Thursday, June 7, 2012

Their Grievances Justified – A Case in Defense of Capitalism and Paul Krugman

The dynamics of greed, or a milder version of it called ‘pursuit of wealth’, has favored the rich over the poor in the past few decades. The norm of greed, nevertheless, was and has been equally endorsed by both the classes. Greed is not only supposed to make you wealthy. It can also make you poor, not because of the underlying risks, but due in part to the dynamics of the new economic model. Failure to comprehend this model can grossly misdirect grievances of both the 99% and the 1%.

During the last few decades, and more so in the last fifteen years, the rich became rich by earning what was spent by the poor. What the 99% spent by selling the claims on their future earnings, the 1% earned by selling them goods and services. When it became clear that there were no future earnings to claim, the stakeholders should have taken the losses. At least that is what the virtue of capitalism suggests: risk controls greed.

Missing or obscured in the equation, however, was the risk. An examination of how and where the risk was placed and how the steps taken to "solve" the situation guided the distribution of claims can help us better judge whether the responsibility lies in mere deviation from rectitude of the 100%, or a criminal offence on the part of the 1%, or a little less than 1% to be precise.

Pure and simple trade is – I provide you with goods and services and hold claims on what you produce in the future. I take the risk and it is my loss if you don’t produce anything in the future. In the new economic model the claims on future earnings of the spender, the 99%, are not held by the producer, the 1%. The risk is held by "someone else". The 1% keeps what it earns. This is why the 1% was happy when the welfare program was in effect replaced by a program meant to pander to the greed of the 99%. NINJA loans, LIAR loans and credit card loans financed all the spending and the 1% earned all that was spent with little or no risk.

Do the 99% deserve sympathy? Certainly not for the reasons they sight. The 99% were let off the hook for the risks tied to claims on their future earnings were grossly underestimated, thanks to both the government support for many of these debts and the alleged fraud perpetrated via the collusion of banks and rating agencies. Yes, the banks too helped the 99% spend at their will for it was the demand for MBSs and CDOs that was in effect encouraging the inordinate lending. A portion of the extra dollars that went abroad due to the continuing trade deficit were circulated back into these claims perpetuating a vicious cycle, amplified by various feedback loops, of borrowing and spending; the mighty ability of the United States to earn and pay back was undermined by this modern Opium. When the market forces started functioning and it became clear that the spender is never going to be able to pay back, the holders of the hyper-valued claims started to fail.

The 99% could just move away as they had no risks tied to the collateral, and that is exactly what they did. They walked away from the obligation and started saving, and the businesses that thrived on this spending started to fail. Government shifted a portion of the debt on its balance sheet. The poor became less poor now that the debt was purchased by the government. The rich did not become less rich. People who became rich in the process of this debt financed spending remained rich, thanks to the anthropomorphic nature of corporations. Insider trading further stacked the odds against the 99% invested in stocks.

The banks were not allowed to fail. The government incurred debt to pick up the slack in spending, purchased much of the toxic assets and lowered interest rates to prop up the remaining collateral. So instead of the 99%, now the government will have to pay for the claims. The government will pay back this debt from tax revenues of future earnings. So in effect, the money that the 1% have is actually (a function of) the future earnings of tax payers. How did the 1% earn this money? It depends on who are we talking about. Many corporations (employees and shareholders) provided goods and services to earn this money; that seems legitimate, for it might not be justified to expect them to evaluate the supposed risk the spenders, the 99%, were offering. That risk was not written on the dollar bills they were spending; the risk had been taken by the mythical "someone else". Bank employees allegedly colluded with rating agencies, sold the claims on earnings, and took the cut; prima facie this is tantamount to criminal conspiracy and fraud.

Of course, we cannot ignore China, the elephant in the room, before discussing the fairness of the next steps. The Chinese situation is plain and simple trade – The producer (China) sells goods, and bears the risk that the buyer (the United States) might not pay it back. So Chinese seem worse off than the rich in the U.S. who bore no such risk. On the brighter side, however, the Chinese gained enormously via access to capital goods that the Unites States, Germany and Japan took decades to develop. Chinese now have all these capital goods and more than $ 3 trillion to spare. The moment the Chinese de-peg the Yuan, and start consuming the products they produce, the inflation that the U.S. has been exporting to China will start showing inside the U.S. The resulting spike in interest rates will both reduce the tax base and increase the costs to service the debt and will force either default or hyperinflation upon the U.S. So in effect, the steps Chinese, the primary financier, take in the near future will determine the fate of the 99% and the 1% in the U.S.

No signals from the government suggest that it wants to avoid the inflationary path. Spare a thought here for the Good Samaritan, who worked hard, spent responsibly, and saved for future consumption. Although a very rare species, he does deserve sympathy, as he now stands as the ultimate loser for he did not enjoy the "risk free" exuberance back then and will now look at his savings wiped out as the government tries to inflate its way out of the mess.

Having said that, let us examine the other end of the spectrum advocated most fiercely by Peter Schiff. Taking a situation to an impractical level sometimes helps form rational perspectives, so let us do that here. What will happen if we bring capitalism back to the United States – say, as close as we can get to laissez faire? – Stop all monetary and fiscal stimuli, allow the interest rates to rise, demolish the regulatory burden, reduce government spending and stop all forms of wealth redistribution. Not new to the Americans, this is the old American – Grover Cleveland style, a path strictly guided by the constitution. Of course, under such a scenario, the Chinese can just forget about all their claims on future earnings of Americans. Many businesses will close down as the spenders lose access to debt they cannot pay back and the spending patterns readjust. Banks will fail, and will be allowed to fail. New healthy businesses and financial institutions will come up, and the entrepreneurial spirit of the mighty United States will spring back before anyone in the world can realize. However, the foundation of this resurgence would not be as sound as it seems. Under this reversion to capitalism, a portion of the wealth that the 1% own will effectively be what the debt holders around the world earned and will never be paid back. The 99% can live with that. However, not all the government debt is external. Internal debt represents money that future tax payers will earn. The existing 1% possess some of this wealth as well. The 99% can object to that as they never voted for the government to take on the debt. It should have been the banks and holders of the debt that should have taken the losses. Even if we ignore the origin of wealth of the 1%, wealth disparity under this transfer to capitalism will be enormous. While the wealthy will have the luxury of choosing between starting a business and enjoying their wealth, it will be a matter of survival for the 99%. A reasonable assumption that legitimizes sympathy for the 99% is that they could not have been expected to behave in any other way. Is a citizen of the United States expected to deny if he/she is offered a free lunch? How could he/she be expected to pay the price of the steps taken by the government and the banks? Disparity between competent and incompetent makes sense in capitalism where risk ensures fitness. It does not make any sense if some reckless intervention of the government leaves all the capital that engineers and scientists have developed over decades of hard work into the hands of a certain few. Who will answer the indebted generation some of who have not yet taken birth and whose wealth is already in the hands of the existing 1%?

Before discussing the merit of Paul Krugman’s argument, let us try to identify the root causes that led us into this mess. Intellectual tycoon, politician and economist Subramanian Swamy often discusses in his speeches the structure of society in ancient India as described in the scriptures. The model has an element of relevance here. The Varna Vyavastha (presently known as the caste system) was never meant to be hereditary as it exists in India today. Two great sages Maharshi Bhrigu and Maharshi Bharadwaja led a debate to decide the structure of the Hindu society. (You can imagine it as the greatest philosophers, psychiatrists, mathematicians, economists etc. of the time coming on a platform to discuss the structure of the society.) The outcome of the debate was that there should be four sections of society in alignment with inherent human nature.

Elements of power were recognized as knowledge, weapons, wealth and land. To avoid centralization of power, any single person could hold only one of these elements. The highest and the most revered class was that of intellectuals. However they were not allowed to hold wealth, weapons or land. Second in line were kings who had access to weapons. However, they were not allowed to take decisions without the approval of intellectuals. The third caste was that of businessmen, who did not have the intellectual ability to create, neither had the heart to defend their wife and children, but had the risk appetite (financial) and ability to execute businesses within the framework created by intellectuals. They possessed wealth but did not enjoy any social status. Their social status was determined by how much charitable they were. The last caste was that of labor. Transfer from lower to higher caste was a norm; in fact some of the greatest intellectuals in India were born in low caste families.

There are many parallels that can be drawn from this model but let us focus on human motivations. Let us start with two basic primitive motivations: animals want to secure food to survive and want to pass their genes to the next generation. Recognition from other animals, power to control, and access to territory all help achieve these two objectives. Humans desire these same elements – social recognition, power, and access to wealth driven by these primitive instincts. These elements are not absolute, they are relative. So, a human driven by these elements cannot be satisfied with a finite amount of these elements. (I am not touching the spiritual realm which deals with the absolute and might not be applicable to the current scenario. Pursuit of knowledge is considered closest to the spiritual realm.)

If you create an environment where wealthy are revered and where they can influence decisions to control, you effectively give all the three elements of power to a few. This is the present situation in the United States. Access to capital (that was developed by scientists and engineers and proliferated by industrialists with decades of collaboration), social recognition (driven recently primarily by the media), and control of power via government (lobbying for unconstitutional favors) all belong to a few. This has enormous economic and biological ramifications for mankind. Distributing this power fairly will be impossible unless something unprecedented happens as it is human nature not to let go of what he/she has without resistance.

This brings me to the argument raised by Paul Krugman where he argues that a fake alien invasion can bring the economy out of the current slump in eighteen months. The idea of alien invasion may seem dissociated from reality, but this argument is strongly rooted in the relationship between human motivations and economy. Under war-like situations, human motivations make a radical shift. During wars, a lower standard of living does not invoke frustration, it becomes sacrifice. Massive build-up of capital takes place driven by sacrifice of the poor and the rich alike. Wealthy become less wealthy as capital gets devalued. When the war is over, capital goods can be re-tooled for production. The fit regain control of this capital. Aligned human motivations and hard work can indeed bring back the economy on the right track very quickly. The merit of this argument cannot be discounted on the basis of its "impracticality". If there is any argument that directs us to the virtues that can reinstate the health of the economy, its merit, at least in theory, should not go unappreciated.

Tuesday, June 5, 2012

Marshmallow Test

Marshmallow test is a very famous psychological experiment on toddlers. In this experiment, an instructor gives a marshmallow to a toddler and tells the child that he/she can either eat the marshmallow right away or can wait for the instructor to return (the instructor returns after about 15 minutes), and if upon return the instructor finds that the child has not eaten the marshmallow, the child is rewarded with another one.

This experiment does not look like a game as there is just one player i.e. the toddler. It is of course reasonable to assume that the possibility of betrayal by the instructor does not occur to the toddler; neither is that the idea behind the experiment. However, a careful consideration of human psychology and the manner in which we conceive and value time reveals an interesting feature of this experiment that can possibly legitimize it as a game.
Now fifteen minutes is a lifetime for a toddler, especially when there is a marshmallow staring at you. The child has to exercise restraint in order to be rewarded. Although the condition is presented to the child as an if-then clause, a careful examination of the decisions the child faces during the experiment reveal some interesting facets. To eat or not to eat is not the only decision the child takes. At every moment, the child is simultaneously assessing her/his ability to bear pain for the remaining of the time, and the possibility of not being able to cope up with the pressure at a later point. Moreover, the instructor never tells the child when he/she will return, adding to the uncertainty about how much time is remaining. Therefore the child is essentially playing a game with herself/himself at every moment where to eat or not to eat, and whether to trust the assessment of her/his own ability to bear the pain for the remaining time, which in this case is uncertain, form the two dimensions of the game. Notice that eating midway and eating a minute before the instructor arrives have two different payoffs. (Notwithstanding the fact that marshmallow might taste a bit sweeter after a longer wait!)

In short, uncertainty about one’s own assessments can replace the uncertainty associated with another player, making single player games possible.
You can watch this cute video with little souls battling with the temptation:

FYI: Follow up studies after sixteen years indicated that the toddlers who chose to eat the marshmallow scored less on SAT than the ones who exercised restraint.