Source of Our Economic Problems - the Tunnel of Affirmation

I've spent the last few days watching the chaos in Washington and listening to the presidential debate, wondering where the crates of brains are being hidden. We have foxes negotiating over how to best stop the bleeding in the hen house and it is portrayed as if the failing financial companies and individual mortgage holders are entitled to being pulled out of a hole that they are somehow not responsible for.

Then this morning the answer hit me. We went to my son's soccer game. They practice hard and really work on passing and shooting skills. The defenders on the team are taught to get the ball as far away from their own goal as possible. Control risk, wait for opportunity, and strike when the iron is hot...or in this case, when the other goalie falls down. As a result of practicing the basic tenants of soccer, our team won, shutting out the opponent 4-0. If you know anything about soccer (and believe me, I tried to steer them to a sport more enjoyable from the stands...) you know that a 4-0 score is like 100-3 in football...it was not even close. When the game ended, the fans from the other team walked out on the field, spread out in two lines, joined hands across the void and said "c'mon everyone, lets form the tunnel!" To their credit, only one of the kids walked through it while the grown-ups all yelled "woot! woot!" (that's a verbatim quote) over and over. My wife and I stood there in stunned silence as we watched this incredible celebration of failure. My wife named it the "Tunnel of Affirmation", to which I had to fight back laughter to keep the condescending stares of the losing side's bridge supports from focusing on me.

I am not trying to make fun of a kid losing a game. Losing is a part of life. I have felt the pain of losing and it can be terrible. But if we never feel that pain, then we never learn how not to lose the next time. If everyone walks through the Tunnel of Affirmation or gets a trophy at the end of the season regardless of accomplishment then we never learn what it takes to succeed. We only learn that we are entitled to praise and affirmation just because we exist, and while this would be an enjoyable way to live, it just doesn't prepare kids for real life, which is what we as parents are supposed to do.

So what does this have to do with the current state of affairs? Well, when people don't understand winning or losing you get all of the participants in this mess. First, you have people who don't think they should need to pay their bills on time in order to be trusted for a six figure loan on a house. When they lost their soccer game, they walked through the Tunnel of Affirmation. Then you have government types that think its unfair to deny mortgages to those people, regardless of what those risks mean to the solvency of the lending bank. When they lost their soccer game, they walked through the Tunnel of Affirmation. Those loans are bought up by people at FNM and FRE who think that because the taxpayer is guaranteeing them that they can use the system as their own personal penny bank without regard for the principles of risk management. When they lost their soccer game, they walked through the Tunnel of Affirmation. When those loans are defaulted on, the very politicians who created this environment of subprime lending, act indignant and blame the free market for it. When they lost their soccer game, they walked through the Tunnel of Affirmation.

No one wants to be held responsible for their actions anymore. They don't want to be held accountable. They want to win even when they don't deserve it. I am almost certain its because when they lost their soccer game, they walked through the Tunnel of Affirmation.

Bailouts, Bailouts Everywhere…

…but not a drop of common sense in D.C.

Unbelievable. Apparently my fantasy that Ben Bernanke reads my blog was shot to smithereens. Only a day after I praise the decision to pass on a bailout of Lehman Brothers, they decide to go ahead and make you and me the proud owners of a poorly run insurance company. Why? Because it is "too big to fail". In the latest fiasco, the federal government (that's the you and me part) paid <Dr. Evil voice> 80 BEEEELION DOOOLLARSSS </Dr. Evil voice> for an 80% stake in AIG. The company will finally live up to its name…American International Group. That's the only funny thing I can find in it.

The argument that something is too big to fail is compelling on the surface. It is logical to assume that if AIG were to close shop, there would be many external effects on the economy. Others who rely on AIG would have to find alternatives, and in many cases it may cost them their financial well being. This is unfortunate and a byproduct of not allowing the markets to correct themselves in a timely manner. There is a fundamental concept in economics that there is no such thing as a free lunch. What this means is that everything comes with a cost. If the government is giving money to one person, they have to take it from another. It seems free to the recipient, but in reality, it is not. If we artificially prop up a business that is not able to make it on its own, it comes at a cost to those that have to put up the money. Again, that is us. So instead of the people involved with the failing business paying the cost, like the shareholders and management, it is shifted to those of us that have nothing to do with it. This is always the case with a bailout.

This would be bad enough if it stopped there, but like a good infomercial…wait, there's more! When a person or business is not held accountable for their bad behavior, but instead are made whole at the expense of others, it only encourages more of the behavior that got them into the problem in the first place. These financial companies made bad investment decisions by not properly accounting for the risk of those investments. Now, these are professionals, many with vaunted Ivy League credentials, and were certainly taught risk management at those places. So why would they do that? Because they know that if it all goes bad, the government will be there to make it better because they are "too big to fail." By bailing out these firms in order to prevent the negative consequences of their actions on the economy, the government is actually creating more strain because they allow bad firms to keep running, and encourage others to take on too much risk.

Another example that may help in understanding this is government subsidized hurricane insurance. No one wants someone else to lose their home in a hurricane, but should other people pay to replace that person's home? Is there no accountability for deciding to live in a place with a high risk of getting hit by a hurricane? It is very expensive to buy hurricane insurance. Why? If you live on the Gulf Coast, there is an extremely high likelihood that your property will have to survive a hurricane at some point during your ownership of it. The risk to an insurance company is very high and so the resulting premiums, set by the free market competition between insurance companies, are high. The government wants to "help" people by paying for part of the insurance cost. So when a hurricane comes, the home owner gets reimbursed by other taxpayers, most of whom chose a more responsible place to live. They then rebuild their house, in the same risky place, never learning the lesson that should have been learned.

It is fundamentally unfair to force you and me to pay for the folly of others. It is no different whether it is hurricane insurance or AIG or Countrywide or Lehman. The losses should be borne by those responsible for them. This is the only way that foolish behavior can be cut out of the marketplace. When you touch a stove and somebody else gets burned, you will keep touching the stove. That is, until those getting burned start picking up pitchforks and march on your kitchen…

 

Role of Government Rant #1

From time to time I just have to rant, and one thing that really brings out the rant in me is government interference in the marketplace. So when I feel one of these coming on, I will post a paragraph or two and then go to the bathroom until the rant feeling is gone.

In the wee hours of the morning on Monday, Lehman Brothers, a 158 year old Wall Street brokerage firm, filed for bankruptcy. This action will effectively bring the company to an end. As a result, 26,000 employees will have to find other work. Now I feel sorry for each and every one of them, as most of them had little to do with the failure of the firm. But I was listening to NPR this afternoon and they were interviewing employees as they came out of the building.

Many of these employees are Ivy League educated and have presumably had classes in economics. However, one of the interviewees made me doubt my assertion when he was asked if he thought the decision not bail out Lehman by the American tax payer was a good idea. His answer was that it should have been a no-brainer. He couldn't believe there would not be a bailout. How could the government allow Lehman to fail? He finished it off with a snide comment about how much money is spent in Iraq. Presumably he feels that that money could be better spent giving Lehman more money to squander since they ran out of their own. Or perhaps he just feels like he is owed a job and a paycheck. Either way he had me yelling at my radio, which looks really odd to the person in the car next to you.

Who does this guy think he is asking me to pay for his errors? Maybe he didn't personally ruin Lehman brothers, but he certainly contributed through his employment there. In the free market, inefficient use of capital will be replaced by more productive capital...that is, unless the government takes your money and gives it to the inefficient capital users like Lehman so that they can continue in their folly. A better solution, is to allow these firms to fail. They will file bankruptcy, and the investors who willingly took the risk to invest in them, will foot the bill rather than the taxpayer.

This will have two effects that result in more efficient use of capital (and hence more wealth creation.) First, the people responsible for the failure will be held accountable for their poor decisions, hopefully never being given that responsibility again. And second, the investors who lost money will now be better evaluators of risk when putting future capital to work. They will demand more accountability. They will be more cautious, more efficient. This is the natural corrective mechanism of the market. If we don't allow it to operate properly, then we can't complain when things aren't working.

Since the government knows less about running a business than the idiots that sank it, then why would we give them the reins to take over and throw good money after bad? Why should life long politicians, most of whom couldn't run a faucet, much less a business, be deciding what businesses should be saved? Let the market decide! The agregate deciscions of shareholders and customers...the market...ultimately make the best choices. It can be painful, for sure, especially when the problem has been created or fostered by unaccountable management and over reaching governement. We can keep management accountable by becoming informed investors. We can keep government from over reaching by voting. It should be up to us...the market.

Ok, I feel much better now.