nick baily's two cents

A Tiny Apartment Turns Into 24 Rooms

Favorite video in a long while. New Yorkers could learn a lot from this architect, check out the Optimus Prime impression by the apartment walls: 

 

The Buzz on Google Buzz

If there's one maxim in the world of tech media you can count on it's that when Google sneezes, it's news. So when Google makes a bold move to create a next-generation social media platform, it's really big news. This week's announcement and debut of Google Buzz was met with the expected level of breathless hype and cataclysmic predictions. Longtime commentator and internet celeb Jason Calacanis was among the first to weigh in with an unequivocal first impression:

BREAKING: Google Buzz is brilliant, Facebook just lost half its value.

My 30 second review of Google Buzz:

1. Google Buzz 1.0 is better than Facebook after six or seven years.

2. Facebook’s history is one filled with stealing other people’s innovations and doing them better (i.e. Zuckerberg has stolen every idea Evan Williams and the Twitter team have released). How ironic now that Google has out “Facebooked” Facebook.

3. Google has excellent privacy record and Facebook is a disaster. Most folks do not trust Zuckerberg and Facebook any more because of their privacy record (filled with lawsuits) and because they steal every good idea they see (i.e. Twitter’s innovations and FourSquare’s checking in).

4. Google Buzz auto generates your network–this is MUCH better process than Facebook’s.

5. Google Buzz is way faster than the sluggish Facebook–this is a HUGE advantage.

6. Google Buzz puts relies and updates into your GMAIL as threads–this is BRILLIANT and a HUGE advantage.

Facebook is going to see their traffic get cut in half by Google Buzz.

This really is game over for Facebook because you know Microsoft and Aol are going to copy Google Buzz as quick as they can. In fact, Aol would have a HUGE renaissance if they simply knocked off Google Buzz’s exact feature set. You would than have a reason to keep your @aol email address.

This could actually derail the Facebook IPO. It’s that serious. Facebook usage is going to plummet in the next year or two because of this. There really is no reason for non-game playing people who useGMAIL to log into Facebook.

If Google Ads social gaming to Google Buzz Facebook is 2012’s Pointcast.

Wow…. this is just stunning.

The "Facebook-killer" meme spread quickly (check Google News for proof) but is this revolution, or evolution? Let's take a look at some of the key features, straight from Google themselves:

• Auto-following: You don't have to build or rebuild your friend network, it happens organically as you send and receive email.
• Rich, fast, sharing experience: It pulls together a stream of information from your friends, media, photos, comments, in a dynamic way that feels more like a conversation.
• Public and private sharing: Self-explanatory, though it's hard to see how this is a huge differentiatiator. Twitter is of course public, Facebook is mixed (and a bit opaque on this point), but nonetheless.
• Inbox integration: This is the "killer" that threatens to make this a killer app. Let's face it, how much patience do people have to join yet another social network, especially a very generalist/aggregating one like this. It's a tough hurdle to jump -- but boy does it help to have 176 million unique users a month and a war chest of about $32 Billion in cash. Or so I would have to imagine.
• "Just The Good Stuff": This sounds like marketing hype, and is to some extent, but they're aiming for at least some substance with this point. The social media feed is prioritized, at least according to their claims it shows you the posts and updates you're most likely to read, and buries the stuff you least likely to be interested in. An innovation, but interestingly also something that Facebook ramped up hard as well, just this month.

So then -- what's it like? Well here's a quick overview primer:

   

And their five marketing points above leave quite a bit out. Integration clearly is core to the philosphy, leveraging Google's basket of heavyweight online properties such as YouTube, Picasa, and Blogger. The mobile integration looks to be one of the most formidable aspects to Buzz, when coupled with a GPS enabled mobile phone it enables functions ranging from finding people near you (perhaps a little creepy) to your own private Google Map that's like a bookmarks bar for the real world, geotagging your camera phone shot so you can remember where that little out of the way dumpling place was next time you're in the neighborhood. 

OK, so back to Facebook's 400 million users and near total dominance of the core social network space. Is this a threat, a complement, an eventual also-ran? Here's a little more of what the experts are saying:

Techcrunch sums it up well:

The Battle  

Without having had a chance to play with it yet, it would seem that the core idea behind Buzz is to take on Twitter and Facebook as the easiest way to share content online. Google is offering a number of compelling features such as smart curation (it gets better as you tell it what you like and what you don’t), and a rich mobile experience including location.  

Because of the features it adds on to what Twitter does, and its overall look, it’s hard not to compare Buzz to FriendFeed. That service was arguably the better product than Twitter, but never took off in the same way for whatever reason (though I would argue that simplicity was a big factor). You could say the same thing for Twitter rivals Pownce and Jaiku (which Google actually bought) in the past. But by adding it to Gmail, Google is giving Buzz a great weapon to succeed where all of those others could not.  

The big question is: will Gmail users buy into this quick sharing? Google thinks so because it’s a part of the evolution from email, to IM, to status updates. It’s also, in their eyes, a part of the evolution to the next step, Google Wave. So far, the public has proven to be not ready for Wave yet. But Buzz might be the perfect tool in getting people to think about communicating in a way beyond email and IM. Or it may be another misstep in Google’s social quest.

Core social media news source Mashable is measured, tackling the "zero sum game" question head on, but ultimately concluding that "Buzz Won’t Win the Social Web Without Facebook Integration"

We ought to consider the consequences of Buzz’s relationships with Twitter and Facebook. What are the relationships? Will Buzz, Twitter and Facebook co-exist elegantly or is this a zero sum game with a winner you can place your bets on? 

... 

I predicted at the end of last year that Facebook is well-poised to try to pry web dominance away from Google in 2010. Buzz doesn’t change my mind. Facebook is threatening Google, but Google isn’t threatening Facebook because it doesn’t offer any features so great that they incentivize people to leave behind their existing networks or spend their time updating and following yet another one when their friends are already all on Facebook or Twitter.  Facebook now dominates the social web so completely that it’s difficult to imagine an exodus to a competing service, unless that service offered some revolutionary new features that Facebook couldn’t possibly match — Buzz doesn’t. 

I can picture one other success scenario, though: a service that aggregates other services’ features and content, and then offers up its own set of unique perks (like Buzz’s noise-control algorithms) that make the social web experience better. People would feel comfortable switching for the extra perks, because they wouldn’t have to leave their existing connections behind. 

The outlook could change if Buzz integrates with Facebook the way it does with Twitter. Unless that happens, though, you’re better off keeping your bets on Facebook in the coming year or two — at least if your standard of success is something greater than niche appeal.

And tech guru Kevin Rose is witholding judgement as well:

Not sure where Buzz fits in my arsenal of social media tools, how often I’ll use it, or if it will eventually feel too much like unread email — but I’m happy to see Google taking social media seriously. It’s early days, let the attention/follower wars begin.

Indeed, let the games begin -- my thoughts as well. This was what I wrote late Wednesday night as a first take, before I read what everyone else was saying:

10 minutes in. Snap reaction -- they've got this more right than wrong. It'll stick. I don't know if it's going to kill Facebook. It actually doesn't feel that much like Facebook to me -- but I have this feeling it's going to kill something.

It's a fast moving space to say the least -- in fact just as I finished writing this post I hit refresh and saw two new headlines pop up on (where else) Google News:

"Google Snags Social Search Service Aardvark" 

 and 

 "Google Buzz Surpasses 9 Million Posts and Comments" 

Nine million? Hmmmm.... this story is just a little over two days old. It's going to be interesting.

"A counter argument that has been gaining some ground..."

That's a similar title to the last post, but this blog post in specific drew my attention. 

A counter argument that has been gaining some ground goes like this – if the rich are responsible for so much of the problem, we should work with them to solve it... does this general approach make sense? Is it pragmatic? 

“Most people see this as a reason to loathe the affluent, but wouldn’t it make more sense to see them as an enormous opportunity to create fast and dramatic change for global warming? If the 20% well-to-do offset their CO2 emssions by 50%, that would mean an overall decrease of 40%.” 

Everything within me rankles at this suggestion, but I wonder if I’m just to idealistic? Can the wealthy really just buy us out of this mess?

A very good question. Any new approach is bound to be met with skepticism. But new ideas are never without controversy, and it's heartening to see people who are naturally skeptical give a fair hearing to a novel approach. We're all on the same page -- climate change is almost certainly the greatest existential threat any of us have faced since the end of the cold war. 

It's not going to be easy, but it's going to require open minds and pragmatism, and it's great to see a glimmer of hope that all of us working towards the same goal can recognize that and act accordingly.

Where Pitchfork Meets Keynes

I was having a discussion with some friends in the media and music business recently, specifically about the much-discussed (read: over-discussed) phenomenon where bands emerge and bubble up from the blogosphere and become overnight sensations in a teapot, taking the hipster world by storm, becoming ubiquitous in all the tastemaker places almost simultaneously. Someone commented that this phenomenon is really particular and endemic to the indie rock world -- where there's a massive wave of over-hype and artists are thrust out into the world not even fully formed, subject to a premature "next thing" consensus and an inevitable backlash to come. 

I don't think this is confined to music at all. Political consensus among the chattering classes is probably the most direct and clear example, with so much media, so much airtime to fill on deadline, and so many predictions that "have" to be made in the face of subjectiveness and a major herd mentality. It's also common to quickly moving technology trends (iPhone, Twitter, lots of other gadgets) and even financial opinions (Jim Cramer and Motley Fool come to mind especially). And probably quite a few other things. Just straight old TMZ style pop culture too.

But confining the discussion specifically within the confines of the music business, what I think is interesting is the degree to which the indie rock world exemplifies a certain set of attributes. You don't see the same hyper-"meta" discussions and self referential issues in other genres so much, at least not in my estimation. In straight bubblegum pop you might just as easily have the overwhelming hype and meteoric rise, and even in more esoteric niches like country or jazz or even bluegrass you definitely have flavors of the month, someone who makes a breakout performance at a festival or a last minute substitution. 

As a sidenote -- I actually think classical is a close second to indie in the herd-hype department, with that last example of a last minute substitution and seemingly coming out of nowhere being a great example of how many well known artists -- most notably Leonard Bernstein and Lang Lang, among others -- got their big breaks. And both suffered a torrential backlash several years into their career as well. 

But anyways, the basic concept is pretty well established. What's interesting to me is that in indie rock (which I should make sure to define here as the hipster, Pitchfork, blogger world, etc -- not in the indie=independent sense) it seems to have come to dominate the landscape. 

And of course, it conjures up parallels in economics. Specifically the classic quote about the stock market and investing from The General Theory, by John Maynard Keynes: 

"Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees."

I've always thought this was a pretty good metaphor as well for the worst parts of the hype machine that seems to swirl around indie rock, in the way mentioned above. The issue here isn't that you have a scene that's incredibly dynamic and changing, that artists come out of nowhere and get a ton of hype and then recede. There are plenty of reasons why you'd see those kinds of things happen. For example, another just-as-plausible hypothesis would be that it's an artistic scene that is intensely focused on novelty, hence the quick rise and short shelf life of many such artists. 

But I don't think that's quite it. I think it's the self-referential nature of the whole thing that is the most fundamental attribute. Everyone is looking at what everyone else is doing. In economics or ecology you'd describe it with some concepts from complex adaptive system dynamics, where you have systems or implied algorithms that are self-referential and loop back on themselves, and have both positive and negative feedback loops working at cross purposes. Not too far from the idea Keynes intuited in the 1930's in the quote above. 

So the more hype builds around you the more success you have. That's a positive feedback loop, a network externality. If 10 influential indie blogs plug you then that might lead to 30 more the next month. But there's a negative feedback loop. The more success you have the more you arouse the distaste and backlash of many members of the community. You have everyone looking at everyone else to see what they think before they make up their mind. 

People's opinions of an artist's intrinsic merit are in part based on their perception of who else likes them, what kind of people like them, how many of those people there are, and how long this has been going on. Like in the beauty contest example above, many participants are picking the prettiest competitor at a beauty contest not based on what they personally like, but based on their impression of what they think other people's impression will be. 

So you have two countervailing forces at work -- and the result is the classic boom-bust cycle that has tons of parallels. In ecology the textbook one is watching deer populations skyrocket, then they eat all the available food, and then half of them starve and die. Then they do the same thing over and over again. In economics it's the classic business cycle boom/recession wave in the stock market and economy as a whole. It's the natural outcome of a wicked combination of positive and negative feedback loops, both governing the same variable, in this case success and prestige and "hype." 

Or to simplify: 1) The more successful you are the more people like you. 2) The more successful you are the more people hate you. Pour them together, and you get breakneck change, massive and premature over-hype and massive and premature backlash. Both often divorced from any underlying actual merit of the music in question. Just like financial bubbles tend to affect the good firms as well as the bad, both on the way up and the way down. The truly great stuff endures, but when you're looking at a week to week timetable that boom-bust cycle is all you can see.

I think it's food for thought. The interaction of positive and negative feedback loops in self-referencing systems with network effects is well known in complexity theory to be the driver for some very interesting emergent phenomena, not just in simple rules-based systems but in applied social sciences as well. Perhaps there are some parallels to be drawn in marketing, media, and even entertainment and popular culture. 

Credit where credit is due.

Damm, I should post more often huh. Note to self: get with the program, buddy. 

But this email I just got inspired me to write. If you're going be that guy to trash someone in public, even if it ain't personal and just academic, then you have to give credit where credit is due. This post by Jason Calacanis is one of the most insightful and forward thinking things I have ever read on the subject of online interaction, and its effects of interpersonal and hyper-non-personal relationships. Just read it. 

I remember coming across something that reminded me of the Milgram Experiment last year and thinking that the internet was like a giant accelerant to the basic human condition laid bare by that study. But Jason's taken a vague concept rattling around and crystallized it and made it compelling, personal, and persuasive -- and I suspect may have just kicked off a discussion we'll be hearing more and more about in the near future. 

Quality economics advice? Well we've been over that already. But when it comes to online communities, Jason has to be considered perhaps the most intuitive and insighful expert out there -- if this is any indication. 

I'll be mulling it over for awhile.  

Is tightening mortgage credit the solution?

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...

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. 

Process

"They don't recognize that humanity, developing by a historical, living process, will become at last a normal society. But they believe that a social system that has come out of some mathematical brain is going to organize all humanity all at once, and make it just and sinless, in an instant, quicker than any living process. That's why they so instinctively dislike history, nothing but ugliness and stupidity in it, and they explain it all as stupidity. That's why they all so dislike the living process of life."

- Fyodor Dostoyevsky

Are Capitalism and Altruism Compatible?

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.

Scarcity as the new paradigm

I was trading emails with a very smart friend of mine recently who had this to say:

There is no stopping the growing price of oil over the long haul, and there are no realistic alternatives to an oil-based economy. As a result, in my opinion, currencies over the next 10-25 years will largely be pegged to the value of oil, their dependency on oil / supply of oil, and the resulting health of their economy. Using this as one of many lenses to evaluate opportunities, the US economy is fucked. We have people that commute 80 miles to work in a car.

It's a point of view you're hearing more and more of these days. But I don't agree.

In the short term there is extremely low price elasticity for oil demand. In other words a modest increase in demand causes massive swings in price. It's this dynamic that has been driving the market recently.

However, the world can and will adjust for oil that is much more scarce. As my friend notes above it will make it impossible for people in the US to drive 2 ton SUV's 80 miles to work each day. It will also have major effects on global shipping, just in time business models, massive flows of cheap plastic goods
from Asia, and a lot of other things.

But I would strongly disagree that "currencies over the next 10-25 years will be largely pegged to the value of oil." And I don't think the U.S. economy is fucked. At least not forever.

The next 1-5 years may be rough. I think it's correct to say we've entered a new era of resource scarcity that's not just going to end. But over a 5 year period demand elasticity for oil is non-trivial -- and over a 25 year period almost anything is possible.

There are substitute goods for oil past the short term. There are ways to massively reduce consumption and divert to alternate forms of energy. For some things like air travel it's really hard. For things like home heating oil it's not hard at all.

For auto travel -- which fairly or unfairly tends to get most of the attention, as it's such an integral part of our lives -- it's a medium term shift that requires things like building rail lines, and people changing their habits and where they live.

What bothers me about the gloom and doom set is that I know this can be done in a generation, easily. I know this because we've already done it.

We built the interstate highway system almost entirely from 1950-1970, and we can build its replacement just as fast or faster. If we want to. And when the incentives line up, well then we'll want to.

Let's put it this way, if we could go from most people living in rural areas, to cities, to suburbs, all in about 100 years, we shouldn't be shocked if resource incentives cause another round of shifts over a 25 year
period. That's a long time, it's more than a generation. It's worth considering the change in living habits and demographics from 1925 to 1950 for some context.

The United States continues to be an incredible place for innovation. We have real problems that affect competitiveness (health care, infrastructure, and education high among them) but the economic capacity of the US is still astounding.

Betting that the US will cease to be wealthy and relevant isn't a bet I would take.

I'll pay you to quit.

It's a story that has been forwarded around a lot this week, but I was struck by an interesting philosophy at Zappos. They offer people $1000 to quit after a month -- the idea is that people who aren't committed will take it, but the people who stay will be serious about working there.

I found it here:

I spend a lot of time visiting with companies and figuring out what ideas they represent and what lessons we can learn from them. I usually leave these visits underwhelmed. There are plenty of companies with a hot product, a hip style, or a fast-rising stock price that are, essentially, one-trick ponies‹they deliver great short-term results, but they don¹t stand for anything big or important for the long term.

Every so often, though, I spend time with a company that is so original in
its strategy, so determined in its execution, and so transparent in its
thinking, that it makes my head spin.

My two cents.

Some random thoughts on a Sunday evening, following an interesting discussion I just had. The premise was that the U.S. today looks like Japan in the early 1990's, and that within the next five years the U.S. will be the #3 economy in the world, and just barely maintaining parity with India at #4.

This sentence I think sums up the argument.

The problem is that America has less and less fundamental value to offer the global economy, and this is getting worse, not better.

Let's unpack this idea a little bit.

The United States is the #1 country for GDP in the world with a rough number of $14 trillion.

Next up is China at about $7-10 trillion, followed by Japan at around $4 trillion.

India is number four at around $3 trillion GDP.

As a sidebar - this brings up the question of how to count the EU. You can make an argument that it should be compared as a whole to the U.S. economy, though I don't share that point of view -- for example it seems like similar logic could argue for including Canada in the U.S. figure based on close economic ties and border policies, even if the common monetary policy of the EU is the strongest argument.

Either way, the entire EU comes in at about $14-15 trillion, just a hair higher than the US.

And let's face it, the EU is not a country.

So for India to catch up to the U.S. we'd have to be looking at a five year trend that involves either India growing at an annualized rate of 50% or more a year and/or the U.S. declining at an annualized rate of 50% a year or more.

For reference the worst year of the great depression, 1932, saw a negative growth in GDP of about 13% annualized. And also for reference after 10+ years of stagnation Japan is still wealthy and the third largest GDP country in the world despite its tiny size.

In fairness China is much closer behind, but again, their staggering rate of growth (and it is remarkable, and hard to see as sustainable) is still in the 11-12% annual range. Even starting with an extreme premise it's very hard to see how the current rankings will change in the near term.

But as of today we have heavy, major problems in debt markets, currency markets, job market, and commodities markets, and various other lurking mayhem in the US economy.

It's also true that the economy has been spectacularily mismanaged for 7 years now. One could argue that any looming recession is a byproduct of spending several trillion dollars in national resources on a war that has led to higher gas prices and even more "crowding out" effects in debt markets. Also relevant is a regulatory policy infested with moral hazard issues, and a fiscal policy that seem guaranteed to put pressure on the currency and price level. I could go on.

But business cycle contractions are normal. One thing that's normal about them is every time they happen people go nuts like it's the first time it has ever happened. Much like people thought somehow the rules of real estate had been revoked when they decided to flip houses.

The rules always apply on the way up. But also on the way down. The media tends to gravitate towards the apocalyptic changing of civilization paradigm shifts, but much like it was smart thinking to be bullish but cautious during the bubble, it's equally rash to over react now on the bear side. Same as it ever was.

A new administration, some unraveling of the insanity in securitized debt markets, and it might just start to feel good around here again. In the 1930's people starved, in the streets. Banks failed and wiped out entire communities.

We're still around. It's fun to play mental Mad Max but it's more fun to be an optimist. With every panic lies opportunity.

$.02