May 042013
 

“It’s a sad dog that won’t wag its own tail.”
—Southern Aphorism

In this spirit, I must share an anecdote that provides very strong support for my long-standing admonition to learn how to write software and program yourself out of a job, rather than wait until someone else does it for you, because if it can be automated, then it will be automated.

I began developing the practice utilities at Pecuniology.com in response to students’ requests for practice tests in the Managerial Finance courses that I teach. Previously, I distributed paper copies of sample numerical questions from old exams, and every time typos snuck in when I was not looking. No matter how careful I thought I was, I inevitably grabbed a version that had errors in it that were different from the version that I had distributed in the immediately preceding semester, and the cycle of duelling typos never resolved.

Over the years, the typos reproduced and mutated in a manner that had me afraid that I might wake one morning to find that they had evolved into something particularly virulent and maybe even achieve self-awareness.

Finally, a couple years ago, after having told nearly two thousand students over the better part of a decade that they should learn how to write software and program themselves out of jobs, rather than wait until someone else to did it for them, I decided to program myself out of a job. I’m not there yet, but I learned recently that I am closer than I had suspected, and that doing so has improved my teaching performance dramatically.

In a fit of frustration and in a mood to show off a bit, I followed my own advice to solve whatever problem annoys you the most, and converted those contemptible paper printouts into the first version of the online practice utilities linked to above.

During the first semester, students and I identified errors and omissions that, once corrected stayed corrected, and the flood of emailed pleas for help just prior to exams fell from a firehose to a trickle. This is in large measure, I since have learned, because I took the time to incorporate randomly generated values into the problems. In essence, anyone, anywhere in the world can create seemingly infinite variations on the questions posted, just by clicking the Reload button.

In response to the few cries for help that I do receive, I tend to post my replies in this Blog area, and respond more often than not with the URL of the post that addresses the question, along with exhortations to practice, practice, PRACTICE. When a student asks for further clarification, I edit my follow-up response into the existing post.

Shortly after I integrated those sets into my classes, I noticed a dramatic improvement in my students’ test scores and subsequently cranked up the pressure by asking more realistic (read ‘harder’) questions. For the Advanced Managerial Finance class, which we hold in computer labs, I have my students build spreadsheets that replicate each of the practice utilities and use those to answer some sample questions.

The first time that I was asked to teach Principles of Managerial Finance—one of the handful of dreaded required courses that all students in the College of Business must pass—online, I cringed at the thought of my students suffering in solitude, armed with only a textbook and the accompanying publisher-produced practice questions that are more about solving dense and clever puzzles than about preparing for a career of drafting business plans, seeking investment, and managing working capital accounts.

I envisioned each of them cowering in the dark by the light of a kerosene lantern, in a dank and fetid shack with the wind howling, panthers screaming into the night, and alligators banging their massive tails on the kitchen door—we’re in South Florida; that kind of thing can happen from time to time—as they tried to make sense of some of concepts that run exactly counter to virtually everything that their high school teachers and most politicians have told them most of their lives, like the promise of a benefit in the future is worth less than an actual benefit now, you will not necessarily be rewarded for bearing risk, there is a cost for every benefit, and the future is unknowable although it is not unimaginable. That, and we say it with algebra.

Thus were born the videos on the page that links to the utilities above. As I type this, that page is still as ugly as someone else’s baby pictures, and in one of them I had a cold when I recorded the voiceover. And, you know what? The kids love it.

I know this, because I just received my student survey results from the online section that just ended a couple days ago, and my scores are a thing to be envied. This is not because of any special treats that I hand out, as—and I hesitate to post this—I was horribly distracted this semester, and I had thought that I was largely AWOL. I half-expected them to burn me in effigy and call for my public humiliation. (I exaggerate, but only for effect.)

Granted, I make it a point to respond to email within 24-48 hours, but sometimes a four-day weekend turns into a one-week turnaround time (yes, inexcusable!). However, when I was remiss, students turned in their frustration to each other for help, and the vast majority of the time, a classmate directed the questioner to one of my videos or blog posts.

I am fast becoming the Andy Warhol of Business education, whose art is streamlining the creative process to the point where my own hand never touches the end product. And, with Direct Deposit, I don’t even have to endorse and cash the checks. (Again, I exaggerate, but not all that much.)

Here’s the kicker: I use the same exams, albeit with different numbers, in the classroom and online, and my mean scores and distributions are insignificantly different from each other! I very nearly have achieved the Holy Grail of ensuring that my online and face-to-face sections are as closely aligned as is possible.

So, to repeat, if you teach Business, especially Accounting, Economics, or Finance, learn how to write software and program yourself out of a job. Alternatively, contact me and have me do it for you. Seriously.

Invest accordingly.

Prof. Evans

Mar 192013
 

Approximately once per decade, the market experiences a Gold Rush, a once-in-a-lifetime opportunity that, once missed, is gone forever.

Examples include the introduction of competitive long-distance telephone service in the USA in the 1980s and mobile telephones after that; two- and three-letter domain names in the late 1990s; privatization in newly democratized countries; etc.

Bitcoin appears to be such a Gold Rush, especially now that it has received the regulatory green light in the USA.

A user of virtual currency is not an MSB under FinCEN’s regulations and therefore is not subject to MSB registration, reporting, and recordkeeping regulations. However, an administrator or exchanger is an MSB under FinCEN’s regulations, specifically, a money transmitter, unless a limitation to or exemption from the definition applies to the person. An administrator or exchanger is not a provider or seller of prepaid access, or a dealer in foreign exchange, under FinCEN’s regulations.”
Guidance: Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies
Financial Crimes Enforcement Network (FinCEN), 18 March 2013

Invest accordingly.

Prof. Evans

Feb 132013
 

The graph below is the standard, textbook depiction of the effects of a minimum wage on the labor market.

Hardly anyone ever states explicitly what is meant by the quantity of labor, and the tacit assumption is that it refers to hours worked. Considering that the labor theory of value was abandoned except by Marxists and other cranks nearly a century-and-a-half ago, this is a dubious assumption.

However, the graph above is fine for general, broad-brush discussions.

Think of quantity as the number of employees, the number of hours worked for hourly wages, or whatever.

The dotted line in the middle that rises from L* is the market-clearing quantity of labor. This means that the number that choose to work equals the number that employers want to hire at the wage indicated. At any wage below the market wage, fewer choose to supply labor than employers choose to hire (labor shortage); and any wage above the market wage, more choose to supply labor than employers choose to hire (labor surplus, aka unemployment).

Offer 10¢ per hour, and hardly anyone will show up for work. Offer $10,000 per hour, and surgeons, nuclear physicists, and talk show hosts will quit their jobs to come work for you.

If one set the minimum wage at $10,000 per hour, then not only those willing to work for the market wage would be closed out of the labor market, but those willing to work for $9,500 per hour would be closed out.

This process is multiplied by automation.

A half-century ago, about half of the working population in the USA was involved in manufacturing and distribution; today it is a bit less than 10%, and the total value of goods manufactured in the USA continues to exceed the total value of goods manufactured in China.

American factories no longer need an army of proletarian meat-that-talks, when robots are more accurate, don’t organize labor unions, and do not demand insurance and retirement benefits.

It is such a shame that we have so few political rulers who understand basic corporate finance. Instead of increasing employers’ cost of labor, policy makers should be doing everything they can to decrease employers’ cost of labor, if their goal is to reduce unemployment.

If one wants to institute populist policies—and I am not saying that one should, only if—then one would do better to focus on the lower end of the income statement than on the upper end.

Income Statement
+ Gross Sales
- Variable Costs (supplies and materials)
- Fixed Costs (rent, payroll, insurance)
- Depreciation or Mark-to-Market Adjustment
- Interest
= Earnings Before Tax (taxable profit)
- Tax (some percentage of taxable profit)
= Net Income (after-tax profit)

If one raises the minimum wage, one increases Fixed Costs, thereby reducing Earnings Before Tax, and potentially making it negative. In such a situation, the natural response for managers is to reduce the scope of the firm, to automate, or both, and lay off as many workers as is feasible.

Better to let the market determine the appropriate wage rate and to increase the corporate income tax—since it is paid on before-tax profit—and use the additional proceeds to fund transfers to workers. That way, the firms’ executives would have an incentive to increase the scope of the firm, in order to increase Net Income to its previous levels before the tax increase.

Granted, this would create an incentive for firms to relocate to lower-tax jurisdictions, but that’s the sort of thing that one must accept, if one insists on instituting populist policies.

At the very least, the effects of the corporate tax would be known and predictable—X% of taxable profit—rather than hit-or-miss increases in payroll costs caused by the arbitrary political fiat of a minimum wage.

Invest accordingly.

Prof. Evans

Feb 052013
 

My expertise is in the field of Finance and Economics education, and not in the field of Criminology. I do not pretend to understand the underlying psychological and sociological causes of criminal behavior. However, I can identify a business opportunity when I see one.

Amy L. Solomon, a Senior Advisor to the Assistant Attorney General in the Office of Justice Programs at the US Department of Justice, wrote in the National Institute for Justice Journal (207, June 2012):

[N]early one-third of American adults have been arrested by age 23. This record will keep many people from obtaining employment, even if they have paid their dues, are qualified for the job and are unlikely to reoffend.

Granted, arrest does not always lead to conviction, and conviction does not always lead to incarceration, but the likelihood of getting called back for a second job interview drops by 50% for those whose background checks turn up an arrest. Those who have convictions or—Heaven help them—incarcerations on their records might as well forget ever being reintegrated fully into mainstream society, it seems.

Also, having an arrest record—just arrest, not even conviction or incarceration—can result in being denied entry into some countries, including US citizens who try to visit Canada.

Even more tragic, the effects are not uniform across the population.

One recent study estimates that 25 percent of African Americans born after 1990 will witness their father being sent to prison before their 14th birthday.

Imagine, for a moment, that you were born into a poor family living in a crime-infested part of town. Imagine, further, that you made some kind of mistake as a teenager—say, you were caught selling marijuana, possessing an unregistered firearm, or standing lookout for a local street gang—and you wound up going to jail. Mind, you never injured anyone; you were arrested for committing a victimless crime. You’re no angel, but you’re not a real danger to anyone, either.

While in jail, you would be distracted from advancing your education and developing the behavioral habits of mainstream society. Upon release, you would be behind your peers in school, perhaps you would feel angry and betrayed, and you would have developed a demeanor appropriate to surviving in jail and in a neighborhood populated by others with biographies and résumés similar to yours. Chances are that you would use illegal recreational drugs to take the edge off.

Now, you are barred from many jobs and from renting an apartment in all but the seediest neighborhoods, and you have no credit history. Nonetheless, you must eat and find shelter.

This is the day-to-day reality of a distressingly large proportion of the US population. For billions of humans outside the USA, the situation is only marginally better, regardless of criminal history.

What is a single individual to do about a problem this large, and—much more fundamentally—why would anyone who is not a Mother Teresa even want to bother?!?

A Proposal

As it turns out, someone has identified this niche and is doing something about it.

Defy Ventures [is] a yearlong, MBA-style program that [Catherine] Rohr created to teach former inmates how to start their own companies… Defy Ventures has raised more than $1.5 million in donations and pledges from VC firms, hedge funds, businesses, and private foundations.

We at Pecuniology.com propose to work with police departments, judges, parole boards, and charities, to provide Business education to those who have criminal histories and those at risk. This is based on the idea that, if one is a business operator, then one does not have to face the specter of drug tests and background checks.

As we demonstrate on this website, we are carving a niche for ourselves that involves the development of tutorials and practice utilities for students in Business disciplines.

This is a call to anyone who would like to incorporate our work into their programs, especially those who cater to the disenfranchised, worldwide. We have completed the proof-of-concept phase, and are using what already is available in a large government university. The next stage involves rounding out the Pecuniology.com offerings, so that they largely automate instruction, leaving facilitators on the ground free to focus on the specific and particular needs of face-to-face interactions.

Please share this with anyone who might be interested.

Invest accordingly.

Prof. Evans


Dec 192012
 

17 December 2012, the San Francisco Chronicle had a story—”Solar Power Adds to Non-Users’ Costs“—that provides background for a very good Microeconomics test question:

Q: Under what circumstances can the combination of a decrease in demand and an increase in supply lead to an increase in prices?

The short answer, of course, is, “When government interferes with the market process.”

If you are required to show your work, here’s what you do:

First, note that the own-price demand elasticity for electricity tends to be low for most consumers, meaning that one tends to consume the same quantity, seemingly regardless of the price. For example, one would not expect someone to throw open the windows in the middle of summer, with the air conditioner turned to its lowest setting, if the price of electricity fell substantially. More likely one would continue to consume electricity at approximately the same rate and use the cost savings on something that had a higher own-price elasticity of demand, like those things that collect in one’s shopping cart at Amazon.com, but one rarely gets around to ordering for delivery.

You can illustrate it this way:

Vertical Demand Curve in Equilibrium

Fig. 1 : Vertical Demand Curve in Equilibrium

This is very similar to the textbook Supply & Demand graph, but with the Demand curve at the same quantity demanded for every price. (Of course, this is not realistic for all prices, and the real world is not so well-behaved. Such is the nature of economic models.)

As indicated in the article above, the increase in solar panels being installed on the roofs of residential and commercial buildings in California is causing a decrease in overall demand for conventional electricity.

In an unregulated market, we might illustrate it this way:

Vertical Demand Curve with Shift in Demand

Fig. 2 : Vertical Demand Curve with Shift in Demand

As the demand decreases, due to the existence of solar-powered substitutes, price tends to fall.  In an unregulated market, executives and shareholders in waning industries receive signals in the form of accumulating inventories—unsold output—that they either should reduce their prices, reduce their output, or both.  If the trend continues—as happened with sailing ships, tools for making whale oil, steam locomotives, buggy whips, etc. in earlier generations—the executives and shareholders receive signals that they should consider whether liquidating and reallocating their existing resources might be more profitable than clinging to a dying firm or industry.  (Schumpeter referred to this as ‘creative destruction‘.)

However, in a regulated market, suppliers and regulators agree on a price and fix it ex ante.  Typically, the price is below the equilibrium, at least in the first iteration, so that consumers will be happy and express their gratitude to the politicians who oversee the regulators.  (This sometimes is referred to as ‘the iron triangle‘ of regulation, and it is related to the concept of ‘regulatory capture‘.)

We can illustrate it this way:

Vertical Demand Curve with Regulated Price

Fig. 3 : Vertical Demand Curve with Regulated Price

Here, the regulated price (Pr) is below the equilibrium price that would clear the market, but is at least as high as is needed to generate sufficient revenues to cover the costs of production.  The executives and shareholders of regulated firms generally are rewarded for their cooperation with monopoly rights in the form of franchises that grant them the exclusive right to serve a particular geographic region.

The firm’s total revenue is illustrated as area of the pink rectangle below, which is price * quantity.  It is possible that a firm’s executives and shareholders might want to increase output, so that the firm could sell the excess into neighboring markets, but the jurisdictions of most regulated industries do not adjoin jurisdictions where competitors are unregulated.  Most likely, every neighboring territory is served by a different monopolist franchisee.

Vertical Demand Curve with Regulated Price / Total Revenue

Fig. 4 : Vertical Demand Curve with Regulated Price / Total Revenue

Returning to Fig. 2, as solar panels reduce demand for conventional electricity, the demand curve shifts to the left.

Vertical Demand Curve with Regulated Price and Demand Shift

Fig. 5 : Vertical Demand Curve with Regulated Price and Demand Shift

Because the electricity providers’ prices are fixed by regulation, and they have very high fixed costs, they are loath to lower their prices.  In fact, the fixed costs of maintaining a capital base that consists of indivisible centralized facilities, power lines, poles and waterproof underground conduits, substations, and other large and expensive infrastructure can vastly exceed the variable costs of fuel and peak-time labor, and these large fixed costs are the primary drivers of the price that suppliers and regulators agreed to previously.

Now, with a smaller consumer base, the utility operators have fewer customers to divide their fixed costs among.  In order to arrive at a rectangle with the same area as the pink one in Fig. 4, given that the utility operators not only cannot force consumers to buy conventional electricity, but are required to buy the excess electricity produced by the owners of the solar panels.  In other words, the suppliers are doubly pinched, and their only savings are in the form of electricity purchased at full retail from their customers, accompanied by a relatively slight decrease in variable fuel costs.

The only viable alternative in this situation is for the operators of the regulated conventional electricity utilities to petition the regulators for a price increase to be passed along to the remaining conventional electricity consumers.

Vertical Demand Curve with Regulated Price / Price Increase

Fig. 6 : Vertical Demand Curve with Regulated Price / Price Increase

Considering that solar energy becomes more economically viable, when its primary competitor—conventional electricity—becomes more expensive, the rising prices in this scenario create an incentive for even more consumers to adopt solar energy, thereby shifting the demand curve even further leftward toward zero… creating yet more upward price pressure.

And, in this way, regulation creates an environment, in which a decrease in demand can lead to an increase in price.

Invest accordingly.

Prof. Evans

Nov 262012
 

The vast majority of firms do not pay dividends, which renders the use of dividend discounting methods for estimating their values moot. In this case, one can use discounted expected cash flows: net income (NI), operating cash flows (OCF), or free cash flows (FCF), depending on the level of sophistication required by the analyst.  However, all of these require the analysis of the firm’s financial statements, which might involve more effort than one is willing to expend in a preliminary analysis.

With publicly traded firms that do not pay dividends, another option exists using the price/earnings ratio (P/E).

Remember that:

NI = Dividends + Retained Earnings

P/E = Equity/NI

NI is the pool of funds from which a firm would pay dividends if it paid dividends, and dividend discounting models assume that all of the value of the firm is paid out to shareholders in the form of a dividend (D).

In this way, we can see P/E = Equity/NI as being similar to P/E = price-of-equity (P) / D:

P/E = Price / Dividend = P / D

To use this in our dividend discount formula, we need to take the reciprocal:

P/E ratio discounting formula

where

re : return on equity / cost of equity
D : dividend
P : price
P/E : price/earnings ratio
g : growth rate

Start with the P/E ratio, take its reciprocal (1 ÷ P/E), multiply by (1+g), and then add g.

You can practice this in the WACC Quiz, by clicking the Practice link above.

I hope that this helps.

Prof. Evans

Nov 152012
 

3 November 2012, Clayton Christensen, whose earlier works I have found inspirational and illuminating, published an article in the New York Times—”A Capitalist’s Dilemma, Whoever Wins on Tuesday“—that starts with a reasonable premise, and veers hopelessly off course.

To Wit: “Whatever happens on Election Day, Americans will keep asking the same question: When will this economy get better?”

Fair enough. That is a very reasonable question, and it is a very reasonable expectation that Americans will keep asking it.

So far, so good.

Then, we get this:

“The Fed has been injecting more and more capital into the economy…”

<facepalm>

The Fed has been pumping more and more money into the economy. The value of money is measured by the ratio of units in circulation to the value of stuff. If the number of units in circulation increases faster than the quantity, value, or both of stuff, then prices rise.

Capital is the long-term means of production: drill presses, trucks, robots, etc.. The Fed doesn’t have any of that, and Fed governors are not in a position to command others to make such things available.

The Fed lends money to the US Treasury, buys toxic assets from commercial banks, and regulates banks. It isn’t a hardware store.

Now, if one is sitting on a lot of money that one can convert into capital assets, then one might adopt the financier’s habit of referring to that money as capital, but one should avoid conflating fiat inflation with the means of production.

“And yet cash hoards in the billions are sitting unused on the pristine balance sheets of Fortune 500 corporations.”

Firms are supposed to keep pools of cash as a kind of self-insurance policy against slow economic times. We call this ‘working capital’. When the future is even scarier than normal, the prudent thing to do is to hold more cash. The ‘Fiscal Cliff’, Pres. Obama’s political rhetoric expressing open disdain for those who are wealthier than he, the unknowable effects of Obamacare, the ongoing transition away from a capital/labor economy toward a service/knowledge economy, and the specter of another decade of ‘Bush’s war’ are enough to render all expectations of the future little more than random bets and wild guesses.

And, no one gets fired for playing it safe. So, until things settle down, executives play it safe.

“Billions in capital is also sitting inert and uninvested at private equity funds.”

Does Prof. Christensen believe that fund managers have piles of big, canvas sacks with dollar signs on them, filled with cash… like Scrooge McDuck or the dapper little fellow from the Monopoly™ game?!?

The money is invested somewhere, most likely US Treasury debt, because the US Treasury has a reputation of always paying its debts… even if it has to print more money to do so. In these highly uncertain times, the safest bet is the safest bet.

“Empowering innovations create jobs, because they require more and more people who can build, distribute, sell[,] and service these products.”

Sadly… no, no, no, and no.

Build: Factories are increasingly automated, and when meat-that-talks is needed, one hires labor where it is cheap; i.e. Latin America, Southeast Asia, and increasingly Sub-Saharan Africa.

Distribute: DHL, FedEx, UPS, already have that pretty well covered.

Sell: Amazon.com.

Service: What is that? Throw it away and buy a new one.

“[T]he Toyota Prius hybrid is a marvelous product.”

Except that [o]nly 35 percent of hybrid car owners bought a hybrid again when they purchased a new vehicle in 2011.

“‘[E]fficiency’ innovations… almost always reduce the net number of jobs…”

This one is spot-on. It is unfortunate that Christensen did not make it the centerpiece of his analysis.

“The economic machine is out of balance and losing its horsepower. But why?”

Peter Drucker answered this question in Post-Capitalist Society, which was written nearly twenty years ago, and reads today like a play-by-play account of what happened in the 1990s and 2000s.

[Reread the sentence above, click on the link, and buy the book. You can thank me later.]

Also, the total value of goods manufactured in the USA continues to exceed the value of goods manufactured in China.

The scorpion’s sting is in the tail. Toward the end of the article, Christensen states, “We can use capital with abandon now, because it’s abundant and cheap. But we can no longer waste education, subsidizing it in fields that offer few jobs.”

No one knows where the ‘jobs’ of the future will be. Social engineering always fails. In the 1960s, it was plastics; in the 1980s, software development; in the 1990s, Dot.Com… No one knows what it will be next decade.

“[T]he [capital gains tax] rate should be reduced the longer the investment is held — so that, for example, tax rates on investments held for five years might be zero — and rates on investments held for eight years might be negative.”

It might have made sense a century ago, when technology changed slowly, to make it costly to change plans quickly in response to new information, but Christensen’s advice in a highly dynamic—even chaotic—integrated global economy would create an incentive to keep sub-optimal plans running beyond their use-by dates.

“Federal tax receipts from capital gains comprise only a tiny percentage of all United States tax revenue.”

This suffers from two fatal flaws. 1) The universe does not end at the US border. 2) If capital gains represent a trivial portion of the federal budget, then eliminate the cost of collecting and enforcing them and call for their repeal. Leave the money in the owners’ hands, rather than seize it at gunpoint, if it is hardly worth collecting.

“It’s true that some of the richest Americans have been making money with money — investing in efficiency innovations rather than investing to create jobs. They are doing what their professors taught them to do, but times have changed.”

Indeed, times have changed, but that does not mean that this time is different, as Christensen seems to assume. We are in the latter stages of a transition as profound as the 18th Century Industrial Revolution, from a capital/labor division—in which semi-literate proletarians drive industrial machines—to a knowledge/service division, in which skilled workers are the ‘capital’ and are not interchangeable.

However, the wealthy will invest where they expect the greatest opportunities are, as has been the case since the Renaissance a half millennium ago. When princes, presidents, and parliamentarians create uncertainty, the wealthy will hunker down and wait until circumstances stabilize.

Christensen started with the premise that the president and the Fed do not have the power to fix things, and then concluded that the IRS does have such power.

This conclusion is counterintuitive. An alternative would be for presidents, princes, and parliamentarians to enforce transparency, and otherwise to mind their knitting, rather than concern themselves with affairs that are beyond their abilities.

Invest accordingly.

Prof. Evans

Nov 042012
 

We examine the effect of securities laws on stock market development in 49 countries. We find little evidence that public enforcement benefits stock markets, but strong evidence that laws mandating disclosure and facilitating private enforcement through liability rules benefit stock markets.”
(La Porta, Lopez-de-Silanes & Shleifer 2006)

In general—and vastly oversimplified—regulatory regimes fall into three categories: Authoritarianism, Anarchism, and Transparency.

The term authoritarianism here refers to what one might think of as over-regulation, as when entrepreneurs in a particular country must seek permission—perhaps even an act of parliament or specific permission from the ruling junta—before being allowed to register a new firm.

The term anarchism here refers to a de facto, even if not a de jure lack of government oversight, where regulations either do not exist or exist but are not enforced.

The term transparency here refers to a regime, in which individuals are more or less free to do as they want, but must make public disclosures of actions or decisions of material importance.

Markets that could be described as ‘authoritarian’ tend not to attract much capital from investors outside those jurisdictions, and investors within those jurisdiction—particularly those who are not politically connected—often tend to prefer to invest abroad. This is in large measure, because they are highly constrained in how they can respond to new information, changing supply conditions for inputs, and evolving demand conditions among consumers.

For example, if one were required to declare the precise nature of one’s enterprise as a condition of registration and permission to operate, and one were forbidden to deviate in the future from this stated purpose in response to changing expectations, regulatory inflexibility might create an incentive for one to take one’s business to a jurisdiction less plagued by bureaucratic micro-management.

At the other extreme, ‘anarchic’ markets tend not attract much capital from outside those jurisdictions, and investors within those jurisdictions—particularly those who are not politically connected—often tend to prefer to invest abroad. This is in large measure, because they have little recourse to dispassionate enforcement institutions, like unbiased judges, neutral regulators, and incorrupt police.

For example, if one were subject to routine breach of contract, expropriation of property, or threat of violence, regulatory apathy might create an incentive for one to take one’s business to a jurisdiction less plagued by uncertainty.

Between these two extremes are ‘transparent’ markets, which one tends to find in English-speaking countries and non-English-speaking countries where the legal systems have been based on or even borrowed from England or the USA (and possibly the commercial code from Germany). In these countries, one has a relatively free hand to organize one’s affairs as one sees fit and to change plans as needed.

For example, in Australia, Canada, the UK, the USA, etc., one can incorporate, regardless of one’s standing in the community, family membership, political affiliation, or even criminal background. One does not need to declare the specific purpose of one’s firm—the boilerplate ‘purpose’ being “to engage in any lawful activity”—seek sponsorship or permission to incorporate, or submit to a background check. One submits articles of incorporation, pays a fee, and stays current with one’s filing requirements.

The executives of privately held firms must communicate all decisions and actions that have a material impact on the firm to their shareholders, or risk civil or even criminal complaint. The executives of publicly traded firms must file public disclosures for seemingly trivial matters, or risk regulatory penalties.

Jurisdictions where transparency is the order of the day tend to attract both domestic and global investment, have efficient and liquid markets, and recover from crises robustly.

The optimal level of regulation lies somewhere between authoritarianism and anarchism, in which executives are free to form expectations, make plans, take action, and to modify their plans in light of new information—including rumor, superstition, and noise—changing supply conditions for inputs, and evolving demand conditions among consumers.

Invest accordingly.

Prof. Evans

_____
La Porta, Rafael, Florencio Lopez-de-Silanes, and Andrei Shleifer, 2006. “What Works In Securities Laws?” Journal of Finance 61(1), 1-32.

[possibly available at: http://works.bepress.com/cgi/viewcontent.cgi?article=1000&context=florencio_lopez_de_silanes]

[2003 Working Paper available at: http://www.nber.org/papers/w9882]

Oct 172011
 

Based on a post from 14 March 2009

In early 2009 independent economic policy analyst, Geoff Gitlen, modestly proposed an intriguing solution for future banking crises that Occupy Wall Street activists would do well to embrace: reorganize all banks as non-profit organizations.

[Note: The following is my interpretation of the Gitlen Plan. If it isn't in quotation marks, Mr. Gitlen didn't say it.]

The rationale for the Gitlen Plan is straightforward and unexceptional. Already, credit unions in the USA operate as non-profit organizations, and it would be a small step to expand this to include all institutions that are regulated by the Fed or the Office of the Comptroller of the Currency (OCC). Commercial banks already are among the most heavily regulated firms in the economically developed parts of the world. Bank managers are encumbered by all manner of restrictions on how they can conduct their businesses, and they are burdened by social requirements, e.g., ethnic, gender, racial, and socioeconomic preferences in lending that favor individuals who are members of politically favored groups. Meanwhile, depositors are insured against loss, which removes one source of critical oversight.

Reorganizing banks as non-profit organizations would be much less radical than having the central government buy controlling interests in them, as we saw in 2008/2009.

For starters, non-profit status would remove the perverse incentives that lead the managers of insured banks to engage in highly risky and politically motivated — or mandated — practices. If banks operated so as to cover their expenses, but not to seek excessive profits, the same way that the Red Cross, the United Way, and other large charities operate, bank executives still could earn salaries that are many times the national average, work in prestigious and comfortable offices, and jet around the world to exotic places and hobnob with power brokers and washed-up pop stars.

However, they would not be under pressure from shareholders to take on the kinds of risks that led to the S&L Crisis and the recent housing/subprime mess.

Gitlen argues, given that banks do not operate as normal commercial enterprises, why take half-measures? Rather than perpetuate one-foot-on-the-brake-one-foot-on-the-gas [accelerator] policies, where regulators compel banks to pursue social goals on the one hand, and banks have coopted regulators* on the other hand, Gitlen argues that we should heave this syncretic mess overboard to the sharks and crabs and embrace an institutional structure that could be more harmonious with the realities of modern banking.

The Gitlen Plan is in stark contrast to libertarian calls for deregulation, free banking, and market discipline, which have no hope of gaining political traction in today’s climate, where otherwise intelligent individuals can decry the current crisis — with utterly straight faces and in the sincerest tones — as a failure of unbridled capitalism, even though the firms at the center of the crisis are among the most heavily regulated in the world, outside of healthcare. With this kind of doublethink passing as conventional wisdom from the corner pub to the halls of Congress, we must choose among viable options and put away our dog-eared copies of Atlas Shrugged, Human Action, and Das Kapital for now.

Gitlen has identified one such option:

Reorganize banks as non-profit organizations, and let those individuals who work for banks and chafe at the notion of working for a charitable organization seek employment in private equity funds and offshore finance centers, like Bermuda, Grand Cayman, Hong Kong, Nassau, and Singapore.

As in all things in life, there is a cost for every benefit, and the Gitlen Plan is not cost-free, but the choice is not between utopia and the status quo, but between available options. Given the worldwide movement for change loosely organized under the Occupy Wall Street banner, the Gitlen Plan could be the most viable option.

Invest accordingly.

Prof. Evans


* For more on regulatory capture and the current crisis, see Buiter (2008) (Warning: PDF).

Oct 162011
 

In business, economies of scale means that it is less expensive, per unit of output, to produce goods, if one produces a lot rather than a few. For example, one would not build a factory, buy raw materials, and hire workers to make only one car. Similarly, one would not set up a restaurant to make only one meal.

Once the oven is hot, the freezer cold, and the employees on-site, the additional cost (what economists call the ‘marginal cost’) of producing a second meal is substantially less than the cost of going from zero to one meal. Likewise, the cost of producing the third, fourth, and subsequent meals can fall even further, as the employees get into the rhythm of the job, several items bake in the oven at a time, and the freezer is cooling more than air and empty shelves.

The larger the operation, the greater the output relative to the costto a point.

However, as with plants, animals, and essentially everything else, there is a limit to how much a firm can grow, before costs begin to rise faster than income.

Sticking with the restaurant example, let us assume that a good day’s gross income is $10,000, and that the pre-tax profit is about 15% of that, after paying for groceries, utilities, maintenance, payroll, insurance, etc. [Feel free to substitute an appropriate amount of your local currency, if you reuse this text.]

Now, imagine that the owners have hired a new general manager — we’ll call him Skippy [Feel free to substitute a culturally appropriate derogatory name here.] — who wants to double the gross revenue to $20,000 per day, even on historically slow days.

Skippy holds ‘motivational’ meetings and exhorts the employees to “work smarter” and to be “dedicated” to the “mission” and “vision” of the organization. He wants to run three eight-hour shifts per day, seven days per week including holidays, and to minimize costs.

One young man at a meeting asked, “Um… If we wanted to minimize costs, shouldn’t we just shut down? That way, costs would be reduced to zero.”

Skippy replied, “You have a bad attitude. Ask not what this firm can do for you; ask, rather, what you can do for this firm.”

One problem with selling more meals than is optimal is that one has to provide incentives for potential customers to become actual customers. One option is to offer larger servings, but customers typically eat only so much at each meal. Another option is to reduce prices, either across the board, during times that the restaurant is usually closed or business is slow, for individuals who are members of a favored category — females, a particular ethnicity, a profession, etc. — or some other form of discrimination against those who are not members of the favored category.

By doing so, the restaurant operator reduces the income from each meal sold, even though the costs of producing those meals do not fall. Quite the contrary, by running the equipment without break, one is unable to clean, maintain, or repair it, and by working one’s employees harder, they get tired, make mistakes, and become resentful; beyond the optimal scale, costs per unit of output rise.

It does not matter if it is a restaurant, factory, bank, or whatever, each firm has its optimal size, and anything larger or smaller than that optimal size is less efficient than it would be if it were operating at the optimal scale.

If Goldilocks were a management consultant, one might hear her say, “This firm is tooo small. This firm is tooo big. And, this firm…? This firm is juuust right.”

In general, two things systematically prevent firms from operating at their optimal scales: hubris and regulation.  Things that unsystematically prevent firms from operating at their optimal scales stem from the unknowability of the future: uncertainty, surprise changes in market conditions, natural disaster, and other things that one cannot foresee.

Hubris is the kind of overconfidence that leads one to believe that one knows more than one knows, and thus can do more than one can do. It is one of the qualities of the kind of narcissist that is expert at climbing to the top of an organization, in spite of a lack of actual knowledge, talent, or skill.  Such individuals often conflate speculative hypotheses with proven conclusions, confuse ‘could’ with ‘must’, and are loath to admit when they are in error.  They speak with great bombast, demean those who ask for clarification, and typically refer to their track records when pressed for details.

In positions of power, hubris can lead to doublethink, especially a desire to minimize costs and to maximize gross sales simultaneously, in spite of the fact that there is a cost for every benefit.

Granted, one can try to minimize fraud, abuse, and waste, but any more than this implies fewer raw materials, fewer fixed assets, and less available labor, and thus reduced output; decrease costs, decrease revenue.  Similarly, if one wants to increase output, this implies more raw materials, fixed assets, and available labor, and thus increased cost; increase revenue, increase costs.

Hubris tends to result in firms that operate above their optimal scales, based on the notion that bigger is better.

Regulation leads to inefficiency most commonly through the misapplication of the observation that price tends to approximate the marginal cost of production in a competitive market.  Only in a monopolistic market can one charge a price higher than the marginal cost of production, because in a competitive market – i.e., a market that has a very large number of relatively small suppliers – if one tried to charge a higher price, a competitor would undercut the price.  This process would continue, until no one were willing to charge a lower price.

In monopoly markets with only one supplier or in oligopoly markets with a small number of relatively large suppliers, sellers can charge prices that are substantially above marginal cost, because buyers have nowhere else to go.  The choice is between paying the high price or going without.

This reasoning underlies antitrust statutes.  The idea is that, since perfectly competitive markets have the lowest profit margins, and thus the lowest prices to consumers, a small number of large suppliers is de facto bad.

This ignores economies of scale.

Some productive processes have very high barriers to entry, typically in the form of expensive equipment, as is the case with airlines, cruise ships, railroads, electrical utilities, etc.  If it makes economic sense for suppliers in these industries to be large and highly concentrated, then the tendency will be for the successful to acquire the unsuccessful.

Some suppliers operate in a ‘winner-take-all’ environment, as is the case with search engines, social network websites, operating systems, etc.  If consumers tend to favor a particular supplier to the exclusion of essentially all other competitors, then the optimal supplier will tend to be a monopoly.

Regulations that hinder concentration where it results from economies of scale serve only to force suppliers to be inefficient.

The main thing to bear in mind is that hubris is ultimately its own undoing, and, in an increasingly integrated global community, regulation at the national level is increasingly anachronistic.

BEARING THE DISCLAIMER AT THE BOTTOM OF THIS PAGE IN MIND, a contrarian speculative strategy might be to sell short assets that are darlings in the popular media (i.e., subject to hubris) and buy long assets that are under intense government scrutiny (i.e., likely to migrate from unfriendly jurisdictions to friendly jurisdictions).

Invest accordingly.

Prof. Evans