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The Cost of Economic Protectionism…

March 8, 2009

Now that times are getting bad, protectionist sentiment seems to raging all over the world. Everywhere you look, there are calls to “buy American”, “buy Canadian”, and “buy local”. The economic stimulus package that recently passed in the U.S. Senate also originally contained a buy American requirement for receiving funds. Hmm…

At its core, protectionism is based on the feeling that it is better to buy goods and services produced locally rather than produced far away. The rationale is that if I spend my money locally, it’s more likely to then be spent at other local businesses, including potentially my own. Or more generally, it means preferring to employ my fellow countrymen rather than foreigners. After all, we have to protect our own first, right? Well, before you jump on the “buy American” bandwagon, just make sure you understand its costs first…

The standard of living for those of us living in the western world has dramatically improved over the last hundred years. Today we have more books, clothes, iPods, big screen TVs, and cars than our grandparents would have imagined possible. We also have bigger houses, we work shorter hours, and we often have health coverage and pensions. We, on average, have a much more comfortable standard of living than those living a hundred years ago. So how did we achieve such levels of prosperity?

  1. Huge breakthroughs in manufacturing technology and materials
  2. Efficient global shipping & transportation
  3. Government deficits and borrowing from our children
  4. Outsourcing labor to emerging economies

People like to complain about their jobs going overseas and protectionists may argue about the benefits of outsourcing, but it’s quite straightforward if you think about it.

Labor costs, just like everything else in free markets, are driven by supply and demand. If you’re offering your services at a cost of $40,000 a year, and someone else is offering the same services at a cost of $4,000 a year, what do you think is going to happen? As long as there are enough people willing to do the job for $4,000 a year, eventually no company (that wants to remain solvent) will be willing to pay $40,000 for that job anymore.

And outsourcing isn’t the only reason why the value of a job can drop. The same thing happened with automation in factories – millions of jobs were destroyed and replaced by cheaper machine labor. And the refrain was the same: machines are bad, they put people out of work – we must protect our good paying jobs.

You might call outsourcing labor to emerging economies exploitation, but then it becomes a moral debate. The fact is, if you can pay someone overseas (or build a machine) to produce goods for you at a fraction of what it would cost to produce locally, the economy will benefit because companies are able to do more with less.

The mistake protectionists make is to think that they can somehow prevent this natural revaluing of jobs; that somehow we can pretend that a job is magically still worth $40,000 a year when it’s not. In order to artificially “protect” domestic jobs you can do a couple of things. You can subsidize domestic production, or you can tax or add tariffs to foreign products. But both options reduce the society’s wealth, and thus standard of living, because it protects less efficient methods of production and puts that cost onto the society. Does anyone think it’s a good idea to tax machine-created products, or subsidize manual labor over machine labor?

Protectionism often seems more interested in protecting the effort associated with producing goods. But don’t forget, the point of the economy is not to create jobs for people; it’s to produce stuff. And the only reason to work is to have money to buy that stuff. And despite many decades of outsourcing, we don’t seem to be running out of jobs yet. People get retrained and find new jobs.

There may be legitimate political reasons to endorse protectionism, like avoiding dependence on less than friendly foreign regimes, but there aren’t good economic ones.

[Content © 2009 SorryToConfuseYou.com, All Rights Reserved.]

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The "Wealthy" Barber

March 1, 2009

Lotto Ticket

I saw a local news story a little while ago about a 70 year-old barber winning a $32 million lottery jackpot. Apparently he and one of his customers had been playing the lottery together for 35 years.

My first thought was: wow, I bet he wished he had won the lottery 35 years ago instead…

My second thought was: wow, how many people are out there wasting their money playing the lottery for 35 years and not winning?

Playing the lottery is an attractive thing in that anyone, at any time, can win it big. It’s the great equalizer; the great hope; the great fraud… I find it sad really, the false hope that these lotteries generate.

There’s even a whole industry built around "helping" you improve your odds of winning the lottery. Whether it’s magic mathematical systems or divine inspiration, there are hundreds of web sites willing to take your money in order to let the government take your money. For example, one system I saw boasts:

"Win more than every 8 out of 10 times – guaranteed"
"The secret to real lotto system winning success that no other lottery system tells you about."
"Discover the lotto winning solution that really works!"

Brutal! They even offer an affiliate program to ensure that they have an army of people producing "unbiased" testimonials to drown out unhappy customers.

Bottom line, there are only 3 groups getting rich off of lotteries:

  • The government (who takes half the ticket price)
  • The scam-artists who sell these magic "systems" to "help" you win
  • The store clerks who steal their customer’s winning tickets

The odds of winning the grand prize in your lifetime is, at best, something like 1 in 4,000 (1 in 14,000,000 x 35 years x 52 weeks x twice a week) – obviously it depends on which lottery you play. By the way, the odds of being struck by lightning in your lifetime is around 1 in 5,000. Hmm…

If the barber and his friend had invested the $3 they spent twice a week, for 35 years, adjusted for inflation, it could have been worth about $35,000 today. Obviously $32 million is much better, but for the 99.975% of people that will never win the jackpot in their lifetime, $35,000 is better than zero.

In fact, if you invest just $30 a week for 35 years (like some people spend on lottery tickets), you could have a pretty good retirement nest egg of something like $175,000+.

So, how do you win at the lottery? You don’t play…

[Content © 2009 SorryToConfuseYou.com, All Rights Reserved.]

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Artificial Government Controls…

February 17, 2009

Our public officials sometimes seem to think that more government intervention is better than less; that somehow central planning creates better results than free markets. Apparently we didn’t learn from the Soviet experience… There are probably a million different examples I could use to illustrate this point, but one specific local situation has been in the news recently.

In the city where I live, the municipal government decided 3 decades ago that it should license and regulate the taxi business. Fine, we wouldn’t want convicted felons driving taxis, right? But as part of this process, they also decided to cap the number of licenses they would issue. Hmm… Maybe someone thought having too many cabs would be a nuisance, or maybe it was the cabbies that wanted some guaranteed job security. Either way, it was a really bad decision that has led to a number of predictable and undesirable consequences:

  1. Since licenses are scarce, people sell them for $100,000+, even though they’re not technically worth anything
  2. Since the licenses are worth so much, the city can’t issue more without destroying some of that value and thus making the existing license holders irate
  3. The service is generally mediocre because there’s no incentive to improve and no risk of competition
  4. The service is slow, especially at peak times, because there’s artificially too few cabs

Wouldn’t it make sense if the city issued as many licenses as the free market demanded? Then if we needed more cabs because, say, the city grew, more people could get licenses. If we had too many cabs, some people wouldn’t be able to make a living and would find other jobs. Better yet, maybe some people would decide to drive cabs part-time. That way, they could choose only to work on the busiest nights, to make a little extra cash on the side. These part-time drivers would also be available to help increase service in situations like transit strikes, as we happen to have just survived.

But as with most situations of goofy government intervention, the free market finds a way to fill the void anyway. In the case of our local taxi service, we now have so called ‘bandit taxis’, which run completely outside of the regulations. Despite being illegal, the need is so great that drivers and passengers are still willing to take the risk. Since unlicensed cabs are obviously not the best solution, maybe city officials should take a hint, although so far they claim to be ‘perplexed’ by the situation…

[Content © 2009 SorryToConfuseYou.com, All Rights Reserved.]

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‘Tis The Season To Be Really, Really Busy…

November 16, 2008

I’ll be taking a break for the next several weeks to enjoy the many holiday season festivities, and catch up on some long neglected projects. I shall return in the new year with new (and hopefully interesting posts) – thank you for reading, and enjoy the season!

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What Will Drive Markets Higher (or Lower)?

November 9, 2008

What drives the price of stocks on a day-to-day (or year-to-year) basis? What causes the price to go up or down? A lot of people talk about “cash flow”, and money flowing in and out of the market. For example, it’s not uncommon to hear snippets on the news like:

Liquid capital could come back and fuel a rally.”

There is a lot of money waiting on the sidelines.”

I think there’s enough cash on the sideline that any pullback is being greeted with buying.

But does cash really drive markets? Let’s see…

1) Say Bob has a comic book that he bought for $5, and $15 cash for buying other comic books. Jim has $20 cash for buying comic books.

  Cash Comics Total
Bob $15 $5 $20
Jim $20 $0 $20
Total $35 $5 $40

2) Jim offers to buy Bob’s comic book for $10 because he thinks that it’s going to be more valuable in the future. Bob agrees to the price. The comic is now worth $10, and Bob makes $5 on the deal.

  Cash Comics Total
Bob $25 $0 $25
Jim $10 $10 $20
Total $35 $10 $45

3) A few days later, Bob regrets selling the comic and really wants it back, so he begs Jim to sell it back to him. Jim reluctantly agrees, and sells it back to him for $25. The comic is now worth $25, and Jim made $15 between the two transactions.

  Cash Comics Total
Bob $0 $25 $25
Jim $35 $0 $35
Total $35 $25 $60

4) The next day, the comic publisher announces that it will run another printing of Bob’s comic because it’s so popular. Now anyone can buy that comic for $5.

  Cash Comics Total
Bob $0 $5 $5
Jim $35 $0 $35
Total $35 $5 $40

Notice two things:

  • The total “cash on the sideline” doesn’t change. Every time a transaction takes place, cash moves, but the total cash available doesn’t change.
  • The system is not a zero-sum game – it’s possible for everyone to win (or lose) at least for some period of time.

This is exactly what happens in the stock market every day. There are a fixed number of shares in the stock market (except when there’s a secondary offering, or an IPO). A rally doesn’t actually “use up” (nor require) cash sitting on sideline. Cash moves around from person to person, but doesn’t “enter” or “leave” the market except when its owner decides to reallocate that cash for some other purpose. Hmm…

So what happens when a bunch of people want to move a bunch of cash from other asset classes into the stock market? Back to the above example: if Ted has $1,000 and wants to get into the comic business, he might buy Bob’s comic for $50 (or not). His decision isn’t based on the fact he has money burning a hole in his pocket. His decision is based on whether he can buy the comic at a lower price than that at which he can later sell it – i.e. it’s all about sentiment. If Ted doesn’t believe that he can make money buying the comic at $50, regardless of how much cash he has, he’d be an idiot to pay that much for it…

The same thing happens in the stock market. The only reason to buy something is if you believe you can make money in whatever timeframe you’re looking at – it doesn’t matter how much cash you have. Prices rise when greed and optimism are prevalent. Prices fall when fear and pessimism rule the day. All cash does is provide liquidity for this to happen efficiently (“sideline” cash has actually been rising for years by the way). Don’t worry – there will always be more than enough sideline cash looking for opportunities regardless of the state of the market. The thing that changes on a day to day basis is sentiment.

So when some talking head says, “the markets will rally when cash comes into the market”, what he really means to say “the markets will rally when optimism comes into the market”.

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

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Who’s Better For The Economy, Obama or McCain?

November 2, 2008

Leading up to this U.S. election, there’s been lots of talk about how to fix the economy, and which Presidential candidate would be best for the country. Sometimes, someone will come up with reasonable, unbiased analysis like Andy on the Saving to Invest blog. But more often than not, the debate will degenerate into partisan bickering.

For example, a common tactic is to compare stock market returns under Republican Presidents and Democratic presidents – as was discussed on the Carpe Diem blog. The claim there was that if you had invested money since 1929 under one party or the other, the outcome would have been:

  • Democratic Presidents: $10,000 became $360,000
  • Republican Presidents: $10,000 became $11,000 (or $51,000 skipping the Hoover years)

Hmm… This merits a little investigation. The first thing to wonder is why they would start the comparison in 1929, just before the great crash? It would have been nice to at least go right back to the turn of the century. Too bad. I’m starting in 1929 because Yahoo only provides data back that far.

The next thing to do is to make sure we’re comparing apples to apples. Were Republican’s Presidents in power as much as Democratic Presidents? Yes, 40 years each. Good.

How consistent were the returns? I’m not sure which markets they were analyzing, but I’ll use the Dow Jones Industrial Average.

President Party Years Average % Return Per Year
Hoover Republican 4 -35.6%
Roosevelt Democrat 12.2 9.3%
Truman Democrat 7.8 8.0%
Eisenhower Republican 8 10.4%
Kennedy Democrat 2.8 4.1%
Johnson Democrat 5.2 5.3%
Nixon Republican 5.5 -3.2%
Ford Republican 2.5 8.9%
Carter Democrat 4 -0.2%
Reagan Republican 8 11.3%
Bush (H.W.) Republican 4 9.7%
Clinton Democrat 8 15.9%
Bush (W.) Republican 8 -1.6%

When looking at these numbers, 2 outliers stand out – Hoover and Clinton. What if we compare the average % return per year without these outliers?

Party 1929 – now 1933 – now 1933 – 1993
Republican 0.4% 5.5% 7.6%
Democrat 8.4% 8.4% 6.6%

Hmm… Was Hoover (or the Republican presidents before him), directly responsible for the 1929 crash? I don’t know enough history to know. But I wouldn’t be surprised if it was just lack of economic knowledge at the time, where anyone would have made the same mistakes.

Was Clinton directly responsible for the historic bull market during his term? Not really. The bull market started back in 1980, and continued through the end of the century. Was Bush responsible for tech crash in 2001? No. If anything, we can blame Clinton for creating the tech bubble, which led to the outsized returns during his term… Can we blame Bush for the current credit crisis? Sure

But overall, looking at the chart, there are obvious bull periods, and obvious bear periods.

Dow Jones Industrial Average vs. Presidential Party

Presidential Terms Annual % Return Per Year Years Republican Years Democrat
1933-1937,
1945-1961,
1981-2001
13.7% 20 20
The rest -4.1% 20 20

You can slice and dice the numbers however you want, and come up with just about whatever result you want…

Bottom line, the economy has larger business cycles, that I think have little to do with the Presidents of the day. Besides, how much policy does the President implement? He can’t pass laws, he can only veto them….

So back to the original question, who’s the best person to help the stock market? Neither, I fear.

Everyone’s trying to figure out how to avoid a recession. The problem is, recessions are a natural and necessary part of the business cycle. “Creative destruction” cleans out the deadwood and inefficiencies in the economy, and leads to prosperous periods in the future.

The 2003-2007 bull market was based on false growth created by spending money we didn’t have, in order to avoid having a mild recession. Now we’ve created an even bigger mess, and presumably an even bigger recession. Eventually we need to pay the piper.

There is no quick fix to our problems because our problem is not lack of available credit or lack of confidence – our problem is lack of reasonable expectations. Until we, as a society,  change our mind set about what is reasonable and normal, we can’t move on. We had a 20-year bull market, we had 25 years of housing price appreciation compressed into 5, and we had commodity prices triple this decade. These things are not normal. Artificially pushing up prices faster than is warranted just leads to a bubble, not sustainable growth…

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

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