Competing For State Contracts is Not Competition

Here in Britain, we hear the word competition a lot. Since Margaret Thatcher, there has been a general trend — in the name of competition — toward the selling-off of utilities such as water, railway, electricity and telecoms providers. More recently, there has been a trend toward government services being provided by private companies, such as the bungled Olympic security arrangements contracted out to multinational security giant G4S, as well as work capability assessments contracted out to French IT consultancy ATOS, and the contracting-out of some medical services.

The way this works is that the government provides the funding for services, which private sector companies then bid to undertake. This is also the way in which defence contractors have historically competed for defence contracts, a sector which is renowned worldwide for its profligacy, waste and inefficiency.

This is a bizarre arrangement. Competing for government contracts is nothing like the free market. In a true market environment businesses compete for the custom of individuals based on their ability to provide the best products and services. Individuals spend their money to satisfy their needs. New businesses can generally enter the marketplace at any time, and take business away from existing competitors. Competition is beautiful, because it allows economies to quickly adjust capital, labour and resource allocation to the preferences of society based on which goods and services people choose to purchase.

Under a model where private contractors compete for government cash, this is impossible because contractors are essentially bidding for a state-backed monopoly. State bureaucrats determining which contractor will get the money is not competition; there is no market mechanism, there are no consumer preferences. Contractors are just bidding for handouts from the taxpayers’ purse based on the preferences of economic planners. Consumers cannot take their custom elsewhere, because the custom is involuntarily coming out of their taxation.

This has also been the reality of privatisation. Although I am no fan of government-controlled industry, the reality of privatisation in the UK has been the transfer of state monopolies into private hands.

One very clear example of this is telecoms infrastructure. BT Openreach, an arm of the privatised BT, has a complete state-enforced monopoly on telephone exchanges. Other telecoms providers have to lease their infrastructure in order to operate.

And the same for railways; rail lines are sold off as monopolies for ten-year periods. For travellers who want to travel by rail from one destination to another, there is no competition; there is only a state-backed monopoly operating for private profit. No competition, only endless fare hikes, delays and a complete lack of market accountability as contractors take the government cash and do whatever they want.

Ultimately, the state-backed-monopoly model seems to manifest the worst of all worlds. Costs for taxpayers remain high, budget deficits continue to grow, and utilities remain inefficient and messy. The only difference appears to be that taxpayers’ money is now being funnelled off into corporate pockets.

A free society cannot be based on economic planners allocating resources based on a bidding process. A free society is based on the state letting society allocate resources based on the market for goods and services that people want and need.

The Origin of Money

Markets are true democracies. The allocation of resources, capital and labour is achieved through the mechanism of spending, and so based on spending preferences. As money flows through the economy the popular grows and the unpopular shrinks.  Producers receive a signal to produce more or less based on spending preferences. Markets distribute power according to demand and productivity; the more you earn, the more power you accumulate to allocate resources, capital and labour. As the power to allocate resources (i.e. money) is widely desired, markets encourage the development of skills, talents and ideas.

Planned economies have a track record of failure, in my view because they do not have this democratic dimension. The state may claim to be “scientific”, but as Hayek conclusively illustrated, the lack of any real feedback mechanism has always led planned economies into hideous misallocations of resources, the most egregious example being the collectivisation of agriculture in both Maoist China and Soviet Russia that led to mass starvation and millions of deaths. The market’s resource allocation system is a complex, multi-dimensional process that blends together the skills, knowledge, and ideas of society, and for which there is no substitute. Socialism might claim to represent the wider interests of society, but in adopting a system based on economic planning, the wider interests and desires of society and the democratic market process are ignored.

This complex process begins with the designation of money, which is why the choice of the monetary medium is critical.

Like all democracies, markets can be corrupted.

Whoever creates the money holds a position of great power — the choice of how to allocate resources is in their hands. They choose who gets the money, and for what, and when. And they do this again and again and again.

Who should create the monetary medium? Today, money is designated by a central bank and allocated through the financial system via credit creation. Historically, in the days of commodity-money, money was initially allocated by digging it up out of the ground. Anyone with a shovel or a gold pan could create money. In the days of barter, a monetary medium was created even more simply, through producing things others were happy to swap or credit.

While central banks might claim that they have the nation’s best democratic interests at heart, evidence shows that since the world exited the gold exchange standard in 1971 (thus giving banks a monopoly over the allocation of money and credit), bank assets as a percentage of GDP have exploded (this data is from the United Kingdom, but there is a similar pattern around the world).

Clearly, some pigs are more equal than others:

Giving banks a monopoly over the allocation of capital has dramatically enriched banking interests. It is also correlated with a dramatic fall in total factor productivity, and a dramatic increase in income inequality.

Very simply, I believe that the present system is inherently undemocratic. Giving banks a monopoly over the initial allocation of credit and money enriches the banks at the expense of society. Banks and bankers — who produce nothing — allocate resources to their interests. The rest of society — including all the productive sectors — get crumbs from the table. The market mechanism is perverted, and bent in favour of the financial system. The financial system can subsidise incompetence and ineptitude through bailouts and helicopter drops.

Such a system is unsustainable. The subsidisation of incompetence breeds more incompetence, and weakens the system, whether it is government handing off corporate welfare to inept corporations, or whether it is the central bank bailing out inept financial institutions. The financial system never learned the lessons of 2008; MF Global and the London Whale illustrate that. Printing money to save broken systems just makes these systems more fragile and prone to collapse. Ignoring the market mechanism, and the interests of the wider society to subsidise the financial sector and well-connected corporations just makes society angry and disaffected.

Our monopoly will eventually discredit itself through the subsidisation of graft and incompetence. It is just a matter of time.

Whitewashing the Economic Establishment

Brad DeLong makes an odd claim:

So the big lesson is simple: trust those who work in the tradition of Walter Bagehot, Hyman Minsky, and Charles Kindleberger. That means trusting economists like Paul Krugman, Paul Romer, Gary Gorton, Carmen Reinhart, Ken Rogoff, Raghuram Rajan, Larry Summers, Barry Eichengreen, Olivier Blanchard, and their peers. Just as they got the recent past right, so they are the ones most likely to get the distribution of possible futures right.

Larry Summers? If we’re going to base our economic policy on trusting in Larry Summers, should we not reappoint Greenspan as Fed Chairman? Or — better yet — appoint Charles Ponzi as head of the SEC? Or a fox to guard the henhouse? Or a tax cheat as Treasury Secretary? Or a war criminal as a peace ambassador? (Yes — reality is more surreal than anything I could imagine).

The bigger point though, as Steve Keen and Randall Wray have alluded to, is that DeLong’s list is the left-wing of the neoclassical school of economics — all the same people who (to a greater or lesser extent) believed that we were in a Great Moderation, and that thanks to the wonders of modernity we had escaped the old world of depressions and mass unemployment. People to whom this depression — judging by their pre-2008 output — was something of a surprise.

Now the left-wing neoclassicists may have done less badly than the right-wing neoclassicists Fama, Cochrane and Greenspan, but that’s not saying much. Steve Keen pointed out:

People like Wynne Godley, Ann Pettifors, Randall Wray, Nouriel Roubini, Dean Baker, Peter Schiff and I had spent years warning that a huge crisis was coming, and had a variety of debt-based explanations as to why it was inevitable. By then, Godley, Wray and I and many other Post Keynesian economists had spent decades imbibing and developing the work of Hyman Minsky.

To my knowledge, of Delong’s motley crew, only Raghuram Rajan was in print with any warnings of an imminent crisis before it began.

DeLong is, in my view, trying to whitewash his contemporaries who did not see the crisis coming, and inaccurately trying to associate them with Hyman Minsky whose theory of debt deflation anticipated many dimensions of the crisis. Adding insult to injury, DeLong seems unwilling to credit those like Schiff and Keen (not to mention Ron Paul) who saw the housing bubble and the excessive debt mountain for what it was — a disaster waiting to happen.

The most disturbing thing about his thesis is that all of the left-neoclassicists he is trying to whitewash have not really been very right about the last four years at all, as DeLong freely admits:

But we – or at least I – have got significant components of the last four years wrong. Three things surprised me (and still do). The first is the failure of central banks to adopt a rule like nominal GDP targeting or its equivalent. Second, I expected wage inflation in the North Atlantic to fall even farther than it has – towards, even if not to, zero. Finally, the yield curve did not steepen sharply for the United States: federal funds rates at zero I expected, but 30-year US Treasury bonds at a nominal rate of 2.7% I did not.

Yet we are supposed to take seriously the widely proposed solution? Throw money at the problem, and assume that just by raising aggregate demand all the other problems will just go away?

As I wrote back in August 2011:

These troubles are non-monetary: military overspending, political and financial corruption, public indebtedness, withering infrastructure, oil dependence, deindustrialisation, the withered remains of multiple bubbles, bailout culture, systemic fragility, and so forth.

These problems won’t just go away — throwing money around may boost figures in the short term, but the underlying problems will remain.

I believe that the only real way out is to unleash the free market and the spirit of entrepreneurialism. And the only way to do that is to end corporate welfare, end the bailouts (let failed institutions fail), end American imperialism, and slash barriers to entry. Certainly, cleaning up the profligate financial sector would help too (perhaps mandatory gladiatorial sentences for financial crimes would help? No more paying £200 million for manipulating a $350 trillion market — fight a lion in the arena instead!), as would incentives to create the infrastructure people need, and move toward energy independence, green energy and reindustrialisation.

Then again, I suppose there is a silver lining to this cloud. The wronger the establishment are in the long run, the more people will look for new economic horizons.

Liquidation is Vital

Many Keynesians really hate the concept of liquidationism. I’m trying to grasp why.

Paul Krugman wrote:

One discouraging feature of the current economic crisis is the way many economists and economic commentators — apparently ignorant of what went on over the last 75 years or so of macroeconomic debate — have been reinventing old fallacies, imagining that they were coming up with profound insights.

The Bank for International Settlements has decided to throw everything we’ve learned from 80 years of hard thought about macroeconomics out the window, and to embrace full-frontal liquidationism. The BIS is now advocating a position indistinguishable from that of Schumpeter in the 1930s, opposing any monetary expansion because that would leave “the work of depressions undone”.

Andrew Mellon summed up liquidationism as so:

The government must keep its hands off and let the slump liquidate itself. Liquidate labor, liquidate stocks, liquidate the farmes, liquidate real estate. When the people get an inflation brainstorm, the only way to get it out of their blood is to let it collapse. A panic is not altogether a bad thing. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.

In light of the zombification that now exists in Japan and also America (and coming soon to every single QE and bailout-heavy Western economy) — zombie companies, poorly managed, making all the same mistakes as before, rudderless, and yet still in business thanks to government intervention  — it is clear that the liquidationists grasped something that Keynesians are still missing. Markets are largely no longer trading fundamentals; they are just trading state intervention and money printing. Why debate earnings when instead you can debate the prospects of QE3? Why invest in profitable companies and ventures when instead you can pay yourself a fat bonus cheque out of monetary stimulus? Why exercise caution and consideration when you can just gamble and get a bailout?

Unfortunately, Mellon and his counterparts at the 30s Fed were the wrong kind of liquidationists — they could not heed their own advice and leave the market be. Ironically, the 30s Fed in raising interest rates and failing to act as lender-of-last resort drove the market into a deeper depression than was necessary (and certainly a deeper one than happened in 1907) and crushed any incipient recovery.

Liquidation is not merely some abstract policy directive, or government function. It is an organic function of the market. As the stunning bounce-back from the Panic of 1907 shows — especially when contrasted against the 1930s — a  market liquidation on the back of a panic avoids a depression. Prices fall as far as the market deems necessary, before market participants quickly come back in into the frame, setting the market on a new trail toward growth. For without a central bank, asset-holders who want to maintain a strong economy and growth (in 2008, that probably would have meant sovereigns like China and Arabia) have to come in and pick up falling masonry as lenders of last resort.

Under a central banking regime (especially a Bernankean or Krugmanite one committed to Rooseveltian Resolve) all expectations fall onto the central bank.

My own view is not just that liquidation is vital. It is that the market mechanism is vital. Without their own capital as skin in the game, central bankers are playing blind. The pace of the liquidation and the pace of the recovery should be dictated by market participants — in other words, by society at large — not by the whims of distant technocrats. Society has more skin in the game. The Great Depression was not a crisis of too little intervention — it was a crisis of too much well-intentioned intervention.

As we are learning in our own zombie depression, a central bank doing the opposite of the 1930s Fed and reinflating may solve the problem of debt-deflation, but it causes many of its own problems — zombie banks, zombie corporations, zombie markets, corporate welfarism, and the destruction of the market mechanism.

Facebook & the Bubble Mentality

So Facebook keeps falling, and is now floating around the $27 mark.  We’re a third of the way down to my IPO valuation of FB as worth roughly $2-4 a share (or 5-10 times earnings), although I wouldn’t be surprised for the market to stabilise at a higher price (at least until the next earnings figures come out and reveal — shock horror — that Facebook is terrible at making money).

The really stunning thing is that even after all these falls, FB is still trading at 86 times earnings. What the hell did Morgan Stanley think they were doing valuing an IPO without any viable profit model at over 100 times earnings? The answer is that this was an exit strategy. This IPO was about the people who got in early passing on a stick of dynamite to a greater fool which incidentally is precisely the same bubble mentality business model as bond investors who are currently buying negative-real-yielding treasuries at 1.6% hoping to pass them onto a greater fool at 0.5% (good luck with that).

This was achieved by convincing investors to ignore actual earnings and instead focus on projected future earnings. From Bloomberg:

Facebook, with a market capitalization of $79.1 billion, is trading at 29.5 times the company’s projected 2014 profit of $2.69 billion, data compiled by Bloomberg show.

Or much more simply, counting chickens before they hatch.

There’s an interesting comparison to the development of AAPL. Steve Jobs — who went on to do great things — was never fully in charge of AAPL until much later on. AAPL externally recruited CEOs with business experience, and Jobs was eventually thrust out of the company he founded, to continue his journey on his own. Failure is a really valuable lesson. Jobs was lucky to experience it and learn from it early before he ever got a chance to destroy AAPL.

FB isn’t really a bad business, and prospects would look much rosier if it were priced more realistically. It’s generating a profit — just a much smaller one than suggested by the IPO pricing. And management are being swept along by everyone else’s irrational euphoria. Zuckerberg can freely throw away a whole year’s earnings buying Instagram — an App whose functionality FB actually duplicated in-house almost certainly for a tiny fraction of the cash thrown at Instagram. And Zuckerberg — who controls a majority of the voting rights — isn’t going to get thrust out into the cold by shareholders. He can keep wildly throwing cash around so long as it keeps flowing into FB. The problem is, given the steep price falls, it looks like the river is running dry.

As I wrote before FB started falling:

The big money coming into Facebook just seems to be money from new investors — they raised eighteen times as much in their flotation yesterday as they did in a whole year of advertising revenue. For an established company with such huge market penetration, they’re veering dangerously close to Bernie Madoff’s business model.

That’s life. Bubbles get burst; the Madoff bubble, the securitisation bubble, the NASDAQ bubble, the housing bubble, the Facebook bubble, the treasury bubble. The trick is not getting swept up by the irrational euphoria. Better to miss a blow-out top than to end up holding a stick of dynamite.

Enter the Swan

Charles Hugh Smith (along with many, many, many others) thinks there may be a great decoupling as the world sinks deeper into the mire, and that the dollar could be set to benefit:

This “safe haven” status can be discerned in the strengthening U.S. dollar. Despite a central bank (The Federal Reserve) with an avowed goal of weakening the nation’s currency (the U.S. dollar), the USD has been in an long-term uptrend for a year–a trend I have noted many times here, starting in April 2011.

That means a bet in the U.S. bond or stock market is a double bet, as these markets are denominated in U.S. dollars. Even if they go nowhere, the capital invested in them will gain purchasing power as the dollar strengthens.

All this suggests a “decoupling” of the U.S. bond and stock markets from the rest of the globe’s markets. Put yourself in the shoes of someone responsible for safekeeping $100 billion and keeping much of it liquid in treacherous times, and ask yourself: where can you park this money where it won’t blow up the market just from its size? What are the safest, most liquid markets out there?

The answer will very likely point the future direction of global markets.

Smith is going along with one of the most conventional pieces of conventional wisdom: that in risky and troubled times investors will seek out the dollar as a haven. That’s what happened in 2008. That’s what is happening now as rates on treasuries sink to all-time-lows. And that’s what has happened throughout the era of petrodollar hegemony.

But the problem with conventions is that they are there to be broken, the problem with conventional wisdom is that it is there to be killed, roasted and served on a silver platter.

The era of petrodollar hegemony is slowly dying, and the assumptions and conventions of that era are dying with it. For now, the shadow of that old world is still flailing on like Wile E. Coyote, hovering in midair.

As I wrote last week:

How did the dollar die? First it died slowly — then all at once.

The shift away from the dollar has quickly manifested itself in bilateral and multilateral agreements between nations to ditch the dollar for bilateral and multilateral trade, beginning with the chief antagonists China and Russia, and continuing through Iran, India, Japan, Brazil, and Saudi Arabia.

So the ground seems to have fallen out from beneath the petrodollar world order.

Enter the Swan:

We know the U.S. is a big and liquid (though not really very transparent) market. We know that the rest of the world — led by Europe’s myriad issues, and China’s bursting housing bubble — is teetering on the edge of a precipice, and without a miracle will fall (perhaps sooner, rather than later).

But we also know that America is inextricably interconnected to this mess. If Europe (or China or both) disintegrates, triggering (another) global default cascade, America will be stung by its European banking exposures, its exposures to global energy markets and global trade flows. Simply, there cannot be financial decoupling, not in this hyper-connected, hyper-leveraged world.

And would funds surge into US Treasuries even in such an instance? Maybe initially — fund managers have been conditioned by years of convention to do so. But how long  can fund managers accept negative real rates of return? Or — much more importantly — how long will the Fed accept such a surge? The answer is not very long at all. Bernanke’s economic strategy has been focussed  on turning treasuries into a losing investment, on the face of it to “encourage risk-taking” (or — much more significantly — keep the Treasury’s borrowing costs cheap).

All of this suggests a global crash or proto-crash will be followed by a huge global money printing operation, probably spearheaded by the Fed. Don’t let the Europeans fool anyone, either — Germany will not let the Euro crumble for fear of money printing. When push comes to shove they will print and fiscally consolidate to save their pet project (though perhaps demanding gold as collateral, and perhaps kicking out some delinquents). China will spew trillions of stimulus money into more and deeper malinvestment (why have ten ghost cities when you can have fifty? Good news for aggregate demand!).

So Paul Krugman will likely get something much closer to what he claims to want. Problem solved?

Nope. You can’t solve deep-rooted structural problems — malinvestment, social change, deindustrialisation, global trade imbalances, systemic fragility, financialisation, imperial decline, cultural stupefaction (etc, etc, etc) — by throwing money at problems. All throwing more money can do is buy a little more time (and undermine the currency). The problem with that is that a superficial recovery fools policy-makers, investors and citizens into believing that problems are fixed when they are not. Eventually — perhaps slowly, or perhaps quickly — unless the non-monetary problems are truly dealt with (very unlikely), they will boil over again.

As the devaluation heats up things will likely become a huge global game of beggar thy neighbour. A global devaluation will likely increase the growing tensions between the creditor and debtor nations to breaking point. Our current system of huge trade imbalances guarantees that someone (the West) is getting a free lunch , and that someone else (the Rest) is getting screwed. Such a system is fundamentally fragile, and fundamentally unstable. Currency wars will likely give way to economic wars, which may well give way to subterfuge and proxy wars as creditors seek their pound of flesh, and debtors seek to cast off their chains. Good news, then, for weapons contractors and the security state.

Drone Warfare in America

What would Obama supporters think if they learned that their beloved President was running far-to-the-authoritarian-right of arch-hawk Charles Krauthammer on one particular civil liberties issue?

Sadly, the answer is that most Obama supporters probably wouldn’t feel very much at all, because support for Obama has always been predominantly emotion-driven (he promised change “you can believe in”, not “change that I can logically convince you will be beneficial“).

But I digress. Charles Krauthammer weighed in on FOX yesterday to telegraph his opposition to bringing drone warfare to the skies of America.

Krauthammer said:

I’m going to go hard left on you here, I’m going ACLU. I don’t want regulations, I don’t want restrictions, I want a ban on this. Drones are instruments of war. The Founders had a great aversion to any instruments of war, the use of the military inside even the United States. It didn’t like standing armies, it has all kinds of statutes of using the army in the country.

I would say that you ban it under all circumstances and I would predict, I’m not encouraging, but I am predicting that the first guy who uses a Second Amendment weapon to bring a drone down that’s been hovering over his house is going to be a folk hero in this country.

The Founders were deeply opposed to the militarisation of civil society. There is all kinds of aversions to it and this is importing it because, as you say, it’s cheap, it’s easy, it’s silent. It’s something that you can easily deploy. It’s going to be, I think the bane of our existence. Stop it here, stop it now.

And this is a big deal. A recent report by Micah Zenko noted:

Worried about the militarization of U.S. airspace by unmanned aerial vehicles? As of October, the Federal Aviation Administration (FAA) had reportedly issued 285 active certificates for 85 users, covering 82 drone types. The FAA has refused to say who received the clearances, but it wasestimated over a year ago that 35 percent were held by the Pentagon, 11 percent by NASA, and 5 percent by the Department of Homeland Security (DHS). And it’s growing. U.S. Customs and Border Protection already operates eight Predator drones. Under pressure from the congressional Unmanned Systems Caucus — yes, there’s already a drone lobby, with 50 members — two additional Predators were sent to Texas in the fall, though a DHS official noted: “We didn’t ask for them.” Last June, a Predator drone intended to patrol the U.S.-Canada border helped locate three suspected cattle rustlers in North Dakota in what was the first reported use of a drone to arrest U.S. citizens.

But I’m going to go even further than the threat to civil liberties: I am fairly certain that the militarisation of U.S. airspace by drones is itself a huge national security threat. While Zenko notes that drones “tend to crash”, the downing of a U.S. drone over Iran late last year — supposedly via an Iranian hack — seems to suggest that it is possible for drones to be commandeered by hackers or hostile powers. And if that’s not the case today, then it almost certainly will be tomorrow. Putting drones into the air above the United States is like going to sleep on a bed of dynamite. It’s an invitation to anyone to try and commandeer a plane, possibly one stocked with high-tech weaponry.

The Federal government would do well to quit groping Grandma at the TSA checkpoint, and start worrying about the potential negative side-effects of systems they are putting into place. All the TSA security theater in the world cannot stop a determined hacker from commandeering a drone.

Charles Krauthammer is right (and after the Iraq invasion which he championed I never thought I would say that): it could be the bane of our existence. Stop it here. Stop it now.