Bank Deposits, Savings and function of Money

We will divert from our series a bit and get to an important aspect of Money which is its function.  However, Money performs two functions.

Raison d'etre of money
Money came into being to facilitate exchange of goods. Money split the old time barter (which was one transaction) into two transactions (goods-I-have for money and money for goods-I-want). This allowed for both transactions to achieve market efficiencies. Enabling transaction is the first function of Money. So money is medium of exchange. In this process Money conveys information about prices of goods. When the prices change, it conveys information about changes to the product or the environment or some other thing. This information function of money is as important as the second.

Second function of money is that of a store of value. Value of money means its purchasing power. Bank deposits are storing value. Technically, money should not be performing this function. But this function is inadvertently taken up by money when the information about the product or money itself changes the price levels and hence the purchasing power. Thus, for example, after exchanging goods-I-have for money, when I was having money with me, the price of goods-I-want halved. That means the purchasing power of money increased and thus money became more valuable.

Thus when we hold money and there is change in the information available leading to change in prices, the function of money is that of store of value.

What should money do?

1. Money should enable transactions - so it must not hinder your transactions (by credit card not being available). Or by becoming so valuable itself that people want to post-pone their transaction to get a better deal.
2. It should convey information about prices so that you can compare and match your funds, needs and compare alternative purchases (apples vs apples vs oranges etc). This information must be reasonably stable. So if I understand that price of a shirt is about $25 then tomorrow it cannot be $150 or $5 because that will create confusion. But it can be say $23 or $27 and it would not be much of problem.
3. Money has no business being store of value by itself. However, the fact remains that money remains the only way to measure value. We do not have other unit to measure it.

Douglas Rushkoff (starting about 23 min) on money should push transactions.

Use of money and current and deposit accounts

So actually, money in our current account is actually money to be used for transaction as a medium of exchange while the money we have in time-deposits or other deposit accounts is actually money as a store of value. Now if you ask any lay person, if the amount of money in both the accounts reflects this functional segregation and you will find it does not. The way we use money mixes up the two functions of money.

One way to clarify the usage is to make it clear that current account is your money awaiting transaction while deposit account is your investment into the bank. This segregation will make it clear to users what exactly they are using money as. Thus, banks should provide the analysis of expenses from the account and that should indicate a certain current account balance. The rest should be into deposit accounts.

Now, from the level of deposit insurance available to the bank, there should be disclosure about the amount of your money protected by deposit insurance. When deposit insurance is applied it must be applied to current account first and then to deposit account.

Purchasing power of the money

In an ideal case the purchasing power of the money should remain perfectly the same. If the purchasing power remains exactly the same the productivity gains will result in lowering of prices which is also termed as deflation. Now we also do not want that because in a deflationary scenario, holding money becomes lucrative as its value only increases and this affinity for money creates a hindrance in transactions. As we discussed, ideally money should not hinder transactions in any way.

To overcome this, we settle for a slight inflation. If we do it right, then the inflationary force exactly balances out the productivity gains and therefore results in no change in the prices. But such ideal outcome is not possible. So the policy maker must err in his judgement. A better side to err (it is debatable) is on the side on inflation but only ever so slight inflation.

George Selgin on Good Deflation and Bad Deflation

In Sum
The function of money and our appreciation of the function itself has policy implication. We must understand the function of money before we understand monetary policy itself.

Note: This post is derived from my book Subverting Capitalism and Democracy. You can read the book at the link below.

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

Money Supply Inflation and Economic Growth

After having discussed the basics of Money supply and Inflation, it is essential to discuss growth based on our model of money supply. At the moment, we are assuming there are no imports/exports. Let us refer to our equation:

Now using this equation it is clear that there are only three ways of creating growth in the economy. First two are obvious. First, increase "n" or number of products available in the economy. Thus, when new products and services are discovered we have growth. Secondly, by increase "Q" by increase of  population since when number of people increase, the total product consumed also increases thereby leading to growth. These are obvious and let us call them basic growth. It is the third that is interesting.

Increase in Q or Quantity by increasing Purchase intensity

Purchase intensity means the amount of product "i" one person buys. When the purchase intensity increases the demand goes up and leads to growth. But the beauty is it is "purchase" and not "consumption". Thus, even hoarding will also create growth. Now this seems silly when you relate it to goods but relate it to assets and things start looking quite different. We will term them differently, one we will call Asset building and other we will call asset hoarding.

Asset building is excess creation of assets than required or justified by future demand of such assets. Such asset building also creates demand if asset creation involves economic activity i.e. leads to increase in "n" or modifies the "PI" of existing goods as a consequence. Thus, if some one buys homes and blocks them, you have demand since other products related see increased consumption (steel, cement, wood, etc.) *(Refer Note)

Asset hoarding is of different type, say buying mines and mineral deposits, hoarding leads to inflation and not to real growth. This type of asset hoarding works on Pi and thus does not contribute to real growth. Concurrently, asset hoarding of this nature, ties up money supply reducing its velocity.

QE and growth

It is clear that QE is effective when it triggers basic growth or asset building even though such asset building may be excess. (Refer Note 2). If QE leads to asset hoarding then it does not lead to growth but leads to inflation. 

Notes:

1. There is slight technicality here, homes though termed as assets can also be termed as consumption goods. But the principle is applicable for all assets that influence n or PI.
2. Technically, the difference is "how much excess". Some excess is allowed but major excesses leads to depressing of long term demand and as such creates a drag. Essentially, asset building prepones the future demand.

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

About Money Supply and Inflation

A lot of times we discuss money supply and possible inflation it can cause and wonder why it doesn't cause that inflation. So here I attempt to explain what happens with money supply and when inflation happens and when it doesn't.

Here is the modified Money supply equation.

Here:

M = Money supply

V = Velocity of Money

P = Price of good (product or service) "i"

Q = Quantity of good (product or service) "i" sold

n = Total number of goods

M*V = Money Momentum

Explanation of the equation - ideal money supply

The Money Momentum must be equal to economic activity in the country. In any given period, there is a change in the total number of goods available (i.e. "n") in the economy, there is change in quantity of available goods sold (i.e. Q) in the economy and there is change in the velocity of money (i.e. "V") in the economy). Central banks must consider all these variables to tweak Money supply (i.e. "M") and if done successfully there will be no change in the price of the goods (i.e. "P").

Real Economic growth

Real economic growth, from layman perspective, refers to growth in the products and services produced by the economy. When the price of the goods increases but the quantity produced does not it does not imply real economic growth but refers to inflation. In our equation, real economic growth comes only from the following two ways:

1. Increase in Q for various goods: Thus, if suddenly more people start going to their hair-dressers to get their hair done up then you will have economic growth.
2. Increase in number of goods available in the economy: If total number of products in the economy increases then there is economic growth. For example, when telephone was invented, it lead to new products and services being made available to the consumers which would be economic growth.

What is inflation and deflation

When there is no increase in the price of goods then we have no inflation. Conversely, when the price of goods drops then we have deflation. Thus so long as the variable P in above equation remains the same we have neither inflation nor deflation.

What is velocity of money?

In layperson language, Velocity of money is number of times money changes hands. Thus, if $100 was paid by one person to A, then A to B who paid to C and who, lastly, paid to D, then velocity will be 4 within that period. 

Because of velocity, in any given period many more people feel they have money than actual money in the system. In above example, 4 people were able to conduct their transactions each worth $100 while in reality there was only one $100 bill floating in that economy.

So why do economist want to increase money supply?

Generally, during crisis, the velocity of money decelerates abruptly as people want to hold on to the money they have. This reduces the Money Momentum drastically leading to collapse of demand and therefore slowdown. 

To prevent this, central bankers pump in money to compensate the loss in velocity thereby holding the prices level in the economy up. This stabilizes the economy and pacifies the participants. In the current crisis too, US Fed has increased Money supply exponentially as seen in alongside figure (from St. Louis Fed from business insider).

The question really is whether the increase has compensated the change in velocity or not. The answer is slightly more complicated.

What Fed did

Let me interpret the Fed actions using our Money supply equation. Let the Money supply M has been split into two components and let us assume MA is usual money supply while MB is what Fed added post crisis. 

Ideally, the left hand side should have looked like (MA+MB)*V to have the maximum effect. However, Feds action created amounts to splitting the above equation to something like this:

Note that each type of money supply has its own velocity component to it. The Fed policy and the mechanism they used kept the VB very close to zero but not exactly equal to zero. Naturally, it has miniscule impact on the whole economy. Therefore there is no inflation.

Notes:

1. In reality, economists cannot measure Velocity and it is the variable that is calculated. In principle, that is wrong. Velocity does not adjust itself and is independent variable depending on psychology, mood, history etc. What really happens is economists tend to guess the change in velocity. Their guesses tend to be wrong and we end up with changes in prices. Milton Friedman believed that we should err on the side of inflation (slight) rather than deflation.
2. It is also incredibly difficult to estimate the right hand side of the equation. If one really does go through the fine-print we realize that it is all guesswork on RHS too. The key as an expert once told me is to have consistent guesswork so that changes are almost correctly perceived. Now whether the guesswork is consistent or it has been tweaked a bit here and there has tremendous implication about what the central bankers should do.
3. This post has been adapted from my book "Subverting Capitalism and Democracy".

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

Revisiting my assessment of Financial Crisis

Back in 2009, I made an assessment about the financial crisis. In 2013, I agree with most of my assessment. Some of the parts of the situation have changed a bit but the overall picture has not been modified as you can make out.

Introduction - March 9, 2009

I have been amongst the most pessimistic about the prospects of global economy. There has been a lot of harping about what got us into the current mess. Together the blogosphere has painted a picture of gloom. And now that we have painted this dark tunnel it is time to paint the light and the end of it! It is time to decipher the solution to the crisis.

One of the reason great depression lasted as long as it did was because of delay in acknowledging the solution. The solution was always there - no doubt - but it took time for the solution to win over the decision-makers into coordinated action. Thanks to globalisation and internet based coordination, we should be able to do it faster this time. If only we had the solution - or may be we do!

I present my side of solution in next few posts. Let us march towards a light - any light to begin with!

Consumption Centers - March 10, 2009

Who can be consumers?

Citizens, who have savings and income to replenish the savings post buying goods and services, can be consumers. Rest cannot! That implies the developed world - probably with exception of Germany and Japan, cannot be consumers. China, India, Indonesia and other countries with domestic savings will be our consumers. 

Value of consumption

Currently, the exchange rate equations are aligned to repress the consumption behaviour of these populations. In the interest of global recovery these equations will have to be reversed. This will entail a lot of protectionist pressures that are detrimental to consumers. Such measures will wipe out any hint of global recovery. 

Not consuming is always an option

Typically protectionist measures reduce the quality of local goods, increase prices and thereby cheat consumers out of their hard earned money. Today, the globalised consumer, is aware of product benchmarks and price parity across geographies. In current situation, consumers may simply "not consume" inferior products. They will choose to increase their savings. 

How protectionism is detrimental to the world?

This means the advantages of protectionism will accrue only if it continues for prolonged period of time in near future. Till it continues - global depression will continue. It means you will see more enforcement at customs counters in airports, ports and national borders. It means increased smugling of attractive goods establishing a supply chain for drugs, weapons and other illegal trade. All detrimental in socio-economic terms.

Dispersion of Production - March 11, 2009 

Changing producer competitiveness

The question is invariably based on Michael Porter's work on competitive advantage of nation. The only modification is understanding the structural or fundamental advantages. We need to separate out the transient, artificially imposed advantages. A deliberately devalued currency is such a transient man-made advantage. And it will break down. Michael Pettis, makes a fantastic argument how trade policies can influence producer dispersion. 

Who will be new producers?

Producers are located due to various competitive advantages of a region. One of the reason is quality and cost of manpower - let us call this man power profile. Similarly we have a job profile of an economy. Job profile, for simplicity sake, is based on technical knowledge pre-requisites and volume of work. Now ideally in sustainable case the job-profile and man-power profile of an economy should match. Currently there is a mismatch in developed world. US and EU jobs are getting polarized between unmovable low value addition activities on one side and exceptionally high value adding activities on other. 

Man-power profile will stabilize

The volume of low-value addition jobs will have to rise in US - to fit with lowering relative education standards. Now education system in US is way better than other nations. So we are simply comparing US in the future to US in recent past. The problem is in very short-term jobs movements are a zero-sum game (time till entrepreneurship discovers new jobs). So it means US wanting jobs will mean job losses in other part of the world. That, to my mind, is a seed of discord in near future. Hope is migrant workers might go back to home countries and US might actually have a brain drain to ease the pressure a wee-bit. In medium to long term US entrepreneurs will definitely figure out a way to create value in new and innovative ways -creating jobs for the economy. 

Seamless dispersion of production centers

The intersection of man-power and job profiles will mean a more seamless dispersion of production centers across the world. The first demonstration of this will come when some manufacturing jobs moving back to US.

Alternate Credit Channel - March 12, 2009

The global credit channel is a central sysmptoms and collateral damage of current crisis. The core of this is in US and therefore US government agencies are attempting bailout after bailout. The US government is not liable for rescuing an essentially global channel. It's first duty to clean the domestic channel. The two are cross connected to such a degree that they cant tell what they are fixing. 

The solution, to my mind, is simple. Create an alternate credit channel - what I call "the modified good bank solution".  

• Create a good bank - with regulatory charter that allows lower capital norms, higher government guarantees etc. so that it will have liquidity, capital and ability to acquire assets.
• Let it give credit to worthy borrowers who have the ability to repay.
• Create a mass loan transfer drive - where the borrowers to move their loans to this bank - rather than buying loan books from established banks.
• Accelerate the process by establishing uniform common minimum norms for acquiring loans. Start with lowest risk with highest documentary evidence.
• Augment the document checking using other government agencies workforce.
• Repeat the drives till you have covered big chunk of population. Government can take over some homes and convert them into temporary offices - establish geographically wide network - quickly.
• This bank should be broken up into managable units and privatised at a pre-committed date in 5/7 years time.

The global bailouts are more complex. This should be funded with pooled money. Using the IMF or world bank is a good starting point. More on that later.

Addendum: Why Us needs to fix domestic credit channel first?

US is biggest consumer of the world. The world needs able US consumers to continue to spend albeit to their comfort level (and definitely to lesser degree). The able and wanting consumers are currently being denied a chance to consume. This is dtrimental to everyone.

Create Earnings, credit will flow - March 20, 2009 

Current problem won't resolve by just establishing an alternate credit channel. Once the US credit channel is available. Credit flows based on certainity of earnings. Economist's View: Galbraith: No Return to Normal indicates how Galbraith points to this critical point. Let me paraphrase Galbraith:

In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war—from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war. 

The New Deal rebuilt America physically, providing a foundation (the TVA’s power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so. 

What did not recover, under Roosevelt, was the private banking system. ... If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn’t overcome until the war ended. It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. ... But the relaunching of private finance took twenty years, and the war besides. 

A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.

We have to realised that credit and banking feeds off global real economy. It is actually a cost, however small, for the real economy. So once jobs come back and incomes stabilize (at whatever levels), you will see credit coming back. Without certainity of earnings, the credit channel goes in self-preservation mode - waiting for certainity to return. Being global, the channel can absorb far more bailout/stimulus than any single nation can provide. 

The problem of global income adjustment and therefore credit offtake ability will hit us next. This is the heart of the problem. Next: we will see how we can fix this!

Global Crisis - First Principles Approach - March 26, 2009

Global crisis is a result of three elements freezing together - an overleveraged buyer unable to buy more, a seller without access to credit to create supply and non-existant market where no one trusts anyone. 

We cannot fix all three together as all three elements are vastly globalised and hence too big to fix all at once. So it makes sense to get back to basics. The entire economic system was created with demand at the center. When demand existed - supply emerged and market appeared to match producer and consumer. So we need to fix demand first, help supplier get started and things will start taking care of itself. But! 

First lets get demand straightened out. Demand in recent past was excessive - it will never be that high any time soon. But however small - we need it. Demand comes from wages and employment certainity. This is the basic of Keynesian stimulus - create jobs system will fix itself. So this would have solved our problem this time as well - had it not been for credit starved supplier. 

The supplier, earlier, was driven by equity and debt was but a cash-flow smoothening mechanism. Then we realised the power of leverage to amplify returns, create surplus wealth thereby creating a separate investor class specialising in just providing capital unleashing entrepreneurial energy. This class made the entrepreneurs leverage themselves to the maximum possible limit. This culminates today into credit being necessary mana for the suppliers to produce goods. Without supplier there is no market! 

The market essentially is an infrastructure provided to suppliers to help them address demand - through exchange of goods and services. Market works on marginal cost of exchange. Markets usually take care of themselves so long as demand and supply exists. The maximum fixing markets needs is through ensuring rule of law - enforcement of contracts, protection of aggreived, ensuring people don't cheat or muscle out others etc. Markets are even oblivious of fairness of law - so long as law exists and they get implemented markets will get created. 

Hence the crisis will be resolved if we solve the demand (consumers') problem first. Then we need to fix suppliers' access to credit. It is ok to have latent unsatisfied demand - that often gets channeled into savings. But excess supply translates into inventories and they have costs and lead to supplier anemia. Ensuring law and order will help markets get back in shape soon enough. 

US Solution has been antithetical to first principles

The solution so far has exactly moved in opposite manner. We tried to make market functional by rough-shodding over contracts and ensuring cheater get away with it. We tried to ensure liquidity to help with supplier credit. All this while - the consumer is facing increasing credit card debts, lower job prospects and total loss of confidence in possible return to reality. We haven't really done anything to prevent creditors making predatory moves on consumers. 

The solution to the crisis is essentially a modified Keynes' approach. We need to create jobs while fixing the system in coordinated precision. The kind that won Nadia Comaneci her perfect 10. And the stakes are higher there is not saffety net - no silver medal!

Going Green and Blue - April 21, 2009 

Given that real stimulus will take a form of modified Keynesian approach- we need to know what are the "highways" of today. During the last depression, the building of highway and rail infrastructure got the US out of trouble. This time, to my mind, it has to be Green and Blue infrastructure. 

Going Green

US has been victim of development invention. Most of the infrastructure / engineering of the country is based on older technology thats not green. Few years ago when the green revolution was knocking at the doorstep, it was difficult to see how US and developed world can re-engineer the entire setup to go green in a meaningful way. Luckily the current situation presents us with an opportunity to do just that. In doing so, US will lay the foundation for competitiveness for the coming decade or more while adding to comfort on global warming. 

Going Blue

While green is important, blue is even more so. By blue I mean developing potable water resources. Greening, apart from using lower emission fuels, also means creating tree cover and rebuilding green-ecosystems. Initiating this will require potable water sources. Further water is the most essential commodity for sustaining life. Investing in rain water collection ponds and lakes, water seepage assistance to rebuild ground water resources etc will have to take precedence. India has got an initiative off-ground through India water portal. 

Implications for cities and homesteads

If at homestead level we can create sustainable water and green infrastructure, we will have a much better self-sustaining planet. That imlies our city-oriented development models will have to be modified to make it more sustainable. 

Implications for current economic slowdown

The ability of these initiatives to create jobs is under-rated. If properly deployed these initiatives may create more jobs and more self-satisfaction than most optimistic forecast. These initiatives have unique character. They need huge manpower up front and then possibly the overall manpower requirement for sustaining this effort will be about 3% of original. This means they can create enough jobs to reduce unemployment rates by some percentage points in initial years. And the man-power can be freed in few years as economic activity resumes full steam. 

In Sum

Green and Blue are compulsions. We either take up our share of responsibility or implications are large and life-threatening. As they say, "nature does not do bailouts". The opportunity has presented itself - lets grab it!

 Next I will look at what has changed and what can be our road ahead from this point on.

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

QE and the priming of the World Economy

Steve Keen has a super post explaining why QE does not work or explaining how in fact it is supposed to work. At the same time, world worries about the effect of impending withdrawal of QE. But my focus is somewhat different.

Can the QE be expected to create a global turnaround?

I would say no. The reason I am keep a small probability open is because theoretically it is possible but quite a long shot. If you look at Prof. Keen's first cut model, the Banks need to buy assets (he calls it stocks but assets is better term) from the economy. This creates money supply which allows producers access to capital, employ people and therefore give consumer access to income and therefore spending power leading to pick up. As you will note, this is not quite that simple.

In principle, I would say the current model of QE will work if banks make tremendous profits and spend it priming the spending cycle to create employment and resulting spending. Now you realize that to effect that kind of priming, bank profits will have to soar and corresponding banker salaries have to push far northward. All in all, not happening.

The purchase we get from this type of QE per dollar of traction gained by the economy is fairly low.

What kind of QE WILL work?

Any QE which will create jobs with certainty of income over reasonable period of time, say 15 years, will be adequate. The exact amount of income does not matter so long as it is above a bare threshold and so long as it is decently correlated with nature of job. Even when so provided, the purchase from such QE will come over 3 year period provided there are correlated reforms in market place to protect the income from malicious extortion using penal mortgage rates or credit card frauds etc.

For the record, any kind of job will do but jobs which build future capability will be more valuable than crude "dig-a-hole-fill-that-hole" jobs. The benefit from these jobs will be a bonus. Ideally, you want the population to work on the next big thing. At the moment it is not clear what that thing is - it is most likely green and blue.

What has the current QE achieved?

One may ask if the current QE is totally useless. It is not. The crisis of 2008-2009 was result of three things freezing together - an over-leveraged consumer, a credit-starved producer, non-functioning market. The present QE worked on easing the producer, though at a great cost. Sadly, it has not quite helped with over-leveraged buyer or not much has been done to fix the market. Further the over-leveraged consumer is going to bear the burden of easing of producer through higher taxes limiting his ability to spend for quite some time. In effect, the current QE has eased the producer at some cost to the consumer.

My approach would have been different. I would have focussed on the jobs and when income stabilizes the credit would have automatically flowed to productive quarters. The benefit of this approach was its moral compass was pointing correctly. Government was taking care of people rather than focussing on the corporates, returns on credit would have been available where it was productive. Where credit was lent inappropriately it would have been marked down by players themselves because of inter-firm rivalry. And in the process, the overall expenditure would have been lower.

What kind of recession are we in?

The worst kind! No, it is not smaller than the Great Depression rather it is quite larger than that. We are at the threshold of global realignment of geographical dispersion of production and consumption. The ideal world we imagined when we studied "competitive advantage of nations" will come to bear if each of the nation acts prudently. This cannot happen in the current environment of mistrust and currency wars. We need sanity to prevail - and usually, it doesn't and usually this kind of thing results in a real war. On that somber note I leave you, let us pray sanity prevails and politicians do the right thing.

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

What is a fair Pay?

Knowledge@Wharton has really so-so article about what is fair vs unfair pay. But this post is not about why the article lacks depth per se but it is about what really decides fair vs unfair pay. And to this end, we will rely on the model discussed in Understanding Firms - A Manager's model of the Firm.

We will take two aspects from the book, first relates to ESK (Effort-skill-knowledge) profile for every job and second relates to profile of employee when she works on Firm's transaction chain, namely scout, commando, bureaucrat. As I explained in the book, employees perform dual functions. They work IN the firm's transaction chains and they work ON firm's transaction chains. In the first function, their work is classified as ESK profile. In the second function, their work is classified into "roles" such as scouts, commandos and bureaucrats. 

First about ESK profile

First it is common-sense to understand that an E-dominated job will pay vastly lower than K dominated job and S-dominated job will lie somewhere in between. Now, any given job has a combination of ESK requirements and thus has a ESK profile. It is here that the confusion starts. You can immediately see that this is a 3-D surface plot and the nature of surface is not clear. 

Thus a job with high effort and knowledge requirement cannot be equal to effort job + knowledge job. In other words, when you expect a high-knowledge job to supply effort, you pay higher for the same effort than when it is supplied by someone who does not offer the high-knowledge part. Thus it makes sense to carve out the E-type part and make someone else do that job. This is the benefit of specialization.

Let us think of an example. (With reference to Ironman) A scientist at Stark industries who is as brilliant as Tony himself will have a high K profile. But when you compare Tony and that scientist, Tony Stark comes with equally high K profile along with strong E and S profile as well. That makes Tony Stark more valuable than that scientist. (We are assuming this comparison way before Tony becomes Ironman.)

Another example can be that of surgeon. A surgeon works in S-K profile with both equally highly demanding. Therefore it is only fair his compensation is quite high.

Next about employee roles

When you consider employee roles, there is even more confusion. Usually, employees have a favoured mode of operations, that is to say they have a natural inclination to be either scout OR commando OR bureaucrat. However, considering the bargaining power equation across the transaction chain and the nature of transaction on which the employee is working demands a certain role from the employees. When employee supplies such a role to such a transaction, she contributes positively to firm's bargaining power. 

Any addition to firm's bargaining power is easier to perceive in terms of financial returns and is thus rewarded substantially. However, the share of rewards are not commensurate with the contribution to the bargaining power by various employees. Thus, a person winning a deal often gets more credit than a person who creates conditions within delivery side to win such a deal.

In our earlier example of Ironman, when Tony Stark is faced with a problem of lack of resources (in the cave for example), he re-wires the entire transaction chain, creating it all by himself, operating in a strong scout-commando combo-role. This makes Tony Stark truly superior to all other employees. Now Tony Stark gets higher compensation not only because he can be scout-commando but because he knows that he needs to be scout-commando and supplies that role. Thus it is not the role per se, but the aptness of the role to the situation that is valuable.

What firm values vs. what is valuable to the firm

We know and understand that firm pays more for what it values more. But there is a difference between what a firm values and what is valuable to the firm and firms do not always value what is valuable to it.  

Quite often, employees know what is valuable to the firm but firm is unable to recognize it. This is because of lacunae in leadership rather than anything else. In this case, the employee making a valuable contribution feels that he is unfairly compensated.

Some times the reverse is also true, that employees think certain this is valuable but in larger scheme of things it is not that valuable to the firm. This is problem of expectation matching at employees side but even this is a lacunae in leadership.

Relativity of fair compensation

Fair compensation also depends on relativity. Whatever the firm's stated policy, the employees know who is paid what in approximate. Further, employees also know the relative performance of people in the team. If firm rewards are not in line with relative performance a feeling of unfairness develops. No one compares his compensation with that of CEO directly, you compare your compensation with someone who has performed better than you and to some other who has done relatively poorly. If the compensation satisfies the hierarchy of performance employees feel it is fair.

Secondly, employees also compare compensation of others with others. So they will compare compensation of A(a not-so-high-performer in their eyes) with that of B(a star in their eyes) and check if the fairness holds. If they feel this is unfair then they ascribe unfairness to their own compensation even though in isolation they may feel their compensation is fair. To make this point clearer, employee is happy to receive his compensation for the year but becomes unhappy when he goes out and interacts with others.

Thus, fair compensation is not as simple as K@W makes it sound. It is way more complex. But you know better now!

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

Digitizing Permission marketing

When companies want to sell their products they advertise. What if a consumer, who wants to buy a product, does the same? Will companies flock to them and try to sell their wares? Well they should.

Imagine this 

A customer wants to buy a camera. He logs into any social website and says to his contacts - "I want to buy a camera what do you recommend." Immediately, a small site will be automatically created by search engines on their own within this say google will create a microsite, bing will also create one etc. 

What information will these site have? 

1. A section on information where product reviews and comparisons. 
2. A section on basics: For a camera site it will discuss photography, digital, films, about focus, aperture etc. 
3. There will be a section on offers by various shops. 
4. There will be a social feature indicating who amongst your friends owns which camera and what do they feel about it. You can also send them questions about shops and models.
5. Camera companies can embed flash program to allow user a simulated learning experience. Similarly for other products like phone A/C, washing machines etc.
6. A camera company site may also have some public visuals (untouched/unphotoshopped) that were clicked by that camera.
7. A well-known camera expert could have some auto-suggestions for your profile. 

Reverse Wikipedia 

Think of the site as a reverse Wikipedia created for just one reader. This makes sense because a photography company or a camera company can spend its time looking on the web for resources while a single user cannot do so without intruding on his schedule. This information collected by different vendors then pools into a single place created for the user. This allows prospective sellers to market to exactly that person. However, since this information is ranked as per the relevance of the user by knowing his web surfing habits and his web contacts and things that they like to search and access, it will be completely customized.

Reengineered forums

If you visit a forum then one common comment you get on many post is that someone has already shared this or solved this previously and you should search within past posts. If only searching through past posts were that easy! Wouldn't it be easier if the forum found out what was already said and entered them as comments in my post?  

Curator lounge

Alternatively the site can be hosted by a curator. Thus a person who deals in wine can answer the questions once and the site back end can mine these answers while creating solution specific to the customer.

How does this use the Firm model?
In "Understanding Firms", we detailed the transaction model. One of the factors of innovation - namely incremental innovation was to shorten the transaction chain. The traditional marketing chain needs to be shortened by bringing the product closer to consumer. 

Traditional marketing, Seth Godin calls it interruption marketing, was designed to interrupt your work and bombard you with things they want to sell. Permission marketing, a Seth Godin innovation, changed this when companies sought to find out what you wanted and then try to sell it to you. What we have described is actually digitally enabled permission marketing and customized it for the user based on his/her habit and profile.

If you want to use this idea, you have to pay me royalty. Terms and conditions apply!

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

The Role of Regulators and Regulation

One of the critical findings of the sub-prime and subsequent crisis is about role of regulation.

The role of regulations is to balance the lop-sided accumulation of bargaining power against the citizenry. Specifically, where the interaction is between firms (organizations) and ordinary citizens, the nature and language of regulation becomes important as the firms actively try to usurp bargaining power against ordinary citizens. 

The job of regulator, as against regulation, is to be hyper-responsive in protecting the balance in bargaining power equations. Regulator, as against regulation, is speedier and active element introduced into the system to prevent the speedier innovations from disrupting the intended effect of regulations (which are rather hesitant to change).

Here is Senator Elizabeth Warren trying to force this concept on regulators who have become guard dogs of industry they regulate.

I have written along similar lines in my book "Subverting Capitalism and Democracy - Systemic faults that caused the financial crisis."

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

Risk Adjusted income and certainty of employment

Mike Kimel has a post Reproduction, Income, and the Future where he quotes comments from breadth of political spectrum and cites his own experience as under:

my wife and I got married late and had one child (one and done) very late. Economic worries were a big part of the decision making process. On paper, my wife and I are doing relatively well financially, but we are extremely aware that a job loss - something that has become extremely common in recent years - or one financial mis-step could mean the difference between whether our son will have far greater opportunity in life than either my wife or I did growing up, or far less opportunity. There doesn't seem to be much in-between. In talking with my parents, they also seem to believe outcomes are more stark for families today. Many of my friends tell me the same thing. And when I talk to people ten or twenty years younger than I, in general, their costs seem to be higher than those I faced, and the potential opportunities fewer.

Yves Smith also weighs in on similar issue - in Disposable workers: Why throwaway employees are bad policy? This post covers a slightly different angle. However, the central issue remains the same.

Now we know that the incomes have grown over the generations but we fail to notice that correspondingly risks to that income have also increased. Thus in general language, while the earning has shot up, the stability of the earning or certainty of earning over long periods has declined. If we truly use risk adjusted income, we will realize new generations are worse off than previously thought. Similar line of argument is followed by Elizabeth Warren in her book Two-income Trap.

This also gives us a corresponding corollary with reference to macro-economic recovery. A recovery is sustainable when there is reasonable certainty about some level of income. That level income, which is certain, forms our debt carrying capacity - not the fluctuating actual income number. Thus, unemployment numbers by themselves do not convey anything about recovery but certainty of employment over most of working life should signal recovery.

I have written along similar lines in my book "Subverting Capitalism and Democracy - Systemic faults that caused the financial crisis."

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

NYT Chart GDP, stock markets for key countries 2008-2012

Super chart from NYT about GDP, stock markets for key countries between 2008-2012. Following points of interest:

1. Remarkable correlation between markets with different GDP movements. To me that points to singularity in source of money pushing the markets.
2. Indonesian markets are substantially bullish. Someone must have made a ton of money there. Conversely, it signals time ripe for reversion.
3. Britain stands out among those countries with declining or negative GDP and stands with US and Germany rather than Japan, Italy or Spain. Again remarkable correlation between Italy and Spain surprised that there is no time difference in the moves since their economic future will not be as coincidently timed as their markets.

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

How a buy order get processed?

Bloomberg Businessweek has a super infographic about how stock market orders get filled. Courtsey The Big Picture - Barry Ritholtz.

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

Of Pizzas and quantitative easings

Bill Black takes on P.J. O'Rourke's Pizza critique of Obama. Prof. Black does it well so I simply quote him here and then add some of my comments below:

O’Rourke has gotten his pizza metaphor reversed. Obama’s positive-sum policies produced economic growth while the eurozone’s negative-sum austerity programs caused a recession. Under O’Rourke’s metaphor, it was Obama who made more and bigger pizzas. Had the members of Congress who, like O’Rourke, favor the negative-sum policy of austerity not diminished and warped Obama’s proposed stimulus Obama would have created even more and larger pizzas with better toppings available to a broader group of diners.

Simply put, the problems in terms of the pizza example during adverse economic conditions like we are facing are following:

1. Without government intervention, the number of pizzas produced declines leading to pizzas being available only to wealthy thus skewing the pizza availability in favour of those who already have some.
2. If government intervenes, it can make as many pizzas as before or more. However, in making them, government must spend money which it must borrow. Further, government cannot sell pizzas at profit as people cannot afford them even at cost price. Thus, government must incur losses. It can truly recover these losses when it no longer needs to produce pizzas and it can tax the profits of others who are able to profitably make and sell pizzas.
3. If government already has some money due at the time pizza production falls, and it decides to reduce its debt burden, then number of pizza available falls drastically - more than in first case.

Now, A correctly executed stimulus will yield more pizzas and need less money. The need for stimulus is undoubtable and so is the fact that such stimuli will cause rise in deficit. The focus of debate should be ways to improve the effectiveness of government stimuli rather than the need for stimuli itself. Such a debate would have been more productive in keeping the increase in deficit as small as possible. Unfortunately, 70 years after Keynes explained all this we are still at the same point having learnt nothing.

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".