toosigma

A friend of mine asked:

What are the short- and long-term economic benefits and costs associated with our current high federal government budget deficits? Do you think the economic benefits outweigh the economic costs, or not? Why? If we wished to reduce the budget deficit then how would you advocate that be accomplished?

The short term benefits are relatively easy - by pumping more cash into the economy via government spending and/or tax cuts, aggregate demand is stimulated (because everyday people have more money to spend) which results in moderate increase in economic growth (GDP). The main reason we’re doing it now is to smooth out the trough caused by recent economic failures, hopefully keeping unemployment under control and helping the economy recover more quickly to a new growth phase of the business cycle.

The long term costs are also relatively simple - we’re borrowing money from the future to pay for things today, which is how any loan works. The main reason such a loan has ever been advocated is because, in general, the economy and population will grow over time, and thus be more capable of financing the debt. The chief problem is that we’ve been doing it for so long that our long-term debts are starting to become untenable - eventually we’ll have borrowed so much that we cannot hope to pay it back. The is exacerbated by the fact that our population growth has slowed dramatically in recent decades, and the resulting smaller population will likely also lead to a smaller GDP growth. We’ll eventually be faced with one of two possibilities:

1. We’ll no longer able to sustain our current government policies and service our debt - forcing us to weather economic storms like this one unaided by deficit spending
2. We’ll begin to default on our debts, causing our currency and social capital which allows us to borrow money to be devalued to the point that no one will extend us a loan for fear of our defaulting.

Personally, I think the primary factor which determines whether the costs are justified is how old you are. For the eldest among us, they are unlikely to live long enough to see either of the two crises come to pass - so in their opinion saving a little pain now is worth it - they’ll never have to suffer the larger pains in the future. For the youngest among us (or those not yet born), they benefit the least from our current policies - they typically don’t qualify for entitlement programs, and they have the fewest existing assets and the most time before retirement to recover from economic hardship. And they are most likely to still be around when the bill finally comes due.

Unfortunately, the elderly increasingly outnumber the young, so the popular choice is to “play now and work later” as in the fable of the ant and the grasshopper - mostly for fear of alienating the incredibly powerful voting block represented by the elderly. Plus, most of the elderly feel that they are entitled to their current benefits - being as they have paid their dues to reach that point - which I won’t argue with.

To reduce the deficit, we need to either cut spending or increase revenues (or both). My plans for reducing the budget deficit are almost definitely too extreme to ever pass into law, but here’s a few ideas, any few of which would do the job:

• Reduce entitlement spending to a specified fraction of GDP - say 10%. This can be accomplished by:
  • Raising the retirement age as life expectancy increases
  • Decreasing the benefit payouts for social security (or phase them out entirely over a few years in favor of personal retirement accounts)
  • Replacing Medicare with a fixed annual spending account and supplement it with catastrophic medical insurance (to be further supplemented with personal insurance)
• Eliminate the salary cap on Payroll taxes - eliminating a regressive tax and simultaneously increasing revenue
• Cut military spending - we currently have a military that is roughly 12 times the size of the next 20 largest militaries in the world - most of whom are our allies. If we cut spending by 50%, we’ll still outnumber everyone else 6-to-1, and save ~$350 billion per year.
• Cut the new Healthcare plan and replace it with my preferred version:
  • provide yearly government vouchers for preventative care (boosting the demand for general practitioners, preventing the most costly of long term diseases, and raising the general health of the populace)
  • create a new tax-advantaged savings account for medical expenses (similar to a 401k)
  • cap (or eliminate) medical malpractice awards for “pain and suffering” - allowing the medical profession to no longer require exorbitant premiums (basically paying off lawyers)
  • eliminate or marginalize the AMA - reducing (or changing) the requirements necessary to become a medical practitioner, thus increasing the supply of “doctors” and reducing the costs of health care.
  • eliminate the current medical insurance system and replace it with a purely catastrophic insurance system (e.g. covering 50% of expenses $20k-50k, 75% of 50k-100k, and 90% of 100k+)
• Implement one (or more) forms of consumption taxes, increasing the taxed base and thus tax revenue:
  • VAT (Value Added Tax)
  • Fair Tax - effectively a national sales tax
  • Ideally we would replace the existing income and payroll taxes, but there is probably a happy medium where both can exist
• Provide more incentives for people to have more children - allowing the population demographics to return to levels seen during our “boom” years. This is probably not a good long-term solution, given that there are limited planetary resources and we’re already starting to edge up on those.
• Invest more in education, science, research and development - hopefully the long term payoff in GDP growth will prove sufficient to cover our debts
• Invest in a robotic mission to the asteroid field to recover an asteroid or two - by most estimates the mineral resources of single asteroid would cover our current budget deficits for ten years. (~$20 trillion)

These two videos are a rendering of the Mandelbox - a 3D representation of the Mandelbrot Set.

This is why I don’t believe in Intelligent Design - if a math equation two lines long can generate this much complexity and variation, can we really think that the relatively minor differences in life aren’t controlled by something as deceptively simple?

I have a fairly broad area of expertise, with a substantial degree of depth in some fields. This has led many friends and some family to suggest that I should sign up for Jeopardy - because, they say, “You’d be sure to win.” I typically respond by mumbling some sort of humble version of “I’m not so smart” and leave it at that. The truth is, I’m smart enough to realize that I’m not so smart.

Based on a wide variety of IQ tests, standardized tests, and various placement exams throughout my life, I’ve typically been ranked in the 99th percentile for human intelligence. Based on this empirical and statistical evidence, I can reasonably conclude that I’m fairly smart - smart enough, that if I’m placed in a randomly selected population of 99 people, I’m fairly likely to be the smartest guy in the room. While this might be cause for celebration, I’m familiar enough with statistics that I think about slightly larger populations.

For instance, if I’m placed in a randomly selected population of 1000 people, I’m only likely to be in the top 10 in terms of intelligence. I may still be the smartest guy in the room, but I’m just as likely to be 10th. Increase the population to 10,000, and I’m only in the top 100 - increase the population to 1 million, and I’m only in the top 10,000. If you take the entire population of the US, I’m only in the top 3 million.

Applying these statistics to Jeopardy, if you assume that only smart people apply for Jeopardy, and they get a few million applications a year, then it’s fairly likely that almost everyone who applies (and gets accepted) will be at least as smart as I am. If you figure that Jeopardy only runs 250 games in a year (i.e. every weekday, with 2 weeks vacation - they probably run less often), and they only pick the top candidates, my chances of being the best player on a given day goes down dramatically.

For a real numerical analysis, let’s assume that only people in the 95th percentile or higher ever make it on TV - and that on a given day all three contestants are chosen at random from this population. Let’s assume that only half the qualifying people apply, and that only people from the US are allowed to play - that yields a population of 7.5 million potential players, which yields a 1 in 10,000 chance that I’ll get selected to be on TV in any given year. Assuming I am selected, I only have a 64% chance of being the smartest player on stage. When you factor in that intelligence is not the only determinant of who wins (daily doubles and category selection are paramount), my chances only go down.

While some might say that a 64% chance at winning is still worth it, I prefer to apply the expected value. Consider that the maximum winnings (neglecting daily doubles or final jeopardy) is only $54,000. Based off the numbers above, the expected value for applying is only $34.50 - which assumes I get every question right. Even if you consider the absolute maximum payoff (getting every question with daily doubles, final jeopardy, and becoming a 5-day champion), the expected return is only $457. A much more reasonable expectation is $66 (which takes the geometric mean between maximum values, and then divides that result between the three contestants).

While I’ll generally agree that Unions fulfilled a useful and necessary purpose in the past, they are currently granted far too much power, often by laws passed at their insistence.

A monopoly is a single firm that controls the production and sale of a given good. Good examples are Standard Oil, US Steel, and Ma Bell. A monopoly leads to products of lesser quality, higher prices, and are almost universally seen to be detrimental to society.

A union is a firm (collection of people) that controls the production and sale of a given good (labor). It may only be a regional monopoly, or only of a specific kind of labor, but it still seems like a monopoly to me. They negotiate with everyone who seeks to purchase their good (employers) and negotiate the highest possible price. Because the price is higher than the market clearing price, the demand is reduced, and employers are not able to purchase as many workers as they would like - leading to unemployment. So the union is great for members of the union (they get more pay), but only so long as management has sufficient positions available. As I understand it, any shortage of jobs is inflicted on those newest to the union - so a lazy unproductive do-nothing with twenty years seniority gets priority over the eager young replacement willing to work extra hours at no pay just for the experience.

And yet, not only do we not destroy these vampiric behemoths of inefficiency as we did the other monopolies of days past, we’ve passed legislation to protect them and increase their power? Apparently, instead of lowering the cost of entry into the competing labor market, there are laws that require workers to either be in the union before getting a job, or that they join the union (and pay dues) as a condition of employment. This basically means that it’s impossible for a competitor to enter the market - making the Union a de facto monopoly.

The Right To Work Law controversy makes no sense to me. First off, the simple fact that such a law would be required seems to indicate that the existing rules are hideously broken. The default should be competition and freedom - we certainly should not have to legislate it. Second, the two arguments that union defenders tout in opposition to this corrective legislation are laughable at best.

First, they argue that the law will create a free-rider problem. While they should be applauded for at least attempting to address a market failure, the issue is far from that simple. Yes, a non-union worker can take advantage of the union’s collective bargaining to work at (or below) the negotiated wage and benefits without paying dues. This is most certainly a free rider problem - the employee gains a benefit that he did not pay for - if the goal of society is only to create powerful unions. To make a comparable argument, is it a free rider problem if a new startup firm takes advantage of the artificially high prices created by a cartel of entrenched firms? The new firm is most certainly gaining a benefit that it does not pay for - but that’s the very definition of capitalism. Lower prices are good for society - by increasing overall utility. How is labor somehow exempted from this basic truth? The worst case scenario of the free rider problem is that we’ll end up with fewer unions than is socially optimal. Meanwhile, under the monopoly, employers pay higher than necessary prices (which can be passed on to consumers), unemployment is increased, and the economy as a whole becomes inefficient.

Second, they argue that enforcing a right to work law infringes upon the employer’s freedom to choose to engage in an exclusive contract with a union. While I’ll agree that this is technically correct, what I can’t figure out is exactly why an employer would ever voluntarily choose to enter such a contract. The only case I can see is if, out of all producers of labor, the union is the one that provides the best product at the lowest price - something that is inherently selected against when the union is a monopoly!

I’m not totally anti-union - they were definitely useful in the past, and they may prove useful in the future. Of course, the way I think a union should work is just like any other firm. It sells a good (collective bargaining) for the benefit of its customers (workers) who pay a price (dues) commensurate with the value they perceive in the good. Anyone who doesn’t feel the need to purchase some collective bargaining is under no obligation to do so. If work conditions become too intolerable (hours too long, wages too low, poor safety conditions), then workers will have an increased demand for collective bargaining, driving up the price, which gives the union more power to enforce a more favorable contract. By only negotiating contracts for union members, you’d even have a built-in incentive to join the union voluntarily - as long as the cost of dues is lower than the benefits gained by joining the union. If the benefits get inefficiently high, then unemployed workers will have an incentive to undercut the union’s rates, reducing the power of the union. You could even have additional competing unions - which may offer lower prices (dues) or different values in negotiation.

The way unions are currently configured, however, is an abomination to the ideals of a free and capitalist society. Further Reading

The future is largely unpredictable - especially in the long run. As an example, physics represents arguably one of the most successful areas of human knowledge and prediction. Given two bodies, with sufficient knowledge of initial conditions, we can determine their exact conditions at any point in time from now until infinity. Adding even a single additional body, however, can only be approximated in the short run, and the longer into the future we project, the less certainty we have in the result. There’s also the universal caveat attached to every investment vehicle - past returns do not guarantee future results.

I can’t know the future - so how can I possibly suggest investing in it? I address the assumptions:

1. The world as we know it will continue to exist - basically that we won’t be evaporated in nuclear war or a massive super volcano or asteroid impact or alien invasion that ends human civilization. Given that if any of these come to pass, I probably won’t care much about my investments, because I’ll either be dead or living in a world without money.
2. The world financial markets will continue to exist - if the financial markets completely melt down, then my investments will be worthless. Short of buying lots of guns/ammo and learning survival skills, there really isn’t an easy way to address this risk.
3. Human civilization, science, and technology will continue to grow and improve - while it’s certainly possible to bet against improvement, over long enough time scales, civilization has always improved.
4. Neither I nor anyone else can predict the future

#1 and #2 are basically CMA (covering my ass) - because I can’t predict the future, I can’t really say whether either will come to pass, but the best way to prepare for them is to accumulate as wide a basis of knowledge as possible to aid in both survival and rebuilding, and stockpile a few guns to ward off the occasional zombies, looters, or zombie looters.

Investment Vehicle Priority

Assuming limited cash flow, money is allocated roughly in this order:

1. Establish a $1000 emergency buffer fund - to be used only to avoid incurring further debt
2. Pay minimums on any existing debts, set aside funds to cover necessary expenses (food, rent)
3. If employer offers retirement matching funds, contribute enough to get full matching
4. Pay off the highest interest debt currently on the books
5. Increase emergency fund to equal six months of current salary - to be used only in the case of unemployment, if unemployment seems likely (i.e. you’re afraid), increase the fund to 12, 18, or 24 months
6. Fully fund a Roth IRA for the current year (and the previous year, if necessary)
7. Fully fund any employer retirement account
8. Set aside 10% of remaining funds for discretionary use - use this for whatever you want
9. Fund non-retirement investments

Investment Asset Allocation

Since you typically have less control over employer-based accounts, choose an allocation that resembles the one below as closely as you can.

• 10% - “high risk” venture capital funds - spread as widely as possible to take advantage of unforeseen and highly lucrative events
• 60% - “medium risk” index funds - preferably spread as widely as possible over the entire stock market
• 20% - “low risk” bond funds - again, as widely as possible over the entire bond market
• 10% - “very low risk” CDs/CD Ladders/Annuities/Cash Savings accounts

As you get older (or closer to real retirement), you’ll shift the percentages towards lower risk investments. I would still keep the 10% high risk allocation, just because you never know when you’ll strike it really big - this is the “right” way to play the lottery, since you’re betting on the next Microsoft, Google, or Facebook. If you’re comfortable taking big risks (i.e. losing lots of money in the short run), you could increase the percentages towards higher risk investments for a chance at a bigger payoff.

Dollar Cost Averaging

In theory, you’ll have a certain amount of money at steps #6 and #9 each month to invest. A regular monthly salary guarantees this, while a non-regular paycheck can be approximated (via a moving average). You use this fixed amount of money to invest in your portfolio. Effectively, this guarantees that you will buy low - you buy more shares when prices are low, and fewer shares when prices are high.

Rebalancing

Every so often (yearly, biannually, semi-annually), you’ll want to look at your portfolio and reset it to your target percentages. Over time, some investments will invariably do better than others and change the percentages of your allocation. Maybe the market doing especially well, pushing your medium-risk investments up to 70%, while your very low risk drops to 6%. By moving money from the medium risk to the very low risk, you further reinforce the “buy low, sell high” paradigm. You’re selling assets that are currently very high, and buying assets that are currently very low. This also ensures that you don’t get caught with unexpected levels of risk - if you never rebalance your allocation, you might end up with a very high percentage of risky assets that could suddenly lose value, or, in the other extreme, you might end up with two many low risk assets and miss out on the potential for growth.