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 [↩]

Getting Debt Under Control

Photo by: Corica

Always Have Some Cash

As the economic meltdown ensued, financial institutions argued that they were not having a crisis of solvency, they were having a crisis of liquidity. 1 While it very likely was a crisis of both, it points out the importance of having your value in liquid assets as well as the inherent danger of leverage.

So how are we a mini-version of the larger economy? The average person in America has the exact same problems as these huge banks. Their assets have diminished in value, and they’ve leveraged themselves (debt financing, credit, etc.) to get those assets in the first place. Unfortunately, most of us are not expecting much of a bailout, so what should this tell us?

When times are good, we all extrapolate our current success and live accordingly. We imagine that our well-paying job will last, so, of course, we can buy that big house; it’s just going to increase in value anyway. We can put all our investments in stocks, because they’re rising meteorically. Cash seems boring and unrewarding in such a market, but as those who have cash now can attest, it certainly is nice when things go the other way.

Advice For Saving

One simple rule can give you a method for ensuring you don’t find yourself in this situation again:

Live Below Your Means

This one rule will help you make rational decisions in your life. It’s a subjective goal, but it can make every decision the safest one. Unfortunately, much like the banks, while we should have adopted that policy before, it’s very hard to adopt now. If we’ve lost our jobs and are in severe debt, it’s very hard to live below those means. So for this time of crisis I think the rule can be re-summarized as follows:

Assume The Worst

Many of us are expecting a strong rebound, but are we sure it’s coming? If we continue expecting, we may find ourselves in a very precarious position if the recovery doesn’t come quickly. Instead of thinking “I can keep cable TV as long as things turn around soon,” consider thinking “Cable is not a necessity, and for the time being, non-necessities do not get favor.” While this may turn out to be an unnecessary cut, it may also turn out to be the first step in helping you live below your means.

1. Times Online: Loss of liquidity, not insolvency, caused credit crunch [↩]

Finding Your Net Worth

Photo by: SLR Jester

What Is An Asset?

An asset is something that is owned by you.  Typically used, it would also need to have value.  I may have a wad of used chewing gum, but since I can’t turn it into cash very easily it’s not really much of an asset.  Sometimes intangible things are considered assets, like goodwill or trade secrets.  While you often can’t really sell these, they have value and are considered on your balance sheet.  All this may sound pretty complicated, but when it comes to personal finance, your assets can be summed up pretty quickly.  What do you own that’s worth something?  Those are your assets.

The biggest assets most people have are their home and their car.  They also, of course, include their cash and savings, as well as their stocks and retirement accounts.  Some things that many people forget to include:

• Cash Value Of Insurance Policies
• Jewelry
• Furniture and other household goods
• Timeshares or other partial ownership

An important thing to remember however, is that these assets are worth the amount for which you can sell them, not what you paid for them.

Liabilities

Liabilities are what you owe.  The most common liabilities are mortgages, car loans and credit cards.  Personal loans count as well, and many of us are still saddled with student loans.  Generally the value of liabilities are much easier to calculate than assets, as usually we have an outstanding account balance.

Net Worth

Once you’ve summed what everything you have is worth and removed the value of what you owe, you have your net worth.  Sadly for many Americans this value is less than zero.  For these people they’ve worked all their lives and have less to show for it than the day they were born.  One of the easiest ways to get into this circumstance is to purchase a depreciating asset on credit.  Every time you get a car loan you are purchasing–on credit–an item that will decrease in value.  Often during the course of ownership we are upside-down on our car, meaning we owe more than it’s worth.

The current economic crisis stems largely from a variety of people making similar purchasing decisions, but on a much more dramatic and large scale.  Homeowners, for example, rushed out and bought homes that they couldn’t afford under the premise that the homes would appreciate.  When they depreciated instead, these people were suddenly making interest-only payments on a house that wasn’t worth its original purchase price.  At the same time, banks were purchasing–on credit–Collateralized Debt Obligations and other confusing debt instruments that they didn’t understand.  When those turned out to be worth much less then anticipated, they found themselves in very similar circumstances.

The lesson is to not only monitor your net worth carefully, but to take into account which of your assets have realistic valuations.  House and stock prices fluctuate, and you should be amassing net worth outside any perceived increases in the value of these assets.  Ultimately you need to be saving in addition to purchasing.  Buying a house is not an investment strategy, it is a chance to fulfill a need for a place to live.  Recent history has certainly shown that housing prices do not always go up.  If the only saving you do is making your house payment, then your real net worth may not be changing, or it may even be changing to the negative.  Paying close attention to your net worth and its make-up is a key to a secure future.