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?

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.

David Beckworth outlines the case for benign deflation:

an increase in the growth rate of productivity or the labor supply should raise the natural rate of interest and create deflationary pressures. If, however, monetary authorities attempt to offset the deflationary pressures by lowering the policy interest rate, they may force the real interest rate below the natural rate and create an unsustainable credit boom. The resulting macroeconomic disequilibrium will be manifested in unwarranted capital accumulation, excessive leverage, speculative investments,and inordinate asset prices

Every year we make more cars than we destroy. We make more homes than we destroy. This increases the supply of goods. Increased supply lowers prices. So the price of these goods should fall.

The Federal Reserve is afraid of deflation. They are not limited to changing interest rates. The Fed might print money. Who gets the money first? Bankers.

Bankers spend this new money, increasing demand. Increased demand raises prices. This lowers the value of our income and savings. So the gap between rich and poor increases.

The Federal Reserve and inflation help some, but hurt many more. Celebrate falling prices. End the Federal Reserve.

Eric Knight argues for a deflationary default of HSBC’s sub-prime debt:

Knight Vinke, the activist investor, told The Times last night that HSBC should refuse to pay the bondholders that fund Household’s business, which it estimated would save the bank an estimated $35 billion. (£23.6 billion).

Eric Knight, Knight Vinke’s chief executive, said: “Why should HSBC’s shareholders take all the pain when these [Household] bondholders are unsecured?” To do this, HSBC would have to threaten to allow Household to take Chapter 11 bankruptcy protection.

So far shareholders have taken almost all of the losses. Why spare bondholders? Defaulting on debt is deflationary.

Will consumers use debt correctly? Steve Waldman thinks they will make mistakes. The same mistakes Wall Street makes with leverage:

Consumers, like Wall Street quants, may inadequately extrapolate the distribution of their future income from recent observations. They have no access to the true distribution. The interest rates consumers pay for unsecured credit (think credit card rates) are often several times what they receive on money they save. In the world as it is, consumers ought to borrow only to counter severe downward shocks to income, pay off borrowings quickly, and build buffers of precautionary savings, since the cost of dissaving is much less then the cost of borrowing. (You lose 4% interest on your CD, rather than paying 12% interest on your credit card.)

Is debt a social security net? This is Waldman’s argument. A credit card gives you security. You can buy things when you lose your job. Pay the debt back when you get a job.

People don’t repay their debts. People do not use debt as a safety mechanism. Larger incomes cause larger debts. People use debt to optimize.

People use debt to live and invest beyond their means. Say homes appreciate at 10% per year. A person with a $100,000 home can make $10,000 a year. This same person may be able to borrow money for a larger home. He might borrow $500,000 at 5% interest. He buys a $500,000 home that gains $50,000; he pays $25,000 interest. He makes an extra $15,000. This person used debt to optimize his gains.

Optimization is not always good. Optimization comes with risk. The person is optimized for home appreciation; he is vulnerable to depreciation. Instead of losing $20,000, a 20% loss will cost him 100% of his capital: $100,000.

Millions are learning this today. It is a hard lesson.

Lower your debts. Lower your spending. Save.

Will bailing out Ford, GM and Chrysler help increase your income? Eugene Fama finds this unlikely:

Bailouts of auto firms will be financed with government debt. The government deficit gets larger; that is, government savings, GS, become more negative. If private and other corporate savers do not save more in response to additional government debt, the auto bailout displaces productive investments elsewhere. If private and other corporate savers do save more in response to additional government debt, private consumption must go down by the same amount. This lost consumption and investment, and the incomes they would create, are the big costs of a bailout.

Other stimulus programs are no different:

Like the auto bailout, government infrastructure investments must be financed — more government debt. The new government debt absorbs private and corporate savings, which means private investment goes down by the same amount.

The government can allocate resources to auto-workers. These resources are unavailable to electric-car manufacturers. The same thing is true for teachers.

Is allocating resources away from electric-car manufacturers a good idea? Is it better to allocate them to teachers or Ford? These are hard problems.

Government tends to screw things up. Misallocated resources reduces your standard of living.

Will Obama’s deficit spending plan keep unemployment below 8% in 2009? Gary Becker does not think so:

with unemployment at 7% to 8% of the labor force, it is impossible to target effective spending programs that primarily utilize unemployed workers, or underemployed capital. Spending on infrastructure, and especially on health, energy, and education, will mainly attract employed persons from other activities to the activities stimulated by the government spending. The net job creation from these and related spending is likely to be rather small. In addition, if the private activities crowded out are more valuable than the activities hastily stimulated by this plan, the value of the increase in employment and GDP could be very small, even negative.

Maybe the government decides to borrow more money. Maybe the money is spent building a bridge. Were the bridge-builders unemployed? Keynesian economists assume they are. Good engineers may already have a job. Hiring them does not help employment. Other people are still out of a job. They might be poor engineers.

What if no one wants the bridge? Bridges to nowhere do not help the economy. Building a bridge creates debt. Repaying debt prevents other activity.

Job creation does not fix things unless the jobs are productive. Ron Paul:

The goal of a healthy economy is productivity. Jobs are a positive outcome of that. A “job” could be to dig a hole one day, and fill it back up the next, or perhaps the equivalent at a desk. This does no one any good. But the value in that paycheck ultimately has to come from taxing someone productive.

Imagine someone wants a well. Digging a hole for the well has value. Imagine another person dug a hole in someone’s driveway. The effort it the same. The hole is less valuable. It may have negative value. The effort was not productive.

Effort is orthogonal to value and productivity.

Microsoft reversed its decision to lease property in South Lake Union:

Microsoft confirmed Wednesday that the software behemoth will not lease Vulcan’s 2201 Westlake building in Seattle’s South Lake Union neighborhood, as many local real estate brokers assumed.
[...]
At 302,000 square feet, 2201 Westlake accounts for less than 1 percent of the 40 million-square-foot Seattle office market

The commercial real estate industry plans to add another 2.5% of space on top of this in 2009:

[...] Vulcan’s project will be competing for tenants against Schnitzer West’s 660,000-square-foot 1918 Eighth building and Touchstone Corp.’s 500,000-square-foot West 8th building.

All this extra capacity will place downward pressure on lease rates. This will make things difficult for over-leveraged commercial real estate speculators. On the other hand businesses need affordable leases:

Businesses need lower prices to stay solvent and avoid laying people off. Lower lease and purchase prices for commercial real estate will make it much easier for someone to grow a current or start a new business and employ people looking for a job.

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