The present “value” of a future receivable is the subject of speculation. Laws that constrain how much banks may lend should not presuppose any relation between the two. The debate of “mark to market” accounting versus “mark to model” accounting, each of which makes such a presupposition, misses this point.

Take, as an example, a simple toy model: Two mortgage banks each lend $300,000 to two home buyers, in return for $700,000, $300 K principal and $400 K interest, in monthly payments over the next 30 years. They can each make $400 K profit over that rather long time scale. How much is the right to collect the $400 K in the future worth at the present time? Who knows? Banking laws should not be formulated in such a way that their enforcement requires knowing it.

Now suppose each bank sells the other an identical “security” backed by the mortgages (MBS), for $500 K, soon after the loans are made. The exchange of identical securities is obviously an empty exercise in terms of meaningful wealth, yet, on paper, each bank has lent out $300K and received $500K shortly thereafter. Sounds like a $200K profit, right? True, they spent $500K buying each other’s MBS, but in return they each got an MBS worth (for the time being) $500K, so they broke even on that; you can hardly consider it a loss. Where, then, did the $200K profit come from? It came from the future, and was declared a profit in the present. With that profit, the banks can immediately bloat their operating costs by paying its employees bonuses, larger salaries, and hiring more employees.

Now the paper trail in the mortgage industry is of course far more complicated than the toy model, but I bet that underneath all the complicated mortgage derivative paper, the same principle was at work: anticipated future wealth was cashed in and distributed in the present. For example, the obligation in a credit default swap or insurance policy on a mortgage may be activated as soon as the default is declared, even though the default was on a future debt repayment. Creditors that collect their insurance on a defaulted debt enjoy a payment in the present on a debt that would have been collected in the future.

Debating how much anticipated future revenues are worth at present does not change a basic fact of life: A promise is worth less than what is promised. The risks that the promise might not be kept are a form of negative `wealth. Mortgage-backed securities simultaneously create mutually canceling positive wealth (short term profits) and negative wealth (future risk) out of thin air, the way positive and negative charge are created by a spark. In this manner, they allow present wealth to flow, like electric current through a short circuit, from the depositors to the bank administration. In the above example, the promise of $400 K in future interest payments is worth only $200 K at present. The risk that it might not be paid, which is worth minus $200 K, is the “hole” left by the profit grabbed by the bank. There is only one acceptable limit to the amount of negative wealth that mortgage banks should be allowed slip to its depositors without their consent: zero. (Would you debate how many short circuits should be acceptable in a car battery?)

The banking laws should therefore insulate the future from the present to the full extent possible. A proper evaluation of a bank’s solvency should respect the dimension of time; it should both keep track of the bank’s books and regulate their activities accordingly on a year-by-year basis well into the future. The amount of interest they promise to pay out in 2015 should be tied to the amount they expect to collect in 2015. The maximum amount of debt to which they are liable at present should be tied to their present reserves, not to anticipated future revenues. Confusing future receivables with present assets is asking for trouble, no matter by what mathematical modeling procedure you compare the two.

Uncertainty in how much anticipated future interest payments are worth at present should remain the risk of speculators, not depositors. The depositors, whose money was loaned to the home buyers, are already assuming a fair share of the risk merely by parting with cash in exchange for the collateral, whose value may yet go down, and granting occupancy to the home buyer. Anyone’s rights to a share in the future interest payments should be predicated on their waiting patiently for them.

Physicists used to think that a particle had a particular energy at any instant, but finally, in formulating quantum mechanics nearly a century ago, they realized that it doesn’t. The shorter the time interval over which you try to guess the energy of a particle, the greater the uncertainty in your guess. Only after physicists humbly (and therefore with great difficulty) accepted this uncertainty did they proceed to the dramatic advances of the 20th century in understanding the microscopic structure of matter. Maybe it is time for economists and accountants, now puzzling over the microscopic details of failed financial instruments, to make a similar transformation, and accept the fact that future receivables simply don’t have a well-definable present value.

Short term gain and long term consequences go together like love and marriage. The current difficulties of lending institutions is what we folks get from their recent whoopie. The future has just arrived, and there is plenty more of it.

Regards,
David Eichler

June 16, 2009

The Uncertainty Principle in Accounting was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

An employed Chinese laborer in the manufacturing sector, who makes perhaps $3000 per year, together with an unemployed American consume far less energy than an employed American and unemployed Chinese. Leave aside the staggering wage and standard of living differentials.  The energy cost of transporting from overseas all of the clothes, food, steel and cement that an average U.S. household consumes in a year, presently under $100, is less than it costs the U.S. wage earner to drive to and from work.

Fossil fuel is being squandered, of course. The squandering is exacerbated by trying to avoid unemployment at all costs. Protectionism would increase U.S. energy consumption, aggravating unemployment in the long run. It is simply too costly to keep the U.S. labor force fully employed doing what they did during the last century. It is less costly to modestly feed, clothe and shelter the unemployed. The whole point of employment is to create wealth. If society has to burn its wealth to prop up employment, that’s bad, no matter how sanctified our work ethic.

A subsidized enterprise destroys wealth if it would be unprofitable without the subsidy. Cheap access to a precious, limited resource is a subsidy. It destroys the wealth not only of future generations, which everyone claims to be so concerned about, but of the present one as well, because individual entrepreneurs profit at the expense of the society as a whole. The principle is illustrated by the following toy model:

Suppose oil costs $100 a barrel when 100 consumers each buy a barrel per week. Suppose a 101st consumer comes along, able and willing to pay slightly more per barrel, and the market price immediately goes up to $101 per barrel as a result of the increase in demand. How much does the 101st barrel per week really cost? You could be forgiven for thinking that it costs society $101 per week, but you would be wrong. It costs $201 per week – $101 per week to the 101st consumer, and another $100 per week that the resulting price increase costs the first 100 consumers.

Now suppose a barrel of oil can be used to manufacture $110 worth of goods (to be more precise, $110 above the other manufacturing costs). It can then be assumed that, in a society with a work ethic and a free market, someone will be willing to buy the oil at $101 (always per week), produce and sell the goods for $110, thus making a $9 profit.

The problem: While the individual was profiting the $9, the society as a whole took a $91 loss, having given up $201 for goods that were worth only $110.  Has the 101st individual profited because she has created true wealth or because of a hidden subsidy at the expense of the society? I assert the latter; she has received public wealth for less than its true worth.

Yes, I’ve oversimplified, I’ve neglected the lowered cost of goods manufactured from oil that an increased supply would cause, but the principle is nevertheless a valid one. When unrestrained demand drives up the unit cost of a finite resource indefinitely, the default ceiling on that cost becomes the point of zero profit to the individual, and this may be well beyond the point of zero profit for the society as a whole.

The wild fluctuations in the price of gas in 2008 were triggered, accompanied, and followed by relatively small changes in demand – less than 10% in either direction. This suggests that most Americans willing to pay $2 for a gallon were also willing to pay $4. To this majority, the gasoline is worth at least $4 per gallon. This is hardly surprising. If a typical U.S. worker can save an hour of commuting time by consuming a gallon of gas, and his wages are far more than $4 per hour, then it pays to drive to work himself, even at $4 per gallon. (A Chinese worker who makes less than $2 per hour should probably not drive even if gas costs $2 per gallon.)

If fuel sells for much less than most people value it,  and those same people were the collective owners of the fuel back when it was still underground, then the oil company that drilled for it and sold it must have received it from the public for less than its true worth. That’s a subsidy. When government representatives undersell public resources to their friends in the private sector, no doubt in exchange for favors, it is but one more mechanism by which government confiscates your wealth.

If we are not selfless enough to bequeath our publicly owned fossil fuel to future generations, let us at least be smart enough to sell it to them, or to anyone else for nearly as much as the next generation will eventually be willing to pay. With the revenues, maybe we can retire and enjoy life, and leave the job market open to young people. If there are no buyers at the price I am asking, then I want my share left safely where it is, beneath the Earth’s surface, until I decide to cash it in.

Regards,
David Eichler

June 12, 2009

Wealth and the Rising Cost of Globalism was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Taxing consumption of natural resources, rather than labor, would not only be smarter economics, it would be fairer. As the original owners, the people have the right to decide how much of their natural resources they want to sell to the private sector, how much pollution of public water and air they wish to tolerate, and for whatever reasons (environmental concern, profit, esthetics etc…).

Consumption tax, whether by auction of a fixed amount, or by a fixed rate tax, maintains free market principles, as opposed to the “cap-and-handout-and-trade” system that European nations adopted following the Kyoto Protocol. Handing over marketable carbon credits to some players but not to others is not only unfair, it is ineffective. One reason that the Kyoto Protocol failed to achieve its goal (justified or not) of curbing CO2 emission is that, by allocating carbon credits without hosting a fair competition for them, it avoided establishing a true value for fossil fuel.

The argument mouthed by some that taxing consumption would slow down the economy is inapplicable here. We are talking about shifting from income and corporate tax to consumption tax, so the public has at least as much money to spend as before.  By making exhaustible resources more expensive to the individual, the tax would generally increase the amount spent on labor. (Why? Because if a material-intensive method of producing something costs less, before the tax is invoked, than a less material-intensive method, then the latter costs more because it spends more on labor.) The tax thus stimulates employment.

Why is replacing at least some of the existing tax burden with a fossil fuel tax so taboo that it is hardly even discussed in the media, even in the throes of what is widely perceived as an economic cataclysm? Apart from the usual reasons (denial, numbness, self-delusion, stupidity, powerful interest groups intimidating politicians and news media, etc.), there may be an additional factor at work – low self-esteem among the public. Americans have been taught from birth that a tax is something they have to pay, not receive. And they have been taught that oil is something that oil companies sell to them. So they end up fearing both high oil prices and high taxes. The view that they own the fossil fuel in the public domain, and that the revenue collected from an energy tax belongs to them, might make them keener on such a tax.

Wouldn’t the cost of a fossil fuel tax on the energy companies simply be passed along to the consumer? Of course it would be; that’s the point. But the point is also to simultaneously return those revenues to the public. A $100 per barrel tax, while raising current prices from the present value to those of June 2008, would provide the American family of four over $25,000 annually (tax free). This would easily cover most income taxes and the added energy costs. And that would be just our oil revenues. There is plenty more exhaustible wealth in the world. A nation’s citizenry could rake in further revenues for all the metals mined from public territories, and for allowing public land, water and air to be used as dumps.

Would powerful energy and mining companies lobby to quash the establishment of a natural resource tax? If they were smart and honest, they would see the tax as a benefit for themselves too. The added cost of the tax would in any case be passed along to the public, their private holdings would become worth more, and risk entailed by future ventures would be lowered. Currently, corporate bids on, say, drilling rights are surely limited by uncertainty. They can’t be sure of how much they can extract from any given site, so they have to either take a risk or assume the worst in deciding how much they are willing to bid. On the other hand, if they are paying for the drilling rights in exact proportion to the amount they eventually extract, nothing is left to chance.

This is yet another advantage of a natural resource tax: It is harder for corrupt civil servants and other insiders to evade the tax than to evade public scrutiny. Bids can be rigged, government administrators who award drilling rights, etc., can be bribed, but a tax fills in the difference – on which corruption could otherwise thrive – between true value and production costs.

If the word “tax” is too painful, let’s at least demand the right to keep our hard-earned income as well as our natural resources. Then we can spend the former on what we truly desire, and sell the latter for what they are truly worth.

Sincerely,
David Eichler

March 19, 2009

David Eichler is a professor of physics at Ben Gurion University in Israel. He received his Ph.D. in 1976 from the Massachusetts Institute of Technology. Further biographical information can be obtained here.

Taxing Consumption, Not Production: Ethical Foundations was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.