Sunday, December 14, 2008

More Economics

Economics and philosophy really were my true loves in my undergraduate days. After I took a philosophy course (trying to fill in my electives), I thought seriously about switching major to philosophy, after I took an economics course, again, I thought seriously about switching to economics. I didn't because I just did not have enough confidence in myself to pursue a career as risky as those would be, careers with just a small number of available jobs filled by incredibly motivated and brilliant workers. That kind of high risk, moderate reward profile was not very attractive option to me at the time.

Sure many people get undergraduate degrees in philosophy or economics then get a more practical graduate degree, like law or business. But neither of those or anything related to that had any appeal to me. So, I stuck to my engineering pursuits, and now I spend way too much of my free time on "hobbies" that in a different life would have been my preferred career choice.

So, in that vein, I have been anxiously reading Franklin Roosevelt's biography, and like usual when I read a good book, I feel like I'm living the experience as I read it. The 1929 stock crash has happened, the Great Depression is in full swing, FDR just won the 1932 election, and in literally his first day in office, he declared a national bank holiday that would end up lasting five days. Can you imagine the entire banking industry being literally shut down for a full week?

But the Great Depression was both baffling and horrifying, here is a description from the book:

"It could hardly do worse. The late winter of 1933 was the darkest moment in American life since the Civil War, which for all the destruction it wreaked at least was comprehensible to ordinary men and women. The most discouraging aspect of the Great Depression was that if defied common logic. People went hungry while farmers dumped milk in ditches and left crops standing in the fields. The thriftiest of savers, cautious souls who had shunned the stock market as reckless speculation, saw their carefully tended nest eggs vanish overnight as banks collapsed. Factories sat idle while millions wanted nothing more than to go back to work.

The magnitude of the disaster could only be estimated, not least because the Hoover administration hadn't been eager to quantify the bad news. But the evidence available to a subsequent generation of historical statisticians indicated that by 1933 the total production of American farms and factories had fallen by a third, in real terms, since 1929. (The nominal decline was greater but included a sharp fall in prices as well). One-quarter of American workers were unemployed - working part-time or at jobs beneath their skills and training. Five thousand banks had failed or were failing, typically leaving their depositors without recourse. The stock market had lost three-quarters of its value since October 1929, wiping out millions more. Half a million home mortgages had been foreclosed, rendering the owners at once bankrupt and homeless. As property values plummeted, property tax receipts shriveled, forcing cities and states to lay off workers or pay them IOUs.

Hunger scoured the land. Generations accustomed to pulling their own weight often refused to seek organized relief until they were starving; in other locales the relief simply fell short of what was required. Individuals and families hit the road looking for work and shelter; the Hoovervilles that sprang up in every city and many towns were merely the most visible manifiestations of the tide of homelessness that swept the country. Young men and women postponed marriage; the nation's birth rate fell by a third.

Old people were particularly vulnerable. Guaranteed pensions were a rarity in the 1930s; workers expected to save for their retirements or work until they died. But bank failures stole their savings, and unemployment their livelihoods. In the human nature of things they were less mobile than the young, often because they were sicker. Some moved in with their children; millions simply suffered alone."

My limited understanding of economics and of the Depression much of which has come from this book seems to be that the ultimate cause of the Depression was as follows:

1) Pre-twentieth century, our economy largely was built on an economics of scarcity. More people farmed and most people's work went into providing for basic survival related essentials: food, clothing, shelter. Much of what they consumed they produced (relatively speaking).

2) In the 1900's, that changed as the country industrialized. More people moved into the cities and worked in factories. Global trade increased both prosperity and specialization. People become more interdependent and with that interdependence the world grew richer.

3) WWI crippled much of the trade in Europe and severely weakened the economy there. The US came out of the war relatively unscathed, but the US economy become increasingly dependent on other countries' economies as well. So Europe's problems affected the US.

4) This specialization and interdependency in the economy also provides an economic system that's harder to understand and more beholden to bubbles, and that was what happened in the 1920's with devastating consequences. The over exurberance led to over-leveraging and unsustainable debts. This massive bubble eventually popped (in 1929) becoming the biggest economic contraction in our history.

An economy of inter-dependency depends on trust in each other. I will work hard on my skills to produce my product with greater efficiency and greater quality in hopes that you will buy my product or my service. In exchange, I will use the money I earn to buy your product produced from your position of strength.

But this interdependency leads to a certain amount of vulnerability. I have devoted a lot of years of my life to develop skills in software development, but I have no clue how to farm, to sew, to build a house. I have specialized my skills in computers so I can contribute at a higher level to the economy in that way, so I can pay other people to make my clothes, build and maintain my house, and farm my food.

But if we lose our nerve, if we stop trusting in one another, it can result in a massive collapse, and that is exactly what happened in the 1930's. People panicked and they began to hoard, withdrawing money from banks because they stopped believing in banks. This panic literally led to to conditions where you had "idle factories with millions who wanted to work" and "milk being dumped into ditches while people starved."

In modern terms, if people stopped paying for my software, I would lose my ability to pay for another's farmed food. I would starve while our farms were left with a massive over-supply of food.

The brilliance of Roosevelt is that he wasn't afraid to act, and he acted with boldness and learned as he went. On top of that, he injected a sense of optimism, willing to engage directly with the country in the most personal of ways. In his first speech he said "There's nothing to fear but fear itself" which became the halmark of his presidency both during the depression and during WWII.

But one thing is for sure and is obvious. For us to limit these booms/busts cycles in our economy, its important that we trust in each other and that we behave in ways that earn that trust. That we have skilled workers that work with increased creativity and efficiency. That we don't over-leverage. Debt is good and necessary, but we should have a reserve for a rainy day, a reserve that will help us keep our cool when times get tough.

In that spirit, we should try to maintain a consistent spending profile through bpth bad and good times, a bit more caution in boom times, a bit more risk taking during a downturn. This is exactly the Warren Buffet approach to economics by the way. Its an approach that leads to selling high and buying low. Its counter-intuitive but its exactly right. Its a more sustainable, long term approach.

If every one had this spending/saving/investing profile we would see less volatility in our business cycles. Instead we would see steady, consistent growth.

Fear, in the end, is the enemy. We have a lot of reasons to be confident and optimistic, we shouldn't let anybody let us feel otherwise.

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