Ordo Ex Chaos

How to Succeed in Investing Without Really Trying

2015-02-19T00:46:00.000-08:00

Every now and then I hear someone claiming that active investing isn’t worth it or that actively managed funds generally don’t outperform the stock market as a whole. They can’t justify charging X percent to manage your money. The list of excuses goes on. Things are even worse for individuals trying to manage their own money: too many numbers to crunch, not good enough infrastructure to compete with the banks, not enough time to actively manage a portfolio, and a whole laundry list of excuses. The conclusion invariably given is that one ought to invest his or her money in a total stock market index like SPY, VTSMX, etc and go on with their lives.

I wouldn’t dream of saying that individuals have any absolute advantage over institutional investors, but I would contend that anyone can build a portfolio of individual stocks that outperforms the stock market. To that end, I spent about 45 minutes picking stocks without using any fundamental analysis, technical indicators, or any esoteric methodology, and was pleased with the results. Below are my criteria (in bold) with rationale and tests. As a disclaimer: dividends and taxes were not taken into consideration for the sake of simplicity. Assuming a buy-and-hold strategy, and in light of the ultimate results, these are both inconsequential.

First, just because we don’t do the math ourselves doesn’t mean we should disregard the math of others. To start out with, I decided to draw upon four mutual funds that have five-star ratings from Morningstar (the people who do analysis): HSCSX, PMCPX, PRWCX, and FBIOX. To ensure that strong performance wasn’t a recent phenomenon, I made sure that their fund managers had tenures of greater than five years. Morningstar’s website lists the top 25 holdings of each fund and from the hundred in those four funds, I selected the following 17 stocks because they showed particularly strong performance this year: FISV, BDC, OLN, MANT, ACT, VRX, CCI, GILD, BIIB, BMRN, ICPT, ACAD, OPHT, ALKS, PCYC, UTHR, and GNMSF. These I took to Google Finance to cull the best. To qualify as “best”, the individual stock had to be publicly traded since the turn of the millennium (for testing later), have a price not substantially driven by trading volume (so that it wouldn’t be overly susceptible to a bad quarter or the best laid schemes of mice and Wall Street), and most importantly: outperform the S&P 500 Index in the standard time frames greater than one year. So the winnowing began and the following seven stood out as winners: FISV, BDC, VRX, GILD, BIIB, BMRN, and PCYC. After cherry-picking from the universe of over 5,000 stocks, we have a few to run with.

To test, I made a paper portfolio in which 1,000 dollars was invested in all seven stocks on January 7^th, 2000. To contrast: $7,000 was put in the total stock market, SPY. The results even surprised me. The SPY investment grew to around $10,100, an overall return of 44% in the past 15 years. The paper portfolio of our selection grew to $1,687,797, an overall return of 24,112% over the same 15 years.

Individual returns here:

FISV: 1764.39%

BDC: 126.57%

VRX: 515.35%

BIIB: 3237.1%

BMRN: 672.5%

PCYC: 316.36%

GILD: 162,147.8%

It should jump out immediately that GILD gave the lion’s share of the performance. Yet repeating the test without GILD, the weighted return of the portfolio is still over 1,100% ($73,135 from a $6,000 investment) and the worst performing individual security of the group, BDC, still nearly tripled the return of the market as a whole.

The point of this exercise isn’t to suggest that one should adopt this strategy blindly or to ignore the fact that what we see looking back doesn’t assure what we’ll see going forward. Individual stock picking is speculative by nature and the intelligent investor should keep that in mind without being afraid of it. I simply wish to dispel the myth that investing is some kind of black box that is opaque to common people. You don’t have to be good at math or have investment bank infrastructure to get started with stocks, just a healthy tolerance for risk and a dose of common sense.

Baller Example indeed

Performance without GILD

Robinhood: A Shot across the Bow

2014-12-13T00:50:00.000-08:00

  About ten months ago, I discovered a startup promising commission-free investing for the masses. Despite believing that too good to be true, I joined the waitlist at the 55^th spot. Robinhood’s app released to the public yesterday and I couldn’t be more thrilled to be sticking it to the Jordan Belforts of the world. $10 per trade, while not prohibitively expensive, does force some digression in investing than might be prudent. The app’s interface is gorgeous and streamlined but further commentary must be reserved until I’ve used it more.

  Robinhood is just the latest in the larger democratization of finance trend. The finance industry is notorious for being stuck in the past. Despite advances in technology reshaping almost every facet of everyday life, finance relies on infrastructure invented during the Nixon administration (ACH being the archetype example). In areas where it does excel technologically, banks keep the advantage to themselves. Yet in a part of the world hell-bent on the disruption of any and all industries, Silicon Valley has taken it upon itself to shatter these bastions of a bygone era.

  We saw Wealthfront in the last post, which is making algorithmic investing available to everyone, not just hedge funds and other groups with staffs of math PhDs. As a counterpart to Edward Jones and other wealth advisors, SigFig delivers quantitatively sound investment picks in a manner understandable without needing a degree in finance. If you happened to see GoPro’s S-1 filing, you’ll notice it was underwritten by the usual suspects, JP Morgan, Stifel, Citigroup, and the rest of the big banks. Upon closer inspection, you’d notice that a young startup called Loyal3 was given 1.5% of the new shares to offer to the public at large for the IPO price. Prior to Loyal3, a lay investor could only buy shares in the secondary market, typically for substantially more than the banks paid. But now, the spread between IPO price and open market prices became accessible to everyone, or at least the lucky ones that snapped up those shares as soon as they were available. (Twitter is an excellent example of this, with an IPO price of $26 but starting in the open market at over $41, a risk-free profit of more than $15 per share for the underwriting banks.) Slowly but surely, we are seeing the finance industry become more equitable, and more accessible, to the general population.

  So niche startups like SigFig, Loyal3, Betterment, Quantopian, Self Lender, Stripe, and the rest wield technology to make finance easier for everyone. Now we have Robinhood to add to this crew: a company competing with existing brokerages without charging any commission at all. At the time of this writing, there are about 500,000 people on the waiting list. Wall Street ought to take this as a warning shot: old ways and manual processes will continue to fall in the wave of new technology. On the other hand, they might surprise us all and welcome the competition.

"Nasdaq congratulates Robinhood on their launch"

Wealthfront: Investing for the Future

2014-10-28T14:26:00.000-07:00

After working for some time at a company which specializes in automating a touch-heavy component of the mutual fund business (intermediary compensation between brokers and their dealers), the things I had heard about the finance industry being behind the times suddenly became very real. People from within the industry would confess to using infrastructure and technology from the 1970s yet had no plans to change it because their companies had enough money to continue being inefficient. Having seen and heard other horror stories over my years of working in finance, it is incredibly clear that the majority of the industry is in major need of a makeover. Yet it is slow in coming because incumbent leaders (financial advisory firms, investment banks, brokerages, etc) are monoliths that face neither competition nor the resource constraints that cause companies in other industries to innovate. It is customers that are implicitly punished with high management fees, delays in transaction processing, and other inconveniences associated with failing to keep up with the zeitgeist.

Luckily, in the 21^st century there has been a renewal of interest in the money management space which has led to all kinds of new tech startups like SigFig, Betterment, FutureAdvisor, PersonalCapital, Mint.com, Nutmeg in the UK, etc have been pouring immense energy and resources to pick up the slack with the ultimate goal of making it easier for non-finance people to enjoy transparency in knowing where their money is going and how it is performing better than it would be if it sat in a bank account or some other investment service.

It is in this context that Wealthfront comes in. The cause of making investing better for the people is a noble one and they have picked up a lot of publicity lately for doing just that (and also for closing a massive round of new funding). Like many investment services, Wealthfront automates the complex process of finding a perfectly balanced portfolio. Yet what makes them unique is the low management fees (and no commissions) which allow the service to be utilized by the general public. All of the sudden, esoteric investment strategies, daily rebalancing, tax-loss harvesting, and other features previously only available to a lucky few are at the fingertips of anyone who cares to sign up.

People have noticed. Wealthfront’s massively disruptive business has garnered them over a billion dollars of assets under management in just two and a half years. It will be interesting to see if traditional finance institutions take notice enough to alter their own businesses to keep up with the times. It seems unlikely, but in the face of such new technology from Wealthfront and their peers, it might be hard to stay relevant for the generations of investors going forward. I’ve always enjoyed helping friends get started with investing and offering specific guidance with which securities to pick. Yet after reading about the automated investing industry, I think my direction for them will be much more succinct going forward.

Mark Cuban on a Great Pitch

2014-10-09T10:02:00.001-07:00

I recently read an article on TechCrunch about the four broad components of a good venture capital pitch according to Mark Cuban. It is a good thought exercise for any startup, however, regardless of if or where it is in the process of fundraising because developed thoughts on each point are crucial parts of the nascent company's soul searching process. These come in the form of answering four questions: what is your core competency? Why are you great? How will you scale? How is your idea protectable? The first two relate to business and the latter two relate to product.

The business questions are Sun Tzu repackaged for the 21^st century. “If you know the enemy and know yourself, you need not fear the result of a hundred battles…If you know neither the enemy nor yourself, you will succumb in every battle.” It is of paramount importance that a company understand itself internally as well as externally as it is oriented in some market space. The core competency question asks what you’re the best at and the question of “greatness” compares you to your competitors. How are you better than other players in the space?

The product questions relate to what comes out of your business. Once the idea is executed, how difficult will it be to reach 10,000 people, 10 million people, a hundred million, and so on? Is the product touch-heavy enough that employee-count will have to grow dramatically to accommodate an increased user base (such as insurance) or is it fairly self-service where most of the interaction is done independently by the customer (such as Pinterest)? In this case, there is not a right or wrong answer since some products require more company involvement by nature than others. Yet it is still important for a growing company to understand and convey the scaling situation to be adequately prepared ahead of time. The question of being protectable is straightforward. Barring instances where the first-mover advantage in highly capital intensive industries seals dominance (utilities, natural resource extraction, etc) there are always copycats out there that will try to capture market share when they identify good ideas. Since protection is vital, patents are so important. Beyond that, it is important for a company to be its own biggest competitor. If a company does not innovate itself, someone else will innovate it to obsolescence.

In my own experience with researching and writing investment memos, absent answers to any of these questions means it will be sent back for revision. Yet once they are answered, everyone involved in the investment process will have a clearer idea of what the company in question is about and be able to make an informed decision from there.

Impact Investing As It Hits

2014-09-07T19:55:00.000-07:00

If you asked me a couple years ago what I thought of “double-bottom line” investing, I might have half-jokingly guessed you meant only considering net income, a reference to the peculiar formatting of that item on it's namesake statement. Yet since working at Kiva for the past few months, I’ve come to appreciate more the merit of taking ideology and other intangibles into consideration when investing as opposed to merely seeking the highest monetary return.

At Kiva, we often use terms like “risk-tolerant capital” or “patient capital” in conversation to describe the liquidity that runs through our pipes. It has been unique, coming from a traditional finance background, where cash rules everything around me, to see the inner workings of a finance firm that facilitates lending money at zero interest. What inspires people to do this? Having been part of the organization for some time, I see the return first-hand. Conscientious citizens given the opportunity to put their money where their mouths are will seize it and give nearly 1.5 million borrowers not a hand out, but a hand up: a chance to build themselves out of poverty.

The vast majority of investors, however, do not have the luxury of allocating their money simply based on good feelings. Happily, impact investing has become an entire field with methodologies and funds that emphasize values without having to compromise financial return. By looking at how internal and external stakeholders are affected by a business’ operation, an investor can decide whether holding them in a portfolio would be consistent with his or her values. The commonly used metrics are summarized by a research paradigm called ESG analysis: environmental, social, and governmental measures.

According to MSCI and Pax World (providers of research and funds, respectively) environmental measures include carbon emissions, carbon footprint, energy efficiency, water stress, raw material sourcing, toxic emissions and waste, electronic waste, as well as opportunities in clean tech, green building, and renewable energy. Social measures include labor management, human capital development, opportunities in health and nutrition, chemical safety, privacy and data security, and access to healthcare, among others. Governance measures include levels of corruption, anti-competitive practices, fraud, etc. To make an investment decision, the interested party chooses metrics relevant to the company being evaluated and draws a conclusion based on the findings.

This kind of evaluation is esceedingly difficult for the individual investor who does not have the capacity to do this research independently and would find a subscription to research services prohibitively expensive for his or her needs. Thankfully a lot of mutual funds and ETFs have sprung up in the past few years that invest according to ESG principles, though finding one that consistently outperforms the S&P 500 benchmark remains a unicorn hunt. I may have some rebalancing to do ahead of Q3 dividends. If this internship has taught me anything, it’s that the highest payouts may not be taxable.

International Waterways

2014-05-14T21:30:00.000-07:00

People!

My senior thesis for economics is finished and published on the website. A couple of you have asked to read it and now it's here. The topic is international rivers, the Nile and Mekong in particular, but the concept is common-pool resources. CPRs are a variety of resources whose usage is shared amongst several parties. The subject becomes complicated because the repercussions of certain actions or usage do not fall on the perpetrators of the action in the first place. Rivers are a classic example because users upstream, whether for agriculture, fishing, or otherwise, end up impacting the outcomes of users downstream. Over the course of time, stakeholders have sought to find ways to reconcile differences using economics, politics, biology, ecology, etc. and that is the matter at hand here. The document can be found in the Writing Samples page as well as in the link below. I hope you enjoy reading it as much as I enjoyed writing it.

The Curious Task of Shared Goods: International Waterways and their Treatment as Archetypal Common-Pool Resources

Acknowledgements:
Kristi Ellis, Morningstar Academy
Dr. Michael Rizzo, University of Rochester
Dr. Stephen L.S. Smith, Gordon College

Microfinance 3.0: On the Shoulders of Giants

2014-03-31T13:30:00.000-07:00

This is the last of a three part series. Part 1 can be found here and part 2 can be found here.
The first post in this series focused on the inception of microfinance and the second talked about the current state of microfinance. This final one will talk about its limitations, and in light of those: where to go from here in the future. As one browses Kiva or some other equivalent site, he’ll come to the realization that there is a soft cap on the size of a given loan. While the average loan is in the two or three thousand dollar range, the number of available loans tapers sharply after around five thousand dollar mark. There are essentially two connected reasons that larger loans are unrealistic: the repayment period and the large number of lenders. This is best explained by way of example.

Realize that to operate an individual typical loan, with an eight month repayment period to 135 lenders (based on an actual project), Kiva has to collect eight times and disburse that as 1,080 repayments altogether. If the scale was brought up to a ten thousand dollar size, at $25 per average lender, this is 3,200 repayments ([10000/25] * 8). Of course, the borrower would need more time to pay the money back, perhaps a decade, meaning 48,000 repayments ([10000/25] * [10*12]). Kiva already processes an immense amount of payments continuously, so one would have to be uncharitable to believe that they could not scale up to meet this challenge, but it would at least be cumbersome. This is not to mention that from the individual lender’s perspective, who wants to wait a decade to get their $25 paid back? Half of the fun of funding microloans is watching the money lent out come back so that it can be sent out again. It gives people the satisfaction of seeing their money participate in double, triple, and ad infinitum amounts of good as long as they opt to relend it.

So we see the limitation of microfinance for borrowers who wish to start a business that requires more capital than a few thousand dollars could provide but is not so large that an entrepreneur could get funding from a private equity fund or other traditional means, perhaps in the range of 10-50 thousand dollars such as starting a dairy processing facility or a large water filtration service.

Because of their extensive networks with partner microfinance organizations on the ground in developing countries, while being situated in the richest country of the world, Kiva and other US-based organizations are uniquely and ideally situated to conquer this limitation if they have the volition to solve it. Yet to this day, one does not see them acting on the somewhat obvious solution.

The question is: are there investors to whom the larger scale of 50,000 dollars would not be problematic? The follow-up question is: is there a context wherein a payback period of several decades would be a feature rather than a bug? Glad you asked, because the answer is yes! This might even be worth developing an entire post for in the future because this one has already covered a lot of ground.

Kiva builds bridges between people who have money and those who need it. That has always been the mandate. Yet by myopically focusing on the individual lender platform, they have failed to hunt in a greener pasture: the US capital market. The clear solution, therefore, is that medium-sized loans be financed through the issuance of bonds to institutional investors. Bond markets are massive, robust, and there is no shortage of lenders who would jump at buying this kind of security, even though it is riskier than a traditional corporate bond (the securitization of subprime mortgages during the housing bubble proved that). Investors who buy bonds do it for many reasons, but one of the primary appeals of bonds is that it gives steady income from repayments for an extended period of time. Another is that it provides protection against interest rate risk since repayments are contractual. So to put it succinctly, scale is unlimited and the bug, as we say, becomes a feature.

Microfinance 2.0: By the People, For the People

2014-03-24T17:29:00.001-07:00

This is the second of a three part series. Part 1 can be found here and part 3 can be found here.

Last week we talked about the savings groups that allow individuals living in poverty to be able to get periodic access to more liquidity than they would otherwise be able to get. At some point, a Bangladeshi economics professor named Mohammad Yunus realized that the amount of money required to make some simple life improvements was as little as a few dollars. These could be the same things as the savings groups facilitated but also might be things on a larger scale. In Bangladesh, the “larger scale” could indeed be the equivalent to just a few US dollars. In other words, an insignificant sum in the developed world might be a huge sum of money in the Third World. This reality became an important feature as Mr. Yunus innovated the microfinance machine: a platform for allowing philanthropically minded individuals who could spare a few dollars to pool their resources and fund loans to the poorest of the poor. These loans, which range from $25 to a few thousand dollars, are used in some capacity to help a person who does not have access to a commercial bank’s credit to make some investment that would help them work out of poverty.

This “investment” is usually related to their line of work such as seeds, tools, and livestock for farmers, input factors like raw materials for manufacturers, and goods to be sold at a grocery store or restaurant. Having thus borrowed a sum of money, the person taking the loan directs the resources in an appropriate value-adding way and pays back the loan. He is able to keep the profits to fund further expansion, sending children to school, or improving life in some way. It is not uncommon for individuals and groups to take increasingly larger and larger loans as they build up a good reputation for repayment and expand to bigger and bigger projects. While outliers exist, the soft cap on microfinance loans tends to be approximately what can be repaid in a couple years and in practice has been a few thousand dollars.

There are several organizations that facilitate the creation and repayment of loans, but their particularities are beyond the scope of this piece. The prominent ones are Grameen Bank, the first microfinance organization, and Kiva, a San Fransisco based non-profit that streamlines the lending experience for anyone who has a desire to be their own “banker to the poor” (as Yunus phrases it). While almost all finance institutions build pipelines between those with money and those who can utilize it, Kiva has been unique in microfinance circles as it sources funding from small-scale investors rather than institutions like banks, pension funds, governments, or high net worth individuals. Kiva does not only empower the poor in developing nations, it gives anyone with $25 dollars the opportunity to help change someone’s world.

Interjecting with a personal note, I’ve had an overwhelmingly positive experience lending through Kiva. The interface is informative, beautiful, easy to use, and that’s not even mentioning their mission.

Microfinance 1.0: Bootstrapping from the Bottom

2014-03-17T14:27:00.000-07:00

As we are all aware, hundreds of millions of people are living in poverty all over the world. While many societies have been able to build their way to modernity since the Industrial Revolution, there have been many others that have not. Sometimes this is due to lack of natural resources. Other times it is due to ongoing regional conflict, and still other times cultural or religious norms inhibit growth. The state of the world’s poorest is a tragedy of the human condition but much progress has been done to alleviate it in our lifetimes. Globally, poverty is at an all-time low and its rate, according to the World Bank, has dropped from 43.1% in 1900 to 20.6% in 2010. This is a testament to the “rising tide lifts all boats” adage, but it also often due to the sheer ingenuity of the poor themselves.

Such evidence of the poor building themselves out of poverty can be seen in the innovation of informal savings groups. This is the idea that a community of individuals get together periodically (daily, weekly, monthly, etc) and pool savings to distribute to a member of the group. The recipient of that meeting’s proceeds gets to take advantage of a big inflow of money to make a relatively large purchase or some kind: tools, seeds, and the like. Ultimately each member pays as much into the system as they receive but the arrangement works well because it allows each individual to have that access to a large cash flow all at once rather than having to try to save for n number of periods. Other features include enforceability because members of the groups can visibly check to see that the other participants are contributing as their arrangement requires. Anyone who shirks the responsibilities is visibly noted. It might seem like one could forego the group and just save the same amount that they pay every period until the needed amount for some given purchase has been saved. That does happen most of the time, but the reason that people sometimes chose to forego pure savings and opt for this system instead is the reality that frequent small cash outflows and a large inflow periodically is more palatable than trying to keep cash on hand, for security or any other given reason.

What we witness in this primitive capital market is a simple and yet unquestionably effective way of facilitating access to money. The particulars of each group, pay-in rates, payout periods, and other factors vary from group to group. But the general concept stands at the base level. You can read a more thorough explanation of savings groups here (starting on page 7) if you’d like. Though it is a limited solution, it is particularly beautiful because it can be implemented with no more than willing participants and the infrastructure of a record keeping pen and paper. For want of a pen and paper, good memory can suffice.

This is the first of a three part series. Part 2 can be found here and part 3 can be found here.

What the Price Says: Facebook brings WhatsApp into the fold

2014-02-23T15:49:00.000-08:00

Right in the wake of a failed Snapchat takeover bid, the M&A folks at Facebook are the toast of the business world and the founders of WhatsApp, Jan Koum and Brian Acton, are the debutantes of Silicon Valley. I’m sure you’ve read the headlines: Facebook buys WhatsApp for 19 billion dollars. That’s four billion in cash, 12 billion worth of Facebook stock, and three billion in restricted stock to be paid over the course of four years. And that’s billion with a “B”. If you glazed over seeing three big numbers, let me put that in real terms. 19 billion dollars, as TechCrunch contextualizes, is: four times the market capitalization of BlackBerry, one third the market cap of Ford and Hewlett-Packard, and 25 times the size of Facebook’s last in-the-public-eye acquisition, Instagram. I’ll add anecdotally that the London Olympics of 2012 cost 15 billion dollars, as did NASA’s Mars rover program. I could go on…

Let’s not forget that at their last round of fundraising, the company was valued at 1.5 billion dollars. So the question on my mind, your mind, and everyone else’s mind is: what possible reason could Facebook have to spend such an immense amount of money on a texting app? With a claimed 400 million active monthly users, that’s $47.50 per account. For comparison, it takes a decade to get that much nominal ad revenue from a Facebook user. It would be even longer if we were discounting to the present value. At the current subscription price of a dollar per year, whatever the discount rate is, Zuckerberg will be lucky to see the break-even point before retirement.

While all those numbers are true, and our friends at 1601 Willow Road deserve all the funny looks they’re getting from pretty much everyone else, two sentiments seem to float to the surface that explain this occurrence. The first is, as one can imagine, a desire to expand into different markets. Most of WhatsApp’s users are in emerging markets like Mexico, Brazil, and India (countries with lower adoption rates of Facebook itself). These days, the sun never sets on the Zuckerberg empire. The second sentiment, and this might explain the magnitude of the deal, is a fear of obsolesence. From niche news sites like TechCrunch to mainstream sources like ABC and The Guardian, the consensus seems to be the same: the people Facebook is meant for, the “cool kids”, are browsing elsewhere. Time will tell whether the acquisition was worth the cost, and with over a billion users already, Facebook has quite some time before it goes away. Yet it must be in the back of Mr. Zuckerberg’s mind that a decade ago, one Harvard student single-handedly took down the incumbent social network: MySpace.

The Case of the Missing January

2014-01-31T09:57:00.000-08:00

We in the finance major learn about something called the “January Effect”, where an investor can theoretically earn outsized returns by buying securities in January versus other months. Why is that? There is a matching phenomenon that there is a big sell off of securities in the previous December because investors are eager to take the tax advantage associated capital losses on investments that are performing poorly. The intuition makes sense but in the past decade, the market has been down in as many Januaries as it has been up. In fact, the average month increase when the DJIA was up was a little over two percent (2006, 2007, 2011, 2012, 2013). On the other five Januaries, where it went down, it fell by over four percent (2005, 2008, 2009, 2010, 2014). The January Effect seems about a legitimate as the Leading Lipstick Indicator: the intuition is there and “60% of the time it works every time”, as Brian Fantana says. Yet we would be remiss to make buy and sell decisions citing it as a rationale.

As I write, the DJIA has fallen around five percent this year, the worst since 2009…when we (along with the rest of the world) were in a bona fide recession. What could be the cause of this? Ironically, though not surprisingly, one of the stabilizers that helped cancel the recession is contributing to the poor performance now. This is, of course, quantitative easing which has been propping up the stock market as much as the economy. Now that it is scaling back, down to 65 billion dollars this month, the chicanery of the animal spirits is a little more dramatic and a little more visible than usual. People have been calling it a “taper tantrum”. Let’s hope that when Janet Yellen takes the helm of the Federal Reserve on Monday she’ll have the volition to successfully wean capital markets off the easy money they have become accustomed to.

The other major contributing factor to this month’s poor performance comes from the developing world. According to Reuters investors have pulled nine billion dollars out of emerging market funds and bonds in the past week. Yikes. It seems like a lot of the volatility in has been due to weakening exchange rates (Turkey and Argentina, notably), but from reading the news, I get the impression that it largely reactionary as investors see their peers selling off their assets. Hat tip to the animal spirits.

From Yahoo Fiance, cue sad music.

Bitcoin Redux

2013-12-03T20:40:00.001-08:00

I touched on bitcoins in the last post several months ago and had no idea even then that they would take the world by storm as much as they have now. Nearly all the blogs that I’ve read have posted about it multiple times, from tech sites like Wired and TechCrunch to economics ones like the Mises Institute’s blog. It has even come up in mainstream media sources like CNN. You’ve undoubtedly read about them either in my previous post or elsewhere so the exposé is not needed here.

Observe the bitcoin exchange rate in US dollars for the past six months and compare the scales to the chart in my previous post from only a few months ago, when the exchange rate sat around $100/BTC. As I write today, it is over $1050/BTC. It doesn’t take a genus to see that speculators have brought some serious skin to the game as an appreciation of over a thousand percent has taken place in such a short time. Once the playground of computer geeks and contraband smugglers, this digital currency has become the talk of everyone from Wall Street to Main Street. Even the second most powerful man in the world, Ben Bernanke, gave bitcoins a veiled compliment during one speech.

In the past couple months, speculation has become a dangerous game as the exchange rate fluctuates several percent every day, the most dramatic dates being an appreciation of what looks like around 69% on November 17th and a depreciation of 17% on November 30th. The preposterous volatility continues, trending perilously upward while the world sits and watches as the best laid schemes of mice and men succeed…or go awry.

It is important to note that the value of other currencies do not fluctuate this much. Nor it is an exaggeration to say that the world would simply self-destruct from instability if it did. For comparison, the US dollar has been able to purchase .83 euros at its absolute strongest and .67 euros at its absolute weakest, a band of about 24 percentage points, in the past five years.

It is surprising, then, that no one has tackled the issue of why the bitcoin’s exchange rate is so volatile but I will attempt a conjecture today. Take the world of foreign exchange, where currencies like the dollar, euro, yen, and all others are bought and sold for each other. Transactions happen continuously and at the speed of light as perfect information distribution and access to all markets simultaneously keep exchange rates in viciously tight equilibrium. The world’s markets spin on with astonishing stability considering that four trillion dollars worth of currency cross the planet every single day.

I believe that the reason bitcoin has not enjoyed similar stability is that none of the main exchanges offer built-in stability mechanisms. They are only spot markets. In a spot market, one may buy or sell bitcoins in whatever currency he pleases at the prevailing market price. In regular foreign exchange markets, there is not only a spot market, but also a forward market, which allows buyers and sellers to enter a contractual agreement to pay a certain exchange rate at some point in the future. There are also options, swaps, and currency pairs, which are entirely outside the scope of this essay and likely the topic of another. The point is, the existence of derivatives and the forward market self-enforces stability and that “viciously tight equilibrium” from above. Without those checks in the bitcoin market, mutability is the law of the land.

I daresay that the world is witnessing the growing pains of bitcoin, that it has become more popular than existing institutions can handle. Yet when someone has the volition to make a robust market with the same features other currencies enjoy, and if it becomes popular enough, the exchange rate instability will largely end. Bitcoins will be, from an investment standpoint, rather indistinguishable from their government-backed peers.

By the way, if you're a bitcoin user and would like to make a donation to my site, my wallet's address is 1GSCJTsYLEaBF2HX6WmnXDF9QuNezGo4v1 and it'd make my day to see something show up.

What's the Big Deal with Bitcoins?

2013-08-15T12:34:00.003-07:00

Bitcoins…bitcoins...bitcoins! It seems like the world has all of the sudden, or at least as of early this year, become entirely enamored with bitcoins as evidenced by the overwhelming press coverage they have been getting recently. I don’t know how I managed to get this far in the year without writing about it because it has been a fascinating phenomenon to watch unfold.

Recall from the end of my last post that bitcoins are an open-source fiat money that is backed by no government or bank, but rather the citizens of the internet. It is the most fiat of money for that very reason. Bitcoins have been around for several years, beginning in 2009 and growing slowly in popularity since then. The exchange rate of dollars to bitcoins began 2013 at around $13 and rose to an all-time high of $230 by April and then dramatically crashed before leveling off around the hundred dollar mark where it sits now, several months later. What happened in those months that caused the sudden bubble and bust? I have a theory: an educated guess, if you will based on a little reading and some mental puzzle-solving.

Bitcoins have been used primarily for ecommerce transactions of illegal goods because they are, by design, international and anonymous (or at least very difficult to track). Drugs, firearms, fake IDs, and rather significantly more unsavory goods are dealt through illicit marketplaces with bitcoins being used as the medium of exchange, internationally and anonymously like the buyers and sellers themselves. Hold that thought in the back of your mind.

What was going on in the world in early 2013, culminating in March? The European financial crisis had hit Cyprus pretty hard. I even wrote a post about the whole incident when it was happening. Cyprus is a tax haven for Russian business magnates and so one of the things that was suggested by the ECB/IMF/European Commission during the early weeks of March (March 16^th to be exact) was to confiscate 40% of the bank deposits of uninsured accounts with a value over 100,000 Euros: essentially targeting the Russian businessmen. This idea was eventually dropped on March 25^th, but during the days between the 16^th and 25^th, the fate of those deposits were up in the air.

Before looking at the exchange rate graph below, take a wild guess as to when the bitcoin boom started, recalling that bitcoins are the de facto underground market currency and that a substantial portion of Russia’s economy is built on the dealings in such markets…and that Cyprus was a tax haven.

If you guessed that the dramatic boom started in the third week of March, you’d be correct! Bitcoins had been increasingly in the public eye since the beginning of the year but the major step up began when the deposits were threatened by seizure. I suspect that the rest of the world noticed the inflation and speculators carried the bitcoin’s value to its highest point even after the deposits’ threat had gone away. Examine the graph for a while and see if you can’t extract more insight from it. The events of the past few months on the web and in the rest of the world are more interesting than ever and I suspect we can learn about how humans deal with booms and busts by seeing the bitcoin crisis as a microcosm of what has happened, and maybe will again, for other securities and currencies in the rest of the world.

By the way, the exchange rate chart can be made here where you can manipulate the time frame as well as several technical indicators.

The Story of Money Part 2

2013-07-29T12:50:00.000-07:00

As promised, I am back with a sequel to the last piece about the story of money. I mentioned that the main features of money are durability, divisibility, and wide acceptance as having value. I also mentioned that these have not always been the case and that there is at least one notable exception that comes to mind, in the area of divisibility. But this story in turn will take us to the more valuable insight about the nature of money in modern times, the concept of fiat money.

"I'll need some help with getting this to the grocery store."

There is an island in the South Pacific called Yap which until recent times has used large round blocks of stone as their currency, called Rai. The origin of this money is unknown but essentially the scarcity of these stones (quarried and milled on another island), the difficulty associated with transportation (20+ men were required to move the largest ones), and the propensity for the movers to die with stones in tow when storms struck on the open sea made them sufficiently valuable to use as currency.

While not all stone money items were gargantuan, it does not take much imagination to realize that having stone money of any size is not conducive to easy commerce between citizens. This is where the story becomes even more interesting. Once people realized that moving the Rai around was not practical, they started writing promissory notes that entitled the bearer to a particular stone stored in some location on the island. Tangentially, the parallel between this kind of money and gold or silver certificates is easily seen. This allowed easy transactions between people since a stone could be retrieved by anyone bearing the certificate. Theft was out of the question because of the level of trust on the island and the fact that stealing boulders is no mean feat.

On one fateful voyage, a very large and accordingly valuable stone was lost to the sea. But as the inhabitants had grown accustomed to dealing in paper that represented stones, and the representative paper was still in existence, the populace agreed that the stone was out there somewhere and that its document was still valid money. Thus fiat money was born for the island of Yap.

“Fiat” is the Latin word for “it shall be” or “let it be done” and fiat money is money whose value is not derived from an underlying asset like gold, silver, or stone. Rather its legitimacy comes entirely from the faith of the people who use it and, more often that not, the government that decrees it as the legitimate currency of the land.

In modern times, the rise of Bitcoins has been an endlessly fascinating form of currency because it is backed by no government at all. I recommend reading up on it because it is much too involved to deal with sufficiently here. Yet even though there is no ruling authority that mandates it as having value, the faith and trust of those who deal in it online has elevated it to the status of money that is widely accepted in many stores (mostly online) across the globe. But what makes it even more spectacular is the fact that it does not even have a physical presence. In truth, it is the most fiat of money of all.

The Story of Money

2013-07-19T11:41:00.003-07:00

What is money and why do we need it? How did it come about in the first place? This is a question that I addressed in conversation recently with a friend after visiting the Hong Kong Monetary Authority, its equivalent of the Federal Reserve.

Everyone knows intuitively what money is: a medium of exchange and permanent store of value. In other words, one person has coins and bills and another person has coffee beans, guitars, or microscopes. They trade one for the other and everyone goes on his way. The permanence of money is also an important characteristic. It would not do to have currency that decays over the course of time!

Where did money come from and why do people use it rather than just bartering like our ancestors used to, and why do we use paper or metal which have no intrinsic value rather than something that does have value?

The need for money is shown in the following story, as related to our class by my first economics professor. Imagine that you are a maker of guitars and that you want to get coffee. So you take your guitar to a coffee farmer and try to work out an agreement on a trade. The problem arises: what if the coffee farmer does not want a guitar? Or what if he does not have enough beans on hand to pay you for that guitar? In modern terms, for example, 45.4 pounds of Starbucks coffee costs the same as a Fender Stratocaster, (if our ancestors had the benefit of price shopping on Amazon.com)! The problem with a pure bartering system is that not everyone wants what you have or perhaps they do but cannot accommodate your requirements for the trade.

This is where money comes in: a society agrees on something that will be used to facilitate exchange whether it is coins, stones, shells, salt, metal ingots, or any number of other items used by civilizations in the past. Besides society-wide acceptance of their value, money possesses at least one other advantage over trading goods for goods: it is easily divisible. You will notice that half of a guitar, a third of a cart, and the base of a microscope are no good to anyone. In other words, if our farmer from above didn’t have 45.4 pounds of coffee on hand, the trade would not go through. But with money, the trade can happen between anyone who has money and anyone who is selling something. To recap, these features can be seen in money all over the world: easy divisibility, society-wide or universal acceptance in a country, and usually permanence in the material used to make it. There are few exceptions but one or two of the most prominent ones deserve to be the subject of the next post.

China Seminar Post 3: The Real Wealth of Nations

2013-07-06T06:51:00.002-07:00

During one of our several university visits the lecturing professor gave us a particularly unique and memorable talk. The typical speech we’d receive in these lectures tended to involve an economic lesson about some area that was growing such as how the city was planning to develop their infrastructure in this or that industry, or how 300 million people had migrated from rural areas to the cities, or how income has risen dramatically in the past several decades since the late 1970s. This one, in particular, took a much more philosophical slant.

Professor Zhang Yu from Shanghai University spoke to us his philosophy about the reason that a country develops or does not develop. Having grown up and been educated in an overtly Communist state, he learned that there was strength in unity of thought and belief. He learned that the government was the benevolent institution to pass down those thoughts and beliefs for the good of the people. But as he grew older and began to read independently (philosophers like David Hume), he came to a different conclusion. He began to realize, as he told us, that the government cannot be the entity to oversee all aspects of life. He told us that if the government controls thought and belief, then creativity and dynamism of the populace will be squelched, and a nation will be cursed with an inability to move forward. As he said progress cannot be legislated, so he said that the power to transform a nation lies in the minds of its people. Free thought emanating from the minds of free people is how society can evolve and change for the better. So this brought him to his terminal point. These days, those in governance over China’s cities and provinces put so much emphasis on how much is being exported, or how big the country’s GDP is from year to year. This results in a measure of success being confused for success itself. In reality, however, the true wealth of a nation is its people. That country is rich which is blessed with free thinkers, tinkerers, and an environment conducive to the germination and sharing of ideas.

China Seminar Post 2: IBM

2013-06-25T09:07:00.000-07:00

In my last post, I recalled a visit to Baosteel, a symbol of the massive manufacturing capacity China has. The following day, we visited IBM’s flagship office in Shanghai. Not coincidentally, IBM ought to be taken as a symbol of China’s massive service-industry capacity. For those who are unfamiliar, as I was to a large extent, International Business Machines provides custom programming services to business in need of software solutions, among many other things. It is also a major player in the Big Data revolution, which I have written about before, competing with the likes of EMC and Google to meet the world’s growing data needs. IBM has many branches beyond data processing and programming which makes it a major player and competitor in separate but complimentary industries such as financial management services and business operation planning.

IBM is aware that the world is changing, sometimes for the better and sometimes for the worse. But their overall mandate, as we learned in a lecture and saw on public service announcement posters hung around the office, is to build a smarter planet. By “smarter”, they mean more connected, more responsive, and more efficient. As we see, the world is a system of systems which exist not in isolation of each other, but rather as an ecosystem of its inhabitants. In the broadest sense, IBM tries to measure the heartbeat of a city: its traffic, utilities usage, weather, and anything else one could possibly be imagine are all compiled and used to make a city run better. Traffic is regulated more efficiently depending on the time of day, electricity is conserved in times of low demand, etc. Weather readings are used to model climate patterns and make predictions for the future. Even the pharmaceutical and medical research industries are being transformed as huge amounts of information is created from the processing of data at an The value of this kind of data compilation and processing can be seen at the individual user’s level as well when smart alarm clocks know poor weather conditions will exacerbate traffic and wake up their owners earlier. The applications for this kind of technology are endless and as a doctor accesses and make decisions for his patient by measuring vital signs, so humanity can build a better world.

IBM has been a particular boon to a developing nation like China because it is able to bring high technology to rural areas that are just beginning to modernize. Without infrastructure like sewage systems, running water, power grids, public transportation, and the like, small towns are able to adopt the bleeding edge technology of city planning with the benefit of hindsight that is just one piece of the expertise IBM brings to its municipal clients. By using IBM’s services, and the services of companies that offer the cutting edge of technology immediately, a town can make decades of regular development in one swoop of upgrade and join the 21^st century efficiently and quickly. This means dramatic increases in the living standards for the populace touched by these improvements.

IBM Logo

China Seminar Post 1: Baosteel

2013-06-15T16:44:00.001-07:00

I was in Shanghai recently with a school fieldtrip and we had a visit to one of the manufacturing facilities of China’s largest state-owned steel manufacturing company, Baosteel. It is the second largest steel producing in the world after a Luxemburg company called ArcelorMittal. With an area larger than the city of Macau (itself 11.39 square miles), the whole complex was an astonishing and breathtaking sight to behold. One of my initial impressions was the fact that despite being a massive manufacturing area, the place did not give off the odor of pollution one would expect in a place where heavy machinery and metal smelting is in operation. It turns out, and quite contrary to the popular culture belief of Western nations, China is quite environmentally conscious and has taken steps to offset the pollution created by Baosteel by covering 45% of the factory grounds with trees and foliage. In reality, we learned that Baosteel is a small city with a zoo, pool, and other amenities that serve the employees and their families who live on-site. I could not imagine an American company doing so much to take care of their people, and remember that this plant is in a country that often has a reputation for being a “pollution haven” by its detractors in the rest of the world. Personally, I did not smell much pollution in the area and regardless of how effective their efforts are, one ought to give them credit for trying.

We witnessed the miracle of steel processing from the safety of a catwalk above the fray of the factory floor. As we stepped into the room, it seemed as though we had been transported to a scene in Atlas Shrugged. The heaviest of heavy industry came together in a shower of sparks emanating from fiery red steel ingots and measuring initially about three feet wide, by 50 feet long, and a few inches tall. Over the course of a quarter mile of machinery, rollers pressed it down until it was much thinner and several times as long. Before the metal was completely cooled, it was rolled into a coil. Having finished, it was shipped off as the raw material for the next producer to use in his manufacturing. Not only does the product from Baosteel go around the world but is used in a wide variety of applications from weapons to automotive, marine components to soda cans, and many more. As a matter of fact, the 1 Yuan coin is stamped from their alloy.

As we drove around the city-factory, I was struck by many things. The scale of the machinery was beyond anything I had seen before. The blast furnace was actually several buildings because one could not contain it, for example. Baosteel has three port harbors. One is for receiving iron ore from Australia and Brazil. A second is for shipping the finished product all over the world. A final one is for the removal of slag, the impurities taken out of the ore in the smelting process. It is common practice to recycle this slag and our tour guide was proud to inform us that many buildings are constructed of concrete made from Baosteel’s unusable materials.

Despite the rather sun-shiny view we were given by the Baosteel executive/tour guide, I did hear from other sources that it is plagued with some large, but not unsurprising in light of the fact that it is a government-owned institution, problems. First and foremost, and as one might expect, it is a highly corrupt institution. It turns out that the monsters of patronage politics and its twin crony capitalism are alive and well all over the world when business and government are mixed.

Overall, however, the tour was an eye-opening experience by any account and I came away with a more complete appreciation of the Far East’s progress. So often in economics classes we will hear that the Chinese are building towers and buildings at unprecedented rates. But this comes alive when we are greeted by a forest of cranes upon arrival in Shanghai. In the same way, we hear that manufacturing is booming. But I can say with some confidence that one starts to leave the realm of knowing and enter that of understanding while walking through in a room heated and illuminated by glowing steel.

I didn't take this picture, but this is the room we saw. The line of fire is a steel ingot being rolled.

The Enjoyment of Life and Liberty, the Means of Acquiring Property

2013-05-20T14:02:00.001-07:00

I was reading recently that the famous line from the Declaration of Independence that calls “life, liberty, and the pursuit of happiness” inalienable rights is a paraphrasing of an idea that was expressed somewhat earlier that year by the writer of Virginia’s Declaration of Rights, George Mason. See if you can find the similarity.

“That all men are by nature equally free and independent, and have certain inalienable rights, of which, when they enter into a state of society, they cannot, by any compact, deprive or divest their posterity; namely, the enjoyment of life and liberty, with the means of acquiring and possessing property, and pursuing and obtaining happiness and safety.”

That is Section One and clearly inspired Thomas Jefferson to start the US’s own Declaration with a somewhat more concise statement. Mason hit upon a very important point in writing this bit, that the possibility of private ownership is part of the package of rights endowed to humans by the “Law of Nature and of Nature’s God” (to borrow from Jefferson).

The idea of property is something that people often take for granted because it just seems so natural. Yet a large issue arises when a government or some other authoritative entity encroaches on the property of others. Often times, some will take the ideological stance that private property should be abolished and everything be shared equally. Thankfully this is an antiquated view. But a more common view, even today, is that the resources of those who possess more than the average citizen should be taken and redistributed to those who have less. This broad concept is used, in part, for the justification of progressive taxes, entitlement programs, and the like. But I digress.

The ability to have and securely hold property is not only a human right necessary for the individual, but also for the smooth functioning of society as a whole. Imagine what the world would be like if there was no property or only limited ownership! At the personal level, the need for ownership is easy to see. After all, knowing that you have a bed, toothbrush, and cereal that will not be appropriated by others at their discretion is an important part of a smoothly operating life. But at the level of society as a whole, things become more abstract. Bur private ownership is crucial here too. For example, patents, trademarks, and copyrights exist so that the creator of a medicine, the engineer of a car, the author of a book, or the scientist of some new groundbreaking material can reap the reward of his labor. Without that, there would be no incentive to create. Even for people who are motivated purely for the betterment of humanity must at the very least draw in the resources to pay for outlays made in the development process.

In a different vein, think of the owners of businesses. If they cannot operate in a legal environment which protects them from theft, then they will have very little incentive to do business in the first place. One would rightly wish to reap the benefits and profits of his business if he must incur the costs and risks associated with it as well. The benefit for society is the fruits of his labor. Boeing makes airplanes, AstraZeneca makes medicine, and Archer Daniels Midland makes food. Taken as a whole, the product of everyone’s labor is for the benefit of all a country’s inhabitants. This well-functioning economy is made possible by many things, not the least of which being private ownership of the means of production, both physical and abstract. Without property, a nation would function no less if it deprived its citizens of their liberty and even their lives.

Poster of the Year

2013-04-26T21:50:00.001-07:00

Sometimes you see something that just has to be shared on an economics blog. Today's piece is a poster I saw hanging in my friend's room, which was originally painted by Glenn Beck and can be found here. More original content is coming soon. I've just been so busy with school work. Summer is coming soon and that should allow me to spend more time writing here.

Margaret Thatcher: A Legacy of Principle

2013-04-08T12:28:00.000-07:00

Today the world mourns the death of Baroness Margaret Thatcher, the longest serving and only woman to be Prime Minister of England in the 20^th century. Born in Lincolnshire, England in 1925, she began her career as a chemist and later joined politics in 1959 as a member of parliament. She was most notably influenced by The Road to Serfdom, a book by everyone’s favorite: FA Hayek. This piece talked about the evils of government intervention and why a more hands on central government was sure to expedite the downfall of a nation.

Elected as Prime Minister in 1979, she carried the worldview set out in Hayek’s works and set about the enormous task of privatizing government-owned companies like British Steel as well as utility companies and others. She was also famous for fighting labor unions and increasing interest rates to encourage saving. This had the effect of slowing the growth rate of money supply and brought the rate of inflation down from 18% to 8.6% over the course of her tenure.

As is typical of a disciple of classical and neoclassical economics, she slashed government spending ruthlessly in many areas including a 3.3 percent cut in defense, 67 percent cut in housing, and 5.8 percent cut in transport. She did increase government spending in absolute terms between 1979 and 1990 by 12.9 percent by choosing to allocate resources to employment and training (+33.3%), health and social security (+31.8% each), and law and order (+53.3%), among others. She was also instrumental in the skirmishes around the Falkland Islands when it was invaded by Argentina, preserving that territory for the Crown.

She acquired many detractors over the course of time, most notably in the Soviet Union who christened her the “Iron Lady”, a moniker that she embraced. She was known for bold words that were often well received, but had a tendency to offend some who could not stomach disagreement with their own beliefs. The people that tend to leave an impression on society are rarely known to be soft spoken.

When I heard about her passing, I recalled a U2 lyric and thought, “’the last of the rock stars’ is gone”. She belonged to a different era, an era where political correctness had not yet been contrived and a person was willing to be 100 percent transparent regardless of the ramifications for popularity. She was from an era when a person’s beliefs guided his actions throughout time and not just conformed to the circumstances of the moment and disposition of the crowd around him. The Iron Lady was well-beloved by some and well-hated by others. But even her detractors would have to acknowledge that behind all the things she did and what she said was a strong human being that always had the best intentions of the British Isles at heart and would sacrifice anything, even her own interests, to do what she believed was right. That is a lesson I think we should take to heart for our own integrity and the welfare of those around us.

MSN has a page of her best quotes which I found to be an enjoyable read but there is a quote in particular I wanted to share from the 2011 movie “The Iron Lady”, a dramatization of her life, which sums up her character quite well.

“We will stand on principle, or we will not stand at all.”

What's the Big Deal with Cyprus?

2013-03-30T20:43:00.003-07:00

Trouble in paradise?

To be perfectly honest with you, when I first saw Cyprus making headlines I thought to myself, “is this becoming news because the Wall Street Journal is tired of making front page stories about the Federal Reserve’s endless announcements to continue its quantitative easing program until 20xx?” I’m telling you, this shows up on the front page of the WSJ at least once or twice every week and I think that Bernanke needs to realize that the world has caught on to his game. I digress. What is the big deal with Cyprus? That’s the question that’s been in the back of my mind ever since the crisis popped up. I’m sure that a big chunk of the issue is hype related to the fact that the Eurozone crisis isn’t really selling news anymore. At the same time, a few things have happened differently with this crisis that make it noteworthy and not just another country experiencing hard times. So the rest of this post is divided into three sections: an overview of the crisis itself, then a part on why this crisis is a big deal and one on why it is not a big deal.

The financial crisis in America had pretty far reaching consequences as we’ve seen. For Cyprus, which is so dependent on tourism and shipping, those consequences hit quite close to home. As a result of those tough times, it has been in a recession since 2009. Government debt, in a manner similar to most of the rest of the world’s countries, has increased significantly since then. Things got much worse recently when credit agencies downgraded its governmentally issued debt in 2011. As we’ll see in the next section, most of Cyprus’ economy is involved in the tourism industries but there is a large banking industry for off-shore accounts, particularly Russian business magnates. Allegedly 60 billion Euros worth of Russian assets are in Cyprus. Cyprus banks are also very closely tied to the Greek economy as it had accrued 22 billion Euros of Greek private debt. The wave of financial upheaval in Greece did not have very far to travel to drown its island cousin. Still struggling from that issue, the credit downgrade was the spark that set the powder keg off and everything began to fall apart.

Not one to let a comrade go to pieces, especially when it is so heavily invested, Russia loaned 2.5 billion Euros to Cyprus to be able to cover spending and refinance its debt. This was a bandage solution, but a help nevertheless, until the European Financial Stability Facility gave them a bailout at the end of November, 2012. The particulars of the bailout are fairly typical of any given one so I’ll spare the details. The notable activity was the bailout from the European Central Bank and the IMF, which was in the amount of 10 billion Euros and, as part of the deal, took 6.7% of the amount in Cyprus bank accounts up to 100,000 Euros and 9.9% in accounts over 100,000 Euros.

What do you think when you think of Cyprus? I always thought of fishing and I imagine most people do. It may have been the national pastime back in the day, but I was surprised to learn that the populace is predominantly employed in service sectors related to tourism. It is, after all, one gorgeous island nation. Let me give you some particulars though. Pulling numbers from the CIA’s World Factbook, I see that the country’s GDP is $23.57 billion (PPP) and the average gross salary is $2,636 per month. Per capita GDP, also in purchasing power parity terms, is $26,900/year. It has a population of 1,155,403, making it rank 160^th in the world. It is considered a developed nation. All in all, this is a small country and it’s crisis, while a big deal to them, does not really have repercussions in most of the rest of the world. Remember the amount of the bailout? I would venture a guess that 10 billion Euros is not a whole heck of a lot of money for the IMF considering that it holds claim to almost 11 trillion dollars worth of currency. The biggest non-Cypriot consequences will likely be in Greece and Russia and any other folks they do major trading with, but the vast majority of the world goes on unaffected.

That is not to say that we in America should overlook this crisis because of the “creative” measures Cyprus has taken to make the bailout happen. Recall the levy on bank accounts from above. When I first heard about it I was first stunned beyond belief and then dreadfully (and hopefully irrationally) scared that this could become a common tactic. Imagine a government reaching into its citizens’ bank accounts and taking their money! Then I realized that… governments already steal their citizens’ money through taxes. That is a whole other can of worms that will have to be opened some other time. But for now, let us say that taxes are probably a necessary evil that we’ve all come to live with, but the idea of taking money right out of a bank account is just astonishing. It’s really quite unheard of, quite an infraction of property rights, and sets a scary precedence now that this is on the table as a feasible option for ailing countries to solve their monetary crises. That is not to mention the fact that they are taking foreigners’ deposits as well!

The Sicilian, from The Princess Bride, told us that the classic blunder is going into a land war with Asia. We shall see now if Sicily’s neighbor on the other side of the Mediterranean accidentally started one by taking Russians’ money. Perhaps desperate times require desperate measures, and I certainly won’t claim to know what will happen next, but it takes some level of desperateness to steal peoples’ money right out from their bank accounts and I suspect that a financial crisis is only the beginning of their troubles.

The Price of Money

2013-02-11T06:04:00.003-08:00

Anyone with any level of familiarity with economics knows the saying that there is “no such thing as a free lunch”. This is the easy way of summing up the concept of opportunity costs: that when you do something with your time, money, or other resources, that you forego doing the next best thing that you could have done with that time, money, or other resource. If I buy a movie ticket, I cannot use those 10 dollars to buy two five-dollar foot-longs from Subway. It’s a pretty straightforward concept. Now if instead of two hours of entertainment or a sandwich, you wanted to buy money, you could take what we know is called a “loan”. While it might seem counterintuitive to buy money with money in the future, loans are created with interest added onto them to compensate the lender for his initial outlay and to charge the borrower for taking money that was previously not his. In this arrangement, both parties are better off because he is able to fund something right away that might not have been attainable and the lender is able to make money by selling his money. Loans make up a massive industry between mortgages on the personal level, commercial paper on the corporate level, and interbank loans between commercial and investment banks and the central bank. These loans make up transactions worth trillions of dollars every year and the interest rate is the driver that allows all of them to happen. The interest rate is what a borrower has to pay to be able to use the money they take now, as opposed to their own money later.

At all levels, from individuals to the largest banks, the interest rate also encourages people to save or spend their money. For example, if you could get 5% on money saved in a bank account (besides living in a land of unicorns), you’d be much more likely to save it than if the interest rate was only .05%. This is because you get more value from the former situation than the latter. Plus, your “next best thing” might be more valuable to you than .05% and less valuable than 5% interest, prompting your ever-rational self to spend money in the case of the .05% and save it in the case of the 5%.

The Federal Reserve understands this incentive structure and influences the interest rate that banks use as a benchmark for the rest of their interest rates in such a way that they deem best for the economy. They need to be careful though, because the interest rate has such massive and far-reaching consequences. These days, since the United States is in an economic slump, the Reserve has been trying to stimulate the economy by trying to get people to spend. As we know, the way to encourage spending is to lower the interest rate and so that’s what they have been doing. Unfortunately for the Fed, the nation as a whole is spending less and saving more anyways because it is scared of what’s coming in the future. What’s worse for them is that the nation seems to have reached something my professor would call a “zero lower bound” where the interest rate can’t be lowered much more. So the Reserve has gotten creative in its economy-manipulating tactics and is introducing money into the economy in unprecedented amounts. That’s a whole other can of worms to let out and untangle in a different post.

The economy runs on expectations and right now the Fed, one could argue out of necessity, has dedicated itself to keeping interest rates low for years. Fed watchers much have a really boring job these days because I can summarize their past few and certainly next few press releases in one sentence, “We will keep interest rates low until 2014 and continue with our program to buy Treasuries.” 2014 will roll around and they’re singing a different tune, or at least replacing “2014” with “2016”, that is.

The glimmer of hope in this low-interest-rate situation is for those in need of loans, whether it be a home mortgage, student loan, business loan, etc. Buying money is cheaper than ever and the Reserve’s hope is that people will start to again have the confidence to invest in new projects that will bring our economy out of the soup it’s been in for the past few years.

Broken Actions in Broken Systems

2013-01-28T08:28:00.000-08:00

There are a very few broad concepts that economists have identified as being problems that are quite difficult to solve. They go by dramatic and ominous names like “adverse selection”, “moral hazard”, and most difficultly, “tragedy of the commons”. One such problem that I’ve encountered recently is the principal-agent problem, the idea that non-optimal outcomes will result when the person acting is different than the one who will take the consequences of the action.

In economics, we often solve problems by creating incentive structures that will make it in the best interest of a person to alter his behavior. Too much pollution? Carbon tax. This makes it more costly to pollute (the new incentive structure) and so incents companies to find greener practices (the altered behavior) that are cheaper than paying the tax. These kinds of schemes work in the business world too as we see compensation tied to performance. If a salesman doesn’t sell, he makes very little money, and vice versa, thus incenting hard work. These solutions work because people are self-interested and will do what is best for themselves. Ideally, incentive schemes are constructed in such a way that those self-interests are aligned with socially beneficial ones as well, lower pollution and more sales for the company in the former cases.

A problem, which we say is the “Principal-Agent Problem”, arises when the consequences of actions are divorced from the ones doing them. While the name may conjure up an image of school headmasters conferring with CIA members, we use these words in a different sense. So what are principals and agents? A principal is one who enlists the services of an agent to act on his behalf. So by extension, an agent is one who acts on behalf of a principal. People buying and selling houses are principals and the ones who broker the transactions are called “real estate agents”. Take this following story as an example. One of my friends works in the Air Force as a bomb technician and he said that the screws that they use on a particular bomb cost over 100 dollars each and that the only way that they are different than the screws at Home Depot, besides the fact that they only cost 10 cents there, is that they are stamped with a serial number.

The problem arises when there is a mismatch between the consequences of the principal (the general public who enlists and funds the defense services of the military by paying taxes) and the agent (the military, which can use all the money its collective heart desires without any regard to future stability or practicality of its methods). The military can spend indiscriminately because it knows that the tax payers will always be around to foot the bill and so they have no incentive to change their ways. Tax payers end up buying screws for a thousand times as much than if they were a private contractors getting those screws from a hardware store. See the problem? Luckily the government doesn’t yet have monopolies in too many industries besides defense (for good reason, I suppose) and free market competition is allowed to prevail. The average contractor will get his screws at Home Depot because the cheaper he can get them, the cheaper he can pass his services on to customers. There is no principal-agent problem here because the contractor’s actions affect him only. The same applies to practitioners in other industries as well.

But I ask you this, that as we come to a time of eventual governmental dominance of the health care system, what new principal-agent problems will be created? If divorced incentives allow an entity to thrive even when it spends a thousand times as much as it could on a screw, what does that tell you about the people, incentive structures, practices, policies, etc. of the rest of that entity? You must extrapolate because I don’t have the words to express it all. In light of this, imagine that we’re talking about peoples’ lives and not metal fasteners: who’s screwed then?

Why Data Matters

2013-01-19T10:49:00.001-08:00

The final frontier of the human race is proving to be less intergalactic than Star Trek would suggest and much closer to home. Advances in the physical sciences have taught us great and marvelous things about the world we live in and about worlds beyond our own. In the place where science and business collide, a new “space” has emerged that has already begun to revolutionize the way we work, play, stay healthy and safe, and innovate in science and technology.

The idea of “Big Data”, which is the up and coming game changer, will seem foreign without looking at what data is on a small scale and why it matters. Data is collected and organized bits of attributes for the subject being studied. People collect data about where, how fast, and how far they walk when they wear a GPS pedometer. One of my friends keeps a log of the money he spends on gas, etc. All these data collections are good, but are not the end to themselves. Here’s what I mean. If I said that the average tariff rate for a given product in a given country in a given year is 5%, that would be an interesting fact to know, but would probably be a useless fact unless you were in the habit of learning tariff data for countries. Data, when correctly used, can be used to create information. Take tariff data for this country over the course of time and you can make a trend line to support your informative claim that “tariffs in Indonesia have been falling for the past several decades”. If you pool that information with other information learned from other places, you can arrive at the end goal of data: insight. We’ve established that tariffs have been falling, and say that we learned from other data that exports have been on the rise. Then we can turn the information into insight when we compare them and find through analysis that tariff rates and export levels are inversely correlated or when we apply that information and suggest that a country should lower its tariffs if it wants to encourage international business in a given industry.

So data is a precious commodity because it turns to information and information turns into insight. It has the potential to change the way we live and work and, as I said, has started to do so already. Retail businesses have been using data to track inventories and shipments for decades, but now a new level of insight has been made possible through the advent of Big Data science. Companies can now track a particular customer’s purchases and then send targeted marketing materials that are relevant to them. Some might find this invasive, but whether it is or is for the sophists to decide. The advantages of a business knowing itself and its customers are inestimably and undeniably valuable.

Sun Tzu famously said in his book, The Art of War, “If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.” Data and its interpretation unlock the potential for knowing yourself on a business level and a personal level.

Let me use an example that is close to home. This year, I started a used clothing store with some friends. We have a database that records each item that is taken, where the customer is from, and other attributes. At the end of the day, we can look back and know what items are popular, women’s shirts for example, that we’ve served people from nearly 30 states and countries all over the world. We get comments and suggestions for improvements that we can take into account for future operation. Now imagine that we have a massive customer base, huge resources, and are a multinational corporation. Say we’re Target or Wal Mart with access to talented people in all industries. I can attest to the benefit data has had for our operation, small as it is. So I can imagine how it must be driving business elsewhere. Business is not the other place where the Data revolution has been happening. Medical research has grown by leaps and strides with the invention of new data collection technologies and the advent of distributed computing/crowdsourcing has allowed for dramatic cuts in processing time and costs. The benefits of these new technologies have helped in counterterrorism operations and other law enforcement and more sectors than one could even name.

Exabytes of new data are made at an increasingly growing rate and the full potential has yet to be seen. But I suspect that as humanity explorers this new frontier, our newly gained level of self-knowledge gained will allow us to win victories in efficiency and quality of life that are an important par of building a better future.