There are legitimate roles for the government in the economy, but officials should take as their guiding principle the admonition “First, do no harm.” And everyone should acknowledge Ludwig von Mises’ observation that “Government is essentially the negation of liberty.”

The rule of law The primary role of any government is to uphold the rule of law (including among lawmakers and enforcers). Remember, markets comprise the free exchange of goods and services between people engaging in trade for their own self-determined benefit. People must be free to make their own decisions without coercion. The markets cannot be efficient in the presence of corruption or coercion. Individuals must be able to enter into contracts with the faith that they will be enforced. They must be secure in their person and property. If people commonly are at risk of robbery or fraud, their decisions will be founded in fear, productivity will suffer and the economy will languish. Remember that the economy is how we allocate scarce resources in an attempt to fulfill the needs and wants of individuals. Resources allocated toward fighting crime cannot be invested in improved living standards. In the absence of the rule of law, there is a deficit of confidence and the economy will perform below its potential.

Property rights The rule of law extends to recognizing and enforcing property rights. Such rights ensure that an individual may acquire property for her own use. This is especially important for increasing productivity (the key to improved living standards–we’ll discuss this when we talk about wealth, its definition and creation). Physical property can be used as collateral for loans  which may be used to acquire more useful property. Ideally such property includes labor saving devices (like washing machines) but also capital equipment (like factories) that employ people and produce the goods and services that improve the quality of life.

Transparency For government to be effective and fair, its edicts must be nondiscriminatory (applying equally to all people) but they should also be clearly stated and readily available for review. This extends to corporate governance as well. In particular, it is essential that accounting records be truthful, straight forward and complete. The government has a legitimate role in ensuring that businesses comply with such standards, but the impetus for examination falls on the shareholders who stand to lose money if their company fails to comply. An obvious problem with imposing government standards is that corrupt officials (corporate and governmental) may apply such standards unevenly for personal gain. Thus such rules become a potential focus for corruption and this is indeed one of the great hazards of any government activity.

Stable currency A strong and stable currency is a store of value and can be “as good as gold”. Uncertainty is anathema to markets. When deciding how to allocate resources, the more information individuals have, the better. Uncertainty complicates decisions and saps confidence. Such uncertainty arises when the value of one’s currency is prone to fluctuation. Steve Forbes uses the analogy of allowing the length of a foot to fluctuate from day to day. How difficult would it be for carpenters to do their jobs when their standard unit of measure isn’t constant? The same goes for money and the decisions that are influenced by the value of a currency. A currency’s value is most stable when the money supply is kept constant relative to demand. This means that bodies such as the Federal Reserve, if not abandoned, should have very limited powers to manipulate the currency.

Stable government Although our elected representatives change from time to time, the Constitution does not. So regardless of who wins elections, we can be reasonably assured that the Constitution will remain the law of the land. It is the supreme role of elected officials to uphold the Constitution as it protects individuals from all manner of abuses by government. Incidentally, the purpopse of the Founders in writing the Constitution was to limit the power of the government and its role in the lives of citizens, which brings us to the final point;

Individual liberty For markets to function efficiently, individuals must be free to act in their own self-interest. That means allocating their resources as they see fit regardless of what smarter or wiser people might think would be better for them. In reality, all of the prior roles outlined for the government exist in support of this one. The caveat is that free people must accept responsibility for their actions. So, if they choose to spend their money foolishly (as free people might do) they must be prepared to do without the things they might otherwise have acquired with their money. Their fellow citizens should not be compelled to meet their wants or needs after they have failed in their responsibility to fulfill them on their own. This is not to say we should not help our fellow man, only that we should not be compelled by government to do so. I will discuss this more in a post on Charity.

For the economy to prosper, government activity must focus on ensuring that these conditions are met. Doing anything more mutates government activity , however well-meaning, into a malignancy that saps the economy of its strength.

The market, any market, is self-regulating. Like natural systems, markets seek and find their own equilibrium between supply and demand. To insist that the role of government is to regulate markets is to betray a failure to understand the fundamental nature of markets themselves.

The support price, or floor is generally greater than what the market would support. The most direct form of price support occurs when government forbids the sale of a product below a particular price. In such a scheme, buyers and sellers may not negotiate lower prices regardless of how much such a situation would benefit either party.

More often prices are supported by subsidies. In this case, a target price is set by some agency and when the market price falls below that threshold, the producer is entitled to a taxpayer funded subsidy to make up the difference.

Ostensibly, the purpose of price supports is to protect producers from the unpredictability of the market, and in the case of farmers, the weather. The actual effect, predictably, is quite different. By subsidizing marginal producers, inefficient users of resources remain in business and continue to deploy those resources in unproductive or inefficient operations. By keeping suboptimal producers in business, we have deprived efficient operators of the resources they need, or forced up the prices of the raw materials they require (a cost they will pass on to consumers).

In addition, consumers will pay a higher price when they purchase the goods that the inefficient producers take to market. Remember, the purpose of price supports is to maintain a price above that which would be supported by the market. Sometimes the excuse is given that an industry is strategic to national security and so must be maintained at any cost. This is a nonsensical argument during peacetime but it highlights one of the greatest problems with any government program–the possibility of abuse and corruption. Any industry with a powerful lobby can persuade lawmakers to favor their industry with taxpayer funded handouts or other manifestations of favoritism–a practice commonly referred to as “picking winners and losers.”

The argument for price caps is that they protect the consumer from having to pay an excessive price for a product. Price supports on the other hand force consumers to pay excessive prices. Government regulation of prices is necessarily schizophrenic.

Recently my sister asked what I thought of Mexico’s handling of gas prices. In particular the government mandate that gas prices not rise above a set price. In recent days the spread between the price of gas in Mexico and the cost in San Diego was $1.46. It is important to know that petroleum in Mexico is produced by the government owned company Petroleos Mexicanos. So throughout the production process, the fuel belongs to the Mexican government. This means that the costs of production and the price for the consumer can be subsidized by taxes collected by the Mexican government.

The full cost of gasoline production is not borne directly by the Mexican driver. For example, if the production cost of gasoline is $3.00 per gallon, and the state-owned gas stations sell it for $2.50, that 50 cent shortfall has to be coming from somewhere. The balance of the fuel cost is coming from the Mexican taxpayer. So although the taxpayer gets a break at the pump, he is paying indirectly for his cheaper fuel through higher taxes.  There really is no such thing as a free lunch.

Aside from the false savings that appear to result from a government enforced cap on the price of gasoline, there is another more fundamental reason to oppose price controls for fuel, food or any other good or service that may be legally bought or sold. Prices are determined ultimately by the relationship between  supply and demand. Put simply, for any good or service, when the supply is high relative to demand the price will fall and when demand is high relative to supply the price will rise.

Let’s think our way through this: When a product is in high demand, if the supply does not increase, it will eventually become scarce. Scarcity drives the price up as desperate purchasers offer more money to gain access to the dwindling supply. Think of the crazed pursuit of Wonka bars in Charlie and the Chocolate Factory.

In response to rising prices, two things happen. First, fewer purchasers come forward as more of them are priced out of the market. They opt either to do without (skipping vacation for example) or they find an alternative (walking rather than driving). This change in behavior has the effect of reducing demand which exerts a downward pressure on prices.

The second result is that the profits associated with production increase as the price rises relative to the costs of production. As profits rise, production is stimulated in two ways–current producers increase their production and new producers enter the market hoping to reap the profits that accompany rising demand. Increased production exerts an upward pressure on supply. The effect of which is to lower prices (remember, prices and supply move in opposite directions).

The price system provides feedback that helps producers and consumers adjust their behavior to conditions in the market place. Now let us consider what happens when restrictions are placed on prices–when prices are prevented from rising.

When the price of the product is kept artificially low, demand is never curbed as consumers have no incentive to reduce their use of the product. With price caps in effect, the price cannot rise, and may even fall. Consequently demand either remains the same, or even rises. This puts upward pressure on prices, but since prices cannot rise, that means profits for producers must fall.

So, if prices are kept artificially low, profits for producers may fall or disappear entirely. In either case, producers have no incentive to increase production and in fact may lose their incentive to continue production at current levels if they are losing money in the process. The effect of this is that production fails to rise or may even fall.

So what has been accomplished with a price cap? We have maintained or increased demand while simultaneously maintaining or reducing supply The inevitable result is continued scarcity and attendant rising prices. Price controls have an effect exactly opposite to that intended. In other words, price conrols short-circuit the feedback mechanism that is required to increase supply and reduce demand–the only legitimate ways to lower prices. Nevertheless, many people, failing to grasp the relationship between prices, supply and demand continue to believe in and expect a government solution to rising prices.

Coming soon, what is the legitimate role of the government in a free market?

Anyway, I will get my nose back to the grindstone and hope that once in a while someone gets something worthwhile out of the time that is invested by he and me.

Human pomp insists that natural (and particularly cyclical) phenomena can and should be managed. Wildlife (mis)management schemes early in the prior century often focused on the “management” of predators (to benefit humans of course). The unintended consequence was an explosion in the populations of primary prey species, followed by population collapse as birth rates exceeded carrying capacities. Malnourished animals succumbed to disease or starvation. A healthy population of predators would have removed diseased individuals, thereby reducing the population and the opportunities for additional infections.

That same pomp drives attempts to manage the economy. The obvious ups and downs tempt the brightest among us to say “I can fix that.” Less obvious is that any efforts to dampen natural oscillations are destined to amplify them if not collapse the system altogether. We have an excellent example in the current housing crisis. As the housing market collapsed, governments rushed to appear to be doing something. After being driven to artificial highs by a monetary policy that inflated numerous bubbles for the better part of a decade, it was inevitable that the market would collapse. In this chart from The Atlantic:

we see that from the 1960s to the late 1990s the rate of home ownership held to a band betwen 63% and 66%. This might be considered the “natural rate” of home ownership as governed by numerous macro and micro economic factors (e.g. interest rates, economic growth, demographic trends). In the late 1990′s the rate blasted out of that natural range, driven by artificially low interest rates and government policies that encouraged mortgage lending to high credit risk consumers.

After the economic collapse that began in 2008 (the housing bubble actually started to pop in 2007) the Federal government offered tax credits to prop up the real estate market. That plan worked while the tax-breaks were in effect but as soon as they expired (in October 2008) the collapse gained momentum. Not only did the Feds fail to stop the collapse, they ultimately made it worse by coaxing purchasers to accelerate their buying plans. The result was that sales that might have taken place in Novermber or later, instead took place in October and earlier. They stole growth from the future and now that the future is here, the housing market remains severely depressed. Eventuallly the home ownership rate will return to its natural range. In the meantime, it will likely “regress to the mean” by falling well below that 63% floor.

Out of ecology grew environmentalism and a concern for the health of the Earth’s ecosystems. In time ecology taught environmentalists that a hands-off approach was the best way to “manage” the natural world. We would do well to apply that lesson to our economic policies–we should not try to manage what we cannot fully understand or quantify.

Because her income is from salary while Mr. Buffet’s is from dividends and capital gains. Income may be taxed at a rate as high as 35% while dividends and capital gains may be taxed at a rate as low as 15%.

There is a reason for this and “coddling billionaires” isn’t it. Aside from the fact that the lower tax rate benefits retirees, whose income often comprises dividends and capital gains, the low rate is intended to encourage investment and entrepreneurial risk taking–both of which are essential for economic growth and job creation.

President Obama would do well to find better economic advisors. And if he and Buffet are so concerned over the secretary’s taxes, President Obama could reduce them and Buffet could write a personal check as a gift to the U.S. Treasury.

Among some elitists, the pursuit of profit is viewed as a base behavior unworthy of civilized men. But what is profit really?

Profit is residual. It is what is left over after all of the bills have been paid. Describing it as residue doesn’t do much to enhance its image, but the fact is, profit is the motivator that has compelled people to provide goods and services to each other via trade for thousands of years. Think on this–the alternatives to trade are theft or murder.

Profit is the reward for efficiency. And the quest for profit, particularly in a competitive environment, has driven the advancement and refinement of endless waves of human innovation. Profit-inspired efficiency has ensured that we (in the aggregate)* make the most of scarce resources and that they are deployed in the manner most beneficial to the most people.

The pursuit of profit in a competitive (free) market produces three key outcomes (when compared with any alternate system) :

1. more pletiful options
2. lower prices
3. higher quality goods/services

These are all tangible benefits. There is one intangible benefit and that is the increased rate at which innovation takes place when the reward of innovation (profit) flows to the innovator.

*That is to say that given two hypothetical systems, one allowing personal profit, the other not, given equal initial resources, the profit-supporting system will be more productive than the one in which profit is not allowed. The profit-bearing system will not be perfectly efficient, but it will be relatively more efficienct.

Each class may be subdivided any number of ways. For example, there are growth stocks, value stocks, domestic stocks, emerging market stocks and preferred stocks (there are others).

Likewise there are many bond subclasses: junk bonds, corporate bonds, government bonds, municipal bonds, savings bonds, etc.

Real estate classes might include commercial, residential, rental, retail and industrial (as well as others).

Collectibles include coins, stamps, beanie babies, magic cards and pinky fingers of vanquished foes.

Each asset class is characterized by its own risk-reward profile. Because the values of different asset classes are not necessarily correlated, it is recommended that investors diversify across a range of classes in order to maximize returns while minimizing risk.

The chart (click the image to enlarge) from Morningstar ranks annual investment returns for several asset classes over the last 10 years (through 2009). Notice that return varies from year to year for each class.

There is a big difference between saving and investing. Saving is about preserving capital (avoiding risk). Investing is about growing capital and it entails an implicit acceptance of risk.

When choosing an investment, examine your:

Savings goal–To what use will you put the money and how much do you need? Do you need to turn
$1000 into $2000 or do you need to turn $1000 into $10,000?

Time horizon–How long before you need the money, 6-months or 10 years?

Risk tolerance–In general, risk and reward are correlated. When someone puts their money at
greater risk, they demand a greater reward to compensate them for the additional risk.

You invest in order to grow your money. While there is more to life than money, there is no denying that life is better with it than without. So I think we can all agree that growing our money is a desirable goal. Whether you invest with the investment club or somewhere else (actually you should invest elsewhere in addition to the investment club) regular investing should be a personal goal.

Why invest in the stock market? Because historically, the stock market has provided a better return on investment than other asset classes relative to risk, liquidity and accessibility. What does that mean? It means that stocks provide good returns without excessive risk of loss (risk), they are easy to get out of if you need the cash fast (liquid) and easy for the average person to buy (accessibile).

Why invest with the investment club? The investment club has three goals; 1) to earn money, 2) to educate members and 3) to provide cameraderie.

Investing with the investment club gives each of us a chance to learn about investing (and life in general) from each other. We have an opportunity to learn at our own pace from people that respect and care for each us. Besides, hanging out with friends is fun whether you’re discussing yield-curves or goofing off.

Investing with a group means that we are less likely to make catastrophic mistakes. More eyes looking at and brains studying a situation make it more likely that we will catch pitfalls that might be missed otherwise. Pooling resources makes asset diversification easier and lets us spread the risk among more investments. Similarly, by splitting costs, we reduce our own investment-related expenses.

The same goal of reducing risk and expenses can be accomplished with a mutual fund. However, the investment club provides the opportunity to find our own Google, Microsoft or Wal-Mart–all companies that greatly enriched their early investors. You can’t do that with a mutual fund.

I encourage everyone to take advantage of this opportunity, but you must be aware that extended periods with negative returns are possible (you can lose money). But I also would repeat the maxim “No risk, no reward.”

So, an appropriate question for today:

“What is a ‘dead-cat’ bounce?”

A dead-cat bounce refers to a temporary upturn in the stock market in the midst of a longer-term correction or bear market. Of course a dead-cat bounce isn’t identifiable as such until enough time has passed to learn whether the market will resume its decline or has turned a corner and begun a new long-term upswing.

Bargain hunting during a downturn is a good strategy but it is essential to do one’s due diligence to ensure you aren’t acquiring a “dead” asset. Sometimes even free isn’t a bargain.