Banks frequently extend more debt to people than they can afford to repay. These people tend to default. Normally banks write off the losses associated with this debt. Today is no different. But in recent years they out did themselves in their largess. Banks gave out piles of debt to anyone with a pulse. Unsurprisingly, this worked poorly for banks. Credit card related write-offs are now at record levels.

The debt that banks wrote off no longer competes with individuals’ savings and income. This helps people trying to save their income and live without going further into debt.

On the other hand, this is terrible for the financial industry’s profits. Clearly Washington DC needs to do something, right? Congress and the President to the rescue!

MSN reports that on “May 22, President Barack Obama signed into law the Credit Card Accountability, Responsibility and Disclosure Act of 2009.” The bill has the following ominous detail (emphasis mine):

Under the new law, no one under age 21 can get a credit card unless a parent, guardian or spouse is willing to co-sign or unless the young adult has proof of sufficient income to cover the credit obligations.

The bill claims to stop young people from getting into debt. But will it work? The world is full of propaganda encouraging parents to get their children addicted to debt:

Waiting until age 21 to have a credit card has drawbacks. Length of credit history, regardless of age, matters when determining a credit score. And those without a credit history will find that renting an apartment or leasing a car on their own is next to impossible. What’s more, once someone obtains a credit card, there’s a six-month period before the person’s credit is considered “scoreable.”

Even some defenders of the new requirements agree that it’s important to start building a credit history early. “If you can’t qualify on your own, get a part-time job,” advises Campbell.

Many families will continue giving their children credit cards. And thanks to this bill, the families will suffer much more whenever these kids make poor financial decisions:

The bank considers the young person and the parent to be equal players. Now you have two people on hook to the payment rather than just one

In other words, no longer can a child who runs into financial trouble just declare bankruptcy and start fresh. The parent, guardian or spouse must now declare bankruptcy as well. If the parents want to avoid bankruptcy, the parents must repay all the debt the bank gave the child. Or the child must continue living in financial ruin.

Hopefully this scares parents and children away from credit cards. Doubtful. More likely, this law will prevent children from using bankruptcy to repair their financial situation out of concern for their parents. This law will reduce families’ financial redundancy; parents will find themselves with the same financial problems as their children.

I spent a large number of hours in adolescence playing Rummikub with my family. We played the game according to our understanding of the printed rules that came with the game. Eventually we lost that piece of paper, but we kept playing and having fun.

As an adult I sometimes play this game with new groups of people with prior experience of the game. Sometimes they interpreted the rules differently. Generally we resolve these differences without calling the police or giving someone the right to beat up whoever disagrees. I would be very unhappy if the police threw my friend in jail because he wanted to play the game differently. I would be very unhappy if my friend had to pay a heavy fine because he understood the rules differently than a judge.

Do I really need a government forcing my friends to play Rummikub with a specific set of rules? Things seem to work pretty well without it. Maybe the same can be said of coercive government in other areas too.

A person may note the necessity of judges in any highly competitive game. The World Cup and World Series use judges to resolve inevitable disputes. Not all people agree with the results, but the process works pretty well.

Does this idea work as well in real life?

The nature of games and real life have a very importance difference: the goals of a game are predetermined. Everyone playing the game agreed to play by those rules beforehand. It is impossible to play outside the rules or invent new rules while still playing the game.

For example, a player cannot decide during a chess match that he wants to arrange his pawns in the shape of an S. His goal is predetermined: capture the other player’s king. The black and white teams cannot decide to work together to move all their pawns to the other side of the board.

Real life is more flexible. A baby is not born holding a piece of paper upon which a handy set of rules and goals are written.

In Human Action, Ludwig von Mises noted how man must discover his own goals:

man chooses not only between various material things and services. All human values are offered for option. All ends and all means, both material and ideal issues, the sublime and the base, the noble and the ignoble, are ranged in a single row and subjected to a decision which picks out one thing and sets aside another. Nothing that men aim at or want to avoid remains outside of this arrangement into a unique scale of gradation and preference.

And the best way to accomplish them:

Means are not in the given universe; in this universe there exist only things. A thing becomes a means when human reason plans to employ it for the attainment of some end and human action really employs it for this purpose. Thinking man sees the serviceableness of things, i.e., their ability to minister to his ends, and acting man makes them means. It is of primary importance to realize that parts of the external world become means only through the operation of the human mind and its offshoot, human action. External objects are as such only phenomena of the physical universe and the subject matter of the natural sciences. It is human meaning and action which transform them into means.

We will disagree on both goals and the means to achieve them: I want to code; you want to fish.

Daneil Lapin explains how these disagreements are what creates prosperity:

If we all agreed that fishing was better than sitting on a computer, none of us could be discussing such things on the internet.

I read a report today that Massachusetts Representative Bill Delahunt and Wyoming Senator Mike Enzi seek to use the federal government to force our local businesses to comply with 49 other states’ draconian tax laws.

There are 7,000 different tax agencies in the United States. Who do you think can better afford to comply with these myriad regulations: A large, multinational company like Wal-Mart or someone starting up in his West Seattle basement or Queen Anne apartment?

It is hard enough for local, Seattle businesses to get by in this troubled economy. The last thing we need are distant governments making it too expensive for our new businesses to grow and provide new jobs to Seattle residents. Is not unemployment high enough already?

If Enzi and Delahunt believe their local constituents pay too little taxes, fine. They can go to their constituents and collect any necessary taxes. But they have no right to place this burden of collection and compliance on our local businessmen, thousands of miles from their localities.

Seattle needs to concentrate on what we are best at: providing great products and service for the best value. Learning how to comply with Wyoming tax law prevents this.

Please contact your representatives and let them know you feel the same.

Advertising is a dead, decaying disease. Usage-fees are positive-sum games. So why are usage-fees generally unsuccessful and advertising everywhere?

Like so much in today’s society, we can find the answer at the Federal Reserve.

Advertising

Fundamentally, TV exists in order to help Dove and Budweiser convince people to pay more for soap, shampoo and beer. Companies pay based on NBC’s perceived ability to persuade. Hey Busweiser, why not just lower the price?

I suspect that the vast majority of the 20th century’s advertising bonanza depends on cheap debt subsidized by the Federal Reserve.

Coca-cola borrows money at a fixed cost subsidized by the Fed. The money spent today convinces customers to spend more tomorrow. The extra revenue services the subsidized debt and adds a little to KO’s bottom line.

This only works on account of the Federal Reserve and US Treasury’s policy of permanent inflation. Tomorrow’s supply of money is always greater than today’s. This growing money supply makes it easier to stimulate someone into spending nominally more on sugar water tomorrow. In addition, Coca-cola can repay their nominally-fixed debts with a dollar that is increasingly less valuable per unit.

Honest money would make profitable advertising far more difficult: Coca-cola would have to borrow money at higher interest rates today; they would have to repay their creditors with equally valuable money tomorrow. We would have far less advertising in such a world.

Eric Clemons, Professor of Operations and Information Management at The Wharton School of the University of Pennsylvania, gives a dim forecast for advertising’s future:

Advertising will fail for three reasons:
There are three problems with advertising in any form, whether broadcast or online:

• Consumers do not trust advertising. Dan Ariely has demonstrated that messages attributed to a commercial source have much lower credibility and much lower impact on the perception of product quality than the same message attributed to a rating service.Forrester Research has completed studies that show that advertising and company sponsored blogs are the least-trusted source of information on products and services, while recommendations from friends and online reviews from customers are the highest.
• Consumers do not want to view advertising. Think of watching network TV news and remember that the commercials on all the major networks are as closely synchronized as possible. Why? If network executives believed we all wanted to see the ads they would be staggered, so that users could channel surf to view the ads; ads are synchronized so that users cannot channel surf to avoid the ads.
• And mostly consumers do not need advertising. My own research suggests that consumers behave as if they get much of their information about product offerings from the internet, through independent professional rating sites like dpreview.com or community content rating services like Ratebeer.com or TripAdvisor

So why is advertising is everywhere? I only expect to see the end of most advertising after the collapse of either pure-paper currency systems and/or legal tender laws.

For example, Clemons seems to think Google’s business model will be an eventual loser:

Misdirection, or sending customers to web locations other than the ones for which they are searching. This is Google’s business model. Monetization of misdirection frequently takes the form of charging companies for keywords and threatening to divert their customers to a competitor if they fail to pay adequately for keywords that the customer is likely to use in searches for the companies’ products; that is, misdirection works best when it is threatened rather than actually imposed, and when companies actually do pay the fees demanded for their keywords. Misdirection most frequently takes the form of diverting customers to companies that they do not wish to find, simply because the customer’s preferred company underbid. Misdirection also includes misinformation, such as telling a customer that a hotel is sold out when, indeed it is still available, if the hotel has chosen not to pay a promotional fee, and then allowing the guest to choose an alternative property. Misdirection is, regrettably, still a popular business model on the net, although for reasons I explored in an earlier TechCrunch post on Google it seems ultimately to be unsustainable. More significantly from the perspective of this post, it is not scalable; it is not possible for every website to earn its revenue from sponsored search and ultimately at least some of them will need to find an alternative revenue model.

Google still makes money today, but I consider Clemons’ pessimism all too valid in world using sound money. So how will companies make money?

Usage-Fees

People want access for information. Public demand for information access is the primary reason Verizon, Comcast, etc. earn revenue each month. It makes logical sense for me to pay Qwest more as I access more information. After all, this is how things work on my water, electrical and gas bill.

Yet this is not my arrangement with my internet service provider. I seem to pay the same amount regardless of whether I check my email once a day or use BitTorrent to download every episode of every tv show ever made each month.

In other words, Verizon and Comcast’s business model resembles a fitness gym. They make money based on their ability to convince people to buy more than they need or are willing/able to use. The ideal gym customer is the overweight engineer-economist who resolves to finally get in shape and signs up but is too lazy to actually do any physical labor (like me). The ideal Comcast customer is the person who signs up expecting to download movies and music, video-chat and play exciting video games but never actually figures out how to do anything (like far too many people).

The typical gym has too few lockers for everyone to work out as much as they intend. Show me an internet service provider that has enough bandwidth for everyone to video chat with each other at the same time: I will almost certainly show you a calculation error.

So in effect, I subsidize the cost of the fitness enthusiasts’ equipment usage. And grandmas subsidize the cost of their children’s pornographic downloads. While this often benefits the subsidized users, the model often misaligns a company’s financial interests with the demands of their customers.

Misaligned interests cause aggressive, unfriendly behavior towards customers: the fitness center that refuses to cancel my subscription until I appear in person (and turn down the gorgeous woman insisting to know how she can make my membership more valuable). Time pushing buttons on my touch tone phone, waiting on hold for a customer service agent and finally receiving terrible technical support.

Imagine a restaurant that optimized their menu according to what their most frequent patrons like least and told waiters to antagonize these customers. It sounds absurd but this is exactly what service providers do: spend resources to throttle their most active customers.

Luckily the dining reality is that the guy who goes to the same restaurant seven days a week is a favored, profitable customer. The restaurant goes out of their way to assist this person. They are likely to make his desired dish, even if it is not on the official menu.

Internet usages fees would create the same type of customer relationship. New services like BitTorrent or video chat will periodically appear, dramatically increasing bandwidth demand for a subset of users. The increased usage revenue signals a profit opportunity for Verizon. Since Verizon’s financial interests are aligned with what their customers value, they will seek ways to make it easier for as many users to discover and benefit from as many services as possible.

The benefits to usage fees are clear.

So ask yourself: what is preventing service providers from successfully adopting this model?

I always have the first opportunity to consume the fruits of my labor. What I do with the remaining amount enables me to access other things I want in life: clothing, shelter, software. This increases my enjoyment of life; eating only fruit all day long will give me the runs.

I can also decide to exchange my fruit for money. I can save this money until the future, which frees up resources for other activity in the mean time. There is only a particular amount of fruit, clothes or anything else on any given day. You can only use what I do not; I can only use what you do not. Saving money allows other people to consume things instead.

A hungry person is very eager to eat some fruit and bread as soon as possible. He can only eat fruit and bread that I do not. How does he stop me from eating my fruit? He has to entice me with an alternative.

He may have something that I want today. He may offer to exchange a coat for a particular amount of fruit. Lowering the coat price makes me more likely to prefer the coat to eating the fruit and bread he wants. This only works when he has something that I want today.

What if he has no coat today?

If he has nothing I want in his immediate possession, I might eat the fruit or exchange it with someone else. Neither of these actions solve his hunger. How can he convince me to give him the fruit? By promising to make me something I want tomorrow that I cannot have today.

It is not important what the something is. There are infinite possibilities: a better or cheaper coat, more coats, a new fleece jacket invention… who knows! The point is that he offers me a future something valuable enough to stop my present consumption. He must convince me to refrain from eating my fruit or exchanging it with someone else. Only then can the man use the fruit to satisfy his hunger.

I may be hungry or cold today. The more hungry or the colder I am today the more expected value I require tomorrow. This determines the rate at which my savings must become more valuable in order to defer my consumption today and save. This is the cost of money, also called the interest rate.

The interest rate helps me determine how much to consume today and how much to consume tomorrow. Tom Woods explains how interest rates help people serve each others needs in his best-selling book, Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse:

The interest rate coordinates production across time. It ensures a compatible mix of market forces: if people want to consume now, business responds accordingly; if people want to consume in the future, business allocate resources to satisfy that desire as well (p. 67).

In other words, a high interest rate signals how people can help others. Interest rates and the cost of money rise when people have more immediate wants and needs. Increasing the value of money rewards people who produce more and/or reduce their present consumption. This allows others to satisfy those present needs with what is produced and not consumed.

A low interest rate also signals how to help others. Interest rates and the cost of money decline as people’s immediate wants and needs are satisfied. People satisfied with the present state of affairs will value new and innovative ideas. This makes it increasingly affordable for others to satisfy their immediate needs working towards a better future for the satisfied.

A free-market interest rate helps the needs of a poor person in all situations. High interest rates help encourage comparatively wealthy people to defer their consumption, allowing the comparatively poor to consume things instead. Low interest rates make it more affordable for the poor to learn and invent new ways of satisfying the increasingly diverse and complex needs of society.

Why are homes selling so slowly today? Because homes are still priced well above what people can afford to repay.

A person buys a computer solely on its ability to satisfy his wants. He does not believe there is any computer pyramid scheme that will make him rich by selling the computer to someone else.

The computer has the same ability to play music when the price declines. So eventually someone decides he would rather play music on the computer than eat N cheeseburgers. The computer sells.

Housing was priced far above its ability to satisfy wants. People priced housing according to its ability to make money selling it to the next guy. Schiff recently claimed at the Austrian Scholars Conference that the average home buyer in CA expected home prices to appreciate by 20% per year for the next 10 years.

When the price is appreciating by 20% each year, the buyer is not constrained to what he can afford to repay. As a result, he can pay much more. The housing supply appreciates to what he can pay.

Now that the pyramid scheme is over, people will price homes at its non-monetary value — its ability to keep your family warm, hold a BBQ, watch a football game.

The problem is that all these homes were already sold at ponzi-prices using debt. The ponzi prices are gone, but the debt remains.

The home cannot sell until defaulting on or repaying the debt. The man who sees value in keeping his family warm cannot afford to repay the debt. The institution who owns the home does not want to sell it to him at a price he can afford.

The price a man can afford to repay will cause the lending institution to lose money and possibly default. The institution will avoid and delay this loss the more a bailout is expected in the future.

So the price does not fall and home does not sell.

When I look at televisions, cell phones and computers I see continual price declines. I also see people buying these assets by the truckload. The downward price spiral argument does not seem to apply to computers.

People seem to like the deflationary aspect of television prices. Would home prices act more like television prices if we bought homes without debt?

No one is interested in buying mortgage debt today. I find that surprising given the following data points I consider true:

1. The assets backing up the debt (houses) are vastly overpriced.
2. The ability of debtors to service the original terms of debt (homeowners) is questionable at best.

I would be very eager to sell this mortgage. The debtor is unlikely to pay his monthly dues (2). And if he defaults I can only reclaim a fraction of my principal (1). I would want to sell this mortgage to someone else below par to liquidate the bad debt and cover my losses.

However, this is not happening. Why not? I see the following as a primary culprit:

3. The lenders used leverage to create the mortgage.

Fannie Mae did not have $800,000 to loan. Fannie borrowed $800,000 from someone in China or Saudi Arabia in order to make a loan. What happens when the borrower defaults and Fannie sells the home for $400,000? Fannie has no assets, no income and a $400,000 debt to China. They are bankrupt and insolvent.

What can Fannie do besides wait for a miracle or declare bankruptcy? I suspect that this waiting contributes to our stagnant economy. Many resources are tied up servicing overvalued debt. This may cause malinvestment.

But what would the Fannie management gain by reallocating resources to more productive ends? They do not have enough assets to repay their debts; and they have no income without their asssets. Reallocating anything will take out the company. Management has nothing to lose and plenty to gain by praying for a miracle — lobbying for a bailout.

How will excessive debt, malinvestment and an unwillingness to lower prices effect employment and investment? These seem like very negative factors to me.

Citi, BofA, GM and many other financial institutions seem in the same situation.

If I am running a financial institution that has overvalued assets, fixed liabilities and an uncertain revenues, I would probably decide to give up and declare bankruptcy.

But, aside from Lehman, this has not been happening. Let us consider why:

4. The US Treasury and Federal Reserve have clearly stated their intention to insure lenders from loss.

The more I can convince myself and my debtors that my company can escape the day of reckoning, the more likely I am to continue malinvesting resources, the less likely I am to liquidate bad debt.

Insuring Fannie bondholders from loss makes it harder for the homeowner to negotiate a principal and interest rate reduction on his mortgage. Insured debt makes it harder for GM and Citi to negotiate cram-downs with their creditors.

Cram-downs seem like a good solution to this problem. I see evidence of growing support for the idea.

Peter Schiff gave a talk on Why the Meltdown Should Have Surprised No One. The talk was in honor of late economist Henry Hazlitt at the Mises Institute’s Austrian Scholars Conference.

He had many personal stories and metaphors I enjoyed. The following are some notes from the talk:

• Yahoo:
  Would you rather own Yahoo or New Zealand with its $1b dividend? At one point, people said Yahoo.
• Renting:
  • Paying a couple thousand dollars per month to be someone’s landlord is absurd.
  • People did this because they had nothing to lose, so much to gain.
  • Average home buyer expected his home to gain 20% per year for next 10 years.
  • No money down.
• FDIC:
  People spend more time researching what TV to buy than where they deposit $100,000.
• Bankruptcy:
  Falling prices are the market’s solution for overvalued, misallocated assets.

Other highlights:

• Overvaluation of tech stocks
  • Even if doorknobs.com sold every doorknob on the planet, it was too expensive.
  • Investors valued Yahoo above New Zealand.
  • Would you rather have a country and $1b dividend or this company that started a few years ago?
  • People told Schiff: give me Yahoo.
  • A company looking for VC financing with no assets, no revenue, no customers valued itself at $50m.
  • Schiff: I can duplicate your entire business in a couple weeks.
  • Company: you don’t understand, we’re going public!
• Overvaluation of real estate and the importance of rent:
  • Cost more to live in a 20 yr old townhome than a far nicer apartment (same size) next door.
  • Apartment also included free security, racquetball court, better view, etc.
  • NY real estate agent considered paying a $6,000 per month mortgage in order to receive a $4,000 month rent a good investment property.
  • Cannot cash flow at present prices. How could price go up?
  • General idea: Pass up living in this nice place in order to pay more to live in this dump. After a few years, sell the dump to someone else for even more. Pyramid scheme.
• Regulation failures and moral hazard
  • Most regulated entities, Fannie and Freddie, are the most problematic aspects of housing market.
    • Financed the bubble since government insures their debt
    • How will more regulation help?
  • Securitization causes moral hazard.
    Firms making the loans do not suffer the costs of default.
  • FDIC creates a moral hazard.
    Insured deposits remove any incentive to deposit money in a responsible lender.
    People spend more time researching what TV to buy than where they deposit $100,000.
  • SEC regulation did not prevent Bernie Madoff.
    Madoff should be next Treasury Secretary.
• Pro bankruptcy and low prices.
  • Falling prices are the market’s solution for overvalued, misallocated assets.
  • Low, subsidized interest rates cause high prices.
  • People gamble when they have nothing to lose and so much to gain.
    • Nothing down.
    • Average home buyer expected his home to gain 20% per year for next 10 years.
  • Bankruptcy cleanses economy of misallocated resources.
    Non-performing debt is the caboose slowing down the economy.
• Political inability to repay debts.
  • Gave an example of Obama saying something to the effect of, “You know the social security, medicare we promised you? We can no longer give you that. You need to go back to work and enjoy a far lower standard of living because we need to keep our promises with the Chinese.”
  • Huge laugh from audience, which thought it was absurd. Claims everyone knows the US will not repay. Rather disturbing and sad when you think of the implications.

Inelastic demand means that a person really wants a specific amount of something.

When the price changes each individual has a choice: buy or don’t buy. The more inelastic someone’s demand, the less likely a price change will change that person’s purchasing habits. This works in both directions. Consider a healthy person free of cancer. A doctor cuts the price of chemotherapy in half. Is the person much more likely to buy now? Now consider a person with terminal cancer. He believes chemotherapy will save his life. Doctors double the price. Will this man now refuse the treatment?

On the other hand, consider land. How much land will you buy when priced at $500,000/acre? How much will you buy when priced at $5,000/acre?

Essentially the person who spends $500,000 on chemotherapy thinks he would rather have chemotherapy than 5,000 pictures of Benjamin Franklin, 500,000 double cheeseburgers or a new home.

How does one distinguish “necessities” from “luxuries”? For example, man cannot exist without food, but the price of wheat is probably more elastic than the price of chemotherapy. Does this make chemotherapy a greater necessity? Chemotherapy did not exist a few hundred years ago. It is still inaccessible for the vast majority of humans populating the world. Would/should the top priority for such people be to gain this necessity? Do the choices of acting man buying a cell phone in SE Asia support this idea?

Economics must refrain from valuing one thing as more necessary than another in of itself. Value comes from observing the choices acting man makes. Ludwig von Mises:

The teachings of praxeology and economics are valid for every human action without regard to its underlying motives, causes, and goals. The ultimate judgments of value and the ultimate ends of human action are given for any kind of scientific inquiry; they are not open to any further analysis. Praxeology deals with the ways and means chosen for the attainment of such ultimate ends. Its object is means, not ends.
In this sense we speak of the subjectivism of the general science of human action. It takes the ultimate ends chosen by acting man as data, it is entirely neutral with regard to them, and it refrains from passing any value judgments. The only standard which it applies is whether or not the means chosen are fit for the attainment of the ends aimed at.… it is in this subjectivism that the objectivity of our science lies. Because it is subjectivistic and takes the value judgments of acting man as ultimate data not open to any further critical examination, it is itself above all strife of parties and factions, it is indifferent to the conflicts of all schools of dogmatism and ethical doctrines, it is free from valuations and preconceived ideas and judgments, it is universally valid and absolutely and plainly human.
http://mises.org/humanaction/chap1sec4.asp

Ultimate ends are ultimately given, they are purely subjective, they differ with various people and with the same people at various moments in their lives. Praxeology and economics deal with the means for the attainment of ends chosen by the acting individuals. They do not express any opinion with regard to such problems as whether or not sybaritism is better than asceticism.…
Any examination of ultimate ends turns out to be purely subjective and therefore arbitrary.
Value is the importance that acting man attaches to ultimate ends. Only to ultimate ends is primary and original value assigned. Means are valued derivatively according to their serviceableness in contributing to the attainment of ultimate ends. Their valuation is derived from the valuation of the respective ends. They are important for man only as far as they make it possible for him to attain some ends.
Value is not intrinsic, it is not in things. It is within us; it is the way in which man reacts to the conditions of his environment.
http://mises.org/humanaction/chap4sec2.asp

From his point of view the physiologist is right in distinguishing between sensible action and action contrary to purpose. He is right in contrasting judicious methods of nourishment from unwise methods. He may condemn certain modes of behavior as absurd and opposed to “real” needs. However, such judgments are beside the point for a science dealing with the reality of human action. Not what a man should do, but what he does, counts for praxeology and economics. Hygiene may be right or wrong in calling alcohol and nicotine poisons. But economics must explain the prices of tobacco and liquor as they are, not as they would be under different conditions.

There is no room left in the field of economics for a scale of needs different from the scale of values as reflected in man’s actual behavior. Economics deals with real man, weak and subject to error as he is, not with ideal beings, omniscient and perfect as only gods could be.
http://mises.org/humanaction/chap4sec3.asp