Fiscally Fit: A check-up for your financial fitness

1. What happens to home values when the replacement costs increase?

   1. The go up like a rocket

   2. They go down because nobody can afford to build

   3. They are pulled toward the cost of new construction

   4. They don’t change . . . construction costs don’t matter

2. What is happening to the economy now that the debt bubble has burst?

   1. The recovery going to happening, because Ben Bernake said so

   2. The government attempting to re-inflate the debt bubble in order to stimulate short-term demand

   3. It’s just like the great depression, only worse

   4. The recovery has already started . . . the government reporting agencies are just suppressing the information

3. What is happening to real unemployment?

   1. It is going up, contrary the manipulated numbers that are published

   2. Can’t you read? . . . it’s going down because the stimulus package is working

   3. It’s already higher than during the great depression

   4. It’s going to be back below five percent in no time

4. What happens when government spending becomes a bigger portion of total GDP?

   1. It gets the economy back on its feet

   2. It erodes long-term growth by displacing private investment capital

   3. It make people more equal by re-distributing income

   4. It makes the environment better because of government regulation

Answers: 1) c, 2) b, 3) a, 4) b

Explanation of Answers:

What happens to home values when the replacement costs increase?

Over time, home prices naturally converge toward the cost of construction. The reason for this is twofold. First, new housing starts tend to boom when prices are high, creating an increase in supply that generates more competition and usually lowers market prices toward equilibrium. Second, when prices are depressed and market values dip below the cost of construction, new housing starts will drop off precipitously. As an extended period of time passes with no new homes being built it will slowly pull prices up toward equilibrium. Thus, in all cases the cost of construction plus land is the approximate equilibrium point to which home prices naturally converge.

What is happening to the economy now that the debt bubble has burst?

The impact of the debt bubble bursting was a dramatic contraction in the availability of credit. This meant that many people who were previously spending on credit are no longer able to continue spending. In this kind of economic environment, many people begin ‘deleveraging’ or actively reducing their debt burden. However, in this economic cycle the government is attempting to stimulate short term demand with credit based spending, ostensibly re-inflating the debt bubble. The way that they are doing this is with tax credits for new home buyers or rebates for people that trade in old cards to purchase new ones. These programs are all encouraging increased indebtedness in an attempt to stimulate the economy. Unfortunately, sustained economic growth can only come from increases in production and productivity, and none of the government programs is addressing either fundamental factor of economic growth.

What is happening to real unemployment?

The way that government statistics track unemployment is to remove ‘discouraged workers’ from the pool by only tracking people that are actively seeking work. Fundamentally, this means that people who stop looking for work (and are not employed) are removed from the pool for counting the statistics. This means that the total number of jobless people can actually go up, while the unemployment rate goes down like what happened in July’09. Furthermore, the official numbers count people who are under-employed in part time work but would like to work full time as fully employed. It also counts people who work in commissioned sales like Real Estate or Insurance as being employed, even though they may not have earned a commission check for quite some time. When analyzing the strength of the economy, it is important to not only look at the published statistics, but the underlying assumptions.

What happens when government spending becomes a bigger portion of total GDP?

The important to thing to consider when talking about government spending is that the government cannot spend a single dime without taking it away from somebody else first. This comes from direct taxation, borrowing in the credit markets (displacing private capital), and printing money (devaluing the savings and equity of all people who hold dollar-denominated assets). As the government grows larger, it must necessarily displace or destroy private investment and spending to finance its operations. Since government operations are necessarily politically motivated, it naturally follows that the real output of government spending will result in substantially less production and productivity improvement than if that same capital had been deployed though private channels. As the government seizes control over more and more of the economy, it pushes more decisions onto the desk of politicians and neutralizes the market forces that create economic growth.

Fiscally Fit: A Check-Up for Your Financial Fitness

1. What is the best way to avoid future market bubbles?

a. Gold . . . lots and lots of gold.

b. A survival bunker isolated on 30 acres in the woods, surrounded by barbed wire.

c. By directly controlling universally needed assets.

d. By only investing with the “good” fund manager.

2. How does big government relate to big business?

a. Government works for us, and will stop those corporate pigs from cheating the little guy.

b. Government regulations shield big businesses from competition by increasing barriers to entry for new competitors.

c. Big Business has no influence on government now that the Republicans are out of power.

d. It doesn’t matter because all of the jobs in America are being outsourced to China.

3. What causes sustained price inflation?

a. Increases in demand from a hot economy pulling up prices.

b. Increases in the money and credit supply creating more dollars chasing fewer goods.

c. Big Oil, OPEC, and Corporate America.

d. Evil HMOs increasing the cost of health care.

4. What is the principal risk of econometric technical analysis?

a. There is no risk if you know what you’re doing.

b. The risk that your friends and relatives will become jealous of your success.

c. The risk of no government assistance if you are not associated with Goldman Sachs.

d. The risk of excessive reliance on quantitative models that do not have the ability to predict highly disruptive events that have never happened before.

Answers: 1) c, 2) b, 3) b, 4) d

Explanation of Answers

1) What is the best way to avoid future market bubbles?

Market bubbles result from large numbers of people flooding an investment simultaneously based on speculation that the values will continue to climb, even in the absence of supporting fundamentals. It is pleasing to assume that one can find a “good” fund manager who will anticipate these bubbles and avoid them, but the numbers clearly show that outperforming the market on a sustained basis is extremely rare, and that those who do so may only be “coin flippers” who happened to guess correctly over an extended period of time.

Controlling universally-needed assets such as rental housing helps individuals to avoid bubbles by decoupling from financial markets with cash-producing physical assets. Gold represents an inflation-stable medium of exchange (i.e., a constant value currency), but it does not produce regular cash flow, and is therefore dependent on the whim of speculators for its market price. Finally, survivalist isolation may be attractive to some people, but is not the first choice for most investors. Thus, it becomes necessary to find ways for avoiding market bubbles without totally exiting from society.

2) How does big government relate to big business?

Government regulations impact the cost of operation for business entities. As the government increases regulations, it makes things increasingly difficult for new businesses to grow, thus shielding large business entities from competition. The circle closes when the business entities spend on lobbying politicians for legislation that further protects them from competition. In this way, big business and big government become two sides of the same coin, standing in the way of innovation and growth.

3) What causes sustained price inflation?

Changes in commodity prices can create temporary spikes and troughs, but the way that overall market prices establish equilibrium depends on the level of output, the amount of money in the economy, and the velocity with which that money circulates. A spike in the price of one commodity cannot move prices in the entire marketplace unless that price spike significantly contracts production. The only way that prices can increase in a sustained manner is for the government to continually expand the amount of money in circulation at a rate greater than the productivity improvement of capital and labor.

4) What is the principal risk of econometric technical analysis?

Technical analysis can be a very powerful tool, but it lacks the ability to predict future rare events that have never happened before. The reason for this is because econometric algorithms are based on market movements in past years. These models frequently do a fantastic job of modeling normal market gyrations, but cannot incorporate the impact of events that have never happened before. Because of this, over-reliance on technical analysis leaves investors susceptible to the impact of rare events that cause massive market disruptions.

1) When is debt good?
a. When I feel like spending money
b. When I am buying something that I can see and touch
c. When I am buying something like a house or car
d. When I am buying an asset that produces income

2) When is debt bad?
a. When it causes you to be highly leveraged on an investment
b. When it is used to finance consumption
c. When you use your credit card
d. Debt is always bad

3) What causes inflation?
a. Evil businesses raising prices on the little guy
b. The federal reserve increasing the supply of available money
c. OPEC constricting output to push up prices
d. A tri-lateral conspiracy between George Bush, the Illuminati, and the Vanderbilt Family

4) What is the result of inflation?
a. It destroys the value of savings, equity, and debt
b. It creates jobs by increasing the amount of money in people’s pockets
c. It makes me more wealthy by increasing the value of my house
d. It makes me more wealthy by increasing the value of my 401k

5) What happens when the government increases spending?
a. It means that I get free money in my mailbox
b. It means that those rich people will finally have to pay their fair share
c. It means that the government must extract more resources from the private economy through   taxes, borrowing, and inflation
d. It means that the country starts to run better, because the government always does things more efficiently than the private market

1) When is debt good?

The way that debt can work to your benefit is if it is used to finance an income-producing asset that pays your interest costs.  The most typical example of this is rental real estate.  As the owner, you take out a fixed-rate loan on the house, the tenant pays you rent, and you pay the applicable tax, insurance, and mortgage expenses.

Over time, inflation will increase the value of the house and the rents paid by your tenant.  However, the amount you owe on the house will stay flat because of the fixed-rate debt.  This will result in your profits increasing.

2) When is debt bad?

Generally speaking, debt will work against you when it is used to purchase anything that doesn’t produce income.  The reason for this is because the interest for debt that is used to make these purchases must be paid out of your income.  Furthermore, as the amount of debt goes up, it consumes more and more of your income.  By concentrating debt in assets that produce income, you can escape this ‘debt spiral’ trap that keep many people confined in financial prison.

3) What causes inflation?

As tempting as conspiracy theories can be, the money supply is the principal factor that drives inflation for the overall economy.  Supply and demand can create price spikes and drops in specific products like oil or corn, but the only way to make everything more expensive at the same time is to increase the amount of money in circulation while the amounts of goods and services stays flat or decreases.  This phenomenon is known as ‘more money chasing less goods.’

4) What is the result of inflation?

Inflation erodes the purchasing power of all things that are denominated in dollars.  When the prices of everything you buy go up, but your savings account only grows at 0.2% per year, it results in a negative ‘real’ rate of return since the savings will now buy less than it did before.  In practical terms, this means that dollar-denominated assets, like home equity, savings, and CDs, along with liabilities like debt, will all have their value destroyed by inflation.  Because of this, the optimal strategy is to have your assets denominated in physical things and your liabilities denominated in dollar-based debt.

5) What happens when the government increases spending?

The government does not have the capacity to produce anything.  The only way that it can spend anything is to first take it from somebody else.  Sometimes this is done directly through taxes, and other times it is done indirectly through borrowing or inflation.  The way that borrowing takes money is by displacing private debt with government borrowing, effectively reducing the amount of capital available.  The way that inflation takes money is by eroding the purchasing power of people’s salary, savings, and home equity to finance government spending.

Because of this phenomenon, it logically follows that any time the government decides to do something that the private sector could do more effectively, it drags down the overall economy by displacing private economic activity.  (Granted, the government frequently enacts arbitrary laws & regulations that artificially hamper the efficiency of private industry, thereby creating a perception that the private market is broken, when the problems are all a direct result of government fiat.)  The adverse incentives implicit in this balance is that politicians derive their power from the amount of money that government spends.  Because of this, politicians have an incentive to make government bigger, regardless of how much it erodes the economy, because it will result in them becoming more powerful and important.