Tuesday, November 04, 2008

Zero Sum Game

The zero sum game idea says that when I win, you lose. In the economic sense, as I make more money, there is less money for you to make, too.

Now consider the trends of the last 20 years or so: as executive compensation reaches stratospheric heights, the top 10% of the earners in this country are earning almost 50% of the available income in the economy. And the top 1/2% are pulling far away from the rest of the top 10%, too. That means it's getting really tough for everyone else to earn money.

What will people do when faced with the problem of trying to feed their children, themselves or just have a place to live? There is a tendency for people to turn to crime when the economy gets hard and cold. And with advances in technology, the opportunities for low risk, non-violent economic crimes increase. Take spam, for example. Who among us has not received spam? Any women out there *not* getting emails proffering male anatomical enhancements?

Just who are these people who ship spam with their assortment of products and malware to boot? Are they trying to put braces on their kids' teeth? Sending their kids to college? Or are they just trying to make it big in an already crowded market?

The point I want to make here is this: when the wealthiest earners are already taking close to 50% of the economy, and they need to feel like they're achieving something, they're only going to hoard more. That means the rest of us have to work a lot harder just to make ends meet. If you don't believe me, ask Robert Reich, a former official in the Clinton Administration. To paraphrase, "giving wealthy people tax cuts to get them to spend more money isn't going to work; they've already spent all they want to spend and they could easily save the rest."

"Wait," you say, "those wealthy people will invest in the economy with their money!" No, they will buy Credit Default Swaps.

In the current financial meltdown, some very smart people took a huge risk with credit default swaps (CDS). A CDS is basically insurance on a debt, such as a bond, or a mortgage. A bondholder gets nervous about his investment, so he buys a contract that allows him to share the risk with someone else. A CDS says, "I'll pay you 2-4% to share the risk of the debtor on this bond in the event that the debtor defaults on his payments." The reason for the meltdown? More than one institution or entity bought a CDS on the same credit obligation for the same debtor, the companies who sold them did not make the contracts known to the public or the government, and there were no requirements for the seller to maintain reserves to pay off the people who called their option on the CDS. Like I said these investments were created by really smart and wealthy people.

It would seem that this is the free market economy in action. But when these same investors saw that they could lose their investment, they went to the government to get help. So, on the one hand, they didn't want regulation of their investment, and on the other hand they created a situation that required government involvement and financing to fix it. Now regulators and legislatures are waking up to the need for adult supervision of CDS transactions.

But I'm afraid we're in a catch 22. Wealthy people can always pay for the legislation they want. Which means, if they're "too big to fail", they can make the government pay for their mistakes. Being too big to fail means they can take the economy down with them. That means the rest of us will pay for their mistakes in taxes.

Some have commented on the incentives to take such risks. Imagine that you're making $2 million a year as head of an investment firm and you manage $20 billion or so. You want to feel like you're really spending money when you go shopping, so you go to Needless Markup...I mean, Neiman Marcus, to shop for some new clothes. The amount of money you spend will tend to scale with the amount you make. But the amount you save will just be a lot more than the rest of us, unless you're Michael Jackson.

The same is true for making money. If you're making $2 million already and you want to get a raise, the chances are pretty good that there isn't much more room for a raise if 50% of the gross income in the country is already spoken for. Finding a legitimate means of making more money becomes harder and harder as the money supply is consumed by the uber wealthy. This is even worse if the Fed shrinks the money supply, you know, M3. Wait. They don't publish M3 anymore. What's up with that?

Now don't get me wrong here. I believe in capitalism to a certain extent. If you're doing good work, you deserve to earn money from it. But notice how everything came together to create an organized catastrophe. People wanted to buy homes before they got locked out of the market. Real estate investors wanted to make money so they encouraged home buyers to hurry up and buy before it's too late. To help those tardy home buyers, really creative financiers wanted to make more money, so they created wacky mortgages with adjustable rates with payments that increased 50% or more after a set period of time. People who bought CDS instruments could see this coming and $65 trillion of domestic and international investment money was diverted to betting that *other* people would default on their loans. Ha, ha. Did somebody say "infrastructure"?

This unregulated and under-reported investment system gave rise to risk that investors were not willing to finance themselves. So the rest of us are financing it, and that is the zero sum game. No wonder health insurance is so expensive. I say this because AIG, formerly the largest private insurer in the world, was hip-deep into CDS investments. And it turns out that the government will start to report on it so that we know who did what and when with these instruments. AIG is just the tip of the iceberg. On November 4th, we're going to see just how deep the other insurance companies got into it, if they still are.

Oh, and by the way, I hear that John McCain is really worried that Barack Obama will "spread our wealth around." He must be talking about the maintenance payments the rest of us will be making, as taxes, to repay the debt that will have to be sold to finance the bailout. A bailout for McCain's most ardent supporters, really big corporations who bought into this mess in the first place. So, who exactly will be paying for this? People who can buy the legal counsel wise enough to limit their exposure to taxation? Hmmm, probably not.

Perhaps spreading the wealth around might just be the best thing we could do to get the economy going again.
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