Tuesday, July 27, 2010

Cookie Dough

The deluge of red ink generated by the current Congress and Administration has brought into sharp focus the phenomenon of inflation. Unfortunately, as seems to be the case on virtually every area where government action impinges upon economies, there's so much disinformation that people don't understand what's going on. So, I'm going to explain it in really simple terms. This could take a while, so settle down in your easy chair and we'll start off with a story about Mrs. Smith's cookies....

Every Saturday morning, while Mr. Smith is down at the office catching up on work, Mrs. Smith and her three kids have a regular routine. Each of them has a list of chores to do; Mom's list includes baking a batch of chocolate chip cookies to reward them for getting the jobs done. She always bakes an even dozen, nice large cookies, which allows for each of them to have three cookies.

One day, the eldest, Johnny, tells his mom that it isn't fair that he does more work than his younger brother and sister, but gets the same reward, and insists that he should get four cookies instead of just three. Mrs. Smith thinks about it, and makes thirteen cookies so that Johnny can get four, while everyone else only gets three. Well, you don't have to be Nostradamus to predict out what happens next. Mary thinks she's doing more than little Billy, so she ought to get four cookies too, so the week after Mrs. Smith makes fourteen cookies. Now Billy is upset because he doesn't get as many as his older brother and sister, and he wants four cookies too!

Soon they're up to sixteen cookies, four each. But Mrs. Smith isn't mixing up a larger batch of cookie dough; she's just making each cookie 33% smaller than she did before. Everyone has more cookies, but since there's not any more dough, they aren't getting more to eat.
If you can understand the difference between "more cookies" and "more dough", then you're well on your way to understanding inflation.

Once upon a time, money was based on some objective standard of value. Many tribal cultures that herded animals used livestock in their trading activities. The very word "pecuniary" came to English from the Latin word for cattle, "pecus". But cattle are not interchangeable; some are of superior value to others, (as the President's penchant for Wagyu beef demonstrates) making accounting with such a "currency" rather imprecise.

Humans have always considered certain minerals to be precious; the varying quality issues that plague the use of livestock to measure value go away once the technology exists to refine metals such as silver and gold to standardized levels of purity. Those metals are entirely fungible. Most cultures that possessed that technology settled upon either or both of those two metals to define their currency. The US Dollar was originally based upon the Spanish Dollar, a 90% silver coin (about 25.5g silver content) produced in Mexico and Peru as well as Spain itself. Our Constitution forbids any state from making anything other than gold or silver coin legal tender, which suggests the extent to which those the Framers considered those two metals good objective measures of wealth.

What does this have to do with cookie dough? Back when gold and silver were used in coins, governments would sometimes "debase" the coins by reducing their precious metal content. When that happened, even though the new coins had the same name and nominal value as the old ones, they weren't worth as much. Johnny may not realize that his four new cookies have no more dough in them than the three old cookies, but his stomach is no more full. Some people may not notice that the new coins have less silver or gold than the old ones, but some do. When governments put more money into an economy in proportion to the goods and services that money can buy, it drives prices up in that same proportion. If there are 33% more dollars in circulation, with the same level of production, what once cost $3 will cost $4.

This is where the Clever Kids will complain that you can't argue by analogy, and the Cookie Dough Story is far too simplistic. Of course, it's simplistic, because, as I've said before, all economics discussion is "all other things being equal". Fiscal policy doesn't exist in a vacuum; increases in the supply of dollars don't just relate to the goods and services in the US economy, because those dollars can be spent anywhere in the world. Further, inflation depends not only on how many dollars are in circulation at any given point in time, but also on expectations of the future. But the long-term relationship cannot be denied; stable prices depend on stability of the ratio of the money supply to the goods and services available for that money to purchase.

Since we no longer make any pretense of tying our currency to an objective standard of value, and instead leave it to the Board of Governors of the Federal Reserve System to manage the money supply (within the constraints of the spending authorized by Congress and the willingness of the market to purchase instruments of US Government debt), there can no longer be a sudden increase in the money supply such as followed the discovery of gold and silver deposits in the New World. Changes in the money supply are now entirely under the control of the government. It is therefore particularly galling that an asset held over a period of time may be sold at a paper "profit" representing nothing more than the inflation of the money supply.

Consider that with the low inflation rate of 3% per year, an asset need only be held for nine years and nine months for it to experience a purely paper increase in value by the same 33 1/3% as the Smith family cookies. And then, the same government that created that inflation will tax that 33 1/3% "profit". At the 20% capital gains tax rate set to return soon, the paper value of the asset must exceed the inflation rate by a quarter (3.75% if inflation is 3%, 5% if inflation is 4%, etc.) just to leave enough after paying the IRS (not including any state income tax) to have money worth the original purchase price of the asset. An honest tax code would index all capital gains to inflation, so that these paper gains are not taxed.

But under our current tax code, inflation is a double tax. As the above shows, it taxes as "income" these illusory gains. It is also a hidden tax on cash assets (including bank accounts, or contractual obligations of others to pay future amounts defined as some number of dollars. The uncertainty of how severe inflation may be in the future acts as a powerful disincentive to make long-term investments. A common criticism of US corporate culture is the obsession with "this quarter's profits", to the detriment of long-term considerations. How sophisticated are our betters in Europe, who make five-year plans, the Japanese who think in decades, or the Chinese who think in centuries! Well, is it any wonder, under the circumstances?

When people weigh investment decisions, they have to factor in the inherently uncertain nature of the returns to be had. It's one thing to sell your labor today for a specific amount of money; you know exactly what value you'll be getting in exchange for the time and effort you invest to earn it. But a decision to spend today in the hope that it will pay off many years hence is based on considering a wide range of possibilities: A continuum of returns, starting at none and increasing, with various probabilities for each, can be estimated and quantified. The popularity of lotteries and casinos indicates that some people are willing to make a bet that is unlikely to pay off, but that is self-correcting. The people who make rational decisions about risk and reward (and return with the capital to continue doing so) will always limit the former as compared to the latter.

Government policies introduce further uncertainty into that calculus (and I mean "calculus" quite literally; if you don't use that branch of mathematics, or rules of thumb derived from it, in making investment decisions, you probably aren't doing a good job of it). There is great risk that the money supply will be greatly inflated, robbing our currency of its value, and paper profits will then be taxed away, in reality robbing the asset of part of the little value it retains. Combine that with the knowledge that the Bush tax cuts will go away automatically, little if anything is likely to be done about it, and whatever is done will likewise be temporary (the next Congress will want to fiddle with taxes again; it's just what they do), and you have a recipe not for tasty cookies, but for economic disaster.
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Tuesday, July 20, 2010

Interview with a Zombie

Not with our friend Zombie, mind you...

Saturday, July 17, 2010

Let the NAACP explain this

At an Atlanta tea party meeting....

Sunday, July 11, 2010

I am America