From the Mind of Trevor Stone

I remember thinking, in 2010, that the stock market was likely to rise for a while after falling precipitously in 2008 and 2009. I also had a significant chunk of cash (earning really low interest) from five years of living below my means. "I should do some research, figure out how to actually buy stocks, and invest a bunch of that cash."

With the exception of maximizing 401(k) contributions, I didn't do that research and didn't invest anything. Partly this was because I had a continual sense of "I might decide to buy a house in the next two years," so the chance of losing a bunch of money due to market fluctuations was unattractive. But mostly it was because I like to do a lot of research to understand significant decisions and financial research is both endless, in the sense that there are thousands of securities one might invest in and their prospects change frequently, and boring, in the sense that finance takes everything that's interesting and unique about companies and governments and human decision making and reduces them to a whole bunch of numbers about the past and present accompanied by verbose disclaimers that past performance is no guarantee of future results.

It turns out that not investing in the broad U.S. stock market in 2010 came with a significant opportunity cost: the S&P 500 has roughly doubled in value in the last 5 years. International stocks haven't done as well, with non-U.S. developed markets growing around 4% per year and emerging markets growing by less than 1%. Had I invested $50k in 2010 in half-U.S./half foreign indexed funs I would today have about $30k more I could spend on a house (which I'm still not ready to buy). [It's not totally clear that not investing was a terrible decision, though. I spent much of the energy I could have devoted to poring over financial data becoming a better software engineer and making friends and having fun. The total future outcome of these activities in terms of future salary and well-being may well be worth tens of thousands.]

In December I happened to be looking at charts of the S&P 500 over the last few decades and noticed that the shape of the graph has a recent slope comparable to the slopes leading to 2000 and 2008, but with a present value significantly higher than when the market crashed in those two years. I spend a lot of time at work looking at graphs of web traffic and server performance, so a graph shape that matched historic trouble zones looked worrying to me.

After a checkup on and a rebalancing of my 401(k), I set out to the book store in search of a sensible volume educating readers how to invest in the market. My selection criteria mandated a copyright date after 2009, figuring that a book without the lessons of the worst financial crisis in nearly 80 years would be an incomplete read. Fortunately, there's a new edition of A Random Walk Down Wall Street by Burton G. Malkiel. This book argues that investors (particularly average folks) can achieve no better return, over the long term, than to put their money in a low-cost fund tracking a broad stock market index. When the book was initially published in the early 1970s, one couldn't actually invest in the market as a whole (short of buying a few hundred stocks, which a person with modest means can't do). Malkiel's advocacy of this strategy led to the creation of mutual funds based on indexes like the S&P 500 and the Russell 3000.

The reasons for the primacy of an indexing approach to investing are several. Perhaps most fundamentally, the demand for securities which outperform the market exceeds the supply of such securities. With demand exceeding supply, prices will rise until the securities are priced so high that they no longer outperform the market.

More concretely, in order to outperform an indexed fund, the total returns of the security must exceed the index by more than the cost of maintaining the fund. This cost is expressed as "expense ratio" in mutual fund documents and represents both payments to the people responsible for selecting the components of the fund and the transaction cost of buying and selling the underlying stocks when they become attractive or no longer attractive. Index funds of U.S. stocks often have an expense ratio below 0.1% while actively managed mutual funds typically have an expense ratio between 1 and 2%. So to outperform the market, an actively managed fund must not do better than the average stock in the index but must do so by one or two points. Assuming an average return of 10% for the broad market, an active fund must provide a 11 or 12% return; in other words they must be 10 to 20% better than the average. Among professional investors, it would be surprising to find individuals who are consistently 20% better than their peers. And in years when the market goes down across the board, you lose more money the higher your fund's expense ratio.

In addition to the core point of index-fund investing, A Random Walk covers a fair amount of ground in financial education. Malkiel starts by explaining several historic periods of rapid growth and sudden decline in asset prices from the famous Dutch tulips in 1637 through the global financial crisis in 2008. He then explains two general approaches to investing: Castles in the sky, also known as technical analysis, is focused on figuring out what price people are likely to pay for something in the near future, even if it's much more than the asset is worth. Firm foundations, also known as fundamental analysis, focuses on determining an absolute value of an asset based on facts about it, like how much money the company earns. Malkiel then argues against these approaches, proposing instead the efficient-market hypothesis. He uses both the theoretical basis of EMH and plenty of academic studies and comparisons of historical returns to make the case that long-term, low-cost index funds are the best investment vehicles. You can't beat the market, he argues, but you can match the market. And the market, over any long period in history, has done significantly better than other types of investments. The market doesn't need to be efficient for indexing to be a good strategy.

A Random Walk also has several chapters of practical advice on how to go about investing in the market. Though the book is primarily focused on stocks, Malkiel explains how to understand other types of assets and create a diversified portfolio. He discusses how to plan for situations when cash flow is needed like retirement and major expenses. He also broadly covers the impact of tax on investment returns (essentially: invest as much as possible in tax-free accounts like a 401(k) or IRA to take full advantage of compounding and reinvestment of dividends). Finally, he gives his thoughts on the near-term prospects for investing: the stock market is unlikely to grow at the rate it has for the last several years but will probably continue at a modest growth rate, less than 10% total returns. With low interest rates (though the Fed is expected to slowly start raising them), most bonds will not be very attractive for a while.

Having read the book, I've spent much of my free time in the last several weeks working out an investment strategy for some of the pile of cash sitting in my bank account. There are a few tricky aspects to this. First, my high tax bracket as a well-compensated programmer combined with historic low interest rates means that income-producing assets like bonds in a regular brokerage account would produce returns only slightly better than a certificate of deposit in an insured bank, meaning that interest rate risk leading to a decrease in the value of a bond fund could lead to a loss of money. So much for diversification of asset classes.

The second problem I'm encountering as I scour available ETFs is that recent security valuation history seems somewhat at odds with global economic trends. U.S. markets have doubled in value in the last five years despite stagnant conditions for the median American household. As one would expect, foreign developed markets haven't grown much, with the slow-moving Euro crisis playing a large role. Yet with most of the world economic and population growth growth coming in emerging markets in the last ten years (leading to the creation of acronyms like BRICS), emerging market stocks haven't been rising accordingly. One interpretation of these trends is that "emerging market growth" is mostly about folks in the third world having more money they can spend on products made by multinational companies based in the U.S.A. Another interpretation is that a lot of this economic growth is occurring among companies not (yet) listed on stock markets. While I think that's a great trend that may support sustainable communities, as an investor it's much more difficult to take advantage of ("obtain exposure to") such growth. A third interpretation is that the Giant Pool of Money went looking for the next target after the housing, commodities, and debt markets collapsed and the Pool decided that U.S. equities had the best chance for returns. As the S&P graph flattens out, the Pool may head off on the next quest for above-market returns, leading to a decline in U.S. markets and unhealthy growth somewhere else.

So what am I going to do about it?
I'm contributing as much as possible to my tax-free 401(k) with a several-decades-to-retirement allocation. That's the easy part.

I still think it's likely that I'll buy a house in Boulder, with a target date of 2018 or later to allow my sweetie to establish a stable job, reducing the risk that we'll decide that we need to live somewhere else. Three years is too short a period to rely on positive stock market returns, so I'm going to keep most of my pile of cash invested in cash.

I'm planning to take some cash and sell some company-granted stock (which has grown in value but isn't well diversified and can only be sold at certain times) and invest it in a variety of index-tracking exchange-traded funds, which are much like mutual funds but requiring smaller tax payments when not held in a tax-free account. I've spent several dozen hours this month looking at graphs and numbers and portfolio distributions and holding lists and building a spreadsheet. And due to the paradox of choice and information overload, coupled with the uncertainty of returns of a random-walk market, I'm not sure my plan is much better off than it was before.

My plan so far involves investing 45% in U.S. markets, 25% in the "All non-US companies" index plus major developed countries (which make up the bulk of the all-world index), 20% in emerging markets, and 10% in real estate investment trusts. Typical investment advice for someone my age would suggest 20% bonds, but with low interest rates and high income tax, I don't think bonds will be a good investment for several years. This portfolio isn't going to generate much current income in the near future, so it's not going to contribute to the house-buying fund but instead be treated as a long-term investment; a general bet on overall economic growth, particularly in the third world.

So what should you do?
First, take any investment advice with a healthy dose of skepticism. Don't bother reading most short-term focused writings (articles with titles like "7 Energy Stocks that are a Strong Buy" or anything on CNBC). Read books and articles like A Random Walk Down Wall Street that are focused on long-term investing and don't make bold claims about beating the market.

Second, take full advantage of workplace retirement programs. In the absence of a robust welfare state, the two tools most folks have for surviving old age are tax-free investment accounts and kids with good jobs.

Third, carefully examine any investment opportunities for cost. The more money you have to pay someone to manage your money, the less money you get from investments. Index funds tend to be the best investment choices.

Fourth, live below your means. There are hordes of people who would be happy to lend you money so you can make poor financial decisions.

Fifth, if you've got extra money to invest, think carefully about how you want to approach investing. Know that you're not likely to make a huge profit in the near future and that your investments might suddenly shrink if the global financial system suddenly discovers that was again acting on incorrect or incomplete information on a massive scale.

Eric Garland has a collection of articles about Guitar Center, the company which set out to do for musical instruments what Circuit City did for consumer electronics. The first was a short post about how their business model is failing and their bonds were degraded to junk status. A few months later, he wrote a little longer article with a great title Guitar Center's real problem: their customers are broke, pivoting from the store to the disappearing middle class and the country's significant unemployment problem despite a nominal recovery from recession. His latest piece focuses on the byzantine financial structure Guitar Center's set up with private equity firms Bain Capital and Ares Capital Management and the parasitic effect these financial shenanigans have on the economy.

When I recognized how much the financial markets have become like 2006, I finally figured out why some other financier could shell out $50 or $100 or $300 million for Guitar Center junk bonds. For the customers of private equity, a few million isn't that much money. These investors actually need some higher-risk assets in their portfolio, rather than let their money sit around in a zero-interest rate environment. They might be like Warren Buffett and already have huge stakes in sensible things like Too-Big-To-Fail banks, railroads or Coca-Cola. This just rounds out their overall position. Make 6-9% with the chance that the company could finally go tits-up? Why not! If it pays out, then great, and if it doesn't – tax write off!

In the business reporting during the financial crisis of 2008, you might have heard the phrase "appetite for risk;" this is what they were talking about. When an investment is risky (which basically means the thing you're investing in is more likely to fail), you can charge higher interest rates (which basically means you get more money until it fails). So that's why a few big financial companies can spend the better part of a billion dollars on a company that's likely to have a fire sale and go bankrupt: they've got a budget spreadsheet that says "Spend $XX billion on investments at 6+%."

Imagine an alternate world where the same financiers took the same $3 million per Guitar Center retail store and invested, say, $1 million in each of 940 community music centers. A community music center could be something like a coffee shop of sound, with instruments for sale, music lessons, rehearsal space, and an "intimate" concert venue. This would help foster a local music economy and boost both supply and demand for music.

But now that it's run by equity firms, approximately nobody in the Guitar Center management or financing chain is involved because of a deep desire to increase the amount of music being played, expand musical literacy, build a community of musicians, or even necessarily because they really enjoy selling guitars. They're in it because they think they've got reasonable odds of making a significant return on investment and the pieces of paper making up Guitar Center's corporate structure and debt obligations are an available vehicle for the financial joy ride they want to take. The folks running the show would be just as interested if they'd bought a national chain of soup canneries.

Trevor's Rule for Running a Great Company

Use profit as a tool to grow the business. Don't use business growth as a tool to obtain profit.

One of the things I really love about Google is how it's run, from top to bottom, by people who care about what we're doing. We structure efforts to be profitable so that we can easily invest in improving their quality and bringing them to more people–if YouTube makes more money than it costs, we can keep making YouTube better and serve more of the world's visual stories. Yet not every effort must be profitable on its own; many projects are done because they're good for the Internet or good for the world, with the foresight that a better Internet and a more informed world will be a better world for Google to be in for the rest of this century.

By contrast, a business run by people who don't really care about what the business produces or the people it serves (which is basically the point of private equity firms) has no reason to foster the long-term ecosystem its customers live in. When profit is the product, anything that doesn't put money in investors pockets–no matter how relevant it is to the company's ostensible mission–is likely to be slashed and burned. The private equity firm doesn't care if it clear-cuts the spending power of its customer base or strip mines the market for its colonial products as long as it extracts the monetary resources it needs to fuel its endless quest of profit for profit's sake.

The theory of supply and demand explains that when a resource is more plentiful, market pressures lower the price, but when a resource is in short supply and high demand, prices go up. Apples are cheap, lobsters are expensive.

This principle ought to apply to the labor market too. The supply of actors exceeds the demand, so most get paid very little, doing uninteresting work. The supply of folks that can sell fast food or dig ditches is pretty high, so they don't get paid very much. Similarly, there's not much demand for driftwood gatherers, so it's a hard way to make a living.

But the model breaks down for high supply, low demand positions. There's a very small and essentially fixed demand for professional baseball players. There's a huge supply of people willing to do the job. But the people who get the job get paid millions, even though they'd probably do it for much less 'cause it sure beats digging dishes. Star actors get way more money, more control, more fame, and more fun roles than their struggling colleagues. In most companies, a promotion means you get more money to have more power and do more interesting and impactful things. If supply and demand worked like they do on the chalkboard, shouldn't a promotion come with a pay cut? Aren't there people who will work as the CEO of a multinational corporation for less than a million dollars?

This illustrates that when it really matters, quality trumps market forces. Even with thousands of Minor Leaguers to choose from, the Major League pays big money to get top quality. And while a CEO with a $5 million salary may not perform ten times better than one who will do it for 500 grand, he may make more than five million dollars of difference. It's more rewarding to be good than to be cheap.

Alternatively, money follows something like the general theory of relativity: very massive bank accounts distort the gravity of the surrounding economic field.

If you're already a fan of Ignite Boulder, you may have noticed my name on the speaker lineup for Ignite Boulder 14. If you're already a fan, you'll also know you should get your tickets now, because it'll sell out before the event three weeks from now.

If you're not already a fan, here's the pitch. Come see me and 13 other clever folks each give a five minute presentation consisting of 20 slides which auto-advance every 15 seconds. It's on March 3rd at 7 PM at the historic Boulder Theater. I'll be talking about Money and Other Useful Myths, explaining why money is fictional and how true value is people doing stuff. If you can't make it to the Boulder Theater, the event may be streamed live and the talk will be on YouTube later.

As readers of this journal know, I'm really good at being long-winded. So I'm impressed that in test runs, I've been able to say what I want in just three minutes. My second draft has to be longer? Whoa.

(Via this Coding Horror blog post):

This video is a fantastic illustration and explanation of motivation and reward. The speaker is Daniel Pink, author of Drive: The Surprising Truth About What Motivates Us. He says that money is a good motivator for mechanical tasks. If you pay people for each pound of tomatoes they pick, they'll pick more tomatoes than if you pay a flat rate each day. But if the task requires any cognitive skill, people do worse if there's a performance incentive. If you give people the freedom to do something interesting, you'll get much better results than if you offer an innovation bonus and tell them to work on something.[1] Money is a motivator, but to a limited extent: pay people enough to take the issue of money off the table.

This is a pretty good description of my motivations. My actual salary isn't particularly important to me; I'd probably be happy to do the work I'm doing for half the salary (but not a quarter of the salary, 'cause then I'd have to put a lot more focus into getting by on a tight budget). What motivates me at work is (a) interesting projects, (b) socially beneficial results, and (c) having fun.

Pink concludes that, beyond being profit maximizers, people are purpose maximizers. This jives with something I've thought for a while: economists study things in terms of money because it's easy to measure, but that lens is insufficient to capture a wide spectrum of human activities and motivations. "Purpose" isn't easily transferrable, it's hard to measure, it doesn't seem to follow mathematical rules, but it's how those crazy Homo sapiens sapiens work.

Maybe the problem with the Soviet system is that they wanted a very industrial society, but they applied a system that's suited to post-industrial creative jobs. For all Marx's focus on factories and industrial workers, he described a communist society "where nobody has one exclusive sphere of activity but each can become accomplished in any branch he wishes, society regulates the general production and thus makes it possible for me to do one thing today and another tomorrow, to hunt in the morning, fish in the afternoon, rear cattle in the evening, criticise after dinner, just as I have a mind, without ever becoming hunter, fisherman, herdsman or critic." [Idealism and Materialism]

[1] Even worse, if you offer huge financial incentives for easily-measured results to smart investment bankers, you can tank the world economy.

There's been a lot of media noise in the past week or so about over $160 million in "bonuses" paid to employees of AIG, a company the U.S. government has recently spent close to $200 billion to prop up. Many of those bonuses went to employees of the Financial Products division, "the guys who got us into this mess in the first place."

Most people's reaction, hearing it phrased like that, goes something like "What the fuck? Those greedy banker fuckwads have some nerve, throwing big piles of taxpayer money on bonuses for people whose performance was dismal?!?!?!?!?!?" President Obama expressed outrage and said his staff would look into all legal routes of getting that money back. AIG's counter was "We were contractually obligated to give those bonuses."

Now, in my lexicon, "bonus" implies that it's contingent on something. At work, we all get a bonus at the end of the year if our division meets certain earnings goals; if we the division doesn't meet those goals, we don't get bonuses. In the past I've also gotten a performance bonus where my boss said "I think these employees did a great job this year, they should get a special reward." In both cases, "bonus" means "It might not happen, but if it does, you get extra cash."

The $160 million in question at AIG turns out to be from an arrangement where they didn't expect much opportunities for traders to make profitable trades, so they set up their 2008 employment contracts to apply the 2007 bonus in 2008 as well. This is more or less equivalent to a car dealer telling his sales team "I don't expect us to sell many cars next month, but I don't want you to quit, so you can have the same commission next month as you had last month." At that point, I don't think of it as a "bonus" but as a "salary." I'm not sure to what extent AIG was in control of the story as it broke, but using the term "bonus" when the thing under discussion is more like a "salary" doesn't really help the discussion.

This is not to say that AIG's payment structure is a good one, that their employees deserve that much money, or that they shouldn't have renegotiated the employment contracts when the company nearly collapsed, taking the global economy with it. It's just important to understand what's going on and to have the finesse to be outraged about the right issues.

I just got my direct deposit notice by email and said "Huh, that's slightly more than it was two weeks ago. Did I get a very small raise for some reason?" Comparing side-by-side with last paycheck, I found the difference: federal taxes were about $20 less. "Oh yeah, a cut in payroll taxes were part of the stimulus plan." Maybe I'll celebrate by buying... uh... lunch?

I'd love to help the economy, but since I'm putting all my stuff in storage in a month, acquiring new things isn't very attractive. I suppose I could eat out more often, but then I wouldn't have a bowl of left over curry when I'm running short on time. One thing on my to-do list is to pick some non-profit organizations for donations, since they're probably hurting right now.

As a follow-up to my previous post, I'll note that the worst possible currency investment -- by a score of orders of magnitude -- is the Zimbabwean dollar. In July, one U.S. dollar was worth 758,530,000,000 (758 billion) Zimbabwean dollars. On August first, the central bank revalued the currency, making Z$10 billion worth Z$1. In August, 1,780 Zimbabwean dollars were worth one U.S. dollar. Over four weeks in October, the exchange rate went from 2,300,000 to 10,700,000 to 1,220,000,000 to 251,000,000,000. In the middle of November, one U.S. dollar was worth thirteen quadrillion Zimbabwean dollars.

So if you go shopping in Zimbabwe, make sure you do it in the morning because your money will be worth less in the afternoon.

Insofar as Zimbabweans are surviving, they're doing it with the help of friends and relatives outside the country. Zimbabwean expatriots have been sending money to family members for years. On the BBC's Business Daily program a few days ago I heard that Zimbabwean immigrants in South Africa are paying taxi drivers to drive food to their friends in Zimbabwe.

This hyperinflation is due in part to the government's practice of printing money to pay increased salaries to the army and civil servants. It's unlikely that this situation will materially improve until Robert Mugabe is no longer in charge. And even though there's near-worldwide consensus that it's time for Mugabe to go, that doesn't seem likely until he dies.

"It's as if your auto insurance agent came over to your house, got liquored up, borrowed your keys, totaled your car, and said 'Well that'll make your rates go up.'"

That's from today's Planet Money episode on NPR and in the New York Times. It's one of the best "How does the global financial crisis become local?" bits they've done.

slyviolet asks

For those of us with relatively insignificant (in comparison... obviously not insignificant to ME) bank holdings, no credit debt to speak of, no large loans outstanding and no stocks/bonds/other things of that nature, what will the practical personal fallout of the bailout be, if any?

The correct answer to that question requires predicting the future. Economists spend a lot of time predicting the future. But there's a lot of variation between economists' predictions, so you can often pick the prediction you like best and pretend that's what the future holds. "What will happen?" is not nearly as clear as "What could happen?"

First, what won't happen is losing the money in your bank account. The FDIC and NCUA just raised their insurance amount from $100,000 to $250,000. That means that even if your bank or credit union collapses because their loans all fail, you'll keep all your money (checking accounts, saving accounts, money market accounts, etc.) up to a quarter million dollars. So you don't have any reason to withdraw all your cash and stuff it under your mattress.

The key part of the current financial crisis is a halt in lending. Investors have been very reluctant to lend money to businesses and other banks. A lot of companies run on debt—retail stores often don't turn a profit until Christmas season so they borrow money during the rest of the year—and if they can't get loans they may have to fold. I haven't heard of a sudden rash of collapsing companies outside the financial sector. The government has taken a fairly active role in trying to stabilize things and if a lot of companies were suddenly about to collapse for lack of credit, the Federal Reserve would probably step in (which it did a week or so ago when it announced it would buy commercial paper). This is therefore probably a low risk right now, but it wouldn't hurt to check in with anybody you're receiving a regular paycheck from and ask what the company's financial situation is.

I think a bigger risk to companies is a weak Christmas sales season. I heard one time that "If Christmas were canceled one year, the whole American economy would collapse." A lot of people have reduced spending recently due to all the media attention on economic collapse. (Would you buy an iPod after the Secretary of the Treasury says "If we don't pass this bill, we might not have an economy by Monday?") If a lot of retailers collapse due to week holiday spending, you'd probably have some friends that were out of work, you might not be able to buy some of the stuff you want, and so forth. It would be a big sign of wide-spread economic hard times, a recession/depression hitting most Americans. I don't suspect this Christmas Crash scenario will happen, though. September of 2001 also featured a sudden change in market atmosphere and public worry about the future, but January 2002 didn't feature a major collapse of the retail sector (though it was a rough season).

If you're considering taking out a loan soon (to buy a car or a house or start a business or something) you may find it hard to get credit at a reasonable interest rate since lenders are reassessing who they ought to give money to. Depending what options in the bailout plan get activated and what new mortgage-relevant laws get passed, the housing market could go in several directions. If the government takes steps (changing mortgage terms or extra cash or whatever) to help current owners keep homes then I wouldn't expect a big change from the current housing situation, though home prices may continue to fall. If a lot of mortgage holders can't keep their properties, things may get exciting. If you rent a house, or condo (etc.) and the owner can't pay the mortgage, it'll go into foreclosure. If it's bought and the new owner wants to move in, you'll need to find a place to go. On the plus side, if you can afford it there may be some reasonably-priced foreclosures you could buy in such a situation.

Tied to the general economic situation (and not particularly to the bank bailout), commodities prices have fallen recently. Oil was trading around $90 a barrel this week, down from over $140 this summer. You've probably noticed gas prices are down; some of this is seasonal, but some is due to commodities traders selling in the face of uncertain financial future. (I keep typing "commodoties." When their prices go down, it's a nice whirlpool effect.) Food may also get cheaper.

Another thing that could happen: Your parents might get worried about their retirement savings and call you for advice. I spent around an hour explaining recent financial news to my mom last week. I advised her not to withdraw a bunch of money because she wouldn't have a chance to earn back what she's lost in the market. Calls from parents will give you the opportunity to reflect on things that ups and downs of financial markets can't take away: having conversations with people you like. Also: going for walks/hikes/bike rides, lying around in the sun, and socializing over board, card, and role playing games. Anybody want to play Monopoly?

Longer term effects: As the presidential debate moderators have mentioned, the next president will probably need to scale back some of his proposed projects in light of the state of the economy and the fact that $700 billion may be tied up in chunks of mortgages. So if you're hoping for particular proposals to come into effect next year, you might need to brace for disappointment. But really, that's sound advice for any political campaign. On the flip side, if there's a government program you're not fond of, 2009 might be a good time to organize a campaign to defund it. Like, say... "Hey, we've just spent $700 billion on a bank bailout. How about we don't spend another $700 billion on Iraq?"

As things ripple throughout the world, foreign economies may be rather volatile. It might be a great time to go to Europe if the Dollar regains significant ground against the Euro. It sounds like Iceland could use some cash... It's possible that countries who weren't closely tied into the scene become (relatively) better off -- maybe South America will be the place to be instead of China. But unless you're planning on international travel or business, changes in foreign markets won't have a direct effect on you and indirect effects are largely speculation at this point.


Further listening: This American Life: Another Frightening Show About The Economy. NPR: Planet Money podcast and blog. Adam Davidson from NPR (who's also the main guy in the This American Life economy shows) is the best business/economy reporter I've heard. I also like Steve Evans, the sometimes host of Business Daily on the BBC. He has a very engaging interview style

I've been mentally working on a post with a title like "What's Going On In The World: A Summary" lately, but I haven't made time to write it all down. One thing it'll touch on is the "Global Credit Crunch," which grew out of the "U.S. Housing Crisis" stemming from the "Subprime Mortgage Collapse." I don't have any formal education in economics, but I often find that I can construct a decent sense of the key issues by listening to the language of people who do know what they're talking about. But despite all the news references to this major financial current event, I could tell I was missing key pieces of the puzzle.

Fortunately, This American Life is really good at sharing a full story in a way that's easy to understand in human ways. Episode #355: The Giant Pool of Money looks at people involved at each level of the house of cards which has now foreclosed. They define key terms, explain why otherwise sensible people made bad decisions, and what factors came into place for everything to fall apart. The whole episode will be available as a free download on their podcast for the next week; even if you don't want to listen to everyday people's stories about weird stuff every week, be sure to listen to episode 355.

One thing they didn't really touch on is the question "Where did all the money go?" They said "It's just gone," but money doesn't just disappear; it goes somewhere. Somebody class of people came out on the winning side. I think the answer goes something like this:
Global investors (the giant pool of money) bought shares in mortgage-backed securities offered by investment banks on the assumption that payments would be regular, producing dividends.

Investment banks bought loans from mortgage brokers and commercial banks on the assumption that they could sell shares to big investors.

Mortgage lenders gave money to people (many of whom shouldn't have gotten a loan in the first place) on the assumption they'd make regular payments (or on the assumption that someone would buy the loan before it would matter).

Some people took out mortgages to pay other debts on the assumption that the going interest rate was better than their other interest rate. So creditors are one set of winners. And not entirely coincidentally, creditors like the financial megalith JP Morgan Chase Manhattan were major players in the shenanigans we're now seeing fallout from. So they may not have lost as bad as their current numbers look.

Some people took out mortgages to pay for big expenses like college for their kids or trips to Mexico on the assumption that American housing prices would keep going up and they could use the equity in their home as an ATM. So smart spenders are one set of winners. If someone took out a mortgage, paid for college, then lost the house in foreclosure, they at least funded a good education for their kid who can find a good job (even in the current economy, they hope) and get a house with some extra room for their parents. Of course, dumb spenders are one set of losers. If they bought a big screen TV and took a trip to party on Mexican beaches and then lost their house in foreclosure, the best they can say is "The real titties looked better than the high def ones did."

And, of course, some people took out mortgages to buy houses. For several years, American home construction was a booming industry. So one set of winners is home builders. But then they became losers as they discovered they had vast tracts of cookie-cutter subdivisions ready to sell just as everyone started losing the houses they shouldn't have purchased three years before. But before the home builders moved to the loser category, they paid a lot of money in wages to construction crews. American construction work these days is largely done by Hispanics. A lot of Hispanics send a significant portion of their income to family members in Latin America.

So the flow goes something like this:
American consumers buy cheap goods at discount retail stores -> discount retail stores buy cheap goods from China -> China invests dollars in U.S. mortgage bonds -> mortgage bonds create a demand for unsound loans -> unsound loans promise American consumers the dream of home ownership -> dream sellers build ostentatious subdivisions -> frugal carpenters send their share of American consumer money to poor Mexican families.
It's not so much trickle-down economics as it is Gordian-hose economics. The flow doesn't start or stop where I've outlined, but it's interesting to see how two groups (Chinese factory workers and Mexican subsistence farmers) who at first seem to have nothing to do with $500,000 houses on Shady Hills Lane are beneficiaries of the complex transactions of the American housing market. Of course, with major increases in the prices of food and oil, those benefits may rapidly dissipate. I wonder how much of that increase has come from investors fleeing poor assumptions about the U.S. housing market in favor of assumptions about commodities markets...

Remember kids, when investing or making other important decisions: The past is not necessarily a good predictor of the future. Life is one big Hume problem.