Hedging Risk with Leverage

For the last several decades, the investing community has been ruled by a paradoxical notion that investors can hedge their risk by taking a leveraged position. This view is paradoxical because the derivatives used in leveraging were designed to amplify risk.

There are some isolated cases where the hedging strategy works; however, when implemented on a wide scale, this method of taking a leveraged position to hedge risk simply creates a systemic risk and sets up the market for failure.

Classical and Modern thought have a fundamentally different approach to paradox. Thinkers of the Aristotelian tradition sought to avoid paradox. Modern thinkers, from Hegel to Bertrand Russell, made paradoxical thinking central to their world view.

I believe that ideas matter. The ideas from the classical era produced science, the US Constitution, the free market, and prosperity.

The paradox ridden dialectical view keeps creating systems that fail. It has produced communism, fascism, Nazism and a score of radicalized ideologies.

I irk Libertarians in that I draw a sharp distinction between the free market and capitalism. I support the free market, but believe that the modern dialectical view of the market taught in schools (capitalism) belongs in the same scrap heap with all of the other paradox ridden theories of the modern era.

Last week, President Obama made a stir by comparing AIG executives to suicide bombers. I think there is merit to his statement. A suicide bomber holds the paradoxical belief that doing a great evil will bring on a greater good. The AIG derivative department believed that they could hedge risk by taking a leveraged position.

Obama is content to lay blame on a character defect of the AIG executives. I take my thinking one step further and realize that both the suicide bomber and AIG derivative investor learned their snide little world view in a school.

The effects of education are easy to see. Warren Buffet studied investment ages ago when the classical liberal worldview held sway. He learned a system called value investing which was driven by a desire to weigh and measure the values of different investments. Not only did Warren Buffet do well in his career, a fairly large number of people saw an improvement in their lives along with Buffet.

The modern investor, the people who've given us a steady stream of market bubbles and crashes, learned their world view in schools where Marxian thought holds sway under the moniker of modern liberalism or progressivism. The classical liberals and their quaint views about value have been driven out of the picture for shiny new equations and computer models based on material dialectics.

Maurice J. Dupr&ecute; has an interesting article discussing the Mathematical Seeds of the Economic Collapse in which he criticizes the idea that one could simply take Einstein's equations from the study of Brownian motion and build an investing strategy on it. Such a model starts with the hubristic assumption: "Let's assume people are nothing but specs of pollen.")

This question of the source of or woes is extremely important. If our woes are the result of the greed of few bad apples who mucked up the works, then the solution is aggressively enforced regulation. If the problem is our view of the market, then the new regulatory regime does nothing but set us up for the next round of failure. (This was the point I was trying to make in hubris v. greed.

In conclusion, the paradoxical idea that a society can hedge risk by aggressively leveraging investments proved to be as unstable as all of the paradox ridden system of the Hegelian/Marxian tradition. If we wished to return to an age of prosperity, we need to develop a world view that reason and logic over paradox.

Hubris v. Greed

In the wake of systemic failure, it is important to study the error and figure out why it occurred.

Our knee jerk reaction to the failure of a major company like AIG or Enron is that the companies were driven by greed. They took unacceptable risks, and the risks led to failure.

A better explanation is that these companies fell to hubris … with hubris defined as an arrogant overconfidence in one's investing knowledge.

Both AIG and Enron were filled with the best and brightest from top business schools. The students put into practice all of the equations that they learned from the professors at our leading progressive universities.

They hedged their investments feeling certain that their derivatives, short positions, government backed re-insurance and mathematical equations would allow them to invest massive amounts of public capital without risk.

The hubris is that one can hedge risk by taking a leveraged position. In all of the complex equations, the financial world lost track of the real value that backed their securities.

The problem was not with risk taking. Nor is it a problem with people receiving rewards for the risks they take. The problem was that a legion of smug technocrats felt that they could march from the University and take their entitled position in the upper rungs of society simply by plugging numbers into the hedging equations taught in school.

Our financial collapse occurred because our financial institutions had taken leveraged positions to hedge risk while arrogantly ignoring the fact that their leveraged position had created systemic risk.

People who face risk with humility rarely create the systemic risks as those who march onto the battlefield blinded by hubris.

Hubris is not unique to the wealthy. One form of widespread hubris is the belief that we are all entitled to high paying jobs with guaranteed health care and lucrative retirement benefits ... without anyone really laying forth a solid plan to create such a utopia.

Hubris is not unique to the private sector. Politicians, clergy and tenured professors can all fall victim to the vice. Mao's Cultural Revolution is a great example of bureaucratic hubris run amok. There was so much faith in the five year plan that people failed to notice (or even acknowledge) the lack of food in the countryside until millions were falling of starvation.

Properly identifying the cause of the systemic fault is important.

Unfortunately, people have an instinctual desire to place blame on others.

Politicians or regulators, for example, would not want to accept the blame as hubris as such an admission would make the political share blame with the private sector.

The press would never report on the hubris of the press. Academicians see themselves as transcendent and could never accept that they led people students down a blind alley.

I understand the desire to place the entire blame on the nameless faces on Wall Street. However, if the problem is widepread hubris within our culture at large, then laying blame on a single segment of the economy might lead to even further calamity.

One element of our cultural hubris is a belief that we are all entitled to a well paying job with full health and retirement benefits. If we proceed with a misdirected anger at all risk takers, we might end up driving the people with the ability to create well paying jobs from our midst.

Look at the large number of innovations created by people who faced risk with humility and made great discoveries in the process.

If the drum beat of hatred and wealth envy aimed at Wall Street destroys those who face risk with humility, then we might see a dramatic decline in our standard of living. The people who feel entitled to well paying jobs will be led to naught.

The self interest of politicians, the media, and academicians is to blame the greed of risk takers in the private sector for all wrongs. When listening to their words, we must understand that it is against their self-interest to acknowledge any role played by their own hubris in our financial woes.

The financial collapse shows that our financial institutions were wrong in their belief that highly leveraged positions hedged risks. The hubris of the technocrats that built this house of cards is extraordinary.

In acknowledging this problem, we must recognize that hubris is not unique to Wall Street. It can exist in the minds of smug bureaucrats, public servants, lawyers or even in the population at large. America bred a population who feel entitled to prosperity but who seems to have become clueless on how one goes about creating the wealth that they inherited.

We should not simply accept the diagnosis of politicians who lay blame of greed in the free market. Misdiagnosing the malady might lead to a cure which is worse than the disease.

The Stewart and Cramer Show

It is always interesting when the left eats one if its own.

Last week attack-dog commedian Jon Stewart went after Mad Money man Jim Cramer.

Mad Money is a really obnoxious show where a really loud person makes funny noises while panning or praising stocks. There is often a spat of day trading activity when he mentions a stock's name.

Cramer is a former hedgefund wank who encourages the day traders who follow his show to take heavy short positions.

I think it is worth examining the prominent progressive investors in the market. Many of these folks are drawn to hedge funds and strange derivative schemes. Madoff, Soros, and Cramer all are into the hedgefund and moneymaker concepts.

Short sells, derivatives and credit default swaps are not investments. They are side bets on the market.

When the derivative market gets too large, there appears to be a strange tail wagging the dog effect.

I've noticed that both progressive professors and progressive investors are prone to describe market activity in terms of ecosystems, with the progressive investor trying to set himself up as the predator that culls the herd.

There are numerous rogues on the right. The ones on the left, however, are intersting as they seem to better reflect what is taught in our progressive universities. For example, Blythe Masters (who is often credited as the originator of credit default swaps) simply took ideas about the market straight from the classroom and into the boardroom.

I believe that the market is a creation of the human mind. What we learn in school and from the media affects how we engage in the market.

Jim Cramer feeds a day trading mantality adverse to long term investment and that seeks advantage in insider knowledge and desirous to engage in manipulation schemes. This highly influential person reflects thoughts on the market and consequently has profound on how the market behaves.

Different people learned to think in different ways.

According to his Wikipedia page, Warren Buffet learned his value investing technique that built his fortune from professors at Columbia University.

Buffet studied in a day when the University was dominated by classical liberal thought. The modern liberal approach seems to be producing people which much more destructive and unstable investing habits.

Pressing the Overcharge Button

WARNING: This is just a stream of conscious post. I thought about trying to discuss the difference between a political theme and a principle, but realized that any attempt to do such would fail.

Ooops, I meant the title of the post to be "pressing the reset button." Things just got messed up in the translation.

I found Hillary's cute little "reset button" ploy with Russian diplomat Sergei Lavrov irksome. The ploy seems to indicate that the Obama's Administration's foreign policy would be dominated by in house partisan bickering, as opposed to a simple representation of US interests and ideals.

The great advantage of the American system—where we have frequent changes in the administration—is that diplomats are able make changes to foreign policy on a regular basis. This allows an opportunity to hone and improve our foreign relations.

The great danger of the system is that political control of the system opens the temptation for the politically minded to use foreign policy to influence domestic politics.

A theme of the partisan media is that the left is inherently superior at diplomacy. This may be true. Condaleeza Rice may have been the ogre that the press portrayed. However, the stunt where the new administration opens relations with Russia with blatant partisan jab aimed at re-enforcing a domestic propaganda theme comes off as bad form.

That no-one even bothered spending the extra hour needed to check the translation is even worse.

This stunt happened while I was reconsidering the way I go about writing.

Through the years I've developed the habit of opening essays with quirky statements. The primary reason for this ploy is that quirky statements can sometimes encourage people to engage in the thinking process. When people realize the joke, they chuckle, and might be a bit more open to consider other ideas in the post.

Quirky statements are especially effective in the education process as they make a class a bit more entertaining. Quirky statements can help re-enforce the concept that there are many different ways to look at any issue.

The other reason for the trick is that I've encountered a large number of people who seem to wander around with automatic dismal filters between them and the world. People in the automatic dismal mode simply scan a post then snap back with the first dismissive comment that comes to mind.

When I put in quirky messages, they invariably snap at the quirky message.

Conversely, people who are into ideas for the sake of the ideas rarely comment on the quirk. I imagine such people shaking their heads at the intentional quirky statement, but reading on to see if there was something of value.

The method seems to work. But when I read back through posts on this blog, I feel that the method creates an ugly sub-context that tends to undermine projects that employ the technique.

That's not a problem with this blog. This blog has no purpose other than to blog for the sake of blogging. Most of the posts in this blog are free form essays where I start with a topic and see where it goes as I type. I often go back and insert a quirky statement to show the frivolous nature of what I am doing.

While doing this experiment, I am gradually coming to the opinion that quirkiness just for the sake of quirkiness is a net negative.

There should be important things in life.

My last quirky post was about an issue that I believe has deep connotations. It really was about the Hippocratic Oath. This oath resonates throughout Western Culture and is fundamental to the evolution of science and medicine. Medicine makes great strides when it adheres to the oath. We often see calamity when researchers ignore this one basic principle.

Look at the history of pharmaceuticals gone bad! The pattern repeats on a regular basis: A pharmaceutical company is so set on getting their product to market that they chinch on research, ignore side effects, and launch a seductive image driven campaign to hawk their snake oil.

People suffer as a result.

There is merit to the Hippocratic Oath! When medical researchers ignore it, they end up doing a great deal of harm.

History seems to show that whenever a segment of the research community raises concerns about the ethics of a line of research, society at large should be concerned. Many people felt uncomfortable with the direction that research on human embryos (embryonic stem cell research) and the fertility industry was headed.

The result of the demand to debate this issue resulted in a large number of extremely insightful presentations throughout the United States. The ethical debate pulled students into medical research and health care world. IMHO, it was the best science related debate that took place in the last several decades.

My last quirky post compared a fiat by George Bush that launched this debate to one given by Barack Obama that was dismissive of the debate.

Bush's fiat, of course, was that he would prevent taxpayers' dollars from funding the cloning and experimentation on human embryos (an omnipotent embryonic stem cell is just a fancy term for fertilized human embryo). This fiat appears to have given the research community a good starting point of engaging in ethical research. A lot of great research took place.

It is likely that Bush's executive order went too far. The press has told us so many terrible things about that horrible person that I am more than willing to except that Bush's actions were extremist.

I am happy to accept that Bush was a horrible person, but I read the science journals and popular opinion during the debate. It was a great debate on a very important issue.

As there was such a great debate, correcting the excesses of the previous regime should start with stating the reasons for the correction. Otherwise it appears as if the new administration is just engaging in base politics by issuing a new fiat.

Watching the process, I am left with the feeling that the new administration is simply making knee jerk decisions based on political themes without the quality debate that the administration of change had promised.

In a different political area, there is suddenly a renewed effort to frame the holding of "enemy combatants" during a war as the moral equivalency to the worst death camps in history. This reeks of partisan propaganda.

Yes, Bush was foolish to house prisoners in Guantanamo. Were he wise, he would have confronted the courts with the need to house prisoners of war during times of war. It is common sense issue that elitists on the bench aren't quite capable of fathoming, but that is every bit in keeping with a Constitution written by people who lived through war. The Constitution reluctantly gave the ability to deny a writ of habeas corpus when public safety requires it.

In times of war, denying habeas corpus is the best of the bad options.

The idea that we should try prisoners of war and find them guilty of some bogus international law is much more demeaning than recognizing that they are soldiers in an opposition army who are imprisoned for public safety concerns.

In times of war, one captures enemy combatants. One detains prisoners of war for public safety concerns. Their get released through a political process. It is possible that this war has reached a point where we can release the prisoners of war.

Obama's setting things up so that prisoners in the next war will be able demand habeas corpus is just setting us up for failure.

Obama seems to think that labeling a person an "enemy combatant" is some sort of assault on their self esteem. Having some court label a person a criminal is worse than labeling them an "enemy combatant." This is especially true with people who reject the legitimacy of their enemy's laws.

Bush should have argued this point better. He should have expended the post 9/11 outrage to make the case that, in the face of terrorism; we will find ourselves needing to deny the writ of habeas corpus for public safety concerns. This is what the United State's Constitution allows.

Of course there was no way Bush could argue that point. The image-driven partisan press is simply driven by the desire to associate negative images with the opposition party. As such the press frames the better solution to the dilemma of prisoners of war (denying habeas corpus) as villainous. They frame a worse solution (labeling people criminals though an international kangaroo court) as just.

In related news, a passenger on flight 51 to Detroit was diagnosed with Tuberculosis and is being kept in isolation by the CDC. Using progressive logic, we should frame the CDC as a horrible organization full of terrible people who deny the writ of habeas corpus for something as simple as a deadly contagious disease.

Where's the ACLU when we need them?

A man has the right to infect people with whatever disease he might carry! It's a first amendment right. Infecting people is an act of free expression. Dagnabbit!

… or maybe not.

One can't push freedom of expression to an absolute. I might hate ties, but I am not allowed to express that opinion by shooting people wearing ties.

I wish people would realize that the problems we face right now are not the result of Bush or Obama. What is killing this nation is the way that we are being taught in our schools. We are losing our abilities to engage in reason.

I don't think that rebranding "terrorism" as "man-made disaster" is going to stop terrorism any more than the efforts of our wizardly brethren to call Lord Voldemort "He Who Must Not Be Named" stopped dark magic.

I've always found this notion that we can change the world by banishing words from our language to be a bit absurd. It is especially absurd when we realize that the people out to get us speak a different language.



Anyway, through all of the manipulative tricks of new speak and new thought, we are being turned into a nation where an elite media yanks us apart through manufactured images.

Of course, one can't expect a society to engage in reason when the public schools don't teach logic

When people finally start catching on that we need to do a better job examining the principles and reasons for our actions, we suddenly find the media promoting clowns like Glen Beck who push principles to an absurdity.

When one pushes any idea too far, the idea turns into its opposite. If one pushes habeas corpus to the point that the government cannot assure public safety, then everyone loses their ability to roam around freely.

The best path to creating a free society is to promote habeas corpus, freedom of expression and other important freedoms, but to structure things so that there is a way out in extraordinary times.

The system of rights must also be structured to avoid the reflexive paradox. I could not express my opinion that Rush Limbaugh should be silenced by following him with a fog horn blaring.

Speaking of Limbaugh, why is the press secretary trying to frame all opposition to the current regime as a "cabal" led by Limbaugh?

The administration is engaged in a great deal of spending and action. But because they aren't leading with ideas, the quirks of the political techniques ooze through and risk dominating discourse.

IMHO, quality reasoning is firm, but not absolute. A person engaged in the process should be more concerned with the direction of the ideas than their appearance.

Unfortunately, our second rate public school system seems set on creating an image driven population that can be yanked about by the nose ring.

I've filled this blog with quirky posts while trying to figure out how to express my observation that it is the way we are taught to reason that is leading us to naught.

We aren't going to find answers to our problems in the political system. We find the valuable answers by improving ourselves.

The American political system seems to do little more than give the people a choice between the bad and worse.

When I was in school, the worse was in power. Americans rejected the worse for the bad and had a short run of prosperity. People got sick of the bad, and the worse is back on the throne.

This problem is not unique to America. It seems to be the very nature of politics and power.

I apologize for this long floating post. But this is what blogging is supposed to be about.

I was asking myself if pressing a reset button could get things on to a more substantive track, but clicking through the news and reading the paper, we seem to live in an age where the style of the day is dominated by snippy little quicks and tricks.

Rule by Fiat

President Obama ruled by fiat today that the United States will start vigorously funding embryonic stem cell research. Yes, he even used the word vigorous.

Most likely this research will be done at the cost of adult stem cell research … you know, the stuff that is likely to lead to cures for a myriad of diseases.

This fiat comes from a president who promised to usher in a new enlightenment with open public debate on policy.

The funny thing about this dictate is that it was not preceded even by a token effort to show that was a critical need for change.

In contrast, the stem cell debate during the "Bush Dark Ages" included vigorous debate before during and after the establishment of policy. The public debate that occurred during the Bush Dark Ages dramatically improved public understanding

The debate began with Bush, along with most of the world, clueless about both the nature and promise of stem cell research. The policy went through various cycles as leaders from the religious, academic and medical communities spouted out with opinions. The open debate that occurred during the Bush Dark Ages dramatically improved public knowledge and raised awareness of biomedical research.

I believe that the most important thing we learned was that there is a distinction between embryonic stem cells and adult stem cells.

The fertilization of an embryo creates an omnipotent cell. This omnipotent cell apparently can transform into any cell. If implanted in the uterine lining an embryonic stem cell can produce an individual walking talking, public service consuming human.

Of course the development is not direct. The omnipotent stem cells differentiate early in the development process into things called adult stem cells. These adult stem cells end up being able to produce all the different cells in the body.

There are a large number of cancers and other diseases associated with problems in adult stem cells. It is this area of research that promises the miraculous cures and is helping solve the mysteries of diseases. This is the area of focus of the medical community.

The embryonic stem cells pretty much seem to be limited to the earliest stages of development. I mean if our fingernail had omnipotent cells in them, then we would have manicurists becoming pregnant mysteriously as any fingernail cell would become a child on coming into contact with her uterine lining.

I went to a number of debates and listened to podcasts and lectures on this fascinating subject.

During one of these debates a professor who was highly critical of Bush made an interesting observation. He was preparing lectures for sold out crowds interested in learning the different sides of the stem cell controversy. While preparing his attacks on the hated Bush it dawned on the professor that the ethical debate resulted in sold out crowds.

The debate led to a spike in the number of quality students interested in biomedical research or medicine as a career.

The process of re-affirming the ethical guidelines drew students and public interest into the process.

On hearing the news, I felt like composing a piece on the relation of ethics and science that I placed on a different site.

In the piece I argue that science, from its inception, has been an ethical discourse. The article has a pretty picture and, in my opinion, makes some good points. BTW, this long blog post is really just a pointer to the article. Blogs are for bloviating.

The idea that science exists in a difference space than ethics is really a modern contrivance.

Anyway, Obama's dictate reversing the compromises that took place in the Bush Dark Ages appears to me to be bad form. If there were compelling reasons to change the compromise; then a smart leader would have led in with a discussion as to why we needed to change the compromise. The dictate sprung on the world today appears to me to be just political posturing.

Medical S&L

Earlier this week, President Obama invited anyone to toss in their ideas about health care reform. Well, he actually gave a qualified invitation. Obama invited opinions from anyone, so long as they are not part of the status quo. That means Obama does not welcome opinions from any business currently working to provide health care services.

As I have no money invested in health care, nor do I have any special knowledge of the system, I feel that I am duly qualified to voice opinions, according to Obama's formula.

So, here goes:

Personally, I think most of the dissatisfaction with health care arises from the insurance companies, HMOs and government bureaucracies that sit between the patient and doctor. The solution is to create a system where patients are directly buying health care from doctors.

As such, I have been a strong advocate of using medical savings accounts as the primary funding mechanism for health care. Insurance should only be involved in catastrophic care or major health problems.

Charitable organizations or the state should handle care for the indigent.

Medical savings accounts are a great idea. Unfortunately, our health needs will never fall perfectly inline with our investments.

To make MSAs work, one would need to supplement it with a system of medical loans.

The great challenge of medical loans is that there would be a high default rate on the loans. The interest on the loans would not be sufficient to cover the loans. An onerously high interest rate would make the loans untenable.

To make the loans work, one would have to change their thinking about loans. Traditional thinking about loans is that loans must always return a profit for a lender. That means they must charge interest rates high enough to cover defaults and provide a decent profit.

Medical loans are likely to have a high default rate. If you lend money for a tooth removal and the person dies in the dentist chair, then the loan will go into default.

To make the loan system work, there would need to be financial instruments that seeds the loans.

One could seed a system of medical loans by charging a premium to holders of MSAs.

So my ideal insurance program would have multiple layers: The primary layers would be the money in the MSA coupled with a high deductible insurance. For sake of argument, let's say the deductible is an even $50k. The MSA holder would then pay a premium that guarantees a low interest loan for the deductible.

If the MSA holder has a sudden moderate health crisis, they would exhaust their MSA and automatically take out a loan. On recovery, the MSA holder would start paying off the loan when they go back to work. Once back at work, the patient would start making payments on the loan.

To avoid the problem of people being denied care in this repayment stage, one would work out a schedule where half of their payment would to toward paying off the loan. The other half would go into the MSA for future medical expenses. The patient, of course, would be able to take out an additional loan. To keep people from being completely bowled over by health expenses, the Medical Savings and Loan might limit repayment of the loan to x percent of a person's income.

A Medical Savings and Loan system would create a paradigm where the first $50K of care was handled by a direct price negotiation between the patient and doctor. This would force cost cutting discipline onto the system.

For MSAs to become a reality, the system would need a loan component. I had been hesitant to promote the loan component in the past because a system of medical loans would involve a complete rethinking about loans. I was scared about the ramifications that rethinking loans would have on the mortgage business. As soon as we break the expectation that all loans should be repaid in full, our society would start having crisises in the housing and other industries as people took on excessive risk expecting to externalize the cost of the risk when things went south.

Well, my worst fears came true. We are now in a situation where lenders must accept a high default rate on all loans; so, perhaps we are ready to discuss the necessity of having to seed loans to make a lending process work.

BTW, even though I am a pariah, when Obama said he would listen to any idea except those from the status quo, I suspect he meant that he would listen only to ideas that came from the left. A medical savings and loan might be interesting fodder for a scifi novel.

Insurance and Socialism

Young doctor with stethoscope © arosoft

I want to consolidate ideas from the last two posts:

Socialism is a system where the people surrender ownership and power to the government. The government then establishes an internal bureaucracy to distribute resources. In theory, resources will be distributed by some sort of socially just mathematical equation.

Insurance is a scheme where people voluntarily give up a chunk of their resources. The bureaucracy of the insurance company then redistributes these resources according to an equation that is theoretically socially just.

The basic form of the two concepts is the same. They differ in the amount of coercion used to sell the product.

In practice, insurance firms use a great deal of coercion to sell their products. Most insurance policies are pushed on the public through third parties such as an employer. In some cases, insurance is mandated by the government. For example, you must have auto insurance to license a vehicle or to take out a mortgage.

In recent years we've seen an explosion in weird financial instruments like credit default swaps, government backed reinsurance and other schemes. Many of these schemes take place in the background without consent of the consumer.

Over time, the various insurance schemes meld into a private centralized powerbase which starts acting more and more like the socialist scheme.

Unfortunately, Libertarian pundits seem to concentrate only on one outward attribute of the financial system. Is the financial system owned by the government? Or is it owned by a private cartel?

I think they should be looking more at the form of the system. For example, the private insurance regime has driven up costs and systematically destroyed the ability of individuals to control their health care.

Rather than just debating which powerful group controls the bureaucracy, I think we should have debates about the proper place to make health care decisions. Should the decisions be in the hands of bureaucracy or in the hands of the person seeking care?

Should the distribution of health care be driven by formulas created by some third party or should the decisions be driven by people actively taking part in living their lives?

When we relinguish control to a centralized bureaucracy we find the system becomes consumed by the friction internal to the bureaucracy.

As we look back at the market crash of 2008, we find that the financial system had been churning and churning trillions of dollars worth of activity, without really improving life for the majority of the community. This Enron style economy had all sorts of internal activity which created the illusion of wealth, without creating real wealth.

The centralized bureaucracies of government do not fare much better either. For example, when we look at public schools (including charter schools), we find an excessive amount of the resources the public spends on the school being churned up by internal friction within the adminstration while the academic needs of the students often go neglected.

To make the right decisions, we need to be able to discuss the issue at a level that is more fundamental than the petty concern of which centralized authority should have control? Before answering the question of which centralized authority should control our lives, we should discuss the merits of people controlling their lives v. centralized authorities controling their lives.

Pecking at the Issues

sperling © Wolfgang Staib

I hope you don't mind my pecking at a few cracks here.

Capitalism is a system where people invest their resources in an endeavor. On successful completion of that endeavor, they reinvest a portion of their proceeds on their next endeavor on the next endeavor.

With capitalism, people gradually build up equity through their efforts.

Capitalism, per se, is a self regulating system. When people over-invest in a crowded market, their returns drop. They then look for a better use of their capital.

The collapse of the financial system shows that we live in a credit economy and not a capital economy.

This economy is typified by extremely large banks making extremely large loans while using increasingly complex insurance and derivative combinations in an attempt to create an unending fixed high rate of returns.

When one looks at turn of the millennia society, one finds very few people directly involved in the creation and re-investment of capital. Most people are simply working at jobs. They borrow money to buy a house. The buying of a house is a leveraged margin play and not a real investment.

The investment community is now dominated by short selling and option plays and not in the development of capital.

I had been wandering around and photographing towns. My direct observation is that the state of physical capital in this country is in shambles. The little businesses that typified America at the height of its game are gone. We have a land covered with really expensive houses. Extremely expensive public schools, and a lot of office space. Our manufacturing and industrial base has diminished.

The credit economy is something different from capitalism.

The credit economy is driven by mathematical formulas pushed in play by central banks and private bureaucracies. Notably insurance companies like AIG.

This house of cards had become increasingly separated from real capital.

The problem that investors face at the moment is the massive gap between the financial system and real equity.

Pundits repeat the talking point that the problem is lack of regulation. This is an odd argument as we live in a massively regulated world. Most of the really bizarre financial tools were designed expressly for the purpose of regulation capitalism.

The short sell is an artificial construct which lets brokerages sell stock in any company. This allows insiders to increase the float of a company when it misbehaves. Hedge funds are all about using derivatives to shield the richest of investors from the inevitable risks that incur when living a human life. Above all, Allan Greenspan of the central bank sat in an ivory tower regulating the flow of credit through loans from a central bank.

The point I wish to drive is that the financial system is largely independent of the political structure of a nation. The world financial system that we see can exist in a semi-free nation like the United States, in a fascist regime, or even a socialist nation.

The financial system we see actually exists and evolved through all of these regimes.

The collapsing of this house of cards says little about the merits of a free market v. socialism. It simply shows that as an economy becomes divorced from reality, reality has a way of coming back and biting.

IMHO, the best way to return to normalcy would be to encourage the development of financial securities that were directly backed by real equity.

Insurance and Systemic Risk

Today, insurance giant AIG reported a record $61.7 Billion loss. This record loss was seen a big blow to a weak economy. People are worried that all of the weird financial arrangements of AIG might weaken other firms.

Apparently, AIG was heavily into a weird derivative called Credit Default Swaps. These are some sort of funky derivative that banks had been using with the hopes that could insure loans and other investments.

Pundits on the left are using the failure of AIG to push the case that financial markets need powerful centralized regulation.

I wish to toss out a different argument.

I argue that the failure of AIG shows that credit default swaps in specific (and perhaps insurance in general) shouldn't exist.

The idea of insurance is to pool together all of the small risks that we face in life into a large ocean of risk.

No matter how one shapes the large ocean of risk, this ocean of risk is susceptible to catastrophic (tsunami-like) failure.

Unfortunately, I fear that many people will interpret the failure of the insurance paradigm as a failure of the free market. I contend that this episode simply shows the inherent instability of the insurance paradigm.

Interestingly, the insurance paradigm has many of the same goals as socialism. Insurance companies are set up to redistribute income and to regulate risks. It is essntially the same idea as Socialism, but held in private hands.

Like socialism, insurance leads to a great deal of waste, poor service for the individuals using insurance. As we see in health care, insurance destroys the feedback mechanisms the help set price and it leads to inherently instable economy.

I believe that the Libertarians of the past generation got so caught up in the argument of private v. government ownership that they failed to realize that when the private sector tries to create big business to regulate the economy that the big business will suffer all of the same faults as the socialized government.

Speaking of socialized governments. We all know that the US is doing poorly, the socialized countries in Europe are faring even worse in the economic meltdown.

I hope that future generations of Libertarians realize the grave mistake made by our naive faith in big insurance.

Pondering Microstock

I am kicking back with the BigStock Free Photo of the week, cooling my heels waiting for my camera to arrive. My mind is on how I will pay of the debt load I took on to buy the camera.

BSP is just about to break the 3M image barrier. Looking through the site, one finds the vast majority of photos have zero downloads. There are many photographers (perhaps the majority) whose sales are less than the minimum payout.

Fotolia claims to have 5M images. They have a similar popularity system.

I can't help but notice that I have a followerless blog with technorati score of 1. (The proper term for folks like me is "pariah"). Microstock is driven by the same popularity system. I am quite certain that I would rank with the faceless masses on any of the programs.

In the modern world, artistic talent is unvalued. This is especially true in Utah. Utah has an extremely large number of artists, but a very small number of art patrons. I like Microstock as it allows Utah artists access to markets where people actually buy art!

I determined several years ago that the best business model for Utah is to be an art promoter. That is, a person who leeches off the artistic talents of others.

There is a strong need for content promoters: In an iStockPhoto.com press release, Kelly Thompson noted:

"We recently surveyed 1,000 Americans and discovered that more than 30 percent are downloading images from the Internet and using them for personal or professional projects without license rights, demonstrating the need for more knowledge about finding safe, authorized imagery"

The art promotion model pounds the drum that people should buy art, and that stock photography is affordable (about $1 an image).

My business model is one where I would scream at bloggers, amateur web designers and scrapbookers with the message that buying stock photography supports local arts. If your blog post isn't worth embellishing with a dollar image, is it worth writing at all?

The one problem I have is that I really don't like the format of any of the stock web sites.

The first big problem is that most of the microstock web sites have too much of an internal focus for my tastes. Fotolia doesn't have a bio page. BSP has a bio page, but they don't have the decency to give artists a hot link. Worst of all, a very large number of microstock sites are owned by the same firm ... a firm which is trying to have total domination over the industry.

I hate being dominated.

As I study these programs, I can't help but feel that I would do better to simply start from scratch and design my own microstock site. After all, my business model is to leech off the creative efforts of others.

I've been told that the best way to rob a bank is to own one.

Were I to design a Microstock site, I would design it as a program that promotes photographers and graphic designers as individual artists.

Yes, yes, yes. The first step to world domination is to gain people's trust. (oops, I didn't write that outloud. I hope.)

The BSP free photo of the week is a high resolution photo. BSP has a pile of 500 free low res photos which you can see here. I like every thing aboug BSP except their price model as you have to buy 300 credits to hit the elusive price point of $1 per low res image.