Profits And Altruism
What do you want to do?
Is it profitable?
No?: Then forget it. It can’t be done.
Or, maybe… Someone will contribute: Grant money, a government subsidy, a tax break. Maybe someone will look the other way on ‘externalities’: let you cut costs by dumping, pick up the tab for the social fallout so that you don’t have to… Is it profitable yet?
ROI And Discount Rates - A Diversion
Something I learned in a Project Management class has never sat well with me… I knew something was wrong at the time when my classmates couldn’t explain how the professor came up with the discount rates in her example. I jumped to the conclusion that she didn’t know herself. My classmates had only the thinnest grasp of the foundations - they clearly weren’t comfortable tinkering with the numbers beyond the examples from the blackboard. Perhaps this is just one of my bad habits: Asking too many questions… And there was a lot of grumbling from both sides when I would ask questions about this. Everyone just assumed that I was an idiot - Questioning the gospel. The answers tended to go around in circles - circular logic. The answer given was “Cost of Capital”, but with every step away from the core of the material in search of answers, people got understandably wary that it would never end, and irritated with me for caring. So much for education: We were spending a lot of time memorizing acronyms from Earned Value theory of Cost Control. We were too busy to learn about Asset Pricing Models or some-such.
Discount rates make sense in a stable environment: A volatile environment is precisely the situation where you run into difficulties. What’s in store for the future? Inflation? Hyper-Inflation? Maybe Deflation? What discount rate should you choose when you make descisions about a reasonable Return on Investment? In a deflationary period, you could make a profit even with a nominal loss.
But as you may or may not have discovered, supply and demand on money is affected by ‘substitute goods’. Also, if everything is a transaction, how can money be created or destroyed? - Even with taxes or fees, isn’t there a kind of ‘conservation of cash’? When the stock market goes down, it means money is being pulled out. Doesn’t that money have to go somewhere? Money taken out of stocks gets put somewhere else: A bank account, then maybe commodities, durables, consumables. But the seller of those items receives the money. And the taxman takes his cut. No money created or destroyed - just ‘redistributed’. Help me out if I’m working with any bad assumptions here. When you lose money on stocks (or gold, or land, or antique cars), it is actually on a pair of transactions. Same thing when you win: Buy low, sell high. Why doesn’t everybody get to do that?
Inflation is often blamed on the volume of money - the ‘Money Supply’. That’s a big theme in that book “The Great Wave” that I’m reading. And in those plumbing models from 20th century economics. Money supply is more than just cash, depending on your definition, it includes a bunch of I.O.U.s in transit - checks in the mail, but also ‘corporate paper’ and some other financial instruments you and I will probably never encounter in real life. Anything that increases the supply of this definition of money creates a bidding war on anything hard cash can be traded for, and that causes inflation. The only problem with that is we tend only to notice inflation on everyday items. If some complicated theory is used to price financial instruments, the rising prices on things like stocks, bonds, or Collateralized Debt Obligations are either some indication of economic health, or just another place to stash big stacks of money that don’t raise the price of bread, milk, gasoline and washing machines. Bubbles can happen in anything from Internet start-ups to real estate, and the general effect there is once again to prevent all that money from bidding up the price of consumer products.
From “The Great Wave”, I learned that inflation doesn’t affect all products the same way. In historical periods of inflation (the very Great Waves Fischer is referring to), prices on raw commodities go up faster than manufactured goods: Food and fuel that even the poor must consume vs. Fancy goods that only the wealthy would buy anyway.
Many governments have tried to print their way out of a budget crisis, and that makes everything worse. Just look at Argentina, or Weimar Germany… Inflation erodes the value of the cash you’re holding. It punishes the creditor because the money is worth less when they get it back… Enter the discount rate. Let’s jigger it so the debtor has to pay back a little more the longer they wait to do it. Whatever the payment schedule, we can tack on 10% to what’s left unpaid.
Now it’s investing time. I’ll have to measure my ROI against inflation: I’ll want a higher percentage than the inflation that I can expect over the life of the investment - If I stuff the money in my mattress, it’s losing value, so I am virtually forced to invest it in something. There is even some risk to the mattress strategy - maybe the house burns down. Within a certain range, investing is stimulated. Outside of that range, not so much… During deflation, that mattress strategy starts looking pretty good. During deflation, the value of the money you hold is going up, so why would you loan it out to anybody? On the other hand, if inflation gets too high, you’ll have some trouble finding a high enough ROI. Demand all the profits you want, but will any venture be able to provide them?
Did you figure out what the discount rate should be yet?
Then we should add in the ‘risk premium’: If the investment is risky, the discount rate should be higher. The investor should get something extra back, since he might not get anything at all. Paying that back can be tricky, so the expectation of a high profit goes up too.
We’re back to the beginning now: It’s not the good ideas that will win, but the profitable ideas. One school of thought holds that the profitable is the good. But since high profits are often the cover for some negative externality, maybe the ideas attached to them are not so good.
Have I Rambled Too Far?
What is altruism, after all? If we want to give something away, where is a good place to do the giving? Should we give a boost to the profit extractors, or the good ideas that won’t profit left to themselves?
At Wikipedia I read: “For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital.”
Can you refine your definition of “worthwhile”? Isn’t it also worthwhile to achieve a desired goal, even if you should lose some money in the process? Isn’t that a vehicle for altruism? Don’t governments generally engage in that type of behavior to provide for the society in general? By losing money on an investment, you pass along wealth to some effect: But be careful when you do - It might improve life for the masses, or it might ‘line some billionaire’s pocket’.
Posted by Evan Bittner Wed, 29 Oct 2008 14:28:00 GMT
