Protectionism: A Prisoner’s Dilemma?

Photo by: Kyle May

In game theory there is a “game” called the “Prisoner’s Dilemma.”  In the game, two players have been arrested.  If they cooperate and neither “rats” on the other, they will both go free. If one “rats” on the other, he receives a light penalty while the forsaken prisoner receives a stiff penalty.  If they both turn on each other, they both get a moderate penalty. 1  The basic lesson? Each of the parties would be best served if neither of them participated, but least served if they don’t participate while the other party does.

A real-world example of this could be a sporting event:  say something interesting happens and a spectator stands up to get a better view.  This causes more and more people behind him to stand up, just to get the view they had before.  At the end of this process, everyone essentially has the same view they had before, but now they’re exerting the effort of standing.  If they’d all just remained seated in the first place, they’d all be a bit better off. 2

What Does This Have To Do With Economics?

People say that our current financial crisis will not be as bad as the Great Depression because “we make much better decisions now.”  We know better than to resort to things like high interest rates and protectionism.  We won’t make the mistakes of Smoot-Hawley again.  But history shows that, in general, we were actually smart enough to know that at the time.  While economists rarely agree on anything, they were universally opposed to the Smoot-Hawley Tariffs.3 Yet they happened anyway.

Meanwhile, looking to the present, we see signs of the same kind of thinking again.  We know better than to adopt protectionist policies, but the new administration is already discussing whether to “punish” China with tariffs due to their manipulation of their currency value.4 This justification seems particularly unrealistic as we are creating 0% interest rates and pondering bailing out our auto-makers.  Bad decisions are often deemed bad only in retrospect.  People don’t plan to make bad decisions, they make what they think are good decisions in the vain pursuit of “fairness,” a concept that is ephemeral and non-existent.

So are we faced with a Prisoner’s Dilemma?  Will it deal a crushing blow to our economy if we do not “fight” other countries protectionism with our own.  History has little to say, except that free trade has usually been good for all the parties involved.  If we can buy something cheaper than we can produce it ourselves, then we are better off than if we make it at an inflated price.  It may not necessarily be the case that we need to follow suit if everyone else in the world starts pursuing protectionist policies.

How Does This Affect Me?

As Geithner and his fellows debate whether or not to implement tariffs on China, the most likely action item for you is to be very cautious.  While many may be telling you that this recession will not rival the Great Depression, you can watch as we take the same steps that we’ve decried before, thinking that “things are different this time.”  Almost any negative outcome is a possibility in the short and medium term, and it pays to have something that protects you in each case.  In the short term, deflation seems to be a likely demon, but longer term inflation seems to be the opponent.  Meanwhile, it’s difficult to know whether stocks can be expected to perform.  Ultimately, it is pivotal that you develop an investing strategy that involves protecting yourself and optimizing for your personal situation.

1. Stanford Encyclopedia of Philosophy – Prisoner’s Dilemma [↩]
2. Landsburg, Steven – More Sex Is Safer Sex: The Unconventional Wisdom of Economics [↩]
3. The Economist – The Battle Of Smoot-Hawley [↩]
4. The Washington Post – Geithner Say China Manipulates Its Currency [↩]

What We Should Fear Volume One: Inflation

Photo by: grahammclellan

The economy is always fraught with peril.  Your savings and investments are always subject to risk, and it’s your job to protect them.  Unfortunately, if it were easy to identify the risks out there, we’d do a better job of avoiding them.  One problem that seems to loom in the future of every investment decision is monetary policy.

Depreciation

The current crisis is one of deflation.  People have less money and feel less secure, so they spend less money.  This means that companies have to charge lower prices and make less money, which leads to layoffs, which leads to people having less money and feeling less secure. 1 This cycle is very much like the reverse of the bubbles that we’ve seen in various markets.  The bust is the logical opposite of the boom.

The key difference between the boom and the bust is that the government feels compelled to step in and try to ameliorate the effects of the bust.  They may give lip-service to trying to prevent bubbles, but ultimately their jobs depend on appearing to help “solve” a suffering economy.  Whether or not they can be effective is really beside the point, they have to be seen as “trying.”

The Consequences

The natural upshot of all of this is what is referred to as counter-cyclical policy.  When the private sector is not spending, the government steps up to fill the gap.  Hopefully, the things the government spends its money on providing long term benefits, as well as the short term benefit of creating jobs and demand.  While it may seem like any kind of spending will help break the vicious cycle of depreciation, hopefully you can also reap lasting benefits out of it.  A good example is updating infrastructure like highways or utility grids.  Whether this is the best application is debatable, but ultimately the idea of counter-cyclical spending is a fairly well accepted one.

What this ultimately means however is that in the long term the real threat to your wealth is not the deflation cycle.  In fact the deflation cycle is actually making your savings worth more, while devaluing your assets like your house.  What you ultimately have to fear is the eroding power of inflation. While the government has always sought to keep inflation in check, there are several reasons to think its toolbox will be empty when the time comes.

Inflationary Policy

Anyone who has been paying close attention to government policy recently has seen monetary figures unlike any in recent memory.  The TARP is 700 billion, but represents only a fraction of the money that has already been spent to inject stability and liquidity into the system.  This is before all the counter-cyclical spending that the new administration is planning.  Regardless of the efficacy of these plans, there seems very little to prevent them from happening.  In fact the incoming President has told us to brace for TRILLION dollar deficits for some time to come.2

While the government can posture about how it will cut spending or find other sources for this money, ultimately it will be borrowing it.  It will create a huge debt and will have to escape from it.  The natural escape is through inflationary policy.  By “printing” more money (printing isn’t really necessary anymore, but it’s the same effect), the government will reduce the value of that debt.  This will make it easier to manage, but ultimately will punish those with cash in the bank.

How To Protect Your Cash

TIPS are a very attractive means to protect any savings you currently have.  TIPS, or Treasury Inflation Protected Securities, are like normal Treasury Bonds, but your principal is adjusted for the Consumer Price Index (a measure of inflation).  Obviously you will receive a lower interest rate than you would with normal Treasuries; but if you believe the inflation will exceed that difference, then they are a better deal.  Currently, because of deflationary pressures, this differential is not as great as current spending should suggest.

With the current deflationary effects, and no crystal ball to know where it ends, actually purchasing TIPS can provide you a very safe location for your money.  Not only will they be protected from inflationary pressures, they are guaranteed to retain their value.3 Even if inflation is negative, you will do no worse than your original investment, which means you still will have effectively made money.

For those who are feeling very risk averse and who are concerned about inflation as a result of the current levels of government spending, TIPS provide a safe place to make sure your money is safe.  While they aren’t going to provide fantastic net returns, they are at least going to keep up with inflation, which may not be such a bad deal.

1. NPR – The Economic Battle: Deflation Vs. Inflation [↩]
2. Washington Post – Obama Predicts Years of Deficits Over $1 Trillion [↩]
3. Treasury Direct – Treasury Inflation Protected Securities [↩]

The Best Investment In The World

Photo By: dbking

By this point in people’s lives they are well aware of the merits of 401(k)s and other retirement accounts.  Most people have wisely made them a part of their investment strategy, however many misconceptions still persist about them.  While most people do contribute, many of them spend very little time allocating their funds and instead make other hasty decisions based on misconceptions.  So here are some important things to know about the best investment in the world: tax-deferred retirement accounts.

Always Max Your Match

This advice is usually followed, but there remain people, particularly in this downturn, who have ceased contributions.  If your company matches your contributions at any level, this is one of the most amazing investments available to you.  Many times it may even behoove you to defer paying down debts to maximize your contribution.  While paying a debt may make you 20% tax-free on your money, a 33% match would make you…33%.  This doesn’t even take into account the fact that your contribution is pre-tax, which actually makes it an even more compelling option.  It is almost never a good idea to leave this kind of money on the table, barring extreme circumstances.

Be Aware of Your Options

The most common reason people are breaking the first rule is because of the markets.  Many people have ceased contributing to their retirement accounts because of the insecurity in the stock market.  They are waiting for things to “recover” before they contribute.  There are several problems with this approach, but not the least of which is that almost all retirement accounts have non-stock options.  That means you can usually put your retirement account money into a fund that is not dependent on the stock market.  There are exceptions, and I am not aware of all plans, but why forgo tax-deferment and employer matching when there’s an option to put that money into a secure fund?  It’s simply a question of having your cash in a taxed account or a non-taxed account.

Follow Your Strategy

If you were dollar cost averaging, don’t stop just because the market is down.  That’s the whole point of dollar cost averaging.  Now that prices are lower, you should bring your average cost down quickly if you continue contributing.  I can’t promise you that the markets will resume, but if you ever plan to resume dollar cost averaging, stopping because the market is down is counter-productive.

You also need to be aware of when it’s time to get out of stocks and move to less risky options.  As you get closer to retirement, you no longer have years for things to “average out.”  It’s time to start moving money to safer investments.  Don’t let the lure of additional returns keep you in the market for longer than is safe.  Many baby-boomers are learning that lesson right now.  While 3% may seem unappealing, it’s considerably better than losing money when at the doorway to retirement.

Never let temporary factors cause you to overlook the best investment in the world.  Tax-deferrment has huge implications on your eventual bottom line, so you should be making every effort to maximize your contribution.  Why save 65% of your net when you could save 100%?  And why pay taxes on the earnings of those investments?  You may have more limited options, but they would have to be severely inferior to overcome the huge benefits of preferential tax treatment.

Saving: The Best Kind Of Investing

Photo By: Jeff Belmonte

Benjamin Franklin once famously said “A penny saved is a penny earned.” But Ben was seriously undervaluing the value of savings. A penny saved is usually worth considerably more than a penny earned, and this is something you should always consider in your daily life.

Why is the saved penny better?

You may wonder how a penny saved can be more valuable than a penny earned, but it’s very simple if you think about it. Imagine for a moment that you purchase an $80 DVD player. In this theoretical situation, you make $10 per hour and work an eight hour day, earning $80. The difference between the $80 you spent on the DVD player and the $80 you made at work is: you have to pay taxes on the $80 from work. So, even though you’ve earned $80 and spent $80, you’re actually behind where you started.

The United States didn’t have income tax in Ben Franklin’s time, so his thinking is understandable.1 His advocacy of saving, however, is even more true today than it was in his time. Many people pay income tax of 33% or more. To pay for a $100 item at that income tax rate, you have to make $150. In other words, you have to earn 50% more than you spend on something to break even. At those levels, a penny saved is worth 50% more than a penny earned.

What about lower tax brackets?

Credible estimates suggest that 38% of “families” pay no income tax.2 Even these families, however, usually pay Social Security taxes and, of course, sales taxes on their purchases. Usually these are often the families who are most in need of some added security, and quite probably having the most trouble creating any savings. While the penalty for purchasing may be lower for these families, due to increased difficulting creating secure savings, unnecessary purchases should still be avoided.

Advantages of Saving

Saving is a good habit to develop. Here are some benefits to keep in mind when you are having trouble deciding whether you’d rather have that DVD player or the money in the bank:

• The freedom that comes with financial stability will usually last longer than a DVD player.
• Purchases tend to go down in value, savings tend to increase (although not always at the rate of inflation).
• While you may think you can afford something right now, an emergency can change your financial situation very quickly.
• People more often have buyer’s remorse than non-buyer’s remorse.

Ultimately, finding ways to motivate yourself about saving is a pivotal step in financial freedom. Until you see saving as a joy instead of a chore, you will struggle to have the security enjoyed by those who do save.

1. Library of Congress: History of the US Income Tax [↩]
2. FactCheck.org: Do 40 percent of Americans pay no taxes? [↩]