Monday, September 13, 2010

Good reading on the economy

I've recently come across a LiveJournal account called Terrible Swift Sword. The anonymous author, who uses the nom de plume of Kenshi, seems to have a pretty good grasp of reality-based economics, so much so that I've added TSS to my regular financial reading list.

To introduce you to his work, I'd like to link to two recent articles. First, here's one titled "The Nature of the Financial Crisis: an Aviation Metaphor". For those who've never had a basic education in our financial system, it's an excellent introduction. Here's an extract.

I want to discuss for a minute what this financial crisis is and isn't. A lot of people seem baffled by this issue, including many who should know better (our political and financial elites, for instance). It's actually quite simple. Understanding the problem is the first step toward dealing with it.

When looking at the financial health of a business, organization, or individual, we typically look at three types of financial statement:

1. Profit and Loss (P&L)

2. Cash Flow

3. Balance Sheet

These accounting tools measure fundamentally different, though related, things. It's important to understand that a financial crisis (or bankruptcy) can originate from any one of these three areas, whether we're talking about a sub-prime borrower, business, or an entire nation. That's why financial managers watch all three of them like a pilot monitors instruments on the dashboard of an airplane in flight.

A P&L statement is a measure of accumulation and distribution of value over time. It tells you how fast your wealth is growing or shrinking by measuring sources of increase (income, revenue, capital appreciation, etc.) less sources of decrease (such as expenses, cost of capital, taxes, etc.). Once the latter is subtracted from the former, the number left over is either positive (a profit) or negative (a loss). ... The P&L shows how effective you're being at increasing value at any given time, sort of like acceleration and velocity vectors for a plane trying to gain altitude above the ground. Every vector has a magnitude and a direction. So too with P&L statements.

. . .

A Cash Flow statement tells us where our money is coming from and going within a particular time frame. It measures the demand and available supply of actual cash to sustain ongoing operations.

This availabilty and movement of cash is what financial folks call "liquidity." Think of this as fuel flowing into and out of the fuel tank of that plane we were talking about in the P&L statement. If you have enough or more cash available to spend than stuff you're spending it on, then you are liquid. The fuel tank never runs dry, and maybe you can even store the surplus fuel in reserve tanks for the future or use it to make your plane better or fly higher. If you have more things you need to spend cash on than available cash to spend, then you are illiquid, and the fuel tank runs dry (with a "giant sucking sound"). Even if your plane is high above the ground, if you run out of fuel you are going to crash...soon.

One major mode of financial failure is liquidity crisis. Cash management is a big deal, as anyone who has ever received an overdraft notice on their checking account can tell you. It's quite possible for a wealthy and profitable business to experience the need to spend more cash than it actually has available. You might own a million-dollar house free and clear, but only have ten dollars in your checking account. When your weekly hookers-and-blow bill comes due and you don't have the cash to pay it, you can't easily sell your house to raise the funds before Lenny the Pimp comes around to get his money. The asset is illiquid: it can't be converted to cash very easily. So even though you might be very wealthy on your balance sheet, you're cash poor. A sudden demand for cash could push you into financial crisis and bankruptcy.

This is why nearly all businesses and most individuals have lines of credit: a sort of borrowed cash reserve they can tap into if they have a sudden need, which then buys them the time to get more cash or sell assets to re-fill the credit reserve. Credit is a means of teleporting cash from the future into the present, at a cost.

Wait, what? I thought we were talking about planes and stuff, not teleportation and time travel.

Work with me here. The thing about credit is: whenever you spend cash obtained through credit, you're obligating yourself to put that cash back in the future. So in essence, what you're doing when you take out a loan or use a credit card is going one or two or five or ten or thirty years into the future and siphoning fuel out of your future self's tank in order to put it in your tank and burn it right now. Not only do you have to put that fuel back in your future self's tank before he needs it (like Ted reminding his future self to hide the keys to a jail cell in Bill and Ted's Excellent Adventure), you have to spend additional fuel (pay a fee) to use the time machine (i.e. to whoever is loaning you the money and thus enabling you to undertake this bit of financial-temporal legerdemain). The size of that fee (interest) is linked to how far in the future you want to go and how much you want to bring back with you. Big loads and long distances take more fuel.

If you haven't put the money back by the time you become your future self, your future self (e.g. YOU) is in a world of hurt. Mayday! Mayday!

. . .

A Balance Sheet is a measure of your total wealth: the size of your plane and how high above the ground it is. Every balance sheet has two columns: 1) Assets, and 2) Liabilities. The asset column counts up the value of all the things you own and control. The liabililty column counts up the total amount of all your financial obligations (such as a running tally of how much fuel you've borrowed from your future self, and all the agreements you've made to pay people money: e.g. everything you owe or might owe). The difference between these two columns is your net worth, capital, or equity depending on who you're talking to...they're all fundamentally the same thing.

If you have few liabilities compared to your assets, your equity is proportionally large (your plane has lots of altitude above the ground). If you have lots and lots of assets, your plane is really huge, regardless of high above the ground it is (though larger assets tend to require more cash to support them, just like larger planes use more fuel to fly). If your liabilities are larger than the value of your assets, then your equity has gone negative (you just hit the ground and crashed).

Following our airplane metaphor, the point at which your net worth is zero (i.e. your liabilities exactly equal your assets) is sea level on the plane's altimeter. Below that point, you're under water. Airplanes do not make good submarines. The occasional spectacular and heroic competence of a Sully notwithstanding, when most planes hit the water, everybody dies.

There's much more at the link. Highly recommended.

The second article is titled "A Rant About Capitalism". He tries to address the argument that the 'ideology' of capitalism has failed, and must be reformed. I think he does rather well.

Capitalism isn't an ideology. It's an economic system: a tool. It isn't the "ideology" of capitalism that's a problem here, but how ideological world-views currently much in vogue are using and manipulating our capitalist economy to their own advantage. Capitalist economies certainly have their weaknesses and modes of failure, but blaming them for ideological failures is as foolish and disingenuous as blaming a hammer for hitting your thumb. A tool is good for some things and bad for others. You need a philosophy (in the political realm, an ideology) to tell you what you should be using it for.

Foremost among the ideologies that rule the major Western economies is what, for lack of a better word, we call Liberalism. By "Liberalism" I don't mean the arbitrary party platform of some left-of-center political organization or the knee-jerk quasi-socialism so fashionable among the elites these days. Rather, Liberalism is a centuries-old philosophical/ideological stance predicated first and foremost on one thing: radical individual autonomy.

In the Liberal ideological schema, the central concern is that "the forms of social life be rooted in the self-conscious value affirmations of autonomous individuals," (from Bruce Ackerman, Social Justice and the Liberal State). By autonomous, Liberal ideological tradition means: self-created, self-chosen, self-determined, self-authored. A core ideological premise following from this is that every person should be self-authoring in action, identity, and value. The Liberal stance insists that you are whatever you choose to be.

A corollary of this position is that, for the Liberal, that which is unchosen (the given, pre-existing conditions) is of no value: an obstacle to autonomy which must therefore be somehow removed from consideration or destroyed. This is why Liberal political movements emphasize radical social, political, and economic reforms in reaction to pre-existing social/political/economic orders and tend to be highly antinomian in character.

. . .

... the Liberal ideological program of radical individual autonomy is causing our political leadership to treat inflexible mathematical realities of debt financing schemes as irritatingly inconvenient trivialities to be safely ignored so long as we are sufficiently determined to not let them affect us in our pursuit of happiness or social justice or whatever self-authorial windmill we happen to be tilting at on the White House lawn these days. A full accounting of losses in the banking system would reveal rampant insolvency and limit our ability to spend what we want on whatever we want whenever we want? Then change the FASB mark-to-market rules to hide these inconvenient so-called "realities." Perception is reality, after all. Right?

The capitalist engine of productivity is harnessed to the Liberal program, to sustain and facilitate this kind of widespread war on unchosen realities and enable all the pet projects of our various journeys of self-discovery and self-realization. Our capitalist economic infrastructure has allowed us to accumulate vast wealth and generate mind-boggling productivity. It's a powerful tool, no question. But the tool has been used for so long to sustain the Liberal pursuit of autonomy that it has become encumbered with a array of internal contradictions and conflicts. A Capitalist system, as an adaptive, non-directed, evolutionary, self-organizing economic system, must operate on realities: the reality of supply and demand, the reality of truth (facilitating trust and ensuring actual justice), the reality of success and failure. These realities are anathema to Liberalism, and our Liberal policies have been forcing us to use our Capitalist tool for tasks for which it is inherently unsuited. For radical individual autonomy to be our pole star:

* We cannot allow demand to be limited by supply.

* We can borrow our way into prosperity.

* We cannot allow some people to have less than they want to be entitled to.

* We cannot enforce contracts that might make somebody do something they don't want to do or make their life difficult.

* We can create as much credit as we like to facilitate our self-directed consumer lifestyles.

* We can define financial solvency as whatever we want it to be.

* We cannot allow anybody to fail.

This is the conflict between our ideology and our economic system, and it is the root cause of most of our economic problems today. Capitalism may be broken, but it's just a tool. You can break a hammer if you try to use it as a crowbar.

The hammer isn't the problem. The person using it wrong is. The problem isn't our economic system, it's the ideology we're using to drive that system.

Again, there's more at the link.

If you're interested in economics (and in today's economy, anyone trying to provide for him- or her-self and/or family had better be interested!), Terrible Swift Sword makes interesting and valuable reading. Highly recommended.



Anonymous said...

That is some distilled, high-proof smart.


Steve Florman said...

I've been reading Kenshi for a few years now, and although I think he's a little more pessimistic than is warranted, he certainly knows what he's talking about. he doesn't post all that often (at least not long economic stuff) but it's usually worth it.