Nostradoofus

UPDATED 5/25/09:

Hereby retracted.  A reader sent various rebuttals, but the one that resonated is that subsidized loans are not really voluntary, because the unsubsidized rates are so much higher.

I checked, and found this was even more true than he suggested:  unsubsidized loans are now mostly unavailable at any price, due to the credit crisis.  Thus poorer students have no alternative to subsidized loans.  So the above would amount to an unavoidable invasion of privacy unduly targeting poorer students.

The reader posted other arguments.  Another that held some weight with me was that alcohol is far more abused, yet unregulated.

My goal in this proposal was to try to reverse a decades-long descent of American universities from educational institutions into a form of subsidized arrested development, in which late teens party their way through waning adolescence in the absence of either supervision or consequences.  But clearly this isn’t the way.

ORIGINAL:

Require recipients of federally subsidized student loans to take regular drug tests.

This does not violate privacy, because subsidized loans are voluntary.  If you don’t want to take a drug test, get unsubsidized loans instead.

Sometimes a situation arises so slowly, and becomes so established, that we forget how outrageous it is until we state it bluntly:  for decades, we have offered public subsidies for illegal drug use at universities.  Phrased thus, it doesn’t sound like such a good idea, and obviously delivers negative return on investment.

Among many other advantages, testing would be a social leveler:  the poorer students will be less able to afford drugs, putting them at an academic advantage. So we have a rare case where we can equalize opportunity while simultaneously making government more efficient.

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Fellow laissez-fairites, hang onto your hats…

Adam Smith’s “invisible hand” of free markets garners almost as much reverence as Isaac Newton’s laws of physics.  With good reason:  like Newton, his ideas are proven to govern most human-scale, real-world problems.

But of course, even Newton was wrong at the edges.  Small things and fast things do not obey Newton’s laws, much to Einstein’s and Feynman’s good fortune.  Newton is an approximation, albeit a very good one.

Similarly, it is interesting to at least ask the question:  under what conditions does Adam Smith describe the world poorly?  More specifically…

What if labor markets can actually be too flexible?

This might sometimes be the case in at least two ways.  First, in a deflationary spiral, if layoffs are very easy, then public companies will use them to stabilize quarterly earnings.  But in aggregate, this may actually accelerate the deflationary feedback loop, triggering a depression.

Second, what if too-easy substitution of cheap labor stalls domestic productivity growth per work hour — the only engine of long-term eocnomic advancement?

What if it’s actually a liability to have the reserve currency?

Having the reserve currency permits short-term interest rates to be held artificially low, while delaying the inflationary and exchange-rate consequences for many years.  Artificially low rates foster misallocated resources, including but not limited to investment bubbles.

1.   Individuals:  why save if you get a negative real return? Instead, pile into houses and stock.  If rates are really low, asset prices keep rising, so it’s short-run logical to borrow against your house and either double down on the stock market or buy an Escalade.
2.   Corporations:  why issue equity if you can issue debt almost for free?  Lever up, buy back the stock, go private.  Works great unless rates rise again someday, in which case the firm goes insolvent trying to roll over the debt.

Both of the above are short-run logical, long-run crazy.  But if rates are artificially low, and your currency artificially strong, for over a decade — a condition only possible for the reserve currency — then you start to get adults whose entire adult life has been governed by what should have been a short-run condition.  They know no other reality.

People thus learn lessons that cannot immediately be unlearned.  So if irrational conditions persist too long, their judgment is polluted for a long time. They are surprised, and slow to react and relearn, when rates suddenly spike, or assets suddenly crash.

Yes, this section is particularly heretical, yet fits the historical record:  the only two countries to experience massive industrial hollowing (US and UK) are also the only two modern reserve currencies.  No comparable hollowing occurred at industrial powers with no reserve currency (Japan, Germany).

So the reserve currency is not directly a liability, but perhaps is indirectly a liability, because it delays the consequences of bad financial policy for so many years.  This creates irresistible political temptation.  Riskless in the short run.  But then you get a whole generation of people trained to do dumb stuff.

The common thread of the above

Individuals heavily discount the future, even the likely future, if it is far enough away.  In these cases, Adam Smith may not operate efficiently when short-term optimization has long-term negative externalities.  

There is a very easy way to demonstrate this:  one day we’ll all be dead, but this future, though certain, is discounted to zero by most people day to day.  It is logical to assume the same discount applies to other futures, and thus that Adam Smith doesn’t work well under such circumstances.

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I thought Eric and I were the only ones who thought Aristotle and Plato were lame.  Turns out Lucius Seneca beat us by 2000 years, referring to Greek syllogistic game-playing as “childish fatuities.”

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Speaking of the frictional costs of outsourcing, consider that a big reason for offshoring is simply to eliminate red tape.

Let’s say I want to outsource a $1000 job to a specialist, such as a computer programmer.

If I contract it to an American, in addition to the job itself, I must also:

• Have a system in place to remember to file a 1099 next year.
• Have a system in place to recall the paid amount next year.
• Re-read Forms 1099 and 1096, which change a bit every year.
• Fill out and mail Form 1099.
• Fill out and mail Form 1096.
• Risk making a mistake, incurring penalties.
• Risk being late, incurring penalties.

This consumes hours of work, but more importantly consumes valuable attention.  Another half dozen things to worry about.  But it all goes away if I send the work offshore.  Poof.

Yet we really do need 1099s, or something like them, to limit tax evasion.  A reasonable simplification might be:

• Enter data directly at IRS website — eliminate paper and PDF filings.
• IRS Web API for financial app integration.
• PayPal and QuickBooks auto-report to the IRS Web API whenever you send a payment (assuming you set them to do so).
• Eliminate form 1096.
• Stop changing the 1099 every year.

I’ve suspected this for years, but after recent experiments with administrative offshoring, now have direct anecdotal evidence:  low wages are partly a lazy substitute for creative, productivity-increasing management.

This is at once obvious and subtle.  The obvious part is that I, as a manager, have little incentive to produce efficiently if I can produce inefficiently, for less, with cheap labor. The subtle part is to reconcile this with (suddenly unpopular) laissez-faire economic policy, which has a compelling argument for free global labor markets (see comparative advantage).

Here is a micro-anecdote.  Prior to 2008, I did bookkeeping for Company X.  In 2008, I outsourced it.  This was super cheap, just $300 for an entire year of data entry, and that was not even the low bid.  They did good work.

Of course, it was not frictionless.  It took several hours of my time to bid out the job, choose a winner, collect and send the year’s statements, check the results, etc.  But a big improvement over doing it all myself.

Still, for Q1 2009, I decided to see what could be better automated, rather than outsourced. After surprisingly much research (Intuit is stuck in 20th-century communications mode), turns out Company X’s bank still can export transaction data to my arcane old Mac version of Quickbooks.  Yesterday, I reconciled most of Company X’s first quarter financials by myself in an hour.  This included my time to prepare data and check results, and eliminated the friction of working with a counterparty.  Result:  automation beats outsourcing in bookkeeping for Company X.

So is comparative advantage the wrong paradigm for labor?

I assert it is not wrong, but overstated, limited in application, in areas where labor productivity can improve rapidly by just thinking or learning.

Since low wages are easily measurable and easily implemented, there is a tendency to just outsource and be done with it.  But it’s not the only solution, nor the best solution, from the business owner’s perspective.  Even in the short run.

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Wonder why the market is up 25% in a single month, despite no improvement in fundamentals?  Consider this interesting coincidence.

The recent huge market rally began March 10, the same day Barney Frank announced the imminent, nearly certain elimination of the short uptick rule.  Berkshire Hathaway, a popular short in recent months, rose 19% that day.

Meanwhile, judging from what clients tell me, a lot of big funds lately are simply speculating on short-term momentum.

Connect these two dots:  massive short covering began March 10, anticipating the end of the uptick rule.  This caused a mini-rally.  Big momentum investors reacted to that, and to each other, creating self-sustaining momentum.

Result:  sustained rally on no fundamentals.

Not saying that’s definitely what happened, but it is a simple and plausible interpretation of events.  More plausible, in fact, than an abrupt improvement in the economy or financial system.

The previous post on credit card issuer default rates deliberately avoids the question of ethics in lending.  I’ll mostly evade that again here, except for one point:  it would seem patently unethical to earn de facto interest in ways that are not readily understandable to the borrower.

By that standard, it would not necessarily be unethical to loan someone $100 revolving at 40% interest.  I give you $100 today, and you give me $140 next year, or pay $40 next year and roll it over to the following year, etc.  Ridiculously expensive, but explained up front, and readily understandable to the borrower.

But what if I instead lend you $100 at 5% interest, and buried in a long, complicated list of loan terms, in tiny print, is a fee of $30 for late payment, plus a 30% “default rate” that applies retroactively to the beginning of the loan in the event of late payment?  What if I then send no reminders?  Suddenly the effective rate is 60% for anyone who pays the first year’s interest just one day late.

A deal’s a deal.  Yes, it is.  But there is also a “reasonable man” provision in contract law, one I think has not received adequate attention in recent years.  It may be reasonable to expect someone to understand the consequences of 40% interest, but unreasonable to expect someone to understand and remember the dozens of complex features of the dozens of financial products in his life.  

We may have reached, or long passed, the point at which the complexity of personal finance exceeds the capacity of the reasonable man, who then by law cannot be considered negligent if he fails to understand something.  

Watch for something like this in coming years.  Nostradoofus has spoken.

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I’ve mentioned before the general principle that optimization creates inflexibility — in business, investing, computer programming, law and much else.

The credit card industry’s current travails offer an example.  Many have written on this subject recently, many good, but usually with the leftist or moralist subtext that 30% interest rates are somehow inherently wrong, so card issuers are getting what they deserve.  I’ll leave the Biblical debates to other writer.  This post just talks about the relationship between steady-state profit maximization and brittleness in economic shocks.

Credit card issuers mainly make money from so-called “revolvers” — people who endlessly pay interest on high balances, too high to pay down, but never quite high enough to trigger  default.  The issuer’s business revolves around revolvers, endlessly optimizing to maximize cash extraction from that particular group.  (Conceptually similar to the way casinos make much of their money by catering to and optimizing for “whales,” a gaming industry term for high-stakes compulsive gamblers.)

The 2005 bankruptcy reform, in force since 1/1/06, was intended as yet another credit card industry optimization.  By making Chapter 13 harder to qualify for, debtors could not easily write off consumer even in bankruptcy.  Instead, they were placed in repayment programs by the bankruptcy court.  According to at least one reliable source, issuers responded to this by lending more freely, assuming they would always be able to collect, even in bankruptcy.

This and other optimizations were in a sense too successful:  the more effectively the issuer optimizes, the closer it pushes the “revolver” to his absolute theoretical fiscal limit, the more exposed both borrower and issuer become to an economic shock.

Say you are a lender.  Would you want most of your customers to be paying you 100% of their EBIT in interest payments?  A residential lender would answer no.  Corporate bond issuers would say “no way.”  Too dangerous, no margin of safety.  A one-dollar decrease in the borrower’s income would trigger default.  Yet card issuers were actively seeking that 100%.  They tried to control losses with higher rates and better collections, but mainly just crossed their fingers on general economic stability.  That turned out to be an ill-placed hope.

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It’s interesting, initially tragic and eventually uplifting, to watch non-technical friends and relatives use Mac after years on Windows.  Like rats who have been shocked at random intervals in the lab, they exhibit persistent learned helplessness at the keyboard, fearing to tread outside the few simple use patterns they are familiar with.  When presented with a new situation, they simply freeze.

But I have developed a solution, one that could only work on Mac.

“How do I get my computer to do X?” I am asked at regular intervals.  If the inquirer is on Windows, I give them a lengthy step-by-step answer, involving 12 levels of nested menus and dialogs, right clicks, genuflecting, etc.

But if they are on Mac, even when I know the answer, I first ask, “What do you wish were the answer to that question? What would be the most logical, dead-simple, effortless answer?  Try that.”  Nine times out of ten, it works.  After this happens a few times, the user is unstuck, and can enjoy computers for the first time.

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My favorite piñata for demonstrating the principal-agent problem is Microsoft marketing.  But Time Warner also offers good examples in which long-run earnings are sacrificed to serve short-run interests of individual ladder-climbers.

Last year, my kids received the entire Looney Toons collection from a generous uncle.  This vast DVD set includes nearly every Warner Brothers animated short from the 1930s to 1960s.  The kids absolutely loved it, because — and I didn’t yet realize the significance of this — they had never seen Bugs Bunny or Daffy Duck before.

My daughter, then 7, invited a friend over to see.  ”Let’s watch Daffy Duck,” she said.  ”Who?” replied her friend.  It was hard to get her interested, because, I finally realized, no one under 8 in this area has ever seen Bugs or Daffy before.  They are not broadcast here.

You can see how such a situation might arise.  The DVD collection is one-of-a-kind, exhaustive, and very expensive.  The people who buy such things are over 30 and not price sensitive.  So in the short run, if you make the cartoons unavailable on TV, enthusiasts are more likely to buy the DVD.  Sales go up.  For now.

But the TV shows drive DVD demand 20 years on.  In a couple of decades, DVD sales (more likely their digitally delivered equivalent) will collapse, as the first crop of parents arises who have never heard of Bugs and Daffy.

By then, the marketing strategist who came up with this bright idea will be long gone, perhaps even promoted for his ability to increase short-term contribution.  That guy is not necessarily evil — he may simply have responded to bad incentives.  Designing those incentives is the hardest problem in management.

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