Economics

What’s so wrong with socialism?

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As a concept, socialism is appealing. It’s idyllic, it seems to diminish unfairness, promote the less-fortunate, favor equality, all good things. So what’s the problem?

The true problem with socialism is an economic one. It’s about simple math.

Socialism seeks to operate an economy, or society on the whole, by rules and regulations set by a small group of people in power.

Conservatives mainly criticize socialism as a system that misplaces incentives. While humans do operate by incentive, and socialism does skew incentives, this is not the most helpful critique. Socialistic regimes have imposed different forms of incentives throughout history, like fear of torture and death, to coerce their people into desired action.

There is also a basic problem with the idea that a few people should hold so much power over many. Regardless of the purity of a person, power generally corrupts. But, like the incentive criticism, this is not the most basic problem of socialism. The truth is, even under the most compassionate, just, caring leadership in the history of the world, socialism would still be doomed to fail.

The problem of socialism is, at its most basic, a problem of pricing. A truly free market is an incredibly efficient way to set prices and wages. Whenever there is too much of a good, demand (prices) goes down, and businesses and people react by creating less of that good. Whenever there is a shortage of a good, demand (prices) goes up, and businesses and people create more of that good. In a free market, this happens quickly, automatically, and constantly. Communication stems from millions of data points (decisions, knowledge, people) occurring every second of every day accurately determining what people want and delivering those goods.

When a government or ruling body steps in to set prices or fix wages (the standard operating procedure of socialism) instead of letting the market make a determination based on supply and demand, that body is bound to fail. Any group of people, regardless of their level of training, IQ, ambition, morality, etc. can never have a complete understanding of the millions of data points, decisions, and knowledge swirling within the market every second. A few people simply can’t know as much as the several billion people on earth collectively know.

Because of this, a set price or a fixed wage will necessarily result in waste (too much of a good) or lack (too little of a good). This state of mispricing, given enough time, will result in the collapse of society.

An example of wage-fixing can be seen in modern-day minimum wage policies. Minimum wage is an attempt to promote justice and protect the less fortunate from evil greedy companies; an understandable inclination, but unfortunately a worthless solution. In a free market, wages increase naturally (with bumps along the way) as demand for labor increases. In socialism, wage-fixing makes it difficult or impossible for some businesses to hire employees at a price they can afford, even if potential employees would be glad to work for such wages. At worst this creates an insane situation where businesses aren’t allowed to hire people who want to be hired, at best the market is inhibited and incentives are skewed (business may be more likely to hire contract employees or part-time employees to avoid additional costs required by regulation). A much more effective way to thwart greedy capitalists is to give the market space to create better jobs.

Socialism, as economic practice, will always necessarily fail. No group of people can ever possess the collective information of the entire market, and so they will never be able to accurately allocate resources and set prices.

The Savings Quandry

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We live in a fiat currency world. ‘Fiat’ simply means government-backed. The paper that dollars are written on is pretty close to worthless, but the U.S. government guarantees its value and other countries do the same for their own fiat currencies. The U.S. dollar is worth something, more than most other fiat currencies, because it’s backed by the most powerful government in the world. There are a few implications of this:

  1. In the past, humanity has utilized a multitude of different items or elements or commodities as money, ranging from cattle to gold, beads to shells, and anything in between. Very few of history’s currency still exist as anything resembling money for one main reason, they could be produced. The most important characteristic of money, or of anything valuable, is its rarity, the difficulty (or preferably the impossibility) of creating more of it. In order for money to hold value, it can’t be producible, there must be a limited supply. If it’s producible, there’s a massive incentive for people to produce it, and when people produce more of something, that thing loses value. This has happened countless times throughout history. Some Native American tribes used Wampum beads (gleaned from shells and clams) as money and used them to trade with European settlers. European settlers, with superior technology, were able to mass-produce the beads causing a massive devaluation. Wampum beads were inflated (or devalued, they mean the same thing) to the point that they became worthless, leaving the Native American tribes using them destitute. A similar issue is presented when we try to use commodities as money (silver, coffee, copper, etc.). Commodities are valuable (many us would be lost without our morning coffee and we’d have a hard time building skyscrapers without steel), but when demand for a commodity increases, so does the production of that commodity, so its value decreases. Money doesn’t need to have intrinsic value, it doesn’t have to be useful for anything else, it simply needs to be able to reasonably hold value through scarcity.
  2. Since we use fiat currency, the government controls the dollar and consequently has the ability to produce more of it. When they do, inflation happens. The government likes inflation. Since the U.S. officially and fully entered the fiat currency game in 1971, the U.S. dollar has been inflated (devalued) by around 3.86% per year, on average. The government introduces more money into the economy through various convoluted debt instruments and stimulus packages, decreasing the value of existing dollars. The belief is that a certain amount of inflation is good for an economy because it promotes spending and borrowing, the opposites of saving. It’s definitely not helpful for saving. If you left $100k in your savings account in an average year, at 3.86% inflation you would lose almost $4k. If the money is in a savings account, maybe the bank would offer you a tiny bit of interest to offset some of the loss. If you’re lucky you might get 1%, but you would still lose $3k. In one year! Leave your money alone in a bank account or under your mattress for any amount of time and you’re out a significant portion of your savings.

So the question remains, how do we save money?

Thankfully, there’s an answer. The solution to the devaluation of our dollars is investing. Specifically, investing in companies through the stock market. All that talk about long-term investing, diversification, portfolios, the stock market, etc., that stuff all has merit. The best way to overcome inflation in our day and age is to invest money in companies, and let it grow. The stock market is the great hedge against inflation. Market returns, over time, always outpace inflation. It doesn’t happen every year, when the market is down it can definitely be worse than inflation, but if you give it time, the market will always win, and by a large margin.

Unfortunately, as things are presently constituted, saving money is not incentivized. Fiat money and inflation encourage borrowing and spending. But, saving is more important now than ever (who’s in line for a pension when they retire?), and the stock market offers an incredible store of value, one that increases exponentially over time. Don’t skimp on your investments.

Why don’t we use the gold standard anymore?

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Today we no longer use a gold-backed currency. Even when the dollar was backed by gold, the U.S. government would adjust the gold-to-dollar ratio with regularity, essentially muting any effect of the currency’s gold backing. So while officially abandoned in 1971, we’ve been off the gold standard for quite a while, since about 1914.

Beginning in and around the 19th century, developed nations almost universally adopted the gold standard. Uncoincidentally, the 2nd half of the 19th century is heralded as one of history’s great economic eras. But, in 1914, at the outset of WW1, developed nations involved in the fighting began moving away from the gold standard. They were faced with two options to finance war operations: 1) increase taxes, 2) leave the gold standard and print money. Option one would have been supremely unpopular, option two would accomplish the same thing as option one just without the national outrage. Taxes are one thing, people understand what’s happening, they’re giving up their money for a government to provide services that the collective majority generally agrees upon. Fiat money is different. Instead of imposing additional taxes, fiat money allows the government power to print money, devaluing the currency and causing citizens to end up with less money via inflation. Imposing taxes and printing money grant the same outcome for governments, they end up with more money, and it also creates the same outcome for citizens, they end up with less money. The issue is that citizens have a measure of control over taxation by voting, complaining, revolting, etc. They have very little control over printing money.

It’s impossible to prove, but nevertheless an interesting thought experiment: what if governments hadn’t abandoned the gold standard in 1914? In all likelihood the war would have endured for a fraction of the time it did in reality. Taxes would have been imposed (the only way for governments to fund the war), they would have been incredibly unpopular (because ordinary people didn’t care about petty monarchical conflicts between nations), governments would have run out of money to fund their war efforts, and the war would have ground to a halt, almost certainly sooner than four years, and more probably within one year. Again, it’s impossible to prove, but certainly possible.

Since 1914 little has changed, fiat (government-issued) money is the currency of the age. Taxation has steadily decreased over the last one hundred years while government spending has steadily increased by borrowing and printing notes. A return to the gold standard at this point is all but impossible. The fact is that gold, while a great purveyor of value, is impractical for day to day use. It’s heavy, it’s hard to divide into smaller bits, and it’s costly to keep secure. These are the reasons why gold was concentrated into central banks and traded via government promissory notes in the first place.

Unfortunately, every example in history involving the utilization of soft money (money that’s easily producible) has eventually resulted in large-scale economic collapse. That’s not to say it’s impossible for fiat money to succeed, the U.S. government, while far from perfect, has not inflated the currency to disastrous levels, and may not for a long time. But no human or human institution has been able to stave off the temptation to over-print currency indefinitely.

So that’s depressing, is there a solution? We know that hard money (money that’s scarce and/or hard to produce) is foundational to thriving economies. Gold is the best example we have of hard money, but it has inherent flaws that make it difficult to use in our modern world. An interesting development in the last decade is the inception and rise of crypto-currencies. I won’t pronounce Bitcoin the ultimate salve of modern economics, but it’s certainly worth keeping an eye on. Crypto-currencies offer many of the beneficial characteristics of gold (difficult or impossible to produce, widely accepted), and avoids many of gold’s pitfalls (it’s not heavy, not hard to divide, and inherently secure). The market will ultimately decide if some type of crypto-currency is any type of answer, for now, it’s a fascinating concept. 

5 of the best books I read in 2019

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1. Range – David Epstein.

Range is my 2019 winner. It was the best book I read last year, and one of my favorite books related to personal development ever. By range, Epstein refers to a set of broad experiences, inputs, interests, experiments, etc. In a world that values specialization and highlights the ‘10,000-hour rule’ (which says you must dedicate 10,000 hours to something to achieve mastery), Epstein argues that hyper-focus is actually not the path to success, far more often those who have range win. Epstein encourages us to pursue hobbies and interests, to be unafraid of making a change, to never feel behind, and not because life is more fun that way, it’s actually a more effective way to live. I can’t recommend it highly enough, read Range.

2. Atomic Habits – James Clear.

There are few personal development/self-improvement books that I consider must-read, but Atomic Habits is one of them. James Clear notes that winners and losers have the same goals, what sets them apart is their systems (habits). Humans operate by default and we relentlessly fail at improving ourselves because we fail to address our default behaviors. Goals are fine, they help give direction, but only our systems can take us where we want to go. Clear guides us through how habits operate and how to make meaningful and lasting changes by changing our defaults. It’s a fascinating and fun read, and one that has had a profound impact on how I think about behavior and pursue change.

3. Factfulness – Hans Rosling.

Hans Rosling made it his life’s mission to reinform commonly help misconceptions about our world. He penned Factfulness as he battled the cancer which would eventually take his life. Through ten chapters he addresses ten fascinating topics that we routinely misunderstand (world population, poverty, bias, etc.). He emphasizes the fact that the world can sometimes be bad, while still being significantly better than it was before. By offering clarity, thoughtfulness, and objective facts, Rosling helps us to see things they way they are. It’s occasionally mind-bending, which is a good thing, and always enjoyable.

4. Born a Crime – Trevor Noah.

Born a Crime is an autobiography. Trevor Noah takes us through his wild, funny, and unlikely childhood in one of the more engaging books I’ve ever read. It’s at times hilarious (I literally laughed out loud more than once), sentimental (his relationship with his mother is remarkable), thoughtful (interacting with apartheid in South Africa), and ultimately a completely rewarding read.

5. Billion Dollar Whale – Tom Wright.

Billion Dollar Whale consistently made my jaw drop as I read it. The story is absurd, unbelievable, scandalous, incredible, and completely true! It’s about a young Malaysian fancier/businessman (Jho Low) who cons billions of dollars from the Malaysian government in a stream of devious business deals and spends it on some of the most extravagant partying the world has ever seen. The story involves Hollywood actors and actresses, world-leading finance companies, even the president of the United States. Another interesting part of this story (as if it wasn’t interesting enough) is that it hasn’t concluded yet. Jho Low is currently a wanted man hiding out, most believe, in China, but is certainly still active. In fact, his team of lawyers aggressively campaigned to ban Billion Dollar Whale from being sold, and succeeded to keep the book off British bookshelves for a year! Truly, a remarkable read.

Value Investor (part 1)

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Value investing sounds really cool. It sounds savvy, it sounds smart, it sounds responsible, it sounds like it makes a lot of money. I mean, Warren Buffet is a value investor!

So what is a value investor? Well, a value investor is someone who invests in value companies. So what’s a value company? I’m glad you asked. Essentially, a value company is one whose stock price is about the same (could be a little higher or lower) than its intrinsic, or book, value. A lot of words there but stick with me. The intrinsic value of a company is what you get when you add up all the company’s assets, its land, warehouses, products (which can include patents), equipment, cash, etc. It might seem a little odd that a company’s stock price wouldn’t always be close to its intrinsic value, but the stock market prices of growth companies (the opposite of value companies) can actually trade multiples of 8 times higher than its intrinsic value. This happens because the market expects the growth company to continue growing. Value companies aren’t typically expected to grow much, they’re often characterized as distressed. So value investors are analyzing these value companies and deciding which ones they think are actually undervalued and which ones could bounce back. Again, it sounds great, they’re the brilliant nerdy guys reading all of the fine print and finding the deals in the stock market, the companies that are underpriced. All you have to do is hitch up to their wagon and ride those value companies up when everyone else figures out how valuable they actually are. Sounds pretty responsible, right?

A semi-famous value investor, Michael Burry, featured in the Big Short (as Christian Bale) crushed the growth stock market from 2001-2005. In the middle of 2005, he was up 242% when the U.S. large growth market (S&P500) was down 6.84%. Michael Burry is the quintessential weird genius that we love to fall in love with, and hand our money over to. He did things differently, he didn’t take normal massive fees, he was incredibly awkward with people in person, he kept to himself, he obsessively studied the interworkings of the companies he invested in, just about everything you would expect from the next market genius. He’s most famous for predicting, and attempting to short, the housing crash in 2007. And now’s he’s rich, and semi-famous, and still investing. He recently stated that passive investing is a bubble, that he’s concentrated on water (you get it), that GameStop is undervalued, and that Asia is where it’s at. While these investment tips might accord with the laws of value investing, they hardly seem prudent.

Michael Burry is definitely smarter than I am, but here’s what I know:

1) Ken French, a professor of finance at the Tuck School of Business, Dartmouth College, who has spent much of his adult life researching and publishing in the sphere of economics and investing, conducted a study of mutual-fund managers (Luck versus Skill in the Cross-Section of Mutual Fund Returns) and found that only the top 2% to 3% had enough skill to even cover their own costs. Eugene Fama, another father of economic and investing academia, who co-wrote the paper with Ken French, summarizes their findings this way: “Looking at funds over their entire lifetimes, only 3% demonstrate skill after accounting for their fees, and that’s what you would expect purely based on chance.” Of the managers who do exhibit enough skill to cover their own costs, it’s hard to determine whether an actual skill is at work or it’s simply a facet of luck; most free-market scholars lean towards luck.

2) Fama continues: “Even the active funds that have generated extraordinary returns are unlikely to do better than a low-cost passive fund in the future.” Some managers do well enough to cover their own costs and beat the market in a given year. Unfortunately, their success languishes quickly and they regress to the same plane that active managers on the whole occupy, which is underperforming the market.

So is Michael Burry, or any value investor, the weird, brilliant savant that we desperately want to attach our life-savings to, or is he one of the 3% of managers who have done well enough to cover their own fees, but who the data says is more likely to regress to market underperformance mean than to do it again? I know which side I’m playing.