The Parable of the Mini-Cow: The Limits of the Market’s Ability to Price Accurately and the Less vs. More Government Question

To give some context to what I am about to say here, let me first clarify that I cannot rightfully claim to be a tree-hugger, nor a cow-hugger. I was a vegetarian for many years, and it is surely no coincidence that I was more fit and healthy during those years than ever before or since. But as the transition from young to middle adulthood brought more responsibilities my way, there were certain things that the natural force toward equilibrium inevitably moved aside. One of them, unfortunately, was my once-healthy diet and general level of attention to what I put in my mouth.

So, it is in that context, as someone who has nothing in particular against meat-eating, in theory, creed, or practice, that I’ll say that it was while I was listening to some commentary on the economics of meat that some fundamental insights on the market’s ability to accurately price became clearer to me.

I was listening to Talk of the Nation on NPR, and the guest was an author who had recently published a book on the role of food in the development of societies. I tuned in mid-way through his appearance on the program, at the moment that he happened to be discussing with a caller the tradeoffs that are involved when someone eats a steak.

By eating a single steak, a consumer is eating part of a cow (or bull, of course) that may, before its slaughter, have eaten many meals that included grain that could, theoretically, have been fed to human beings instead of livestock -- especially human beings in parts of the developing world where both cattle and grain are scarce and expensive commodities. So one could argue that, for every cow that humans consume for meat, many more meals worth of grain have been made unavailable for human consumption.

The discussion about steak was actually prompted by a caller’s question, and it didn’t venture deeply into the implications of the example of grain for humans vs. grain for cows for the question of how accurate the market is in factoring this tradeoff into the cost of a steak. But the author, interestingly, segued from the steak discussion into an analogy with the cap-and-trade debate, implying that cap-and-trade is nothing more than an attempt to recapture an environmental cost of carbon emissions that is not priced in by an unregulated market.

Producers and consumers of fuel, in other words, are not by nature inclined to think about the external side-effects of carbon emissions when they negotiate a price based on immediate issues of supply and demand. They, and by extension the entire market of producers and consumers, are blind to this hidden cost, because it does not affect their transaction directly. It’s the same phenomenon that explains, for example, why no automobile owner would voluntarily stop by the local department of highways and drop a few pennies on the counter to cover his daily share of wear-and-tear on the roads.

This was an “ah-hah” moment that helped me better contextualize the dogmatic debate on cap-and-trade that’s going on. But it also provided some basic insights into the limitations of markets in setting prices.

To illustrate, let’s take a brief look at a simple model. Imagine two islands. Island 1 is populated by people who don’t have the capacity to grow their own crops or raise their own livestock, so they are dependent for their food supply on importing food from elsewhere.

Island 2 is populated by three types of people: (1) farmers of Magic Sprouts that are nutritious for either human beings or livestock; (2) farmers of Mini-Cows that take about one year each to mature to slaughtering age, are well nourished by the Magic Sprouts, and are of a size that provides a single meal of beef for one person; and (3) Meat Lovers who eat one meal of Mini-Cow beef every day and do not eat Magic Sprouts.

The Magic Sprout farmers have two choices: they can sell to the distant inhabitants of Island 1, or to the Mini-Cow farmers, who are their neighbors on Island 2. Let’s assume, first, that the daily nutritional requirement for one human being or one Mini-Cow is met by the same amount of magic sprouts, that each inhabitant of the Island 1 is able to pay $5.00 (including freight) for a day’s supply of Magic Sprouts, and that the Mini-Cow farmers are also able to pay $5.00 for a day’s supply of Magic Sprouts for each of their Mini-Cows. All other things being equal (more on that later), the first choice of the Magic Sprout farmers will be to sell to the Mini-Cow farmers on their own island, since the cost of delivery will be much lower than the shipping cost of exporting to Island 1.

So each meal a Mini-Cow eats, in theory, makes a meal of Magic Sprouts unavailable to an inhabitant of the Island 1. And since it takes a year for a Mini-Cow to mature, the Mini-Cow requires 365 meals to provide one meal to one of the Meat Lovers on Island 2, meaning that an inhabitant of Island 1 loses 365 potential meals whenever a Meat Lover on Island 2 eats a Mini-Cow. This trade-off, in addition to being an inherently inefficient way to feed the Meat Lovers, also imposes a formidable cost on the inhabitants of the Island 1. Yet this cost is unlikely to be factored into the price that the local Mini-Cow farmers and Magic Sprout farmers negotiate (at least in the short term). But it undoubtedly will be incurred in some form by the inhabitants of Island 1, taking many possible forms, including:

• Suffering and ill health effects from hunger and malnutrition
• Higher prices needed to motivate the Magic Sprout farmers to increase their exports
• The cost of finding alternative food sources
• The cost of developing other goods that would appeal to Island 2 and whose exports would provide additional money that could be used to purchase more Magic Sprouts.

These costs could be incurred at the individual or societal level by the inhabitants of Island 1, but, one way or another, they will be incurred. But eventually, even if further out in time, these costs are also likely to affect the inhabitants of Island 2. This, again, could take many forms, such as:

• An eventual war between the islands
• Trade warfare in which the inhabitants of the Island 1 may withhold or exorbitantly raise the price of goods or services that Island 2 may need
• Foreign aid extended by the Island 2 to help feed and appease the hungry, angry inhabitants of Island 2

If this is beginning to bear some resemblance to some of the international economic and foreign policy issues now facing the United States, perhaps it is no coincidence.

As a side note, this model points to some possible inherent inefficiencies in a society whose diet centers on meat from domesticated livestock. Livestock farming creates entire populations and even subspecies of animals that otherwise would not exist -- and quite likely could not survive -- in nature, and that must, before they are slaughtered, consume numerous meals that may consist at least in part of foodstuffs that could provide meals to humans. It seems, then, that a vegetarian-centered diet is the more efficient solution to the need to feed humanity. Beef cattle, in other words, are very inefficient and expensive “middlemen” in the food chain. So factors that have little to do with efficiency must underlie the focus of the food market in the U.S. toward meat as the primary staple.

But more important to my main argument is that we see in this model a compelling illustration of how a given transaction can create external or longer-term costs that may not be fully factored into the short-term price that buyer and seller negotiate. This is one limitation on the market’s ability to accurately price. Markets price accurately only within the context of information that is available to and cared about by the buyer and seller at the time of the negotiation. That is why economists are so fond of the “other things being equal” disclaimer. Factors that are external, unknown, or not cared about by either party do not affect the negotiation.

The Mini-Cow model is simple, and from an imaginary world; but one doesn’t have to look far for real-world examples that fit at least partially. For example, the adverse health costs of cigarette smoking were not known for a long time. And even after they were known, the tobacco industry and smokers either didn’t understand well enough or care enough about the health effects to price them into the cost of the product. Health factors were not priced in until the situation reached a critical point at which regulation, taxation, and litigation forced the prices to be adjusted. And even now, after significant price increases, it seems impossible to make the case that the cost of a pack recoups the staggering human cost of premature deaths and debilitating illnesses among smokers. What is the life of a nicotine-addicted lung cancer victim worth to him or herself and to his or her family? Would a tax of $10,000 a pack be high enough?

The issue of costs that are hidden, external, or disregarded in transactions negotiated between buyers and sellers in the free market is precisely why we must have governments, taxes, and regulations, however much we may viscerally dislike them. Taxes and government budgets can be looked at, in part, as blunt instruments that enable us to make allowances, however imprecise, for such unknowns.

We often, and perhaps most of the time, don’t get it quite right, but it’s a must. Someone has to pay for the roads and bridges we break down with our cars and trucks. No one will make these payments voluntarily, and the sort of decentralized, privatized system some have called for of numerous local providers of road construction and maintenance seems laughably inefficient on the face of it. And someone has to fund the military of Island 2 to prepare for the possibility that the citizens of Island 1, eventually, may begin to feel that that they are being treated unfairly and get very, very angry.

Or, to bring the argument even closer to home, someone has to fund a social safety net that’s sufficient to prevent state unemployment insurance funds from going broke and tent cities from emerging when the economy tanks. Oops. Those things are happening now, aren't they. I guess someone hasn’t been paying enough taxes.

Again, the measures available to governments to compensate for the shortcomings of markets are blunt instruments, whose flaws can sometimes only be identified when there are failures in certain areas, the kinds of failures we see now. If financial practices were permitted that ended up undermining our entire financial system and putting out of work and homes a disproportionate number of honest, hard-working people who had always played by the rules, then there must have been a failure of regulation. The fact that there aren’t sufficient funds available to the federal government to carry the nation through our current crisis without incurring significant additional debt suggests that sufficient revenue, for an “economic insurance policy,” of sorts, was never being collected in the first place.

Even if you buy the argument that safety nets should be funded not by government but by individuals through personal savings, the insufficiency of personal savings to carry affected families through the crisis suggests that savings were not adequately incentivized, a phenomenon that involves a complex interplay among the governmental, commercial, educational, cultural, and familial domains.

As much as dogmatists on the right may continue to spout the old, Reaganite “government isn’t the solution, it’s the problem” clichés, the present indicators seem to suggest that it’s more government that we’ve needed over the past 30 years, not less. So, after a marked rightward swing of the pendulum 30 years go, we are now making an adjustment and swinging back in the other direction. There is, of course, a possibility that we’ll swing too far; and if that’s the case, we’ll just have to adjust again.

But my hope, and belief, is that with each swing, we are also making improvements to the complexly intermeshed gears and springs that drive the pendulum, putting what we have learned with each swing into adjusting the underlying technology of the clock so that the entire system continues to progress in how intelligently and effectively it operates.

We learned some good things from the swing 30 years ago that are unlikely to be lost, especially in terms of reaffirming fundamental values of entrepreneurship, work ethic, and self reliance. And no matter where the pendulum ends up stopping in its current arc, we’re sure to learn some good things again, this time around, that will also be retained for the long run, leaving us stronger still. Sphere: Related Content

In the Midst of Crisis, Let’s Not Lose Sight of the Good Things About Deregulation

Deregulation, at least of financial markets, has been taking some heavy hits in the news in general, and in this blog. So before I start getting accused of being some kind of big-government, tax-and-spend commie pinko, which is far from the truth, let me acknowledge that deregulation of certain industries has produced many positive effects:

1. In the airline industry, deregulation created more competition and paved the way for the lower fares, in constant dollar terms, that we see today in comparison to those of the 1960s and 1970s. Air travel changed from a luxury to something that was affordable to middle class Americans.

2. Deregulation in telecommunications opened the door to competition in such areas as long distance service which, in its earlier days, was ridiculously overpriced. And telephone bills in general are now substantially less expensive in real terms than they were thirty years ago, and often include, for a flat rate, unlimited long distance and premium services.

3. Opening up more of the spectrum of radio frequencies for commercial use made innovations such as cellular telephones and wireless data transmission possible.

What’s the lesson? Some industries need more regulation than others. And some industries need more regulation in certain stages of their evolution.

So why not take government out of the equation and let industries regulate themselves? Because it won’t work, any more than making payment of your water bill a voluntary option would work. Issues that have no effect on the short-term bottom line or that would affect it negatively tend to be ignored by businesses. This is why there was a time, for example, when factories that were not subject to environmental regulations freely polluted rivers, streams, and groundwater. Without regulation, there was no incentive to do otherwise.

The most dicey issues come up when the need for regulation of an industry emerges in mid stream. There was a time when we didn’t know that tobacco causes lung cancer, or that lead paint in homes can poison children. In this kind of situation, introducing regulations in product categories that are already widely distributed or, if necessary, transitioning them out of the market entirely, can be extremely difficult.

We’ll no doubt face similar challenges in the future. Examples include the question of whether there is a provable link between electromagnetic energy from wireless devices and cancer. In such situations, there may be no easy answer. And this is precisely why transparency of publicly accessible information, disclosure requirements on businesses when negative issues are known, openness of communication, and collaborative dialogue among industry, government, and consumers will remain essential to guiding optimal regulatory decisions and preventing abuses. Sphere: Related Content

Are the Best Investment Practices Still the Best Practices? Examining a Model Retirement Portfolio’s Performance from 1999 through 2008

In the 1980s, as pension-based retirement models began to disappear in favor of investment-oriented plans like 401(k)s, more and more everyday Americans began participating in the stock market.

In parallel, doctrines on effective investment practices emerged to guide investors in managing their retirement portfolios. The theory was that, by contributing regularly throughout their careers to a tax-privileged portfolio and following a simple asset allocation strategy, everyday American workers could hope not to “get rich quick” but, rather, to accumulate net worth slowly, end their careers with enough of a nest egg to ensure a comfortable retirement funded by their personal savings and investments rather than corporate pension plans and, eventually, “die rich,” with a decent financial legacy to pass on to their heirs.

Underlying these ideas were some basic assumptions and principles that, starting in the 1980s and continuing into the tech stock boom of the 1990s, were disseminated widely by increasingly popular personal finance gurus in books, television programs, and radio broadcasts:

• Based on its historical performance, it was reasonable to expect that the stock market, over a long period of years, such as a 30-year working life of a middle-class investor saving for retirement, would deliver a rate of return exceeding inflation and outperforming most other investment options available to the average person.
• A repeat of a financial catastrophe of the magnitude of The Great Depression was nearly impossible due to the regulatory measures that had been put in place and the methods, such as monetary policy, that the government had available to respond to an emerging financial crisis.
• Sound investment practices such as dollar-cost averaging and a strategy for allocating investments between equities vs. current income instruments like bonds would give investors good odds of achieving slow-and-steady growth while minimizing risk and smoothing out the volatility of the equity market. According to the theory, an asset allocation strategy would create a disciplined, built-in approach to the old “buy low, sell high” model. When stocks do well, some are sold into cash-like holdings to permanently preserve a portion of the gains. And when stocks drop more shares are purchased at a “value price,” increasing the benefit from an eventual recovery.
• A good way to invest in equities is through a highly diversified instrument such as an S&P 500 index fund, which follows the overall trends of the stock market, smoothing out the volatility and risk of investing in individual stocks or more aggressive mutual funds and, over the long run, outperforming actively managed mutual funds.
• Equities are an appropriate part of an investment mix for a goal, such as retirement or children’s college, that is more than five years out.

These principles seemed to work well for a while, but there were warnings of trouble ahead. The market crash of 1987 brought to an end “the fat years” of the Reagan 80s, shutting down the “yuppie party” fueled largely by defense-oriented technology companies that benefited from the administration’s deficit spending on military projects.

As the economy recovered in the early-to- mid 1990s there were more warnings, such as the drop in the stock market that followed Alan Greenspan’s infamous “irrational exuberance” speech. And at least a couple of television documentaries presented evidence that the stock market could be overvalued, and spotlighted examples from the past of long periods of economic malaise that, if repeated, could easily eat up a substantial portion of the working years of one person saving for retirement. These historical precedents included “The Long Depression” of the 19th century and the imposing stretch of years it took for the stock market to return to its previous highs after The Great Depression of the 20th.

But once the tech bubble started to form, around 1997, most of us seemed to forget these warnings. We were caught up in irrational exuberance yet again, buying into the story that we had entered “a new paradigm” in which rising stock prices didn’t need to be linked to tangible earnings. Then the tech bubble burst, and the market tanked again after 9/11. Since then, throughout the 2000s, the market has been sluggish and tentative. The Dow struggled for several years to get back to the important 10,000 benchmark, and it wasn’t until June 2007 that the S&P 500 finally exceeded its March 2000 high. Yet by December 2008, in the midst of the financial sector’s meltdown, the market had abruptly fallen back to levels close those of the fall of 2002, effectively erasing all the gains of the decade.

In view of this abysmal performance, we must ask whether investment principles like those listed above still hold true -- if, indeed, they were ever true. To gain insight into this question, I created a model retirement portfolio for a fictitious investor who starts out in 1999 at age 50 with a $100,000 investment and manages the portfolio according to the following guidelines:

• Maintain an allocation of the investment in equities based on the formula “100 percent minus your age.”
• Invest the equities portion in an S&P 500 index fund and the remainder in a Ginnie Mae Fund. Ginnie Maes are bonds consisting of pooled, government-guaranteed mortgages. They are recommended by finance gurus such as Bob Brinker as a low-risk instrument with a favorable rate of return compared to inflation and other types of bonds.
• Rebalance annually to adjust the allocations for market fluctuations and for the yearly change in the “100 percent minus age” formula.

So what happens during the 10 years? As the chart above shows, by the end of 2008, the portfolio has indeed grown, from $100,000 to nearly $124,000. But that total is down from a high of nearly $140,000 as of the end of 2007, leaving the total growth for the 10 years at 23 percent, which translates to an anemic annual growth rate of 2.3 percent. The asset allocation formula worked to the extent that it helped preserve growth in spite of the sharp equity drops at the end of 2008. But our fictitious investor, now 60 years old, is faced with a portfolio that has not accomplished much for the past 10 years -- which, after all, could be one-third or more of an investor’s earning life -- toward achieving retirement goals.

Granted, this simple model leaves out much of what the full picture would likely be for a real-world investor who, between the ages of 50 and 60, would hopefully be at the peak of earning power, regularly making dollar-cost-averaged contributions to the fund at an aggressive rate of, say, $10,000 or more per year, and rebalancing more frequently. This would significantly increase the capital base, and the dollar-cost averaging would help smooth out equity fluctuations and allow the investor take better advantage of gains when stocks were up. One could also envision different asset allocation schemes that could have produced greater growth.

In this real-world scenario we would, in spite of the poor performance of stocks, be looking at a portfolio that is much closer to a level at which, if reinvested at retirement in an income-oriented, capital-preserving instrument, it could provide a reasonable supplement to social security and other assets and income sources during retirement.

Nevertheless, the model does demonstrate that, during the current recessionary period and the 10 years that preceded it, equities have not been an exceptional driver of the kind of value growth investors need to build a retirement portfolio that would provide a level of security comparable to that of the pension plans of the past that 401(k) plans are ostensibly intended to replace.

The recommended practices listed above were not sufficient to ensure a growth rate significantly above inflation and other investment options, and the “more than five years out” rule of thumb for investing significantly in equities did not hold true. The results suggest the possibility that we are in a long-term secular bear market of the sort that some of the contrarian voices in the 1990s told us could occur, even though there have been some short-term bubbles and rallies within the period.

It was nice, while it lasted, to think that we everyday Americans could succeed as miniature Warren Buffetts, building our own little investment empires within the tax-privileged confines of our retirement accounts. But, based on what we have learned from the market’s performance over the past 10 years, perhaps it is time for us to push our collective Rethink button with regard to what constitutes an appropriate retirement system. Having existed for under 30 years -- less than the typical span of working years for one individual -- 401(k) plans are too new to be thought of as having any kind of track record, and the confidence we placed in them was based solely on our understanding at the time of what we could expect from equities markets -- an understanding that, based on the past decade, could be highly flawed.

If 401(k) plans are not the answer, then what is the solution? The old system of pensions administered by individual companies faded away for a reason. It is unlikely to return due to its inherent pitfalls, such as the question of what happens to the pensions of retirees when a company goes bankrupt or is acquired, and the inefficiencies of innumerable individual companies managing investment pools to fund their pension plans. But a huge and Byzantine system administered solely by the government is not likely to be a good solution either. With Social Security already in a precarious position, we don’t need an even larger and more lumbering species of the same animal.

The eventual solution will likely lie in a public-private partnership that, benefiting from economies of scale and time, can viably pool and invest pension contributions from numerous employees and the companies they work for. In this scenario, a highly diversified and balanced mix of investments could be made in a variety of instruments, including those that are oriented toward current income as well as equities. The timeline for deriving returns on investments could be much longer in such a model, far exceeding the period of earning years of a particular worker or even the successful lifespan of a typical business.

Taking the longest, big picture view, such as the seven decades since The Great Depression, it would be fatuous to try to argue that the equities market hasn’t performed extremely well. Its flaw simply lies in the fact that the three-to-four-decade earning life of an individual worker may not be enough time to allow long-term gains to compensate for significant short-term losses. But in a large, long-term system designed to serve the needs of multiple generations of retirees, equities would almost certainly have an important role to play as one of a number of instruments in the investment equation.

Such a system would also create the added benefit of portability. Workers moving among jobs with different companies would not need to be concerned about moving their retirement accounts, about waiting periods to become vested in a new employer’s plan, or about the fate of their funds should a former employer become insolvent or cease to exist.

A new system will also almost certainly need to include a re-thinking of what is an appropriate retirement age for the average worker. Since the Social Security system was first conceived, life expectancies and the level of health of older people have increased enough, in the aggregate, that the current 62 to 67 timeframe needs to be reevaluated. For many people today, an expectation of working to age 70 may be not at all unreasonable.

But any reevaluation of retirement age will need to be in a context that provides stronger protections for older workers against discrimination in hiring practices and workplace environments, and to make allowances for the fact that, in the current state of healthcare and medical technology, the health and fitness levels of individuals in their 60s and 70s remains highly variable.

And, of course, all this is easier said then done. The devil will be in the details. A new retirement system will not be quick in coming and, understandably, does not appear to be among the immediate high priorities of the Obama administration as it faces crisis situations on several fronts.

Unfortunately, there may be no easy answer in sight to address, in the near term, the pain that many individuals are feeling now as they face heavy losses in retirement accounts that included significant investments in equities. But it is good to at least see signs of an emerging consensus that a re-evaluation is needed, and the beginning of a serious dialogue on the subject through forums such as the recently launched Retirement USA initiative.

Finally, for average individual investors, hopefully a more sober and realistic understanding of the role of the stock market will emerge. There is nothing inherently wrong with widespread participation of ordinary Americans in the stock market. Having a healthy level of exposure to the stock market is a good thing, as long as we return to a mindset that the stock market is a place to go with “risk capital” that one can afford to lose, and if we learn the fundamentals of how the stock market works and how to evaluate individual equities, or if we use the services of competent professionals who are pursuing realistic growth objectives rather than lucrative sales commissions or impressive but unsustainable short-term returns.

But recent experience suggests that the stock market may not be such a good place to wager one’s entire retirement future.

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