Jason Calacanis Made Me Do It

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I'm a big fan of Jason Calacanis, he's one of the most compelling writers out there, smart as hell and never afraid to speak his mind, defend it, and damm the consequences.

He has an email. It says you're not supposed to reprint it, it's just for email. Or maybe not, as the case may be.

The latest one is called "The 120% Solution." It proposes some, shall we say, innovative, ideas for facing our current economic crisis. I'll skip over a bunch to keep it from being too tedious, but let's start at least at the beginning:

Many intelligent people I've been speaking with believe that the
economic crisis facing our country today is our biggest challenge
since America's inception.

This is an oxymoron. Let's compare the civil war, 1950-60's threat of nuclear annihilation, the direct attack on our soil by Axis powers. Or, um… a recession consisting so far of a couple consecutive quarters of negative GDP growth.

Let's pick two random examples:

  • Example A: Civil War – 2% of the entire U.S. population is killed in battle.    
  • Example B: 2008 – GDP is found to be declining at half a percent annualized. Investment banks fail. 

Apparently, my definition of "intelligent people" differs from Jason's. But moving on…

I'm suggesting that, until America takes care of its debt, untangles the housing mess and gets unemployment under control, we all commit to working six days a week. Yep, move the standard 35-40 hour work week right up to 48 hours.

This is actually one of those very interestingly counter-intuitive situations you come across sometimes in economics. Having everyone work additional hours will actually be disastrous to the economy.

This seems impossible and like I said, counter-intuitive. But it's true. Think about the most basic economics, supply and demand.

(visual aid here)

You're moving the supply curve to the right by doing this. In other words, because people are getting paid the same wage but produce more goods, at the same price point there is an additional supply of goods. (We have to assume he's made that assumption rather than talking about hourly workers here getting paid overtime for this extra work, right?)

But the problem in the economy right now is facing drastically falling demand. Or the demand curve is moving to the left. If you think about supply and demand curves you can get a sense of what happens next. A massive deflationary spiral. Google: "Japan's lost decade"

Or to be more colloquial, there's no such thing as a free lunch. Right now we're facing a demand side recession. People are buying less, they are borrowing less, spending less, and reducing the demand for goods. This problem cannot be solved by suddenly and drastically increasing the amount of goods available. The solution presented here is entirely supply-side based. Let's try it and see what happens, we won't like it.

There are many examples of things which are prudent for a single economic actor to do, but are disastrous to the economy in the aggregate. And lo and behold, reading further we come across a couple of the most classic examples:

If you've got credit card debt, pay it down if you can.


If you've got a mortgage, pay it off if you can.

This is part of the problem. So everyone goes to work longer and works harder and makes more stuff. Let's call them widgets, economics types love to call imaginary products and services widgets.

OK, so your team is all in there on Saturday cranking out an additional 20% more widgets. Mind you, they're not getting paid 20% more, just spitting out 20% more goods and services.

Simultaneously, the savings rate is skyrocketing. That's what paying off debt means of course, paid off debt is savings. Since incomes/wages haven't increased, and that money going to pay down debt is no longer being used to buy products and services (or shall we call them widgets?) then people don't need as many widgets and when they go to the store they buy fewer of them.

Meanwhile, thanks to Jason's advice the factory is cranking them out now with far more efficiency like there's no tomorrow. Widgets, stacked to the rafters. 

Are we starting to see what's wrong with this picture yet?

I'll save a pedantic part right here and assume the seven people reading this far down can figure out where this is going. It's called turning a moderate recession into a full-fledged economic collapse.

Interesting advice, but, sadly, severely misguided.

OK, let's skip over some other stuff, and on to the summary:

In summary


What made America great was our ability to innovate and create
world-class products, ideas and services that people around the globe
fell in love with and wanted for themselves.

Can't disagree completely. It's hard to ignore things like extracting resources from nearly every region of the world at the barrel of a gun for 200 years, or the massive economic benefits that accrue from becoming the world's default reserve currency. But innovation's no small part of it either, undoubtedly.

From health care to human rights, from democracy to dishwashers, from windshield wipers to the World Wide Web, from search engines to soda pop, we've accomplished so much by dreaming and rolling up our sleeves.

Heh. We've invented many things. But what I'm most amused by as an American myself is our ability to be so self-centered that we do things like claim credit for most of the world's civilization. Or creating the World Wide Web, say.

Fun facts sidenote, check this out.  (Hint: The "E" in "CERN" stands for European, as in Switzerland, where Tim Berners-Lee, an Englishman, was working at the time. But regardless. We, um, made it great too. Without any help or anything, or something.)

Oh, PS: fun fact number two is that Americans didn't invent soda pop either.

But whatever. Go America!™

We need to put down the remote, cut our credit cards in half and start
new companies with new ideas. Our entrepreneurial spirit and hard work
will get us out of this mess.  All we need to do is release them.

OK, we're at the end here, so let me see if I've got this. Step one: put down the remote and see if you can annihilate the media industry. Got it. Step two: slice up them credit cards and wipe out the retail sector.

Then start a business and sell things to people! Don't start an online business though, as everyone just cut up their credit cards in step two and will need to pay by cash or barter. But work hard.

Because hard work and persistence trumps having a f-cking clue about macroeconomics.

Or so it seems.


UPDATE: Looks like I have some visitors, thanks to Owen. Interesting. I've updated and expanded on a few of the arguments, and counter arguments here.

In which I bastardize the phrase “Corner Solution”

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The End Of American Capitalism

And so on. I think the latest round of ignorant economic arguments have started to drive me a little bit crazy. There’s an ongoing sort of battle in economics, more accurately pop economics, or theories of business and policy, that seems to find it impossible to argue without resorting to what I’d call a corner solution. Or said another way, the “it’s all based on this one thing, and everything else doesn’t matter” type solutions. And to me it tends to be instructive to note who advances these arguments, and what their interests are.

It’s not surprising that the entrepreneur class would gravitate towards a theorist who postulates that said class is the root of all virtue and creator of all value, like a Joseph Schumpeter, or the many others since, and their passel of magazine covers and business books sold in an airport near you.


The entrepreneur class finds this interesting.

As an aside, I most certainly enjoy articles that say people named “Nick” tend to me more attractive and successful. For some reason such arguments resonate strongly with me.

It’s not surprising that the vast classes of salaried employees might have gravitated towards the Labor Theory Of Value. It’s not shocking that as the industrial revolution came into full swing, the allure of communism was extremely attractive for large numbers of people around the world. It postulated that the vast masses were the root of all virtue and creator of all value.


The vast masses found that interesting.

It’s not surprising that people who already had successfully acquired wealth and paid quite a bit in taxes gravitated towards people like Arthur Laffer and supply side theories. It’s hardly a shock that people who the market had deemed to be winners would advance the theory that the market is always right, and that it always distributes resources with perfect efficiency. People like Lucas and Sargent and Friedman on the academic side, or Ayn Rand (god help us all) on the pop culture side said that the rentier class was the root of all virtue and creator of all value.


The rentier class found that interesting.

There’s an entire industry devoted to privatization of everything. They’re not interested in discussing the details, asking if privatizing X really leads to more efficiency. Hard to figure out why, until you notice, of course, that they’re the ones looking forward to getting their hands on the assets. You could argue that the private sector does everything more efficiently. It’s a good way to get a contract providing armed soldiers to the US military at 10 times the cost of just having actual, you know, soldiers do the same job.


The advocates of privatization find that interesting.

It’s sure hard to figure out how these theories spread, isn’t it. The reality of course is that a well functioning economy is created by a mix of inputs. Corner solutions don’t work. Total state ownership of the means of production (communism) strips incentives and leads to corruption and terrible allocation of resources. We’ve established that didn’t work. Well sort of, China hasn’t done too badly lately has it, and they are nowhere near an open economy.



In contrast total privatization leads to a mafia state, an oligarchy of one dollar = one vote. Check out what happened in Saipan and the Marianas over the last couple decades for a good idea of what a privatization and entrepreneurship utopia looks like. It’s not so good.

Here’s a quick two theories, let’s throw them out:

1) Markets are probably the most efficient and effective way of allocating resources and creating wealth.

2) Markets almost never work properly without some oversight and command of state authority.

Here’s the kicker: Ideas #1 and #2 are not incompatible.

Prosperity requires effective flow of capital and capitalists and the ability for people to have incentives to innovate and invest and assume risk and reap rewards. It also requires government intervention where market failures occur (like making sure insurers are properly capitalized, or to break up monopoly situations) and to stimulate things that the private sector can’t or won’t efficiently create because of excessive time horizons, risk, coordination issues, or capital requirements (things like the interstate highway system, the internet, air traffic control, etc, for example).


It also requires a properly compensated, healthy, educated, and stable workforce. One that’s able to make rational decisions, live with some risk mitigation to income or life events, and not constantly subject to monopsony pricing of their wages. Not only does it lead to increased efficiency, and greater wealth for all classes, it does have the not at all insignificant side effect of keeping those excluded from the economic system from scaling the iron gates and running up on the lawn with guns drawn. As they say.

It’s been an amazing and historic week. An inspiring one, no matter which side of the aisle you’re on. I would hope. But it’s sad to see that the same tired arguments prevail, on the right, but on the left as well sometimes.


Capitalism is dead. Long live Capitalism. No we can’t have national health care it’s socialist. Multi-national corporations are evil. All rewards are due to the innovative class, labor is valueless and fungible.

And so on…

The reality is that entrepreneurs, bankers, investors, academics, inventors… and yes, government regulators, bureaucrats, factory workers, and cashiers all contribute to prosperity. All or nothing attitudes are kids stuff.


Or more often, the refuge of those who have a vested interest in advancing the interests of the group they most identify with. As it’s been said, It is difficult to get a man to understand something when his salary depends upon his not understanding it.

And now, I will blog about a story about blogging.

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Or more accurately a story about blogging as it relates to real estate, that ran in today's New York Times. 

Yup, that's me. I remember vividly — this must have been more than a few years ago — listening to my friend Jason Calacanis say something to the effect of "If your company doesn't have a company blog you're an idiot. Every company must have one, and it's one of the most efficient and effective ways of communicating with your customers. If you're not doing it, it's a giant missed opportunity." Or words to that effect. At the time I figured it might have been a bit of hyperbole, and of course at the time Jason's day job was building and promoting a company entirely composed of blogs, it wasn't a neutral point of view. 

But it was a comment that really stuck in my head for awhile. How? Why? Do people really care and want to read what's effectively a newsletter? Learn about your office party, or how excited you are about your new product rollout, or what you think about your industry, or the latest interesting article you read somewhere?

The answer is yes, and I think Jason (yet again) has proven to be highly prescient. I guess it's the same thing I said in the story that leads off this post. It's a way to really communicate with your audience in the first person, it's a medium well suited to a unique mix of information, opinion, and personality. When a blogger is well informed and has the background necessary to contextualize information it's one of the best ways to keep your finger on the pulse of some thing, someone — or some company. Your company. A concept anyone with customers, and prospective customers, would be wise to consider.

The concept is not new, but apparently, it's still news.

Is tightening mortgage credit the solution?

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Here's an interesting premise:

What if we slowed lending on purpose, what if we decided there wasn't any good reason to make it easier to buy homes? What if you had to have 30-50% down to buy a home? What if you had to show real income to get a mortgage again? What if you needed revenues for bank loans again? Would that be so wrong? Would it be a hardship?

In Europe folks need 50% down for homes. Perhaps too much, but 0-10% is clearly too little.


That's an interesting and often unexamined question. It's taken as gospel that we (meaning the government and public policy) should do everything possible to make it easier to buy a home. But isn't that what got us into the problems we're facing now? Doesn't that inevitably lead to a bubble?

I think the answer is no, or not necessarily. What if we just went back to the same system we had as recently as, say, 1995 or so? Historically it was typical to have about 20% down, maybe 10% sometimes, interest rates weren't kept artificially low by a Fed determined to flood the economy with cheap credit, and the people who wrote mortgages actually had their own money on the line if it turned out that someone couldn't make the payments, so they'd actually have incentives to make smart loans.

The concept of "disaster capitalism" may be applicable here. Perhaps not in the crash, but in the response to it. 

Market fundamentalists thrive by taking a system that has worked well and been stable for decades, with a solid private sector overseen by effective regulation, and then dynamite it. Then everyone stands around saying well the system failed, we have to do something new. So let's frame the debate with various pet theories and ideas, which we just happen to have studies and white papers for. 

For some reason people find it hard to just let's look back at what the system was before it went to hell, see how it changed, and do our best to change it back to the system that seemed to work for decades. Often the previous set of standards and regulations was hard-won, with small adjustments and tweaks over years each responding to one or another problem that had cropped up. 

From about 1945-1950 through the late 1990's the credit system both for mortgages and small business lending was for the most part relatively stable, with the notable exception being some shocks in the 1970's, and of course the S&L crisis, which eerily echoes the current one, with very similar underlying causes. Still though, despite occasional severe hardship it's fair to say most of our previous problems fell well within standard business cycle limits, and in fact the boom/bust cycle seemed even to be flattening out by the mid 90's.

And most notably, perhaps, is that the residential lending market has never — in the modern era at least — threatened to take down the entire commercial banking system. This in fact is unprecedented. 

But what's wrong with using a system that developed over time and with lots of tweaking, and worked pretty well? The reason to require 20% on a residential purchase is that to align the borrower and lender incentives, and it does that job fairly well. The borrower stands to lose real actual out of pocket money if they overpay or otherwise can't afford and end up in foreclosure. The bank is insulated from all but the worst swings in value and the primary risk stays with the borrower, who after all is actually the person buying the house and assuming the risk. 


If the bank wants to allow a lower down payment they can demand higher returns to compensate for the higher assumed risk. As long as they actually face that risk we can assume banks are competent enough to demand an appropriate risk premium. The bank faces risk of non-payment but it's mitigated by the equity component, or compensated for by higher rates. As far as bundling and selling the loans that's even fine too if there are provisions that keep underwriting risk actually with the underwriters, or are subject to strict and clear standards that amount to a defacto "re-underwriting" by the mortgage purchaser. This is the model — in theory — that justifies the existence of Fannie and Freddie. To allow banks to do what they do well, lend to their local communities, by repurchasing mortgages and freeing up the bank's capital to be able to lend again. 

  
But the "problem" that's endangered our financial system I think is still pretty mis-understood in the common discourse. There's much talk about mortgage backed securities as the root of the problem. I'd even say that when CNBC or the talking heads go on about "toxic paper" most people assume they mean these large bundles of residential mortgages. But bundling mortgages into securities was popular back in the 1980's too. I suspect many have read the book "Liar's Poker," where that innovation figures heavily. The concept is hardly new.


The "real" problem in my humble opinion was the swap market that rose up this time, in parallel with the CDO/MBS market. And the roots of this can actually be traced, possibly to a specific date, December 15th, 2000. Here's a quick backgrounder.  

These swaps, as practiced in the MBS market, were insurance. Period. They were an agreement to pay for a security if that security defaulted. There's no way these MBS instruments could have been sold so easily by the investment banks if they hadn't also been offering insurance. 

It was a great deal for the buyer — hey I'm buying a bundle of mortgages that may or may not work out, but I have insurance on it, so if it doesn't pay out I still come out OK. What can I lose? 

Well if the MBS buyer isn't assuming the risk who is? Of course, the investment banks. But an MBS buyer thinks well what are the chances that Lehman is going to go out of business right? Inconceivable. I'll come out fine, and I don't have to consider my MBS portfolio risky, it's insured.  

But unlike insurance the swaps weren't regulated like insurance, which was not an accident as outlined in the link above. But they were insurance, and  there were no adequate capital reserve requirements. So the exact thing happened that you'd expect. Imagine if State Farm took all the premiums they get for homeowners insurance and called it profit and paid it out in dividends and bonuses. Then a hurricane comes along and with a couple billion in policies to pay out and oops, sorry we don't have that money any more.

Which is why insurance policies are regulated. Swaps weren't. They underpinned the sale of mortgage backed securities. Without those this would never have gotten so out of control, without that assurance the funds could not have flowed into the MBS market in such quantity.

And it all trickled down to main street as money just flooded the market.

But the solution isn't all that complicated. What we had before worked. 


The people taking out these risky mortgages were behaving rationally. There was free money being given away. Of course people took it. They had tremendous upside risk and little to no downside risk. And in many cases these are people who had no other obvious path to escaping their lot as medium level wage earners. This was the clearest and most direct path to wealth most people could see, and in fact an entire industry was built up to exploit this concept. Remember seeing a "make money in real estate with no money down" commercial when you're jetlagged and flipping through channels late at night? Of course you do. 

But the investment banks writing these swaps that were not being rational. That's why they were wiped out completely. There are no more standalone investment banks. Now a public policy type might say this statement falsely presupposes a "Rational Actor" which in this case is the bank itself. In reality the people actually making the decisions may well have been rational, they themselves lieke the borrowers above were also insulated from downside risk. Heads I make a ton of money, tails I lose my job, but still have a lot of money. But as institutions the investment banks behaved in a way that precipitated their failure, hardly something you'd consider rational. 

But borrowers and lenders are of course capable of being rational. Most of the time, for much of history, they have been. And it's not really that hard to go back, it just requires financial regulation that doesn't allow people to assume risk that they are not adequately capitalized to take on. 


Ensuring proper capitalization and reserves has been the entire freakin' point of financial regulation since the Great Depression. This just didn't happen, these results were predictable, and in fact were well predicted by some. But it's not like there's a need to throw out the entire basic system. Just recapitalize and do it right this time. Again. 

Bubbles, they always seem so novel…

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So the talk over the past weekend has been deafening and all on one subject, the Paulson proposal to inject $700 billion dollars directly into the financial sector with no oversight or accountability or review whatsoever. It's beyond what anyone might call a "nuclear option."

Here's a sample of the kinds of discussions I found circulating over the weekend:    

The real problem is that the underlying assets are sharply overvalued due to liberal bank credit schemes from the 2001-2007 real estate bubble. People with no savings, bad credit, and low income could buy $250K to $500K homes. If banks are unable to finance the crazy prices that people pay for homes, then home prices have to come down equally sharply.

Paulson may be able to save banks from some of their stupidity by loaning them $700 billion, but the reality is that this is a $7 to $10 trillion problem, if not greater. 

How is a 10% bailout going to help anything or anyone? Is it not slowing down the inevitable for a six month soft landing at the taxpayer's expense?

If banks can't continue to lend in the crazy format of years past, how can home prices not deteriorate exponentially? If housing prices continue to drop, banks will not be able to continue to lend due to rational reserve requirements. How will banks with no lending capability dump the foreclosed assets that they hold in mass, keeping in mind that houses deteriorate quickly without maintenance? If they sell these foreclosed homes to the government, won't the government dump them for pennies on the dollar and tank the housing market

 

Well in my opinion it's even worse than that description. Paulson's proposal is not to "loan" $700 billion dollars. It's basically to just hand it over. And it happens whatever terms he sees fit with no review or accountability whatsoever. It is quite literally insane. It's more than the entire defense budget, more than our entire social security payouts for the year. All to be given to one person with no real restrictions whatsoever on what he can do with it, with the express purpose of basically just handing it to Wall Street firms. 

It struck me as insane, so literally and unbelievably crazy that I found it odd over the weekend to think that he wasn't literally laughed out of the room when he proposed it. It's the kind of thing that you'd think would cause armies of torches and pitchforks to descend upon the Capitol en masse.

We've all closed on a real estate transaction or worked up financing for something right? Can you imagine a $700 billion dollar deal sheet with the terms on 4 single spaced sheets of paper saying essentially: here's all the money, have fun, and there's no recourse to courts or anything else if we don't like what happens. It sounds alarmist but that quite literally was the proposal.

Thankfully, and somewhat to my surprise, people actually seem to have figured this out and the plan is going to be dead, or amended. As a gambit though it was classic disaster capitalism. Create a crisis and then act like we have to do something right now that gives massive power and money to the people responsible. As they say, it's not a bug in the system, it's a feature. It's the point, it's how this philosophy works.

But returning to the above it's not just a $7 to $10 trillion dollar problem. It's much bigger than that even, by far. It's not just mortgages, the total value of credit default swaps is well over $50 trillion dollars (yes, as much as five times the entire US GDP) and as far as I can tell — and I'm far from a complex securities expert — many of these were traded/exchanged with no regard to the counterparties ability to pay. So it appears there are companies "insuring" perhaps $100 billion in default risk, when they have nothing like that kind of money if there in fact is a default. It's madness, again it's hard to believe it really happened this way. But here we are.

But again, it's interesting to read the discussions of how this all relates to the real estate market as I still think it represents a classic fallacy, which loosely translates to the idea that 1) The problem is primarily based on home prices, and 2) The lack of liquidity and a newfound unwillingness to lend is a main culprit.

Indeed, prices of homes are always affected by access to capital, and bank willingness and ability to lend. But at the end of the day — always — the prices of any asset reflect underlying demand. Sure, housing prices rise and fall by interest rates. But the question is why? Because interest rates help determine monthly payments. And people buy houses based on a calculation of what payments they can afford, guesses as to their future income, and perceived value of being able to actually use and live in the property (ie rental equivalence). Of course as we know the housing bubble installed another variable — perceived appreciation. That's always been there but in this last market that became dominant. Which as we've seen is a problem.

I think it's actually pretty instructive to put this in the context of another bubble we can all understand and remember from the not too distant past, the dot com bubble. Stock prices and home prices have some similarities. Much like the price of Pets.com stock was based on the idea that someone else would be willing to pay more in the future for the stock, the same was true of a lot of marginal real estate. When capital dried up — and it did — I'm sure we all remember CEO's saying that the business was on track to be successful but recent developments in the market have made it impossible to continue. Remember all those homepages that had a note to that effect?

BubbleTech.com is sad to announce we are ceasing operations, even though we had a great product and lots of users the current climate has made it impossible to finance continued growth, so sorry to everyone.

Ummm… sure. But the reason Pets.com had problems at root was not that it lost access to capital. To channel my friend, the brilliantly blunt Phil Kaplan for a minute the reason was that nobody wanted to buy kitty litter over the internet via UPS delivery at a price that could make a profit. The underlying model was, in the parlance of the time, f*cked. Completely.

There was no relationship between the value provided by the company and the value people perceived from it and their willingness and/or ability to pay.

What does that have to do with houses? They're pretty similar actually. Sure, problems with lending are an issue. Just like in technology, where in late 2000 there were undoubtedly actual good — meaning potentially profitable — ideas that could not get funded. Right now there are no doubt people with willingness and ability to pay who are having trouble getting a mortgage.

But as a rule, housing values relate to income and perceived value (demand) and availability and quantity of housing (supply). Some things don't really ever change much. When housing prices got so out of kilter with income and rent equivalency then they were inevitably bound for a crash. That's just the way it is. Just like when dot coms spent $1 to get $0.50 back they were f*cked. Period.

But in housing, like all markets, at root there are market clearing prices. In fact probably quite a few of these mortgage backed securities have value. Because of the way they structured them (ie first loss provisions and tranches) many of them, literally, are valueless. But some will have value. Many of these foreclosed houses have some value.

So yes, there are market clearing prices for real estate, though a discrepancy between buyer and seller expectations can demolish liquidity, compounded by a credit contraction. Nonetheless things are falling fast — but they won't fall forever. Housing prices will probably fall to rental equivalency, overshoot, and then stabilize. Of course it's a moving target as incomes (demand) can drop too during a recession, but still, it's inevitable.

But the banking crisis involves a lot more than just residential real estate and mortgage backed securities. The debt insurance market dwarfs this problem. The reality is that the losses have already been made. People essentially spent on borrowed money, through HELOC abuse and equity withdrawals and the like. It propped up the economy for awhile, but that's over.

But to reference a phrase that was going around quite a bit this week – the fundamentals of our banking system are weak. I think there might be a chance that a good treasury plan will involve recapitalizing the banks (by giving the funds but taking equity in return, which is mandatory and insane that it was not part of the original plan). That kind of capital infusion could indeed work just fine. It could make the banks solvent, and return the economy and sector to some sense of rationality.

But housing prices got too high when they were decoupled from rent equivalence and incomes. Just like dot com stock got insane when it was decoupled with standard notions of profitability and return on investment and revenue. And to keep the metaphor going many people made money in technology during that time. And there will be much money to be made now in real estate for smart people. But the sector will contract and housing prices will continue to fall (in real terms — the idea of inflating our way out of this is another issue, and another 2000 word post). But that aside there's no other way for things to go.

That's a good thing. It just sucks for everyone holding the bag this month.

Are Capitalism and Altruism Compatible?

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Now there’s a light topic.

Or perhaps to state it another way, is being altruistic compatible with acting in your own self interest? Aren’t those two things diametrically opposed?

Or to get to the crux of the matter, can a market based approach be compatible with the goal of advancing the common good? Short answer: yes. For my stab at a long answer, see below. Of course, it depends on how you look at it.

I’ve been meaning to follow up on some of the ideas raised by the Prisoner’s Dilemma issues in the last post, so let’s start by rushing to the conclusion, with a quote from Mario Henrique Simonsen:

Moreover, as game theorists have shown, the ruthless pursuit of self-interest often results in a comparative loss for everyone. Game theorists often appeal to what is known as the Prisoner’s Dilemma. Typically, the Prisoner’s Dilemma provides an example of a situation in which two people are faced with a choice about whether to act in a self-interested way or altruistically, and the example shows that both come out ahead if both act altruistically. Peter Singer gives an interesting variation of this dilemma in The Expanding Circle. Imagine two early human hunters who are confronted with a saber tooth tiger. If the tiger chases them, the tiger will only be able to chase one of them but will have at least a ninety percent chance of catching and killing the one that is chased. If both stand their ground together, there is only a very small chance that the tiger could kill either of them. If both hunters are narrowly self-interested, they will both flee in order to save their own skin and there is a fifty-fifty chance for each hunter of being caught and killed. If, on the other hand, both are altruistic and both stay to help the other hunter, then in fact both will benefit. In some situations, in other words, individuals actually derive more benefit by not being self-interested!

Let’s build our own sabre-tooth-model then. There are ten people who believe in cooperation in one village. Ten who only act in a ruthless and caricatured version of self-interest in another village, on the other side of the river. In each, along comes a saber-toothed tiger that’s hungry. Assume that the tiger only needs to eat one person a day to be happy. Assume that the tiger is faster than any given person. Assume that the tiger is really tough to kill, but 5 people could do it together if they try hard enough.

Day one. Tiger comes. In the first village someone gets eaten as they are caught surprised. In the other, everyone runs instantly. The slowest is killed. In the first village, they get together. The fastest runners decide also that everyone will work together, the next day they gang up and try to kill the tiger. They may lose another one or two, but he’s dead eventually. In the other village, the tiger comes each day and kills the slowest runner. Two weeks later, every single person is gone.

Aha.

So one responds — banding together is not altruism, obviously, since if we don’t do it we all die, so the other village (who act only by ruthless self-interest) would have done the same thing, they say. They’d just do it for a different reason, because it’s also in their self interest.

But how? Nobody knew he was coming back the next day. Or any given person could have just run, and hoped that 5 others were able to kill the tiger and they would have avoided all risk.

Ok, so how do you deal with a system of rewards and penalties that is infinitely more vague and complex than this minor example? People can’t predict the future, they have to make assumptions. You cannot make an absolute case for self-interest against altrusim, because you cannot absolutely define which is which.

In short, one learns how to balance altruism with self interest. Or more accurately, one learns that rational self interest — and hence market based solutions — isn’t the opposite of altruism, with community, or with banding together to solve common problems.

If you view the above example through the prism of markets, and as an example of a market rendering judgement, the results of the invisible hand of said market are clear.

In one group everyone banded together, saw the oncoming existential threat to their entire community, and decided to do something about it. It didn’t necessarily require the authority of command, all it took was the collective realization that the community would live or die by tackling the problem together. In the other group people refused to recognize the threat they faced, or argued that it wasn’t rational for them individually to expend energy to face that threat. They ceased to exist.

When people talk about capitalism and markets that’s just another way of talking about incentives.

There’s no rule that says that self-interest has to be short sighted or blind. There’s nothing magical about markets. But there’s something very powerful about them, they present incentives and with lighting speed they channel resources towards those who adapt and thrive most efficiently.

As we face upcoming existential threats — global climate change for example — it’s comforting to remember that we’re all descendents of the first village, by definition. The second village didn’t make it.