Hotel Proprietors, Prostitutes and Monetary Velocity

The following story is often told to explain monetary velocity and how government money printing helps us all:

In a small town in the United States, the place looks almost totally deserted. It is tough times, everybody is in debt, and everybody lives on credit.
Suddenly, a rich tourist comes to town.
He enters the towns only hotel, lays a 100 Dollar Bill on the reception counter as a deposit, and goes to inspect the rooms upstairs in order to pick one.
The hotel proprietor takes the 100 Dollar Bill and runs to pay his debt to the butcher.
The Butcher takes the 100 Dollar Bill, and runs to pay his debt to the pig farmer.
The pig farmer runs to pay his debt to the supplier of his feed and fuel.
The supplier of feed and fuel takes the 100 Dollar Bill and runs to pay his debt to the town's prostitute that in these hard times, gave her "services" on credit.
The hooker runs to the hotel, and pays off her debt with the 100 Dollar Bill to the hotel proprietor to pay for the rooms that she rented when she brought her clients there.
The hotel proprietor then lays the 100 Dollar Bill back on the counter so that the rich tourist will not suspect anything.
At that moment, the tourist comes down after inspecting the rooms, and takes back his 100 Dollar Bill, saying that he did not like any of the rooms, and leaves town.
No one earned anything ... However, the whole town is now without debt, and looks to the future with a lot of optimism.

Sounds like we have discovered a perpetual motion machine, right?  Let's deconstruct.


Nobody in the town is actually in debt.  Each party has a receivable account of $100 and a payable of $100.  These net out to zero.  That's the setup for the magic trick.  What the story describes is a process for settlement of mutual A/R and A/P, in which the "tourist" unwittingly plays the role of short-term credit provider.  This is one of the fundamental purposes of banks and financial institutions, but even they are not strictly necessary for settlement.  There are multiple ways this could happen without a "tourist" or government printer:


If the parties sold their A/R to each other or to a third party, the third party could net out the accounts with no money exchanged.  For example, if the chain went in the opposite direction you wouldn't need the tourist at all.  The prostitute could sell her A/R with the fuel supplier to the hotelier to settle her account, the fuel supplier could do the same with his A/R, and so on.  The hotelier would wind up settling his debt with the butcher by tearing up the butcher's A/P with the pig farmer that he now owns.  We didn't need the tourist, and yes this type of transaction goes on all the time in the real world.


If any party (e.g. the pig farmer) factors their invoice or otherwise gets a short-term line of credit, the entire chain can be settled in cash.  This type of trade credit is self-liquidating and is indeed the lifeblood of commerce.  The town didn't need the tourist.

It is important to note that no economic activity occurred--this is simply moving money around to settle accounts, with the tourist providing self-liquidating short-term credit (for free, bless his soul).

Therefore this story, which simply illustrates how offsetting A/R and A/P can be settled, cannot be expanded to a larger analogy with monetary velocity or government stimulus.  In the current environment, profitable businesses have no problem getting credit to pay A/P while floating A/R--i.e. managing cash flow.  We are awash in liquidity.  Government stimulus money is never used for such short-term problems.

The kind of monetary velocity increase that is beneficial is demand-driven: the hotelier buys more meat and prostitution services because he has more paying guests.  Faster settlement of A/R doesn't reflect increased economic activity.

The real problem is that the hotel proprietor, the butcher, the pig farmer, the fuel supplier, and the prostitute all owe the bank hundreds of thousands of dollars in debt they aren't servicing, funded by leveraged credit against their own pension funds, while government spends against their children's account.  You're going to need the tourist to actually stay in the hotel to solve that problem and hope he spends a lot of time in the restaurant.

Edit: Other writers have the same idea: View from the Wilds: How a Bailout DOESN"T work

Bloomberg Says Wall Street Protestors Trying to Destroy Jobs

NY Mayor Michael Bloomberg says the Occupy Wall Street protests are a bunch of people trying to destroy jobs.

Thanks, Mike.  I'll put on my Save the Banksters button now and counter-protest.  I, too, find the peasants' revolt revolting.

How Much To Buy a George F. Will Article?

George Will opines that Barney Frank's attempt to strip the banking industry's right to appoint a majority of the Fed board is an attack on the Fed's independence and inflation-fighting mandate.  For example,

Heavy representation of the economy’s financial sector in the governance of the central bank does not seem bizarre.

Sort of how we should have drug companies running the FDA and Mexican drug cartels running the DEA.  Does Will endorse the virtual ownership of the SEC by Wall Street brokerages, too?  Will concludes:

...one of liberalism’s steady aims is to break more and more institutions to the saddle of centralized power.

It takes a truly great editorialist to portray the Fed as a victim of power centralization instead of a poster boy for its dangers.  I would like to know how much the banking industry had to pay Will for this article.

Republicans Don't Like Class Warfare

Republicans led by US Rep. Paul Ryan are decrying the idea of setting a progressive income tax standard around a so-called "Buffet Rule" whereby those making more than $1M per year must be taxed at at least the same rate as those in middle class brackets.

“Class warfare will simply divide this country more. It will attack job creators, divide people and it doesn’t grow the economy,” Rep. Paul Ryan said on FOX News Sunday. “Class warfare may make for really good politics, but it makes for rotten economics.”

This tells us that what we need is a fully regressive tax system in order to grow the economy and create jobs.  Let's cut the job-creating wealthy class taxes to zero and we'll see all sorts of quality jobs created due to all of this extra walking-around capital:

- Yacht captains
- Dog groomers
- Landscapers
- Horse groomsmen
- Life coaches
- etc.

If we tax those paychecks at 80%, we'll solve the deficit problem in no time flat!  Perhaps we can bring back feudalism, and cut the wasteful government taxation middleman out of the picture altogether.

Krugman: More Regulatory Frictional Costs = Economic Growth

A recent Paul Krugman blog post not only rejects the broken windows fallacy (i.e. that destroying things and forcing people to spend to replace them does not actually create prosperity) but makes the case that when government creates regulatory compliance costs for businesses, it forces them to spend the excess cash that they are supposedly hoarding and thereby creates GDP growth.  Krugman writes:

As some of us keep trying to point out, the United States is in a liquidity trap: private spending is inadequate to achieve full employment, and with short-term interest rates close to zero, conventional monetary policy is exhausted.

This puts us in a world of topsy-turvy, in which many of the usual rules of economics cease to hold. Thrift leads to lower investment; wage cuts reduce employment; even higher productivity can be a bad thing. And the broken windows fallacy ceases to be a fallacy: something that forces firms to replace capital, even if that something seemingly makes them poorer, can stimulate spending and raise employment. Indeed, in the absence of effective policy, that’s how recovery eventually happens: as Keynes put it, a slump goes on until “the shortage of capital through use, decay and obsolescence” gets firms spending again to replace their plant and equipment.

And now you can see why tighter ozone regulation would actually have created jobs: it would have forced firms to spend on upgrading or replacing equipment, helping to boost demand. Yes, it would have cost money — but that’s the point! And with corporations sitting on lots of idle cash, the money spent would not, to any significant extent, come at the expense of other investment.

There is no doubt that government can create compliance industry jobs.  H&R Block owes its existence to a byzantine tax system.  It allows government to mop up excess labor and redistribute income, and does it in a less objectionable way than declaring war.   According to researcher Michael Hodges of the Grandfather Economic Report, regulatory compliance is already a $2T component of our economy and rapidly growing in recent years.  Is that a good natural solution to the problem of too much labor and too few jobs, or is there a downside?

Regulatory compliance costs obviously reduce competitiveness vs. foreign companies who do not have the equivalent regulatory burden.  As this could be overcome compensatory tariffs I do not think this is necessarily a deal-killer.  The more important objection is that it puts us further and further down the course of what Ayn Rand objected to: a handful of private producers are surrounded by a growing parasitical class of persons who, instead of being paid to dig holes and fill them in again, are instead paid to administrate an ever-growing set of mandated regulatory spending.  Regulators and consultants get paid by companies for:

- Tax compliance
- Clorofluorocarbon emission (ozone) compliance (Krugman's post cited this specifically as a job creator)
- CO2 emissions compliance
- Green energy compliance
- Racial/gender/religious/etc. equity compliance
- Sarbanes-Oxley compliance
- OSHA workplace safety compliance
- Security compliance
- Hazmat/pollution compliance
- Pricing compliance
- Insurance compliance
- Marketing compliance
- Labor compliance

And so on.  This is not meant to dismiss the need for regulation in the whole; clearly we are better off for having Hazmat and food inspection frictional costs and no economic argument should sway us from ensuring companies are not poisoning the public.  But also in the whole, these frictional costs are already 17% of our economy while not producing any tangible economic value, irrespective of the social value.

Creating jobs and spending through regulatory frictional costs is a slippery slope.  What happens when 5% of the population provide goods and services, and the other 95% are employed in make-work government compliance jobs supervising that 5%?  When 80% of a company's expenditures are mandated by government?  Who is John Galt?

Economists and the Broken Window Fallacy

There has been a notable increase in the advocacy for some sort of disaster to befall the country in order to create a boom in post-disaster rebuilding.  This is an error that is known as the "broken windows fallacy", which refers to a parable in which Bastiat proved that repeatedly breaking a shopkeeper's window to force him to repair it was not ultimately economically stimulative.

For example, Paul "what we need now is a housing bubble" Krugman has been suggesting war, alien invasion, and most recently expressed disappointment that the recent East Coast earthquake did not cause more damage. I see little mention of the effects of the Japanese tsunami and nuclear meltdown.  According to the damage-is-good hypothesis, Japan should be enjoying a rebuilding boom.  Instead, its economy has been depressed since the tsunami event.  This is not surprising when you consider that massive amounts of assets and therefore capital was destroyed, but the Keynesian blind spot with respect to balance sheets prevents its advocates from understanding what really happens when you destroy infrastructure.

Joe Gagnon Says Print Big Money Until the Patient Recovers

Former Fed official Joe Gagnon has a posting that is making the rounds.  Basically he says stop futzing around and start printing dough like mad until all is right with the world.  Currency devaluation will help exports (except if everybody else does it too).  It reduces the value of existing debt.  Lowers your cholesterol.

He tops it off by showing that he still believes in the Philips curve despite its spectacular failure in the 1970s:

Inflation will never increase to a significant extent as long as unemployment lingers at this elevated level.

See, the key is that magic fairies transmute monetary inflation into employment and growth, according to the Philips curve and its dressed-up successor the imaginary NAIRU.

Risk of too much inflation?  Bah, we can quit anytime:

[...] the Federal Reserve could assuage the fears of the inflation hawks by stating clearly that its policy would be rapidly reversed in the unlikely event that core inflation rises above 3 percent on a sustained basis 

I'm sure everyone will believe the Fed at its word.  Massive money printing.  What could go wrong?  It's worked great historically, right?

It's the Fraud!

With worldwide markets going down in flames, the punditsphere is atwitter with attempts to change the narrative to the need for fiscal stimulus programs to create jobs.  Keynesian prayers won't save us now.

We are here because of an accumulation of financial fraud over decades by corrupt parties, and investors have lost confidence in the legitimacy of the game.  Stock markets are dominated by HFT algos, dark pools, and other shady casino operators.  Central banks are monetizing government debt in broad daylight, while handing largesse to favored banks, hedge funds, and any other players with influence.  Tax loopholes let corporations and the wealthy avoid taxation.  Financial players create unsecured credit at will and dump losses on the taxpayer if their plans go south.  Banks sold fake mortgage securities to investors and try to foreclose on homes they don't own.  Bonds have been turned into exotic synthetic instruments like CDS that represent bets instead of real investment in productive activities, and CDS writers find ways of avoiding payouts or dumping liability on the taxpayer.  Finally, the only thing that economists from Alan Greenspan to Paul Krugman agree on is that governments can just print money indefinitely.

We are here because of a total breakdown in the rule of law and the integrity of currencies.  The masses have lost faith in the legal system that is supposed to protect them from financial fraud.  They are now voting with their bank accounts.

S&P Sticks Its Neck Out; Government Parasites Freak Out

S&P has been threatening for months to downgrade the US credit rating and it finally did it.  Elites of all political stripes united to condemn them for daring to say the emperor has no clothes.  The reason you should pay attention to S&P is that they took this action at great political cost to themselves--governments in Europe are talking about stripping their ratings agency monopolies and replacing them with a pliant government ratings committee.  S&P bit the hand that feeds it at great political cost to itself.  This is a first step towards restoring the ratings agencies' credibility and should be respected.

Instead, the elites are howling about the agencies having no credibility and should just keep quiet.

Much is being made of a supposed error S&P made in referencing CBO deficit projections.  Essentially, they used a particular bogus CBO forecast when the CBO would have preferred they used a different inaccurate forecast.  This is obviously neither here nor there, but is being used to try to create doubt around S&P's downgrade or imply that they will withdraw it.

Hell hath no fury like a government bureaucrat (or academic) whose umbilical cord is being threatened.

The Debt Ceiling Deal Saved Us From Financial Catastrophe

To all those who were forecasting crashing markets if the US debt ceiling wasn't raised:

Ok, so the debt ceiling was raised and we got crashing markets anyway.  I thought the Tea Partiers were terrorists playing brinksmanship with the economy.  How come the deal didn't save us?

Austerity and Wasting Money

#8 The U.S. Department of Veterans Affairs spent $175 million during 2010 to maintain hundreds of buildings that it does not even use.  This includes a pink, octagonal monkey house in the city of Dayton, Ohio.

#16 A professor at Dartmouth University received $137,530 to create a "recession-themed" video game entitled "Layoff". 

Finding examples of government waste like this is like shooting fish in a barrel.  That said, in the big picture, dubious projects like this really don't amount to that much in the overall government budget.  Even if all of the waste were eliminated, healthcare costs and other so-called entitlement spending are scheduled to overwhelm us anyway.  So why bring it up?

Well apparently it's common economics knowledge that "you don't cut government spending in the middle of a recession".  That spending adds to GDP, and so eliminating it contracts the economy.  So by this theory, that esteemed professor from Dartmouth will spend his $137,530 into the economy and promote growth, which is good.  If he didn't get it, we won't get the economic multiplier effect, tax receipts will go down, and such "austerity" measures will ultimately be self-defeating and not actually save the government money.  Keynes famously said that at some point it doesn't matter if the government paid people to dig holes and fill them in again, the government (i.e. fiscal policy) needs to inject money into the economy to promote demand.

Those who question this point of view are being labeled promoters of "austerity".

To the extent that there are public investment opportunities that will provide positive economic or social return, and we are in a very favorable interest rate environment for the government to borrow in, then government should clearly make the investment.  There are any number of "big idea" national initiatives that fit the criteria of a positive return:

• Modernization of the air traffic control system
• Roadway and bridge infrastructure repair
• High-speed rail between economically sustainable routes (major metros 200-500 miles apart)
• Nationwide wireless and fiber communications infrastructure available to the public
• Revamped educational system including trade schools, public school choice modeled after European and Asian systems
• Universal day care
• Grant programs to add 1,000,00 new general practice doctors
• Healthcare reform that breaks the health insurance oligopoly that runs up costs in the US--if nationalizing the industry is the answer, then it needs to be done
• A publicly-owned sustainable power grid to reduce the cost of electric power, transmission losses and dependency on fossil fuels and central power plants
• Execute one of the great water diversion projects (see GRAND and NAWAPA) to divert water from Canada and end the US West's water shortages forever

Instead, proponents of Keynesian fiscal policy mostly defend transfer payments, rebates for various politically correct behaviors, and the occasional "shovel-ready" construction project.  Whatever it takes to fill the supposed "demand gap" in the short term, by use of the national credit card as necessary.  This isn't a good use of resources.

To those who would say we can't afford it--it's always a good time to make a sound investment.  Separate bonds could be sold to fund the infrastructure projects (much like municipal bonds or even WWII war bonds) separate from the general fund, and the investment would be a no-brainer due to the obvious return on investment.  To those who worry about government crowding out private enterprise--what's wrong with government taking resources to fund worthwhile projects?  Also, capital for good private enterprise is always available, at worst government may take up resources that might have otherwise ended up in marginal enterprises like Pets.com.

The neo-Keynesian focus on spending-for-spending's sake in order to pump up the short-term economy with ephemeral consumer spending is foolhardy.  The GDP equation regards spending and investment as synonymous, but in the long-term, investment without future returns is a waste of resources.  I'm all for what economist Joseph Stiglitz calls a "well-designed stimulus" package that invests in the future.  But the Keynesians don't do themselves any favors when they just focus on filling the "demand gap" with mindless short-term fiscal spending that has zero long-term returns--we owe it to future generations to invest present resources wisely.

St. Freddie and St. Fannie

Brad DeLong and other commentators seem to have an unnecessary need to prove that Fannie and Freddie's hands were clean with respect to the credit crisis.  The Republican narrative about the mortgage crisis originating with government forcing lenders to loan to unqualified minorities is indeed a bunch of nonsense; the volume of those programs never amounted to anything and subprime borrowers had no particular racial skew.  However, Freddie and Fannie played a significant role in the mortgage crisis because they enabled the market bubble to grow so big.

Fannie and Freddie are $5 trillion dollars worth of the mortgage market.  Their "implicit government guarantee" allowed them to operate at 200:1 leverage ratios, which blew up when not only their subprime portfolio did, but also when their conforming mortgages delinquency skyrocketed.  Fannie and Freddie bought hundreds of billions  worth of subprime and Alt-A-backed securities, which made them a big part of the market for Wall Street to sell their CDO sausages to.

Now, to their credit, the GSEs never touched the most egregious loans like no-docs, "liar loans", and the like that raged at the top of the bubble.  That stuff was the true toxic waste.  But the fact is, the GSEs are in conservatorship right now, pushing losses of tens of billions of dollars a quarter onto the taxpayer, because they took on too much risk with too little capital buffers.  That is what caused this crisis, and Fannie and Freddie definitely contributed to the problem.

What They Never Told You About "Comparative Advantage"

"If there were an Economist’s Creed, it would surely contain the affirmations 'I understand the Principle of Comparative Advantage' and 'I advocate Free Trade'."

-Paul Krugman

David Ricardo first articulated the concept of comparative advantage in 1817.  In a nutshell, it suggests a happy world where each country is better at producing some goods than others, and it pays for each country to specialize in producing goods in which it has the greatest comparative advantage.  In the classic example, Portgual can product both cloth and wine at 90 and 80 labor units, while England can produce them at 100 and 110 respectively.  Even though Portugal is the low-cost producer in both instances, there is more relative profit in wine (30) than in cloth (10), so collectively Portugal can trade wine for English cloth and both parties profit from the relationship.  How all of this magically balances out trade deficits and improves quality of life for everyone is an article of faith within the Economists' Creed.

A key assumption that Ricardo made is today ignored by modern economists:

" ... if capital freely flowed towards those countries where it could be most profitably employed, there could be no difference in the rate of profit, and no other difference in the real or labour price of commodities, than the additional quantity of labour required to convey them to the various markets where they were to be sold."

Guess what?  Capital flows freely around the world today, to every country, except oddballs like North Korea.  Mobile capital seeks cheap labor, cheap land, lax regulatory rules, and low taxes.  Therefore "comparative advantage" is now a race to the bottom for labor, environmental regulation, and progressive taxation.  With free capital, Portugal's low labor costs can now produce both wine and cloth and drive English businesses out entirely.

Modern economists look back upon the 19th century United States with disdain, a country that had booms and busts, no social safety net, little government economic intervention, and no central bank.  It was also strongly protectionist, starting with Alexander Hamilton and maintained by the Whig and later Republican parties.  This was known as the American System, which stood in contrast to the free trade-oriented British System.  These terms are quaint today, but the conflicting worldviews can still be identified in modern free trade debate.

Tariff rates bounced around from a low in 1857 of 18%, to 40-50% that was characteristic of the Gilded Age.  Abraham Lincoln raised tariffs to 49% during the US Civil War.  During the period 1865-1890, America experienced the most rapid growth of its entire existence, hitting 6.8% annual GDP growth and doubling its GDP during the 1880s.  By 1890, in but 100 years, America had eclipsed Great Britain as the world's largest industrial power.  Commitment to protectionism then began to falter, leading to conflict between free trade Democrats and protectionist Republicans.  Future President William McKinley said of this:

"Under free trade the trader is the master and the producer the slave. Protection is but the law of nature, the law of self-preservation, of self-development, of securing the highest and best destiny of the race of man. [It is said] that protection is immoral…. Why, if protection builds up and elevates 63,000,000 [the U.S. population] of people, the influence of those 63,000,000 of people elevates the rest of the world. We cannot take a step in the pathway of progress without benefiting mankind everywhere. Well, they say, ‘Buy where you can buy the cheapest'…. Of course, that applies to labor as to everything else. Let me give you a maxim that is a thousand times better than that, and it is the protection maxim: ‘Buy where you can pay the easiest.' And that spot of earth is where labor wins its highest rewards."

 McKinley successfully passed  through Congress a namesake tariff act in 1890.  To its critics in retrospect he commented:

"What has this Protective Tariff law of 1890 done? Why, it has increased factories all over the United States. It has built new ones, it has enlarged old ones.... [For example, we] used to buy our buttons made in Austria by the prison labor of Austria. We are buying our buttons today made by the free labor of America. We had 11 button factories before 1890; we have 85 now. We employed 500 men before 1890, at from $12 to $15 a week; we employ 8,000 men now, at from $18 to $35 a week."...|Well, but, they said, this tariff law of 1890 was going to increase the price of necessaries of life, and was going to diminish the wages of labor. It has done neither. The necessities of life are cheaper today than they were 18 months ago. The commodities that go into the household of every man and woman are cheaper today ... and the price of labor has increased to some extent."

Contrast this today with those who told us NAFTA and MFN status for China would create American jobs.  Do any pundits today set higher wages and lower product costs as a policy goal today?  No, we are told that higher wages leads to bad "price spiral" inflation, but higher product costs reflect more "quality", demand growth, and other positive things.

McKinley had this to say about land owenership:

``We must avoid in this country the holding of large tracts of land by non-resident owners for speculative purposes, and set our faces like flint against alien land-holding in small or large tracts. Our public domain must be re-dedicated to our own people, and neither foreign syndicates nor domestic corporations must be permitted to divert it from the hallowed purposes of actual settlement by real farmers."

You don't expect to hear Republicans talking like Marxist land reformers.  No doubt the Monsantos of the world are happy to keep this bit of US history dead.

Henry Carey, advisor to President Lincoln and a forgotten economist who promoted the American System, expressed some loftier goals for the battle between the American and British systems:

``Two systems are before the world; the one looks to increasing the proportion of persons and of capital engaged in trade and transportation, and therefore to diminishing the proportion engaged in producing commodities with which to trade, with necessarily diminished return to the labour of all; while the other looks to increasing the proportion engaged in the work of production, and diminishing that engaged in trade and transportation, with increased return to all, giving to the labourer good wages, and to the owner of capital good profits. One looks to increasing the quantity of raw materials to be exported, and diminishing the inducements to the import of men, thus impoverishing both farmer and planter by throwing on them the burden of freight; while the other looks to increasing the import of men, and diminishing the export of raw materials, thereby enriching both planter and farmer by relieving them from the payment of freight. One looks to compelling the farmers and planters of the Union to continue their contributions for the support of the fleets and armies, the paupers, the nobles and the sovereigns of Europe; the other to enabling ourselves to apply the same means to the moral and intellectual improvement of the sovereigns of America. One looks to the continuance of that bastard freedom of trade which denies the principle of protection, yet doles it out as revenue duties; the other to extending the area of legitimate free trade by the establishment of perfect protection, followed by the annexation of individuals and communities, and ultimately by the abolition of custom-houses. One looks to exporting men to occupy desert tracts, the sovereignty of which is obtained by aid of diplomacy or war; the other to increasing the value of an immense extent of vacant land by importing men by millions for their occupation. One looks to increasing the necessity for commerce; the other to increasing the power to maintain it. One looks to underworking the Hindoo [sic], and sinking the rest of the world to his level; the other to raising the standard of man throughout the world to our level. One looks to pauperism, ignorance, depopulation, and barbarism; the other in increasing wealth, comfort, intelligence, combination of action, and civilization. One looks towards universal war; the other towards universal peace. One is the English system; the other we may be proud to call the American system, for it is the only one ever devised the tendency of which was that of elevating while equalizing the condition of man throughout the world.

Once again we see Republicans calling for workers of the world to unite, even using rhetoric reminiscent of historical dialectics.  A far cry from modern Republicans, who have fully bought into the "British System".

Today China, Japan, South Korea, and other nations pursue protectionist trade policies, while US and many European tariffs remain low due to free trade theorists winning the public debate.  Not only is the comparative advantage theory obsolete in this age of global capital flows, but it has obviously unbalanced the distribution of wealth between labor and capital in the developed world.  These faux progressives who advocate free trade today run under a false flag--the capital class rewards them with academic accolades and media play in order to make the public believe that free trade is in their interest.

So Much for "Helicopter" Ben

Setting aside the merits of Ben Bernanke's famous prescription for addressing a depression by dropping money out of helicopters, where are his helicopters now?  Why is he not showering the public in cash to restart the economy, if that's what he believes in?  Methinks his shareholders have his helicopters firmly moored to the ground, as they have no interest in devaluing their debt product.

Modest IMF Proposal to Solve the Greek Debt Crisis: Introducing HABS

This plan, written by an IMF staffer responsible for scheduling evening social entertainment for Dominique Strauss-Kahn, recently fell into my hands:

To: Jean-Claude Trichet, George Papandreou, maidman@imf.org
Cc: ben-contained@federalreserve.gov, godswork@goldmansachs.com
From: [Redacted], IMF Undersecretary for Married Executive Affairs
Subject: Modest Proposal to Resolve Greek Debt Crisis Using Novel Asset-Backed Security
Date: May 12, 2011

Dear Gentlemen:

The ECB has declared that Greek debt restructuring is "off the table".  As negotiators in Europe struggle with an intractable foe in the Greek debt crisis standoff--mathematics--I believe that there is an unconventional option, that has heretofore not been considered, that may be the only way to keep senior creditors whole.  Which is, after all, the primary directive of modern Western governments.  At the same time, we may be able to get these same creditors to accept impairments, which is the key to achieving political compromise.  Let me elaborate further on how to achieve these seemingly contradictory goals.

The Greek debt to foreigners outstanding amounts to some $481.5 billion dollars.  Most of this debt was created by European financial institutions such as Commerzbank, BNP Paribas, Hypo Real Estate Holding AG, Société Générale, and Crédit Agricole.  US financial institutions are rumored to be on the hook for credit default swaps written against this debt.  Nobody really knows the exposure distribution because BIS keeps that secret.

It turns out that history gives us some guidance in this policy matter.  When Roman tax burdens, debts, and inflation got to a certain point, the middle class sold themselves into slavery to wealthy patricians in order to get relief from bill collectors who wielded unlimited powers to terrorize.  In the 17th century, a more humane institution was introduced, that I am proposing to resurrect with some modern enhancements: indentured servitude.  This admittedly unconventional measure will present creditors with a bond swap deal that is too good to refuse.

Here is the heart of my proposal.  There are approximately 6.6 million men and women of working age in Greece.  Each of the able-bodied will be pooled into Human Asset-Backed Securities (HABS) as indentured servants.  The HABS trust collateral assignments will be enforced by the Greek government (i.e. military), and trust administration will be contracted to a qualified financial advisory firm (you reading this, Lloyd?).  The trusts will then grant shares to creditors in proportion to the debt owed, in exchange for outstanding conventional debt dollar-for-dollar.  These citizens will then be be assigned work by the financial institutions, for example in portfolio companies owned by the institutions' private equity divisions.  They may also be used in trading desks to buy US Treasuries and flip them to the Fed, make buy-side recommendations on whatever the sell-side needs to unload, buy up commodities and store them on leased ships anchored in international waters, etc.  The point is these potential Greek servants are very versatile and represent an undervalued asset both to the Greek government and to European financial institutions.  Average Greek worker productivity is twenty dollars per hour or about $40,000 per year, so the financial institutions should be able to get plenty of value out of the servants.

Each former Greek citizen will be allocated a subsistence wage of $11,500 per year to pay for the cost of living (the income poverty line in Greece is about $8,000/year, so this plan will have the bonus social benefit of ending poverty in Greece).  In exchange, Greek citizens will be generously granted by senior creditors a $15,000/year impairment towards the existing debt balance.  Let us not call this an austerity program; it is highly progressive and technically will lift the Greek masses out of poverty.

Table 1: Annual Cash Flow Model For Greek Indentured Servant
Avg Greek Worker Annual Productivity	$40,000
Annual Subsistence Wage	$11,500
Annual Impairment	$15,000
Retained Productivity Per Worker	$29,500

As you can see, the yield on these human assets is very attractive as long as they are performing, and the subsistence wage can potentially be garnished as a form.of credit enhancement to the security.  The productivity value margin is more than 2.5x the impairment credit, and using the same risk models used to predict default rates in CDO^2 deals a few years ago we have calculated that the risk of loss to senior creditors is less likely than the US Congress passing a law to demolish K Street and turn it into a national monument dedicated to the fight against government corruption.

Let us now turn to the debt retirement schedule. We should set a goal of repaying the debt within seven years, which is currently the average maturity of Greek debt, because we don't want to inflict any duration mismatch headaches upon our esteemed financial institutions. With 6.6 million Greek indentured servants being granted $15,000 in impairment credit in exchange for their labor, a total of $99 billion dollars per year in debt will be retired as impairment.  Within seven years, the debt will be entirely extinguished according to this schedule:

Table 2: Greek Debt Repayment Schedule (in Millions)
Schedule Item	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
Debt Balance	$481,500	$405,612	$326,081	$242,733	$155,384	$63,842	$(32,092)
Interest (@4.8% Avg Coupon)	$23,112	$19,469	$15,651	$11,651	$7,458	$3,064	$(1,540)
Annual Impairment	$99,000	$99,000	$99,000	$99,000	$99,000	$99,000	$99,000

At the end of seven years, the Greek balance sheet will be spotlessly clean, and the Greek human assets can roll off of the HABS, once again free to rack up massive debts while drinking Ouzo.  Whenever the Greek government needs to borrow again, a new HABS structure can be created and citizens rolled back into it.

Since the creditors will eagerly sign up for this plan (once-in-a-lifetime opportunity to grab some yield), no credit event need be triggered, so all of the CDS writers can rest easy.  The latter may now have the opportunity to write life insurance policies against Greek servants with their owning financial institutions as beneficiaries.  One could use Greek underwriters and now it's a job program to improve the Greek government's popularity.  The synergies are self-reinforcing.

The key innovation in this plan is to barter Greek citizens' liberty and labor in exchange for credit impairment concessions on behalf of senior creditors.  This is a win-win for all parties: the Greeks gain a novel way to pay off their debts, the financial institutions receive compensation far in excess of their current yields in exchange for impairment on current assets, and the Greek government gains a whole new asset base against which to borrow.  If we can get the Papandreou government to agree to sell the public (literally), we may yet be able to head off the crisis. In the spirit of compromise, let everybody share in the sacrifice.

Q&A
Q: The term "indentured servitude" has some negative connotations.  How do you propose to handle this?
A: I propose to substitute the term "Financial Freedom Contract" to emphasize the freedom the servant will feel when the debt is paid off in seven years.

Q: If all Greek working age adults are conscripted into indentured servitude, what will happen to the children and the elderly?
A: The children can be held in reserve and periodically sold to the black market to provide fixed income stability for the security trusts.  The elderly can be used to provide extra liquidity, perhaps for a Soylent Green-type secondary market.  Lord knows you can never have too much liquidity.  Perhaps this is something that Lloyd would be interested in making a market in?

Best regards,

[Redacted]

PS Dom I think you'll like the service at the Sofitel, don't be shy about asking if you want anything.

The Return of the Luddite

If the Luddite fallacy were true we would all be out of work because productivity has been increasing for two centuries.

This quote from economist Alex Tabarrok is found all over the Internet as the definitive reductio ad absurdum dismissal of the Luddite fallacy.  It's on Wikipedia, and is almost certainly Dr. Tabarrok's most widely quoted quote.

Let me start deconstructing this by providing a counter example:

Productivity has been exponentially increasing for two centuries, and yet we are not all millionaires working one hour per month.

Back in the 1950s futurists projected that, with wage and productivity trends, there would be a major societal problem by the 1980s regarding what workers would do with all of their leisure time, when working four hours per week.  Needless to say that didn't happen.

There are two primary reasons for this: one, is population growth has kept the supply and price of labor in check, and two, workers have not seen most of these productivity gains reflected in their paychecks.

Economist William Easterly offers the following criticism:

[...]the "fallacy" of the Luddites lay in their assumption that employers would keep production constant by employing a smaller albeit more productive workforce instead of allowing production to grow while keeping workforce size constant.

Dr. Easterly never interviewed any Luddites I am sure, but there is no reason to believe that they expected employers to keep either production or workforce size constant.  Most employers are trying to continuously optimizing to produce more with fewer workers--the definition of productivity.  Automation allows them to do exactly that.  In other words, employers face no fundamental tradeoff between production and workforce size--they can and do have both greater production and smaller workforces as productivity improves.

Agriculture is a perfect example of this phenomenon.  We produce more agricultural products today than ever, with a fraction of the labor required in pre-industrial times, thanks to advancements like combines and fertilizers.  US manufacturing output is higher than ever, yet the manufacturing labor force is less than half the size it was back in the 1950s heyday.  The Luddites didn't make any false assumptions--they knew exactly what the plan was and they were right!

Now, one may point out that the agriculture story demonstrated how the loss of jobs and reduction in the cost of goods in one industry (agriculture) freed up labor and consumer spending to enable the manufacturing revolution, and a similar story can be told as manufacturing industry labor need gives way to that of the services economy.  Ok, but this leads to the key question:

When all goods and services production is automated, what's left for humans to do that someone will pay them to do?

The standard answer that new technologies will create new jobs and services is certainly partly true, but saying that there will be enough jobs created thusly to employ the growing population is an article of faith unsupported by any facts.

Immortalized in the tale of John Henry and the Steam Engine, people have recognized for a long time that technology advancement creates labor winners and losers.  Losers are humans replaced by automation.  Winners are those who fulfill new labor opportunities afforded by the new technology.  Economists usually make the following argument that sounds like a law but has no name as far as I can tell:

1. Technology improves productivity

2. Productivity lowers production costs

3. Lower costs means lower goods prices

4. Lower prices means higher demand

5. Higher goods demand results in more labor demand

There is no doubt that technology destroys some jobs while creating others.  I argue, though, that there is no promise that as technology advances, the process of "creative destruction" as von Mises put it will forever result in a positive job growth balance, which is necessary as long as human population is growing and we have a more or less free market system.

As this chart from Jared Bernstein's blog shows, something seems to have happened in the year 2000 that suggests that we may have reached a point where computers and robots have gained the upper hand:

US productivity per employee has accelerated, while employment growth has decelerated.  Certainly multiple factors are at work here.  One is overseas offshoring, which has contributed to US company topline revenue while suppressing labor growth.  Another is the rise of Internet businesses, which are capital intensive but require very small amounts of very skilled labor.  Google makes more than $1 million dollars in revenue per employee, an incredible productivity statistic.

We need only look outside the US to other countries that have high double-digit unemployment rates to see that there is no mystical rebalancing function in an economy that will create an equal number of similar-paying jobs when technology obsolesces a job function.  If there were, then horses would have found jobs by now after being displaced by motor power a hundred years ago.  And don't tell me horses can't learn new tricks.

The Most Important Issue of the Future

I believe that the most important issue that we face in the future is that technology is eliminating the need for human labor at an accelerating rate, while population grows and the need for people to make a living continues.  Much like we produce orders of magnitude more agricultural products today with a tiny population devoted to farming, the same story has played out with manufacturing, and now with other industries as well.  We face a future where we only need 2% of the population engaged in production.  How will the other 98% make a living?

There are two possible outcomes that I foresee: a Marxist revolution where "the means of production" are socialized, or a drastic Malthusian reduction in human population to a level required by the economy of the future.  Hopefully the proletarian revolutions of the future have better outcomes than the ones of the 20th century.

The consumerist capitalism of the 20th century is in a negative feedback loop that is destroying itself: competition is driving cost efficiencies that reduce labor inputs that reduce disposable income and reduce demand.  This has been occurring for many years, and has been masked by an expansion of consumer credit since the 1970s that exploded in 2007.

I found a blog today that features this theme: http://econfuture.wordpress.com/, and I will be writing about it more in the future here.

In Defense of Dominique Strauss-Kahn

The Federal Reserve is in business to create moral hazard. The mere act of being a central banker means your job description involves creating moral hazard.

- Harvey Rosenblum, executive VP of Dallas Fed

Recently, IMF managing director Dominique Strauss-Kahn has had his reputation tarnished by a US scandal that would be barely worth gossiping about in a cafe in France.  Apparently this has been a part of a pattern of consumptive behavior going back many years.

And that kind of economics leadership is exactly what the world needs now.  Someone needs to rekindle what Keynes called the 'animal spirits' in bankers.  As Mr. Rosenblum and other Fed employees have noted, central banking is about creating moral hazard.  Who is more qualified to spread moral hazard around the world than Dominique Strauss-Kahn?  Who can possibly fill his shoes?

The Macroeconomics Credibility Gap

I posted this response to a Paul Krugman column bemoaning how nobody takes monetarists seriously anymore.

The reason the various schools of macro have failed to predict recession cycles for decades, is they do not recognize that the root cause is the buildup of undercollateralized credit, i.e. leverage. This is the essential point that heretics like Hayek and Misnky make, yet it continues to go unaddressed. Instead, a psychological phenomenon called an aggregate demand gap is blamed, when in fact the demand gap represents a (temporary) return to less leveraged financial practices and attitudes. The market failure is set up by the failure of government to properly regulate the use of leverage, and then compounded with moral hazard when government "intervenes" in the aftermath to reward the leverage abusers. 

If the leverage cheaters--the Fannie Maes who issue credit on less than 2% reserves--are not cleaned out periodically, capital is increasingly tied up in zombie non-performing assets (e.g. CDOs and houses) that can pretend they are performing as long as debts can be continually rolled over and increased to cover cash flow losses--requiring infinite dovish monetary policy. This eventually hits the zero bound on interest rates--the "liquidity trap"--unless the market or the Fed ends the party before zero is hit. This is the "liquidity trap" that gets a lot of attention in this space. The proper policy response is not to double down on government debt, but a regulatory and law enforcement response to clamp down on the undercollateralized credit defrauding the nation's money supply.

Until macroeconomists understand that the demand gap represents not a market failure, but the gap between sustainable and unsustainable credit-driven consumption, they will continue to be (rightly) derided outside rarefied academic and Washington DC airs. Monetary vs. fiscal policy vs. free markets is beside the point.

If I had to boil down the structural economic problems in capitalist society today, it comes down to one word: leverage.  Certain persons and organizations are granted leverage privilege; all other must pay cash.  This is what keeps the rich growing richer--they can buy stuff without spending money.

Your brokerage account is settled nightly (and sometimes intra-day if you exceed margin limits).  Goldman Sachs  gets weeks or months to settle transactions.  Banks get to hold assets on their books for years pretending they have value, even if the debtor is no longer paying at all.  The US government plays many games with leverage in its books such as with the Social Security "trust fund".  Finally, there's the whole institutionalized leverage system that banks follow known as fractional reserve lending.  The little guy without access to cheap credit can't get anywhere.

It is worth noting that gold is not the solution to undercollateralized credit.  Banks issued banknotes in the late 19th century that became worthless when no one would accept them.  Credit is created every time a supplier grants 30 day payment terms to a customer.  Instead of the gold standard, we should be better defining the boundaries between credit and fraud, and enforcing sanctions against fraud.

Gio Coglitore (Facebook) Does Not Understand Virtualization

PC Mag today reported on an Intel event where director of Facebook Labs' Gio Coglitore described Facebook's server strategy using a bunch of non sequitors that demonstrate he doesn't understand virtualization.

First of all, he admits that they don't practice IT 101 testing standards:

Coglitore also said that Facebook believes in "testing in production," adding test machines to a live network.

"If you ever experience a glitch [while using the site], it might be Gio testing something out," Coglitore said.

Hey, there's a good idea, let's throw half-baked systems out there and see if it blows up our business.  At least Microsoft gives you the courtesy of choosing to install a service pack/point a loaded gun at your head or not.  Perhaps this explains why Facebook has repeatedly introduced and then had to back off of new software versions, no doubt at great expense.

Coglitore goes on to unnecessarily coin a new phrase, "realized environments" as a counterpoint to virtual environments.  I never realized that running software natively required a new term.  This is like calling a conversation between two people in a room "local acoustic communications" to make it sound like a novel innovation over the telephone.  We already have terms like "native" and "bare metal" that make a term like "realized" unnecessarily abstract.

Within the front end, testing has proven that Facebook's front-end code is better realized, not virtualized, Coglitore said. "Software layers tend to be locking," he said. "One of the things we enjoy at Facebook is rapid iteration."

What does that have to do with virtualization?  Want rapid iteration?  Spawn up a new virtual machine to run your new software.  Bam!  That's a lot faster than installing a new piece of hardware in your data center.  You want to experiment with different configurations of servers?  Spawn up a bunch of virtual machines in your new configuration and performance test it.  Reconfigure on the fly until you have the right balance.  Try doing that with physical servers.

But here's where we really go off the deep end:

But if a front-end server dies at Facebook... well, so what, Coglitore seemed to say. "The microserver model is extremely attractive," he said. "I've said this before: it's foot soldiers, the Chinese army model. When you go into these battles, you like to have cannon fodder to some degree, an ovewhelming force and ability to lose large numbers of them and not affect the end-user experience. When you have a realized environment, you can do that. It's hard to that with a virtualized environment."

Nobody today deploys a SINGLE large server supporting all VMs--putting all of your eggs in one basket, which is the strawman Coglitore seems to be alluding to.  We use a cluster or cloud of equal server, each of which can run VMs.  When you have an army of virtual servers with a technology like VMWare's vMotion, if one of them goes down, another VM is automatically spun up on another machine within seconds in the same execution state as the failed VM was in.  If an entire physical server goes down, all of those VMs find new homes on other physical machines, and processing is hardly interrupted.  Virtualized environments allow you to dynamically reallocate processing resources to accomodate whatever the overall computing environment demands, across the whole array of virtual machines.  The Chinese army analogy supports virtualized cloud/cluster environments, not old-school bare metal environments of the sort Coglitore is advocating!  

To achieve the level of redundancy in a virtualized environment, Facebook would have to deploy a standby node, which takes away the cost advantage, Coglitore said. "I'd have t keep multiple large-pipe pieces of hardware in my environment, where I'd prefer to keep little segments," with a load balancer directing traffic to the smaller computers, he said. 

Again, virtualized cloud/cluster environments do not have idle standby hardware, so this argument is bunk.  The only difference with the virtualized environment is you may subdivide your 4-8-16 node cluster into many more virtual machines, allocate resources asymetrically between them (a web server VM may only need a small RAM allocation vs a database that needs more), allocate those resources on demand (vs having to guess right the first time with a physical hardware implementation), and your VM architecture will be more robust overall because you can prevent any data loss whatsoever by using technologies like vMotion.  The VMs themselves can be the "little segments".

There is also another dark side to these microserver environments that was learned with the older blade systems: because they share common backplanes and power supplies, you can lose a whole bank of servers all at once--a near impossibility with traditional servers that are completely self-contained.  Blade systems were notorious for a bad firmware update wiping out a whole rack of blades, or a power supply failure taking down a node.  I believe that this is why Google does not use blades.  The denser you get, the greater this vulnerability risk becomes.  What's your high availability plan when 16 physical servers become doorstops at once when a power supply fries them?  You don't have this problem with a cluster of better-made higher-end servers running VMs.

I predict that Facebook will within the next two years have some major system downtime due to their production system control practices.  I didn't mean for this article to sound like a pitch for virtualization, but the arguments being made for buying a bunch of microservers instead of virtual machines were ridiculous.  Maybe Intel compensated him for his appearance.

Welcome and Introduction

I have a variety of topics I will comment on from this soapbox, including:

- Economics
- Technology
- Science
- Humor
- Politics

I like to pretend I am a scholar of all of these topics (yes, even humor!) and I will let the audience choose whether to pay attention or not.