Livermore calls) gets in stock market to make some quick and easy bucks. It doesn't take very long for this type of person to realize that stock market is one of the toughest places to preserve money (leave alone growing it). After every loss he starts blaming stock market/speculators/traders who collectively swing the market (sometimes on contradictory reasons). For example: On February 6th 2009 the unemployment report shows a record number of job losses and Dow Jones rallied 217 points. The purpose of this post is not to describe why it rallied but to shed light on some aspects of speculation.

The word speculation has become a taboo in modern society. Indeed there is a lot of moral hazard in speculation and so is the case with any price movement (such as rise in real-estate prices). Before proceeding further let us look into the definition of speculation. As Bernard Barush puts it: speculation is derived from the Latin word speculari which means to spy or observe. Speculation is an action based on observation and investigation. There is an element of speculation in everything. Sometimes the amount of speculatory element in an action/decision is extremely enormous and often downplayed as a logical decision. For example: A teenager decides to pursue his career in Chemical engineering. The observation here is that current chemical engineering field is lucrative and is offering high paying job. The speculatory element (that chemical engineering will continue to be lucrative) is so enormous here that he decides to spend 4 years (if not more) for understanding and studying the profession. I can go on and on about describing the speculatory element in our day to day activities but for the sake of brevity I will leave it here by saying every action in our life is based on observation and thus can be classified as speculation.

Speculation in financial market is often equated to gambling. Indeed there are similarities and differences. The similarity is that both involve putting capital at risk. The difference is: speculation involves risking your capital when odds are in your favor whereas gambling is taking risk when odds are stacked against you. There is no such thing as a DEFINITE return in financial world. Everything from bonds to futures involves putting capital at risk and chances of loss are always there. This is also the case with any business in this world. For example, if you open up an ice factory chances are that you might suffer loss due to numerious reasons. In this sense, speculating in financial markets is no different from investing in say a friend's company which makes ice (lets call it the main-street business). But there are differences.

The key differences between actually investing in a physical business and stock market are:

1) Frequency of capital appraisal: In financial market it is done everyday and in many cases every second (of business hour) whereas in a main-street business it might not be done for years (the maximum you get to know is the book value of the business).

2) Participants: The number of participants are huge in the business (which trades on stock exchange) compared to the same business on main-street. Not only this, the financial ability of these participants is enormous compared to the main-street business participants.

3) Ease of getting in and out: In financial markets you can buy and sell ownership by a mouse-click whereas in main-street business it is relatively difficult to get your stake back.

4) Response factor: Stock markets respond fast to changes in general condition compared to their main-street counterparts.

5) Pricing method: Like I mentioned above the main street business's value is vague and can only be estimated by its book-value. A single stock of the same kind of business is based on book value + anticipatory element.

It is not hard to judge after looking at the differences as to why the chance of success in stock market is thinner than main-street business.

The single most important danger in stock market is the heuristic nature of buying-price(entry point). Markets are always changing. Prices move. It is not possible for anyone to know the actual value of the stock. And the fact is there is no actual value of a business. People use different measures like book value, price to earnings ratio, price to sale ratio. But all these terms are very frequently violated. In recessions many stocks trade below its book value. The primary reason is book value itself is ambiguous. Book value is derived from the prices of assets which themselves are based on speculation. It is beyond comprehension how a stock that was not available at a P/E of 50 in bull market becomes undesirable at PE of 20 in bear market.

The next reason (which is a corollary of first reason) is that the frequency of capital appraisal. This high frequency creates fear/anxiety/greed among the participants. One should read Theory of Reflexivity by George Soros to see how reflexivity works in financial markets. The response factor due to these emotions goes above the brink.

The "green-outsider" doesn't bother to pay attention to this. He doesn't realize the extreme difficulty in deciding the entry price. All he needs is a tip from a friend and an internet
connection and he becomes an owner of something which might be (and many time it is) worth less than what he paid for. He tries to bottom-fish a stock which has fallen from cliff thinking he knows the value of the company more than anyone else in this world (although in many cases he doesn't even know where the company is headquartered). As Livermore puts it: A man does more due diligence in buying a small appliance for his home than he does in buying stocks.

I am sure many people lose money in main-street business too. The rate of failure might be a little low because the participants do more due diligence before handing over money to main-street business men. But the percentage loss of capital when a main-street business fails is much larger than the stock market losses (due to lack of transparency). Also, if the main-street business fails, the participants know about it a lot later from his entry into investment (in stock market the investment anxiety starts right from the entry point and remains constant).

Saturday, February 7, 2009

A Prayer Tip

As a Muslim, it is obligatory upon us to perform Salat (Namaz) at the prescribed time. We all know the importance of these 5 prayers and it is not the intent of this post to revive its importance (click here for a powerful essay on this topic). Rather, I want to present a short/powerful tip for bringing more concentration/consciousness to our Salat.

The thought of standing in front of Allah (SWT) in itself should bring complete attention in the prayer. This thought is the key to consciousness in the prayer. Any deviation from it will cause a person to lose concentration which in turn will dwindle the full benefit of Salat.

In my personal experience, an important way to bring back the concentration (after losing it) is to concentrate on the word "Allahu-Akbar" and quickly ponder over its meaning. A little extra emphasis in thinking about this word will produce great benefits Inshallah. We all know Allahu-Akbar means "Allah is the greatest". This word should create an awe in us that we are in front of the greatest being (who knows everything about our thought process) and at this point he/she knows that I am not doing what I am supposed to do (i.e. concentrate on the prayer).

Allahu-Akbar is one of the most repeated words in the prayer and its full-realization should also bring more concentration on what we do in between its utterance.

Lastly, the best way to check on how conscious your prayer was: Try to remember which Surahs were read in 1st and 2nd Rakah of the prayer. If you cannot recollect it, you know where your mind was!

Click here for translation of what we recite in salat

Monday, January 5, 2009

Two Ways of Living Life

“Two roads diverged in a wood, and I
I took the one less traveled by,
And that has made all the difference.” – Robert Frost (1920)

The above lines (taken from Robert Frost’s “The Road Not Taken”) beautifully describes two distinct ways of living a life.

First let us look at the “More traveled road”. This is a style of life which is mediocre, in which a person lives like the normal “crowd”. He does not have a vision of what he would like to see in future. Making difference in the society, bringing a change in this world etc. is not even in his remote thoughts. All he is concerned about is his survival, his family, his means of earnings and other trivial things. The maximum achievement in such lifestyle is a well-settled job (with adequate means of sustenance), a happy family and well-educated kids. This type of crowd does not have the vigor to put effort towards a cause rather (in many cases) they do not have a goal. When they look at the “wrong” things around him, he is taken over by hopelessness and all he can think is: “It is beyond my scope to make any change”. He always looks for safety. Venturing, entrepreneurship are not found in his dictionary. When such person reaches old age and when he looks back at his passed-life, he will not have anything significant to enumerate which has affected other’s life. After his death, people will not have anything significant about him to remember. His name is “lost” and surely he is not missed by the society.

The analogy of such people is like a spectator in a soccer game. They watch events and maximum thing that they can do is cheer (or boo) which is not even noticed by the guy sitting next to him.


The other way of living life is what Frost described as the “Less traveled” road. This is the road in which a person tries to be distinct. He tries to be outstanding from the normal crowd (success of which depends on what God has destined for him). He has a vision, a goal to make a difference in the society. His efforts are completely directed towards realizing his vision and achievement of his goals. He doesn’t view his job and “means of survival” as the end but as a means-to-end. This does not mean that he deserts his family/job etc. but contrary to that many times such people fare far better than the normal crowd in these areas. It is just that their center of struggle is not restricted to his survival and his family, rather he has bigger goals. The key to the success of such people is time management and one can hardly find them idle. They never suffer from hopelessness and they always strive to change things which they don’t like. The attitude of this person is to set a goal and strive for it. He does not care about success; primary importance for him is to work towards his goal. Such people do not search for safe-havens rather they are entrepreneurial and venturesome. Indeed, when such a person reaches old age, he can look back at his past-life with dignity. He feels satisfied that he has struggled for “something” during his age and has positively impacted the society. Names of such persons are engraved on hearts of people after their death, and they are missed by the society.

The analogy of such people is like that of a player in a soccer game. These are the people who impact the whole arena and are not silently impacted like the spectators. Indeed, if such people were to be absent in this world, then nothing would be left except selfishness and the world would become a wretched place to live.