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Daily Speculations The Web Site of Victor Niederhoffer & Laurel Kenner Dedicated to the scientific method, free markets, deflating ballyhoo, creating value, and laughter; a forum for us to use our meager abilities to make the world of specinvestments a better place. |
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9/7/04
Producers by Rudolf Hauser
Ken Smith and Larry Williams came out with some posts under this title on Thursday that reflected a lack of a full understanding of how our economic system works. Their views were followed by some rejoinders that addressed some of this but not fully in my humble opinion. Given the importance of understanding basic economic ideas to all of us, particularly those who trade, I am posting this longer rely on the Spec List rather than the open list. It is a long weekend, so I trust it will not be too disruptive of your time. To keep it relatively short there is much ignored.
In primitive times when mankind hovered close to bare survival, the focus was on material goods namely food, shelter, weapons, clothing and means of transport. But in more recent few millennium we have been able to increase our standard of living thanks to a number of factors. One of the most important of these was division of labor in which we did not all try to do everything but specialized in a few areas and traded the goods we made with others for what we needed and did not make ourselves. Another key factor was that we increased the amount we did not consume immediately but instead saved it for delayed consumption and, most importantly, investment that allowed us to take advantage of technology and methods we developed that enabled us to produce more efficiently. The introduction of forms of money that greatly facilitated trade relative to barter and trade over vast distances were other factors that facilitated economic progress. In time, we developed capital markets and other forms that allowed the savings of some to be used for the investment of others as firms of strangers came into being that enabled us to take advantage of technologies that needed far more funds than a family business could raise within itself. With this prosperity we were no longer concerned just with subsistence but increasingly with luxuries such as entertainment. It was both this increase in living standards and an ever-increasing amount of division of labor that caused a market for services to assume increasing importance. This was at a time when productivity first in a agriculture and then in direct manufacturing was so great that a smaller and smaller portion of the working population was able to provide all our needs for their material output and more and more of the labor force became part of the service economy.
Now questions have been raised about the greater importance of material production and the view that this is all that matters and that service workers are contributing something of much less value. This is false. It is necessary to understand that in a free market economy each of us is free to attempt to pursue our happiness with whatever resources we are able to muster with our abilities. Each of us is free and likely to try to achieve the greatest benefits for our labor and ideas. We do so in an economy marked by division of labor by contracting with other parties and exchanging money payment (or direct goods or services) for the goods and services we desire, and vice versa. We are free to obtain the best deal we can subject only to our abilities in terms of information and transaction costs. The market decides the mix of material goods and services it desires. If material goods were indeed worth more than services, we would spend more of our money on material goods and not on services. Before long the market would adjust to the greater mix of material goods and lesser degree of services. While the dynamics of our wants is constantly in flux and the market adjustment process is not instantaneous, the basic mix we have at any time is what the economy finds most desirable given all the limitations of the moment (unless a major shock just occurred which changed the desired mix significantly ex ante and the market is just starting its adjustment process).
Now it has been suggested that the creation of new wealth ONLY comes from natural resources. This is not quite correct. First of all, we should reflect on what services are not. They are not just what a butler, cook and maid in your home would do. Most are actually part of the production and distribution of those material goods, or more correctly put the conversion of natural materials into products, some highly sophisticated, that we find desirable for our use. (I should emphasize that getting the product to the consumers who value it most is just as essential as producing it in the first place.) It is also necessary to know what wealth is. In short it is postponed consumption, the part of the current fruit of efforts of our labor and ideas that we save for the future. It can consist of consumption goods we consider more valuable for future than current consumption (such as for a period of poor production in the future). It can consist of goods that are expensive and best consumed over time such as a home or all sorts of durable goods. If we had to build a new house every year and discard the old one, few of us could ever live in a house. Then it consists of all sorts of investment of our efforts in the production of goods and services that will enable us to produce more in the future to take advantage of technology and more efficient ways of making and selling (distributing, marketing, etc.) the goods we will make. As we no longer just make simple goods we need people who get those goods to the ultimate buyers world-wide instead of being in the local village where a person who needed a new shoe for his horse knew where to find the local blacksmith without any further distribution or information network. We need to let enough people know of our product and how it will be of use to them to get enough of a market to let our mass production methods be most efficient. We need people to do research to create new products, better products and ones more desirable to the consumer. We need people who can find better ways to finance the investment we need for production or for the consumer to buy the partially deferred consumption item (such as a home) with borrowings from others who find the returns greater that way than if they just used their excess for their direct investment. And the savers need experts to help them with the best way to invest those funds wisely so they can achieve the mix of likely risk and returns that best meet their needs. To be efficient we need not only invest in inventories of materials and new machines but in the abilities of human workers to take advantage of the new methods and technology that require much more knowledge gained from on the job experience, formal training and education. That requires teachers. To engage in so many transaction of long duration with strangers we need legal systems to give confidence that arrangements made can be relied on. That requires legal services. To keep us healthy so we can live longer lives and work more efficiently for longer lifetimes of work, we need medical technology and all those workers involved therein. In effect most of our services facilitate the production of material things. When we save material things they incorporate part of the costs of those services. The services are paid for directly by producers and also by the consumers. When we get an education we are making a direct investment that makes us more valuable to an employer and gives us higher pay. As economists we try to measure what we can. But economic concepts should not be restricted to just what we can measure. Our increase in wealth includes all the products of R&D, increased knowledge that will serve us long into the future and the human capital derived through training, experience and education. That is a most important part of our stock of wealth even if we do not count and measure it. The speed at which the WWII war-ravaged economies of Europe and Japan recovered demonstrates that that human capital is far more important than any physical capital investment.
With regard to work, we do not measure the work we do for ourselves. But it is work nonetheless. One of the biggest increases in productivity has been in the home, which is what allowed more women to enter the workforce. They had always been working just look at some of those PBS programs in which people tried to live like we lived 100 or more years ago to see how much work they had. But the productivity gains thanks to such things as washing machines has reduced that required labor. With division of labor it is possible to greatly increase productivity. Much of the consumer service movement is related to that division of labor. When you eat out or buy prepared foods, go to the dryclearer, etc. you are just doing the same thing the farmer did when he stopped making his own tools and went to a manufacturer who could make them cheaper than you valued your own time doing the same thing. You are spreading the division of labor. And yes the ultimate good is material getting longer use of your clothes, getting food you enjoy eating, etc. but you are making that material more attractive (gourmet cooking say) and cheaper by division of labor. And to repeat the point with which I started each finds it in his or her best interest to spend their time, labor and money in the most advantageous way according to their best judgement and available information. (And the cost of finding information is also included in that mix.)
For such a complex system to work on a global scale we need a number of things. Among them is a legal framework that allows future contracting with some know degree of certainty (you cannot have complete certainty), some stability in monetary values, peace and the greatest freedom in the ability to make contracts or at least a high degree of freedom to do so with relatively stable restrictions instead of constantly changing restrictions. To facilitate the use of savings where they will be most productive it is necessary to have well functioning capital markets. When you have professional managers in charge of corporations with a diverse group of small owners it is necessary for those managers to have some indications that they are doing what is best for their shareholders. One could say the most profits, but one has to consider risks and long-term impacts and the changing value in the minds of investors of the worth of the present versus that of the future. In short, the role of the capital markets is not only to raise new funds but to give managers an idea as to what they are doing is being valued by investors, to give potential new entrepreneurs and investors information as to where the greatest needs and potentials are, etc. Given the importance of capital and the need for such information, this is one of the most important functions in a modern economy. Ken raised questions about the function of the players in the market. The market to do its job efficiently needs those who try to determine the true fundamental value of companies based on current market time and risk preferences and the actions of managements and economic forces that will impact individual companies and the future profitability of their likely products. All those who attempt to do this contribute. It also needs liquidity to even out the erratic timing of the forces that cause investors to buy and sell (which includes their personal needs and alternative opportunities as much as the prospects of the company in question). Those who attempt to profit by trading create value in one of two ways. They do so to the extent that they speed the adjustments necessary to reach the proper value based on shifting fundamentals and by providing liquidity to smooth out the erratic movements in prices around those fundamental values.
Now you may ask who wastes resources? Clearly anyone who does not profit has wasted resources. It is the pricing system of the market that gives the clues to all as to what they should do that is most efficient. Futures markets give some clues to future prices and allow risk reduction activities that facilitate efficient investment. But on the whole price information is current while the consequences of investment decisions stretches way into the future. Mistakes will be made in judging costs and revenues. The measure of success is profit. Losses mean bad judgements have been made and that those resources could have been employed better in other uses. But to innovate and advance requires acceptance of greater risk of potential failure. The potential returns are also often greater if things work out, and the fact that returns to risk are usually positive ex post over the long-run overall tells us that it is good that a certain amount of risks are taken in that the overall rewards to society are greater than the resources wasted in the failures.
Likewise the value of the trader to the market process is measured by his profits. If he was right it was because he moved the market in the right direction and if he was wrong he wasted resources in terms of his time and money. But here the question is more complex than that. Efforts devoted to efficient production help society. But sometimes we seek to obtain profits in zero-sum games such as gambling. From a value point of view, gambling is a form of entertainment and its value is no different than any other use of time and money. It is the choice of the consumer. In all such analysis one assumes rational economic behavior. More than some other areas the gambling urge has some psychological problems, but that is a problem of a different sort. But when men (and I use men to represent men and women wherever I use the term here) gamble not for entertainment but as a means of earning a living they are not contributing anything of value if it facilitates others doing so not for entertainment but also to earn a living. In short, these people have implicitly made a judgement that is false, namely that they can all make money. Naturally they all realize it is a zero-sum game (less the returns to the house for providing the gaming facitities) but they all believe that they will win (unlike as an entertainment in which you realize it is a game where all, including you will not be net winners if you play long enough.) The problem with traders is that some are like the gamblers. As a result, whether a profit or loss is made depends not only on those who like Vic carefully study the markets and profit as a result and those who try hard to gauge the fundamentals but those who rely on techniques without merit like the gamblers. These people cause market moves that are erratic. Those who work to contribute a worthwhile function may as a result have losses when they do not deserve to have them and others might have gains they would not have were it not for gamblers luck. And to do something well we all have a learning experience in which we are not productive. That is part of the cost of eventually doing something well. As such you might be tempted to say there is a parasite in the markets namely a trader who has losses, has been in the markets for some time without really learning and still not knowing what they are doing. Consistent use of unproductive techniques is a waste of trader s time and the economy s resources. Of course such an incompetent trader is not really a parasite as when they have losses not gains. The only one he is hurting is himself and others whose money they are managing. (Of course if they misrepresent themselves with deceptive marketing those management fees might be considered parasitic.) If such a trader has temporary profits because of gamblers luck random chance they do have parasitic profits. Likewise in the producing world, the person who expects to profit not by investing in a way he expects will bring profits but by deceiving potential investors deliberately and then profiting from management fees, they are like any criminal who engages in theft-- a parasite. In crime a person can be guilty either because of intention or to a lessor extent because of gross negligence. If one is doing the best one can and believes one is going to make it, one is just wasteful of resources, not a true parasite. But there comes a point at which the gross negligence standard might apply. When Vic emphasizes the need to count and not engage in use of untested systems based on myth, he is urging us not to be negligent for our own sake, but what he says is also of benefit to the economy by keeping us from earning just temporary parasitic gamblers luck profits at best while at the same time helping the economy by creating more efficient prices. The fact that you readers are on the list and working hard to work with intelligently with fact not with myth places list members among those useful traders who contribute to efficient markets.
The real main source of parasitic activity in the economy is government. By hindering the ability to contract freely, by putting in all sorts of rules and regulations and by enabling excessive use of the legal system it hinders economic activity. There might be times when there are overall economic benefits to the economy even when it taxes to engage in activities that for limited reasons can be done more effectively by government such as national defense. There might be other social reasons why the costs of inefficiency are worth it. This is a complex separate issue I will not get into here. But efforts to interfere in the functions in the economy through law, regulation and the courts and to distribute the benefits and the pain in ways that are not economically neutral cause many to find it more efficient to lobby the government and sue in the courts rather than to find ways to produce more efficiently. Like the gambler, it is a zero or negative sum game in which no productive value is added. But whereas the gambler mainly just hurts himself, the government extracts its parasitic fees. It creates the needs for lobbyists and tax-advisors and lawyers, lawyers and more lawyers. To have efficient production anything that makes production more efficient is worthwhile. So those tax-advisors, etc. to the extent they are being defensive and not offensive are working to make a bad system as efficient as possible. The same is true of lawyers. And to a certain extent, you are perhaps justified in not just opposing others favorable legislation but trying to get some of your own even though it is a negative game for all in the whole. But those who are most aggressive in tort lawsuits, in lobbying for special advantage and for social legislation that has limited benefits and great costs are the true parasites of our economic system. But where you draw the line on a particular individual in all this is often quite unclear. Sometimes intentions are good even if the results evil.
Mr. Kretschmann argues that much invention took place before we had patents, etc. True enough as it goes, but it begs the question as to how we got the economy we have today now and not 1000 years earlier. When social conditions encouraged the use of reason and had rewards for those who expanded our knowledge as under the Greeks in their Golden Age, progress takes place. When man makes efforts for which he will be rewarded, he will find it worthwhile to make the effort. The problem is that often innovation was not rewarded and actively discouraged. The innovators do not just come from the elite and a system that discourages those on the basis of status rather than rewarding merit will have fewer innovators. The more sophisticated we become, the more expensive it is to develop something new that has practical applications from such knowledge. Much basic knowledge is not invented because of the profit system. It is because some people seek understanding and are given a way to engage in that desire. But to take such ideas and turn them into useful products requires much investment of time and resources. To do that certain protections such as intellectual property rights are a big help. To create conditions in which the quest for basic knowledge is encouraged, it is most useful to have a prosperous economy which is aided by turning those ideas of basic science into useful products. I also suspect that more progressive change takes place, the more the spirit for finding the new is encouraged, everything else being equal.
The final issue I want to get to is money, on which Ken raises various attacks. I have disagreed with him here before and as it is not an easy issue to understand I probably will not convince him this time either. The basic role of money is as a median of exchange a way to store the value of a sale of goods and services until the seller can get to the market for the goods and services he wants to buy instead of trading via barter. Money in a narrow sense would mainly only be kept for short-term transactions. It also provides us with a uniform pricing mechanism. There is a great deal of efficiency in saying wheat in Chicago for next month delivery is worth XX Dollars per bushel rather than saying it is worth half a shoe or twelve oranges, etc., etc.,etc. There are other investments such as bank savings accounts that can easily be converted into narrow money, which for purposes of monetary analysis are often considered money. Money also serves important functions as a store and measure of value long-term. Narrow money is a material that costs something to produce but has no value other than facilitating transactions. As with any intermediate economic good, it is best to keep its costs as low as possible. No material is worth as much as its use as money or else it would be used for that purpose rather than as money. As such, it use of money means it is in excess, and it cost of production is its cost as money. If we can use paper instead of gold or silver or other similar more expensive material we are better off in that very narrow sense. There is a difference between the use of paper and gold however. If gold is used, as much gold will be supplied as is profitable at the price paid for the gold. The producer of gold gets paid and buys goods and services with it. That demand raises the prices of those other goods and services. The price of other costs of production are included in the price of the good or service. Here the price is raised by demand for all goods and services and the cost is borne by all holders of money. To the extent money makes all production, inclusive of distribution to the final buyer, more efficient, that increase is offset by lower costs. If the value of the coin is greater than that paid for the material that went into it that benefit goes to the government that issued it. With paper money most of that benefit goes to the issuer, be it the government or the central bank. But for money to have an inflationary impact it must be spent. For purposes of convenience we all find it useful to hold certain money balances which we hold in reserve and do not spend. To the extent money does not exceed what we wish to hold it has no inflationary impact. There is only one advantage to gold over paper. It is that it is limited to what can be produced at the price paid for it. That can still cause variations in the amount of money that are disruptive of the price level but historically that change over long-term periods has been relatively limited. A properly managed paper fiat standard could be even more stable with much less productive cost of the product. The problem is having the discipline to keep it so when the temptation is to benefit the government in the near-term by increasing its issuance at more than a non-inflationary rate.
9/7/04
Russell Sears Responds...
Wall Street produces individual owners, ownership and borrowers and lenders. Yes it is only paper, but its paper that are backed by the law and laws that are enforced by the government. But our government only says so because "we" give it the power
I am sure you have waged your personal battles with this government and have experienced the wrong end of a gun and cell bars. So perhaps you have a perspective the rest of us do not have. I am sure you know of instances of government laws being flimsy and justice high handed. But if it becomes too much for us to bear we can change the government. The loop is individuals>>owners>>paper>> laws>>government>>individuals
But my grandparents experienced Government justice with as much violence and vigilantes as the ghettos alleyways full of substance abusers, as they fled from the communist Yes, they "proved" that ownership is only "paper". Paper the government says is legit or is not. But if it is not private ownership, it must by default be "government" ownership. But the loop broke down when individuals did not set up a checkable government. Because they outlawed "wall street". Without "owners" no one cared enough to risk his life to stop the government. The "fiat" paper was stronger than ever, for it now said government can kill the past owners.
We all know how motivated and what quality of production of houses, an caterpillars the communist produced when it is done for the love of the state. Just because you sit in a house, and can dig a hole with a caterpillar does not mean you are entitled to the fruits of making that house a home or that hole a foundation, unless of course the government says so on a piece of paper. Wall Street produces individual ownership of producers, these individual owners are therefore motivated to keep the producers producing, but perhaps more important keep the government from stealing and stoping or hindering production .
This of course does not mean that Wall Street does not try to get you to pay more than its worth, that they know every angle of the law and prey on your naivete of it and will take the best deals for themselves. But what realtor, car salesmen and tractor/caterpillar dealer does not do the same thing?
We maybe a bunch of hillbillies but, what rural red blooded guy has not had "Red Dawn" taughts of how they would defend their home if the "ownership" changed overnight. Yes, its paperm, but paper backed by millions of individual defending their right to "own", so in a very real way Wall Street is on your side against Government overstepping its powers. Let us just hope in our lives it never comes to point of violence being necessary to enforce that papers rights.