Reducing Income Inequality when Productivity Exceeds Consumption

Among the last bastions of labor demand is Agricultural Harvesting. Every fall, groups of migrant workers follow the maturation of fruit and vegetables across the different climates. But even those jobs are going away. In one case, Abundant Robotics is developing robots that use image recognition to locate ripe apples and delicate manipulators to harvest fruit without bruising it.

In my last post I described how creatively destructive innovations like these have increased productivity in the United States until it exceeds basic needs by nearly four times. If it weren't for distribution problems, we could eliminate poverty altogether.

The problem is that when production exceeds consumption, prices fall and the economy goes into recession. As I wrote previously the U.S. and most of the word economy have relied on a combination of advertising, increased standards of living, and fiscal policy to stimulate demand sufficiently to keep up with productivity. But these stimulus methods have a side effect of increasing wage disparity.

The impact is mostly on the unskilled labor force as these jobs are the easiest to automate or export. Even though the income pie keeps growing, the slice owned by the lowest quintile shrinks. Free trade exacerbates the spread between skilled and unskilled labor as do attempts to stimulate consumption through government spending, low interest rates, and tax cuts. (Please see that previous post for details on all of this.)

Conventional Solutions and Their Limits

This is a gnarly problem. Potential remedies tend to have side effects that can make the situation worse, or at least limit the positive impact. In this post I'll name some of the conventional solutions and then attempt to frame up the kind of innovation that will be required to properly solve the problem.

Infrastructure Investment

Investments in infrastructure are a good short-term stimulus. Constructing or upgrading roads, bridges, energy, and communications infrastructure employs a lot of people of all skill levels. As most infrastructure is government-funded, it's a convenient fiscal stimulus. Trouble is that in the long run these infrastructure improvements result in greater overall productivity thereby reducing the labor demand.

Progressive Taxes

A common method of wealth redistribution is a progressive tax. Presumably the wealthy can afford to pay a larger fraction of their income than those with lower incomes. Progressive taxes are effective tools but, in the U.S., we have pretty much reached the limit of how much a progressive system can help low income households. Those earning less than the income tax threshold already pay no taxes. For a single parent with one child, the marginal tax threshold for 2016 was approximately $21,000 before accounting for federal and state health care benefits which amount to approximately $9,400 more.

Since the lowest tax bracket is already zero we can consider increasing the tax rate in upper tax brackets. While that may increase the amount paid by the wealthy it doesn't directly benefit the poor. Indeed, the resulting economic slowdown may worsen the situation.

Refundable Tax Credits

Through tax credits you can reduce the lowest effective income tax rate to negative values — paying money rather than collecting it. In the U.S. the Earned Income Tax Credit (ETC) serves this role with progressive benefits for the number of children in the household. Because the ETC is designed as a percentage of income, the benefit increases as the individual earns more money before being phased out at higher income levels. This is intended to incentivize workers to find and improve their employment even while drawing government benefits.

The downside of tax credits is that they are tied in with the very complicated process of filing income tax returns. The Government Accounting Office and IRS indicate that between 15% and 25% of eligible households don't collect credits to which they are entitled. Nevertheless, this is a promising approach because tax credits are unrelated to productivity and they have a direct impact on income inequality.

Increased Minimum Wage

Recently there have been increased calls for a $15 minimum wage. Many cities and some states have already passed laws to increase wages to that level. Critics of the minimum wage point out that increased wages can lead to increased prices — thereby reducing the benefit to low-income workers. And indexing minimum wage to the cost of living, as certain states and municipalities have done, may eliminate entry level jobs and accelerate inflation.

Many are watching to see how experiments in Seattle, New York City, and San Francisco will work out. Two recent studies of Seattle's minimum wage offer early indicators. One, from the University of Washington indicates an increase of 3% in total wages in low-paying jobs (the desired outcome) but a reduction, by 9%, of total hours worked (not so desirable). A study by UC Berkeley confirms the increase in total wages and indicates no reduction in overall employment though it does show a decline in employment of workers by limited-service restaurants (fast food). Hours worked was not among the data in the Berkeley study.

These are preliminary results but they tend to confirm the expected pattern. An increased minimum wage incentivizes greater automation and, thereby reduces the total labor demand. For example, fast food restaurants are deploying self-serve kiosks in place of human cashiers. So, while the employed benefit from higher wages, many jobs may be eliminated.

Idling Portions of the Workforce

A recession naturally reduces the number of workers until production is a closer match to demand. Unfortunately, those who lose their jobs are predominantly low-income workers, people who are least able to tolerate job loss. Better options preserve household income while reducing hours worked. These include mandatory vacation time, a shortened work week, and more holidays. When couples elect to have only one spouse be employed that also reduces the workforce.

Education

Increasing educational achievement is the intervention most dear to my heart. Not only does a better education enable better wages, but it also results in better health, greater happiness, more active citizenship, and reduced violence. Those with higher educational attainment make better financial decisions. All of this results in a better quality of life.

As more and more routine jobs are automated, the opportunities for those without a postsecondary degree or certificate will continue to diminish. A recent study at Georgetown University indicates that, by 2020, 65% of jobs in the U.S. will require postsecondary education. That's up from only 28% in 1973.

Certainly greater educational achievement is a part of the solution as it moves more people into higher-wage jobs. But those jobs pay higher wages precisely because they are more productive. So, as more people achieve higher levels of education, productivity will continue to increase.

Working With Market Forces

Nobel Laureate Milton Friedman observed that the communication function of markets is as important as the commerce function. When demand rises then prices rise. Rising prices signal suppliers to produce more goods. On the other hand, excess goods result in falling prices signaling manufacturers to reduce production. No command economy has achieved the signaling efficiency of the market.

The same signaling occurs in labor markets. Higher wages for more-skilled jobs will encourage people to seek the necessary education and training to qualify for those jobs. But the counter-point is our contemporary concern, when there is excess labor available, especially for low-skill jobs, then wages may fall below the point where workers can earn an adequate living. Some workers will retrain, and many programs will help pay for that. But retraining takes time, interest, and an affinity for the new field.

With worker productivity in the U.S. soon to crest 4 times basic needs the natural market signal is for less production – but that would mean unemployment. To date, we have interfered with that signal by artificially propping up demand. Massive advertising, high consumer debt, low interest rates, the housing bubble, planned obsolescence; all are symptoms of the interference. Besides, the overconsumption caused by this stimulus is also damaging to the environment.

As productivity continues to increase we will have to allow the signal to get through – it will inevitably anyway. The challenge is finding ways to match production to demand while sustaining employment and wages especially for the most vulnerable.

Framing the Problem

The innovation we need is this:

A way to distribute abundant resources more equitably; while preserving incentives to learn, work, and make a difference; and allowing market signals to balance production and consumption.

We can't look to the past because the challenge of abundance is different from any faced by previous generations. It's going to require a generous sharing of ideas, some experimentation, and development of greater trust between parties.

I'm optimistic that there is a solution because never before in history has society had such plentiful resources as today.

Cut Taxes or Increase Spending - Is the Debate Obsolete?

As the Trump administration turns its attention to a tax reform plan debate swirls about the best way to stimulate the economy. Traditionally, Democrats have advocated for increased government spending while Republicans have fought for reduced taxes. Both methods succeed in stimulating and both have their roots in the theories of prominent economists. But it may be that both strategies, and the theories that support them, are obsolete in a day when production is many times basic needs.

Government spending advocates cite the work of John Maynard Keynes. Prior to Keynes, neoclassical economists theorized that free markets should naturally balance the economy toward full employment. Keynes observed that economies tended to swing between boom and bust cycles and advocated government intervention through fiscal policy (government taxing and spending) and monetary policy (central bank regulation of the money supply) to moderate the swings. Keynesian theory was influential in addressing the Great Depression and remained dominant following World War II into the 1970s.

Among the expectations of early Keynesian economics was that high inflation and high unemployment should not co-exist. Economist Milton Friedman challenged that notion and was proven right when "stagflation" emerged in the 1970s. Friedman theorized that stagflation and related poor economic conditions result from excessive or malinformed government intervention. The solution, he said, was to free the market through reduced regulation and lower taxes. This school of thought is generally known as "supply-side" or "monetarist". President Reagan successfully employed that approach early in his presidency launching a sustained period of economic growth that continued through the Bush and Clinton administrations.

Today, Keynesian economics is associated with greater regulation, increased government spending, and with an overall trust in government interventions. Meanwhile, monetarist economics is associated with free markets, reduced taxes, and with an overall trust in the market's ability to self-balance. In fact, both schools of thought are much more nuanced than these broad strokes. On the Keynesian side, it matters a lot where the government spends its money. On the monetarist side, it matters a great deal which taxes are reduced and how regulations are tuned. Earnest theorists on both sides have a healthy respect for the other theory.

But the nuance is quickly lost in the morass of political debate. Indeed, I fear that most political Keynesians choose that theory because it justifies their existing desire to increase government spending. And most monetarists choose supply-side theory for it's justification of reduced taxes and regulation. In each case I think they first choose their preferred intervention and then select a theory to justify it.

Through the latter half of the 20th century U.S. government economic focus was pretty much what Keynes described - moderating the boom and bust cycle toward more stable continuous growth. During slow cycles this meant adding economic stimulus, through increased spending and reduced taxes. When inflation started to get out of hand, government would slow things by increasing taxes, reducing spending, and reduced interest rates. Reagan met the stagflation challenge (high inflation and high unemployment) with an unusual combination of reduced taxes (to stimulate hiring) and increased interest rates (to slow inflation). Nevertheless, Reagonomics still used the same tools, just in different ways.

Our contemporary challenge is a new one. Since roughly 2001 the economy has required continuous stimulation to maintain growth. Radical new stimuli such as Quantitative Easing and zero interest rates have been used. Previously experts avoided those stimuli because of their potential to provoke high inflation yet inflation remains at historically low levels and it seems that, without continuous stimulation, the economy will slow to a crawl.

Production compared to Basic Needs

The new economic challenge is due principally to the rapid increase in workforce productivity. According to the U.S. Bureau of Labor Statistics individual worker productivity has more than quadrupled since World War II. Overall productivity per person in 2012 was 412% that of 1947.

Productivity growth becomes even more striking when compared with basic needs. In 2014 U.S. per capita GDP was $54,539. The basic needs per capita that same year was approximately $13,908. So, per-capita production exceeds basic needs by nearly four times. And while the basic needs side of this equation includes the whole population, the productivity side only accounts for those employed, it doesn't include unemployed workers and people choosing not to seek paid employment. So productive capacity compared with basic needs would be even higher.

If it weren't for problems of distribution this would be a great thing! For the first time in history, society has sufficient capacity to provide comfortable housing, plenty of food, health care, entertainment, and leisure time for all. The challenge is that, in a market economy, productivity increases disproportionally benefit those who are already at the higher end of the wage scale.

Disproportionate Benefits

Creative destruction is the term economists us to describe the transformation of an industry by innovation. It is usually associated with the elimination of jobs due to new technology but any innovation that increases individual productivity qualifies. Some examples: The backhoe replaces the jobs of several ditch diggers with that of a more-skilled heavy equipment operator. Computerized catalogs reduce the demand on librarians. Industrial robots replace factory workers. The common feature of such innovations is that they substantially increase the productivity of individual workers. Frequently, these innovations also result in jobs moving upscale — requiring more skill or training and with correspondingly higher pay.

Creatively destructive innovations have led to enormous productivity increases in recent decades thereby reducing the demand for labor. As with any market, when supply increases or demand declines the value also declines. In this case the value of routine jobs has declined dramatically. Here's how economist Dr. David Autor describes it.

And so the things that are most susceptible to computerization or to automation with computers are things where we have explicit procedures for accomplishing them. Right? They’re what my colleagues and I often call “routine tasks.” I don't mean routine in the sense of mundane. I mean routine in the sense of being codifiable. And so the things that were first automated with computers were military applications like encryption. And then banking and census-taking and insurance, and then things like word processing and office clerical operations. But what you didn’t see computers doing a lot of — and still don't, in fact — are tasks that demand flexibility and don't follow well-understood procedures. I don’t know how to tell someone how do you write a persuasive essay, or come up with a great new hypothesis, or develop an exciting product that no one has seen before. ... What we’ve been very good at doing with computers is substituting them for routine, codifiable tasks. The tasks done by workers on production lines, the tasks done by clerical workers, the tasks done by librarians, the tasks done by kind of para-professionals, like legal assistants who go into the stacks for you. And so we see a big decline in clerical workers. We see a decline in production workers. We see a decline even in lower-level management positions because they’re all kind of information processing tasks that have been codified.

Recent creative destruction has predominantly affected lower-middle-class jobs and manufacturing jobs. While increased productivity has made our nation more wealthy as a whole, large sectors of the labor force have been left behind. This may be the biggest factor behind the slow recovery from the 2008 recession. Automation substituted for jobs that were eliminated during the recession; those jobs are not coming back.

The decline in U.S. manufacturing employment has been balanced, in part, by growth in the service sector. This makes sense; growth in productivity has resulted in greater overall wealth. On average, people in the U.S. have more money to spend on eating out, recreation, vacations, and health care. But again, the benefits are not evenly distributed. As workers displaced from manufacturing have moved into the service sector, wages in that area have stagnated.

Disproportionate Impact of Globalization

Economists have consistently advocated for free trade. The math is incontrovertible; when regions or countries with different costs of production trade goods and services, all communities benefit as each is able to specialize and all benefit from the overall productivity increase.

Only recently have economists begun to study how free trade impacts sectors of the economy rather than the economy as a whole. Unsurprisingly, the impact to the U.S. has disproportionally affected manufacturing and routine labor. Here's another quote from Dr. Autor:

When we import those labor-intensive goods, we’re going to reduce demand for blue-collar workers, who are not doing skill-intensive production.  Now we benefit because we get lower prices on the goods we consume and we sell the things that we're good at making at a higher price to the world. So that raises GDP but simultaneously it tends to make high-skilled and highly educated labor better off, raise their wages, and it tends to make low-skilled manually intensive laborers worse off because there is less demand for their services — so there's going to be fewer of them employed or they're going to be employed at lower wages. So the net effect you can show analytically is going to be positive. But the redistributional consequences are, many of us would view that as adverse because we would rather redistribute from rich to poor than poor to rich. And trade is kind of working in the redistributing from poor to rich direction in the United States. The scale of benefits and harms are rather incommensurate. ...

We would conservatively estimate that more than a million manufacturing jobs in the U.S. were directly eliminated between 2000 and 2007 as a result of China's accelerating trade penetration in the United States. Now that doesn't mean a million jobs total. Maybe some of those workers moved into other sectors. But we've looked at that and as best we can find in that period, you do not see that kind of reallocation. So we estimate that as much as 40 percent of the drop in U.S. manufacturing between 2000 and 2007 is attributable to the trade shock that occurred in that period, which is really following China's ascension to the WTO in 2001.

During the campaign, Donald Trump and Bernie Sanders both advocated rethinking free trade. Perhaps we can use tariffs or government incentives to return manufacturing back to the U.S. As it turns out, that's already happening even without incentives. As labor costs increase in Asia the offshoring advantage is diluted. Many manufacturers are, indeed, opening new U.S. plants. The trouble is that returning manufacturing doesn't result in substantial job or wage growth. These are highly automated plants, employing a fraction of the workers whose jobs were eliminated when manufacturing went overseas. For example, Standard Textile just opened a new plant in Union, SC to make towels for Marriott International. Due to automation, the plant only created 150 new jobs. A generation ago the same plant would have employed more than 1000 people. And many of the new jobs are more highly skilled — designing, operating, and maintaining automated machinery.

Creative destruction and globalization are working together here. Both increase overall GDP, both increase individual worker productivity, both increase total wealth, and both disproportionately benefit skilled upper-middle-class workers over blue collar and middle-management workers. Any benefit from manufacturing returning to the U.S. will be blunted by the increase in automation reducing labor needs and shifting what remains to more skilled jobs.

Demand-Side Economics

So far, we have looked at the supply side of labor. The massive increase in productivity over the last six decades has been driven by innovative technology with global trade as an accelerant. As noted before, when the supply of labor exceeds demand then the value decreases. When supply exceeds demand across the economy as a whole then you get a recession.

From the end of World War II through the rest of the 20th century we succeeded in driving demand to keep up with supply. Advertising grew tremendously as an important demand driver. Television programs established new norms: two cars per family, a large home in the suburbs, annual luxury vacations, and designer clothing labels to name a few. Home appliances like air conditioning and a dishwasher went from luxury to necessity.

Government has participated in driving demand. Housing programs made home ownership much more accessible. So much so that it resulted in the 2007 real estate bubble. Likewise, the Federal Reserve has kept interest rates down ensuring that consumer credit remains accessible and people can buy ahead of income.

In the 21st Century we seem to have reached the limits of demand stimuli to compensate for ever increasing productivity. Smaller cars like the Mini Cooper or Fiat 500 have become stylish. Even the wealthy are choosing to reduce consumption — buying smaller homes or moving into the city. The result is that it takes increasingly strong stimuli to keep the economy moving. For the recession of 2008 the government spent unprecedented amounts of money borrowing directly from the Federal Reserve to do so. Despite this pressure, interest and inflation rates remain at historically low values.

Increase Spending or Cut Taxes?

And so we return to the contemporary debate: Should government increase spending or cut taxes to stimulate the economy? When government cuts taxes, individuals and companies have more disposable income. Presumably they will spend some of that income and save part. When government increases spending, it chooses directly where that money will be spent. Both theories depend on "trickle-down" effects even though that has traditionally been associated with tax cuts. In each case, the direct beneficiary of government policy employs more people and purchases more goods and services; those employees and suppliers also do more business and the impact "trickles" through the economy. The primary differentiator is whether you have greater trust in government (increase spending) or the market (cut taxes) to determine who is at the top of the trickle-down pyramid.

The question is really obsolete. Regardless of which stimulus you choose, demand stimuli are increasingly unable to keep up with increased productive capacity. As a country, we already produce nearly four times basic needs and the multiplier will continue to grow. Meanwhile, the twin pressures of Creative Destruction and Globalization will continue to drive the greater benefit of demand stimulus to those who already earn higher wages. Under either strategy, wage disparity will continue to worsen despite attempts by policymakers to direct tax breaks or government spending toward lower income households.

It seems that we will need a greater economic innovation than either of these 20th century solutions. In my next blog post I will write about some promising ideas. More effective education for all students is, of course, an essential component but insufficient by itself.

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Estimating Basic Needs Per Capita: The Self-Sufficiency Standard is an measure of the income necessary to meet basic needs without assistance. Values are in terms of household. National averages aren't published so we have to make an approximation starting with samples of two cities. The cost of living index for Milwaukee, WI is 101.9% of the national average. Rochester, NY is exactly 100.0%. The 2014 Average household size in the U.S. was 2.54. We round up to 3 - two adults and one child. For Milwaukee the 2016 Self-Sufficiency Standard for that household is $43,112 annually. For Rochester, the 2010 Self-Sufficiency Standard for the same family is $40,334. Per-capita values are $14,371 and $13,445 respectively. Averaging the values comes to $13,908 approximate U.S. basic needs per capita in 2014. To be sure, there's a lot of variability across region, household size, medical needs, and so forth. I also mixed figures across 2010-2016. Nevertheless, this is a good enough working figure for comparing to per capita production in the same timeframe.

Bitcoin - What Makes a Currency?

Today I'm diverging from the education theme to write about cryptocurrency. I am provoked, in part, by this quote from Alan Greenspan:

“It [Bitcoin] has to have intrinsic value. You have to really stretch your imagination to infer what the intrinsic value of Bitcoin is. I haven’t been able to do it. Maybe somebody else can.”

Now, Greenspan should know better than to say something like that. As a fiat currency, the dollar doesn't have any more intrinsic value than Bitcoin. And that's why I decided to write about this. Most of the supposed "Bitcoin Primers" out there are more confusing than helpful. They don't explain how money works or how cryptocurrencies like Bitcoin satisfy the requirements to become a currency.

What makes a Currency?

Currency is a form of money that accepted by a group of people to exchange value. A functional currency must have three important characteristics:

• Scarcity - If you have too much of the currency, it's value will plummet toward zero. So, there must be a limited supply.
• Verifiability - You must be able to verify that a unit or token of the currency is valid and not a forgery or imitation.
• Availability - Despite scarcity, there still must be a stable supply of the currency to match growth in the corresponding economy.

Precious metals like gold and silver were the first common currencies. They meet all of the foregoing criteria. Gold is scarce; there's a limited amount of it available thereby endowing a small amount of gold with considerable value. It's verifiable; gold has certain characteristics, such as density, malleability and color, that make it easy to distinguish from other materials. And gold is available; while it is not common, gold mines still offer a consistent supply of the material.

One of the difficulties with early uses of gold currency was the complexity of exchange. Merchants had to use a balance or scale to determine how much gold was being offered. To facilitate easier exchange, governments, banks, and other trusted organizations would mint coins of consistent size and weight. This would allow someone to verify the value of a coin without resorting to a balance.

Fiat Currency

"Fiat" means, roughly, "because I said so." Fiat currency has value simply because some trusted entity says it does. It need not have any intrinsic value.

The first fiat money was the banknote. When making a large payment it could be inconvenient or dangerous to move large quantities of coins or bullion. Banks solved this problem for their customers by issuing banknotes. A banknote is a paper that a bank or other entity promises to exchange for a certain amount of coin, gold, or other currency. The bank could keep the corresponding gold locked away in a vault and people could carry more convenient paper certificates.

Beginning in 1863, the United States began issuing gold certificates as a form of paper money or banknote. Certificates like these were backed by stockpiles of gold held in places like Fort Knox. European countries did similar things. With the stresses of late 19th century wars and World War I that followed, countries discovered that they could issue more banknotes than their corresponding stockpiles. This led to a lot of instability until countries figured out how to regulate their currencies. But, by the end of the Great Depression, pretty much every economically developed country had fiat currencies controlled by a central bank. While backed by gold or other reserves, the value of these currencies is not directly tied to the value of gold.

Here's how the U.S Federal Reserve system works: The Federal Reserve Bank creates the money. Money is issued as currency (the familiar U.S. coins and bills) but also simply as bank balances. Indeed, far more money exists as bank records than in actual physical currency. Originally this was done through careful bookkeeping in bank ledgers. Now it's all done on computers. The money is issued in the form of low-interest loans, primarily to banks, which then lend the money to their customers and to other, smaller banks. Other central banking systems like the European Central Bank work in a similar way.

So, how does fiat money meet our requirements for currency?


Scarcity: Only one entity, the central bank, has the authority to create and issue the currency. The central bank limits the issue of money in order to preserve its value.

Verifiability: Coins and paper money are printed or minted using materials and techniques that are difficult for average people to reproduce but are fairly easy for to verify. Money in the form of bank balances is verifiable because each bank or credit union has accounts with higher-level banks ultimately reaching the Federal Reserve. So, when I write a check from my bank to yours, our two banks contact each other and transfer the value sending records up the banking chain until they reach a common parent bank which may be the Fed. Each bank in the chain verifies that the appropriate balances are in place before allowing the transaction to proceed.

Availability: Central banks can create as much money as they think the economy needs. The primary challenge for central banks is manage the money supply - ensuring both scarcity and availability.

Cryptocurrency

Bitcoin is the first, but by no means the only cryptocurrency. The challenge that the pseudonymous creators of Bitcoin tackled was to achieve the three features of currency - scarcity, verifiability, and availability - in the digital realm. They magnified the challenge by prohibiting a central authority like a government or a central bank. Trust, in the case of Bitcoin, is in the system, not in any particular institution.

Scarcity: The "coin" part of most cryptocurrency names is somewhat misleading. Bitcoin doesn't consist of a bunch of digital tokens that are exchanged. If that were the case it would be hard to prevent double-spending of the same token. Instead, cryptocurrencies work more like bank account balances. Bitcoin has is one, big, public ledger that is duplicated thousands of times. All transactions in the ledger must balance - for one account to receive value, another account must be reduced by the same amount. This ledger is called the block chain and it contains a record of every transaction since the creation of the currency.

Verifiability: Cryptocurrences rely on public-key cryptography to ensure that only the owner of a currency balance can initiate its transfer. The bitcoin owner uses their private key to sign the transfer record and then posts it to the network of block chain replicas. Any entity in the network can use that owner's public key to verify that the transaction is valid and that ownership has been transferred.

Availability: Those who host a copy of the block chain have to perform the cryptographic calculations necessary to verify transaction validity and prevent fraud. Those who do this fastest are periodically rewarded through the creation of new Bitcoin balances. Because of the reward, maintaining the block chain is known as "mining" and a small industry of Bitcoin mining software and devices has developed. All users of cryptocurrency benefit from this because the more miners exist, the more secure the currency becomes due to the duplication of records and validation.

This is a tremendously clever scheme because it simultaneously ensures a consistent supply of currency, decentralizes operation, and secures the network against manipulation by creating thousands of replicas of the block chain.

Potential Impact

The true value of any currency is the willingness of a community of people to use it for daily transactions. The three requirements, Scarcity, Verifiability, and Availability combine to cause people to trust a particular currency. When that trust is lost you can get bank runs, hyperinflation, or simple destruction of wealth. Meanwhile, the community rushes to find a new currency.

The advent of the internet with myriad handheld devices capable of initiating transactions makes it possible for multiple currencies to coexist. For the first time in history, people may have a choice among currencies to use in daily transactions. Central bankers, and the sovereign countries that endow them with their power, are appropriately worried. An industry that has historically been immune to competition no longer has that protection.

I think this is a good thing. Just like any other competitive market, competition should incentivize good behavior both from established central banks and from upstart cryptocurrencies.

Illusions of Success when Inputs are Confused with Outputs

Prosperity has been defined as, "the state of flourishing, thriving, good fortune and / or successful social status." In the United States we tend to measure prosperity in terms of wealth, or lack thereof. Indeed, the U.S. government defines poverty (the lack of prosperity) as having an income below $15,730 for a household of two. The trouble is, that this confuses the output (or outcome) of prosperity with one of its inputs, income (or wealth). And while the two values often correlate, they can be quite different.

In the early 1800's, Georgia gave away millions of acres of land through a series of land lotteries. Nearly everyone who was eligible entered the lottery because an individual had a roughly 1 in 5 chance of winning and a typical parcel was worth about the median net worth of a Georgia resident. A penniless person who entered the lottery had a one in five chance of suddenly becoming wealthier than half of the residents of the state.

When Hoyt Bleakly, of the University of Chicago, and Joseph Ferrie, of Northwestern University, learned of this event they found it to be a convenient natural experiment. Does handing out wealth to random individuals elevate their prosperity and does that prosperity carry over to future generations? The answer, at least in this particular case, seems to be "no." Even though wealth and prosperity are correlated, increasing wealth didn't increase the prosperity of the children. As Bleakley said on a Freakonomics podcast, "Maybe the resources have to come from outside the household, be it say a good public school. Maybe the resources have to come from the parents, but the parents don’t know how to provide it in terms of nurturing, in terms of reading and communicating ideas to their children, etc." In other words, wealth is only one of the contributors to prosperity and it may be among the least important.

Optimizing the Wrong Thing

When two features, like wealth and prosperity, are correlated, and one is easier to measure or influence than the other, a common mistake is to focus on the more convenient factor. The result is a host of unintended consequences.

This is a case where feedback loops offer insight:

A feedback loop with a short-circuit bypassing the system (or student).

In a proper feedback loop, we measure the output, compare it with the reference, and use it to choose the proper input. But when inputs are confused with outputs, the feedback loop is short-circuited – as with the red line in the above diagram. The evidence of this is when we get all kinds of reports showing how good the inputs are. Meanwhile, the real goal suffers.

A Pedagogical  feedback loop measures student outcomes (in the form of competencies or skills), compares them with standards of what students should know, and uses the result to choose appropriate learning activities. But, when inputs are confused with outputs we get reports of good student attendance, appropriate construction of curriculum, the prescribed amount of seat time, properly trained and certified teachers, high quality facilities, and all kinds of other reports about the inputs. Meanwhile, the output, in terms of student skills, remains unimproved.

Here are a few other inputs and outputs to consider:

• Revenue vs. Profit
• Seniority vs. Performance
• Seat Time vs. Competency
• Wealth vs. Prosperity
• Prosperity vs. Happiness

To be sure, there's correlation in every one of these cases. But, just as with the Georgia Land Lottery, manipulating the input frequently diminishes the correlation and results in a less-than desired outcome. Focusing on, and reporting about the inputs can give the illusion of success. Focusing on the outcome helps identify other factors that contribute to the desired result.

Furthermore, excess focus on inputs results in missed opportunities. As Michael Horne and Katherine Mackey wrote, "Focusing on inputs has the effect of locking a system into a set way of doing things and inhibiting innovation; focusing on outcomes, on the other hand, encourages continuous improvement against a set of overall goals and can unlock a path toward the creation of a student-centric education system."

Incentives are Inputs

Just as mistaking outputs for inputs causes trouble, the reverse is also true. A 2011 study by the Hamilton Project compared incentives tied to inputs with incentives tied to outputs. Groups of students were offered financial incentives tied to input activities such as number of books read, time spent reading, or number of math objectives completed. Other groups were offered incentives tied to outcomes such as high test scores or class grades. The study found that input incentives were much more effective than output incentives. Among their recommendations are:

• "Provide incentives for inputs, not outputs, especially for younger children."
• "Think carefully about what to incentivize."
• "Don't believe that all education incentives destroy intrinsic motivation."

This shouldn't be surprising. Incentives, at least when given to the student, are inputs. Incentivzing outcomes is a different kind of short-circuit in the feedback loop.

Feedback loop with a short-circuit bypassing instructional influence.

In a Pedagogical  feedback loop the instructional system interprets the results of assessment before passing them on to the student. When we incentivize the outcomes (or assessment thereof) we bypass the capacity of the education system to interpret student needs and prescribe the right learning activities.

It's notable that the Hamilton Project study found that incentivizing outcomes was especially ineffective for younger students. Among the goals of any educational system should be to develop students into independent learners. A mature, independent learner has taken on pedagogical skill and responsibility. For independent learners, incentivizing outcomes should be more effective.

Nevertheless, the Hamilton Project study didn't neglect outputs. In every experiment, the effect of the incentives was evaluated according to student outcomes. Only the point of intervention was changed.

Effective Measurement and Improvement

In 2005, New Hampshire abolished the Carnegie unit – a measure of seat time by which most U.S. schools quantify educational credits. "In its place, the state mandated that all high schools measure credit according to students’ mastery of material, rather than time spent in class." Thus, New Hampshire has shifted their fundamental measure of student achievement from an input to an output. Early results of that change are promising.

To be sure, optimizing certain inputs still has a positive impact. Otherwise schools would have completely failed since the institution of the Carnegie Unit in 1905. But shifting the focus from inputs to the outputs we wish to optimize will open the door to greater innovations and more rapid improvements in student achievement.

Winds of Change: Higher Productivity in Higher Education

Note: This first appeared last week as a guest post on the Next Generation Learning Challenges Blog. I highly recommend both the blog and the NGLC website.

My first lecture hall experience was American Heritage at Brigham Young University. The course was required for all freshmen and more than 500 of us at a time attended two lectures a week. In a third “lab” period we met with a TA. The professor was charismatic and the instructional design team supplied him with carousels full of colorful slides. Still, a large fraction of the class was asleep at any given time.

Large lecture hall courses are one common method of increasing productivity in higher education. Another is weed-out courses – those designed to convince students that they should choose another, less expensive major. For me the weed-out subject was Discrete Structures. This Computer Science subject is rich with metaphors like trees, maps, chains and links. It can be taught through story, modeling, manipulatives and real-world application. But our version was deliberately dry with an emphasis on precise vocabulary and obscure notational forms. The pass rate hovered near 50% and hundreds of students were convinced that they weren't capable of understanding computer science.

Higher education in the United States is sandwiched between twin pressures, increasing societal needs and expectations on one side with flat or declining funding on the other. To meet this challenge, institutions will have to dramatically increase productivity. But traditional productivity boosts like large lecture halls, weed-out courses or greater admissions selectivity won’t be enough this time around. What’s required is fundamental change to the way we support learning. We need a more personalized approach.

Societal Needs and Expectations

Employment projection is from the Bureau of Labor
Statistics Job Outlook. Supply is based on National
Center for Education Statistics data on annual
Computer Science BS degrees awarded. Attrition
is based on a 40-year career span.

While the U.S. unemployment rate hovers around 8%, there is a shortage of engineers and technicians. In 2012, the unemployment rate for software developers was only 2.8%. An Association for Computing Machinery study indicates that the United States will need more than 150,000 new computer scientists each year through 2020 yet our collective colleges and universities only produce 40,000 degree holders to fill those jobs. Healthcare workers are also in short supply. In 2012 the unemployment rate for physicians was 0.8%. For Physical Therapists it was 2.0% and for Registered Nurses, 2.6%.

At a recent Technology Alliance conference it was noted that colleges and universities in Washington State produce less than half as many engineers, technicians and software developers as the state’s employers consume. The rest have to be imported from other states or countries. A speaker from the University of Washington pointed out that they have increased introductory Computer Science enrollment from roughly 1200 to over 2000 per year. But the Microsoft representative responded that they have 3,600 engineering and computer science openings and they’re competing with Amazon, Boeing and many others to fill those spots.

Of 4.3 million freshmen who started college in 2004, only 2.2 million (or 51%) graduated within six years. This isn’t a perfectly accurate figure. Because of the way records are kept, it’s hard to count students who transfer and complete at a different institution. But inadequate record keeping is another symptom that institutions haven’t focused enough on ensuring their students are successful. Higher completion rates will save a lot of wasted student time.

As we move into the 21st century the fraction of unskilled jobs continues to diminish while those requiring advanced skills increase. It’s no longer appropriate to sort students by “aptitude.” We must give students the support and guidance they need to master advanced subjects.

The Funding Landscape

Education is the largest item in most state budgets. In California it accounts to between 52% and 55% of the state general fund. With the recession hitting state revenues and the expiration of stimulus supplements, state fiscal support for higher education dropped by 4.7% between 2011 and 2012, remaining flat in 2013. Overall, annual support has dropped by 10.8% since 2008. On a per-student basis, state and local financing dropped 24% in the 10 years preceding 2011.

At the same time, tuition is rising much faster than inflation. Tuition and fees at U.S. public universities rose 4.8% for the 2012 school year to an average of $8,655. At nonprofit private colleges tuition and fees rose 4.2% to $29,956. In addition to drops in public funding, the cost to provide education is increasing and the recession has diminished private endowments.

Total student debt in the U.S. now exceeds $1 trillion making it higher than the nation’s credit card dept. Student loans aren't a big problem if they are correlated with significantly higher earning potential. But loan approval is not connected with choice of academic major or the graduation rate of the institution.

Personalized Learning

The demands on higher education are greater than ever. We need more graduates – especially in certain fields. We need better completion rates. We need to support students in tackling challenging subjects. Moreover, we have to do this with flat or declining budgets.

The Bill & Melinda Gates Foundation has assembled representatives from a dozen colleges and universities that are trying new approaches with promising results. The Personalized Learning Network, as it's called, includes innovators like Western Governors University and American Public University; pioneering programs at Arizona State University and UC Berkeley; and NGLC grantees like the Kentucky Community & Technical College System, Rio Salado College and Southern New Hampshire University.

Recently I had the privilege of meeting with this group. There’s a lot of variation in their personalized learning programs but they share these common features:

• Mastery Learning and Independent Pacing: Students have to master the current topic before moving to the next step. Self-pacing grants this freedom and ensures that there aren't gaps in understanding due to bad days or illness. And students don’t waste time on topics that they already understand.

• High Expectations: The institutions make a commitment to support all students sufficiently so that they can master the material.

• Feedback: Students and instructors are constantly informed about conceptual understanding and progress through the material.

• Adaptive Learning: The learning system adapts according to individual student actions and performance.

• Individual Attention: The programs facilitate abundant 1:1 time between students and faculty.

• Motivation: Systems and attitudes that foster student motivation include interesting activities, student autonomy, recognizing good performance and avoiding frustration either due to anxiety or boredom.

All of this is enabled through strategic use of technology. Most use some form of blended online and in-person learning. The key point is not to simply add technology but to apply technology in the service of personalized learning.

Personalized learning programs should be able to address higher education pressures for better success and completion rates. But can they also help educate more students at lower cost? I believe so. Technology can automate many tasks that cost a lot of educator time. Video lectures are a personalization technology because they allow students to view on demand and replay as needed. Not only do they save the time in class but they also save the instructor time preparing the lecture. Objective assignments can be graded automatically and feedback given instantly to the student. Feedback to instructors can help them optimize their interactions with students. Subjective grading, while still consuming human time, can also be made more efficient. All of these factors help institutions increase capacity and reduce per-student costs.

Equally important are the savings offered to students. Immediate feedback helps students learn concepts more efficiently and avoids time wasted on misconceptions. Students can advance immediately upon understanding a concept and get credit for things they learned previously. And authentic learning activities support a better and more complete understanding of each topic. In one study by Carnegie Mellon’s Open learning Initiative they were able to teach students the same material in half the time with better retention.

Changing higher education is like turning a glacier. Features like accreditation, tenure, financial aid, credit transfer, and faculty autonomy interlock to form a seemingly insurmountable barrier protecting the status quo. But the twin pressures of increased expectations and diminishing funding result in an unprecedented incentive for change. Like the Maginot Line, traditional barriers won’t be overcome but simply bypassed.

Balancing the Budget

With record-level deficits, balancing the federal budget is once again being debated in Washington. There seems to be a consensus that balancing the budget would be a good thing but how to go about it is such a contentious issue that I have little hope of progress this year.

The seeming consensus on this issue is curious to me. After all, John Maynard Keynes advocated deficit spending especially in recession times and Keynsian economics seems to be the philosophy of the day. But I'll save the reasons for balancing the budget for another post. Today, I'm writing about some of the unexpected side effects of balancing the budget.

Last April I wrote about a lecture by my former Business Finance professor where he explained some of the unprecedented features of the current recession. Among other things, he pointed out the unusual nature of our trade deficit with China. Normally, when a large trade deficit occurs, the currency of the importer nation (the US in this case) weakens relative to the currency of the exporter nation. That's because the exporter nation has an excess of the other nation's currency. That weakening of the currency causes imported goods to increase in price until domestic manufacturing becomes competitive or exports balance out he imports.

However, much of the fuel in China's current economic growth comes from exports and the Chinese government wants to keep feeding that fire. Therefore, the Chinese government buys dollars from exporters in exchange for Yuan. But to balance the trade deficit, they have to get those dollars back into the US. They do so by buying US Treasuries. In other words, we export debt to balance our importing of goods.

So, what would happen if, by some miracle, we balanced the federal budget in 2011? Chinese institutions wouldn't have a place to put their dollars, the trade deficit would weaken the dollar relative to the Yuan, imports would become more expensive to us just as our exports became less expensive to Chinese consumers. Domestic manufacturing would increase, unemployment would decrease.

Of course, domestic economic stability would occur at the expense of reduced growth in the Chinese economy. Whether they would accept that without taking some action we may never know..

How Confused We Are!

When I was in MBA school in the early '90s our Economics class was divided into teams each of which was to propose a new US federal budget. As my team dug into the existing budget we quickly noticed the rapid growth of mandatory spending would soon outstrip discretionary spending. Therefore, it didn't matter what was done about the budget (which only addresses discretionary spending) if the mandatory spending wasn't brought under control. Our projections had mandatory spending accounting for more than 70% of the federal budget by the year 2004.

Welfare reform delayed things a bit but we're still approaching the point at which mandatory spending will be unsustainable. In fiscal 2009, $2.1 Billion or 61% of the federal budget was mandatory spending including Social Security, Medicare, Medicaid and interest on the national debt.

This isn't really a surprise. A recent USA Today/Gallup poll indicates that three out of four Americans "predict that the costs of entitlement programs will create major economic problems." At first, this seems hopeful. With a majority of people concerned, perhaps there's the political will necessary to make reforms. However, only 44% are in favor of raising taxes and only 34% are in favor of cutting benefits. A mere 12% say both remedies are required. That means that for any proposed solution, a majority of Americans are against it.

How confused we are!

Toxic Assets Revisited

I just attended a fascinating lecture by Dr. Hal Heaton who was my MBA Business Finance teacher 16 years ago. He outlined what he called the "Perfect Storm" of events that lead to our current financial crisis. Much of what he had to say is summarized in this business case though his live presentation included some nice graphs illustrating many of the financial trends.

Following the lecture I asked him about my theory that the markets could self-correct the problem of toxic assets (outlined in my previous blog post on this subject). It turns out that he has been serving as an expert witness in several lawsuits related to the meltdown and has direct experience in this area. He assured me that, indeed, the derivatives market has mostly shut down and that the remaining derivative instruments are treated as the risky instruments they really are.

According to Dr. Heaton, one lingering problem is that the Community Reinvestment Act that I talked about in my history of the banking crisis remains in place along with enhancements that were passed in 1999 and 2005. Presently the provisions aren't being enforced but if they are, banks will be required to continue to issue the kind of high-risk loans that helped create this problem in the first place.

From his primary lecture I learned that Dr. Heaton views the sub-prime lending and the associated financial derivatives as only two components in a six-part "perfect storm." Here's the full list.

• High-risk mortgages spurred on by the Community Reinvestment Act and it's more recent kickers. (The requirements remain in place though they aren't currently being enforced).
• Enormous increase in the money supply with interest rates reduced to nearly zero. (Rates are still there.)
• Hybrid mortgages that had a two-year low introductory rate. Homeowners expected to be able to refinance after two years because "home prices always go up as they had done almost continuously for the 40 years preceding 2008. (Many of these have already been foreclosed upon but there remain several waves of ARMs yet to create problems.)
• Asset Securitization -- the financial derivatives used to finance high-risk mortgages and an enormous variety of other investments. (Mostly out of favor.)
• The transfer of manufacturing to China and other emerging markets. This results in an enormous trade deficit. Under normal circumstances, such a deficit would strengthen the yuan and weaken the dollar thereby bringing things into balance. But the Chinese government, not wanting to slow the growth, purchases dollars from manufacturers in exchange for Yuan and then invests those dollars in US Treasuries. (The recession has reduced the trade deficit by half but it remains tremendously high by historic standards.)
• The complicity of Moody's and Standard and Poor's in giving excessively high ratings to mortgage-derived securities based on the incorrect assumption that housing prices would not decline. (This has been corrected.)

Possibly even more concerning is Dr. Heaton's Assertion that many of the "rules of economics" he taught me those years ago have been violated in ways he would never have foreseen. Examples: The money supply has been tripled but interest rates and inflation remain extremely low. We've been able to sustain an enormous trade deficit without currency corrections. The Fed has been purchasing treasuries and yet the sky hasn't fallen.

We are in unprecedented territory. What happens next is anybody's guess.

Toxic Assets

With health care seemingly out of the way, congress is turning its attention to finance reform. Last fall I posted my summary of the crash of 2008. I think there's little doubt that reforms need to be made in the financial markets. However, I've been wondering if those reforms need to be brought about through legislation or if there might be another way.

Most of the blame for the financial crisis has been leveled at investment banks and other institutions that hid risky investments behind complicated financial instruments. However, Credit Rating Agencies like Moody's and Standard and Poor's were complicit in creating the problem because, like the banks, they ignored the possibility of market-wide problems.

So, just as the cooperation of Credit Rating Agencies helped create the problem, CRA's could likewise drive much of the reform. Unfortunately, there continue to be allegations of inflated ratings and the agencies have avoided liability for past mistakes. Despite this I have hope that reform can come from this sector without legislative pressure.

The term "Toxic Asset" was invented in 2008 to describe the financial derivatives for which a value cannot be determined with confidence. The presence of large quantities of toxic assets on corporate and bank balance sheets froze the financial markets. There's are markets for high and low-risk securities. But when a risk or value cannot be determined with confidence, that's when markets freeze up. "Toxic Asset" is very descriptive term for such things.

What I would like to see is an agency that would report on the portion of a security -- stock, bond, or derivative -- that is composed of questionable derivatives. To do so with accuracy would require cascading fractions through the network of ownership. For example, if 15% of a bank's balance sheet is composed of toxic assets and 20% of a mutual fund is invested in that bank then the mutual fund would be rated 3% toxic (15% * 20% = 3%). Of course, some portion of other stocks in the mutual fund might also be considered toxic so the total toxicity of the mutual fund might be higher.

Creating a database that tracks the network of ownership would be complicated but not impossible. The information required is all in the public record. There would have to be a objective way of determining whether a fundamental asset is toxic. However, once the system is in place, it could also be used to rate cascading ownership in many other types of assets. Fractional ownership in business sectors such as manufacturing, education or hospitality could be measured through the cascading layers. Involvement in totalitarian regimes, conflict assets or vice business could also be tracked.

I suppose this is another of my Business Concepts. It would take a considerable up-front investment and a continuing investment to maintain the database but the ability to analyze cascading ownership would be a potent investment tool.

A Brief History of the Crash of 2008

There are a number of contributing factors to our present financial crisis but the biggest issue (and the catalyst that set it off) is the collapse of the financial derivatives market. My friend, Paul B. Allen, has started Crashopedia.com to document the causes of the crash in detail but it can get pretty thick. Here’s my simplified summary of what happened:

1970	GNMA "Ginny Mae" issues the first Mortgage Backed Security (MBS). A MBS is a way of collecting money to lend out in the form of mortgages. Bonds in the MBS are sold and the resulting cash is invested into a pool of mortgages. FNMA "Fannie Mae" and FHLMC "Freddie Mac" follow suit.
1977	Under pressure from the Community Reinvestment Act banks and other mortgage vendors begin issuing high-risk (also known as sub-prime) mortgages with correspondingly higher interest rates.
Early 1980s	Incentivized by the government and attracted by the high interest rates of these mortgages, bankers begin seeking a way to attract capital to invest in high-risk mortgages. Unfortunately, the market for high-risk investments is relatively small and interest rates are high.
1983	Bankers invent the Collateralized Mortgage Obligation (CMO) which is a type of MBS in which shares are divided into risk "tranches." The idea is that if a lot of high-risk mortgages are pooled together the risk is reduced because only a fraction are likely to default. Risk can be further reduced for some investors by dividing the bond pool – decreasing the risk for premium tranches and increasing it in lower tranches. Bond rating organizations like Standard & Poors agree with this theory and offer high ratings.
1987	Realizing that splitting risk into packages can work for more than just mortgages, bankers invent the Collateralized Debt Obligation (CDO) which is just like a CMO except that it may be backed by corporate bonds, commercial paper or other kinds of loans.
Early 1990s	In pursuit of ever higher interest rates (from higher-risk mortgages) but having trouble placing the higher-risk tranches of CMOs and CDOs, bankers find ways of enhancing the ratings of these tranches by using Credit Default Swaps. This is just a fancy name for an insurance policy. The bankers pay an insurance premium and the insurer pays up if the underlying asset (mortgage or bond) fails to make payments. Bankers can afford the insurance premiums because they collect more interest from the high-risk loan than they have to pay to the low-risk bond. AIG becomes one of the leading insurers of these obligations.
1990s and 2000s	Bankers come up with all kinds of new derivative instruments such as CDOs that invest in other CDOs (CDO squared), Single-Tranche CDOs in which insurance is used to raise the rating of the entire package, Strips, REMICs, PACs, Floaters and more. The tantalizing returns of these investments cause people to ignore Warren Buffet’s advice to invest only in things you understand.
2001	Driven largely by growth in financial derivatives, the Financial sector surpasses Information Technology to become the largest sector in the S&P 500 as measured by market capitalization.
2002-2005	Continuation of the longest sustained growth period in U.S. history masks the real problem with derivative instruments. That problem is that an overall decline in the housing sector or in the economy as a whole would cause simultaneous defaults – something that diversity and insurance don’t account for. Unencumbered by hidden risks, derivatives continue to offer stable income to investors and while enriching the investment banks that handle them.
2006	The housing bubble bursts. Due to the ease of obtaining mortgages and the recent history of good real estate performance, a great deal of speculative building occurred in the early 2000s. By 2006 there was a surplus of homes in key markets like the West Coast, the Southwest, the Northeast Corridor and Florida. A mild recession at the time coincided with interest rate increases on Adjustable Rate Mortgages. The result was a wave of mortgage defaults.
2007	The mortgage crisis cascades into the whole economy. Rumors grow that we may be in for a recession. Mortgages become increasingly difficult to get as investors pull out of the mortgage market.
2008	Derivatives turn out to much riskier than their ratings indicated. AIG becomes insolvent as large numbers of CDOs default and they are required to pay up. Only a bailout by the Federal Reserve prevents it from going under. Credit markets freeze because bankers can no longer reliably determine the value of derivates which now account for an enormous part of the financial market. A new tern, Toxic Asset, is used to describe these because not only can they not be valued but neither can any institution that owns a substantial portfolio of them. Hundreds of banks with large portfolios of toxic assets fail and are taken over by the FDIC. The First Bailout Act including the Troubled Asset Relief Program is passed allowing the Treasury and the buy up toxic assets in an effort to relieve the credit markets.
2009	As of this writing, the bailouts have had little success except to protect the profits made by irresponsible financiers. Credit markets are still extremely tight, the country is in a full recession, and unemployment is approaching 10% with certain markets well into double digits. Despite this, Congress and the White House have focused efforts on Healthcare Reform rather than considering regulations that might prevent irresponsible use of financial derivatives in the future.

Missing from this history are all of the forewarnings. For example, the General Accounting Office warned in 1994 that regulation of the market was warranted. Congress held hearings on the subject multiple times in the 1990s and 2000s and Warren Buffet famously wrote in 2002 that derivatives are "time bombs." There were many opportunities to prevent the train wreck before it happened. Unfortunately, the financial lobby was strong enough to prevent any meaningful reform.

I have some thoughts on how reform can be achieved without government intervention but those will have to wait for a future blog post. Meanwhile, this is yet another example of how government seems to be immune to forewarning. Action, if taken at all, occurs after the crash.

Failure Subsidizes Success

Some successes would never occur if it weren't for prior failures.

My father was head of the Mechanical Engineering department at Utah State University when he and others started the annual Small Satellite Conference there. At one of the first instances of the annual event a group of engineers presented a revolutionary idea. A set of small relatively low orbit satellites could form a world-wide cellular phone and data network! Moving the satellites into low orbit would allow the use of simple antennas and satellites would hand off connections as they move past a customer the same way that cellular phone towers hand off as a mobile customer moves around the city.

The initial design was christened Iridium because it utilized 77 satellites -- the same number of satellites as the iridium atom has electrons. As the concept evolved, the number of satellites changed but the name stuck. Iridium is a mesh network; messages are collected at the nearest satellite to the customer then handed off from satellite to satellite until being relayed to a ground station. For such a mesh network to work reliably the entire constellation of satellites plus a couple of spares had to be in place.

The capital cost of launching a satellite network was enormous – estimated at more than $6 Billion. The first phone call was placed on 1 November 1998. Only nine months later they had to file for Chapter 11 bankruptcy protection; the expected business subscribers hadn't materialized. A Wikipedia article offers a number reasons for the failure including better ground-based cellular networks, inter-carrier roaming agreements, unappealing handsets, a bad pricing model and mismanagement.

I think the biggest problem was that real potential return wasn't enough to justify the original investment. If the eventual customer base had been accurately projected, the system would have never left the ground. (Puns are easy in this subject.) The Iridium system shut down service and was considering de-orbiting the satellites and ceasing all operations before the assets were purchased by a coalition of private investors in 2001. The purchase price? About $25 million.

Of course, the new investors had to plow a lot more money into the company to restart operations, run sales and marketing and so forth. Those numbers aren't available as Iridium is privately held but a good guess is a total investment of around $150 million. For the year 2008, ten years after operations started and seven years after the buyout, Iridium LLC reported $320.9 million in revenue with operational earnings (EBITDA) of $108.2 million. This means that the 2008 return-on-investment was around 72% for the buy-out investors. However, if the original investors had hung on instead of writing off most of their investment in 2001, the annualized return at the end of 2008 would only have been 1.8% – certainly not enough to justify a high-risk investment like this.

So, today we have a fantastic asset that supports military communications, offers live television reports from remote locations, keeps our Antarctic scientists in contact with home, provides continuous phone service to aircraft and ships worldwide, offers telemetry from automated outposts and a host of other services. The system is operationally profitable and earning enough money to be maintained and improved. The system exists because the business plan that convinced the original investors was fantastically wrong. Those investors took a loss but society benefitted.

The only other way I can think of for such a system to emerge would be for government to step in and offer a huge subsidy. What's better, subsidy from business failure or subsidy from government? I think we need both which is why I believe capitalist societies must preserve the freedom to fail.

Thoughts on Health Care Reform

A few weeks back I sent the following thoughts on health care reform to my family:

I've tried in vain to find an article or opinion that matches my views regarding healthcare reform. So, I suppose I have to take the time to compose my own essay on the subject. This isn't too long; here's the outline:

• What are the problems with healthcare?
• How does the President's proposal attempt to address these problems?
• What do I suggest?

What are the problems with healthcare?

I grow tired of pundits who repeat “we have the best health care in the world” as if there were nothing that needs fixing. Anyone who knows a married college student, who is self-employed or who is acquainted with their HR director knows that we have serious problems. As I see it, here are the most pressing problems:

Healthcare costs are skyrocketing: As premium increases have rapidly outpaced inflation most employers can no longer cover the whole cost. My employer and I split a premium that could nearly pay for a new car every year. This rate of increase is unsustainable.

The biggest factors contributing to increasing costs are the following:

• Lawsuits and liability driving high costs of malpractice insurance.
• Physicians defensively ordering tests and procedures that would be unnecessary in a less litigious environment.
• Bureaucratic insurance claims processes that account for 25% to 50% of the cost of treating patients.
• Pharmaceutical companies driving demand for newer and more expensive drugs by pushing information to physicians, lobbying for treatment standards and direct-to-consumer advertising.
• An enormous increase in the number of treatable diseases.

Many find it impossible to obtain reasonable coverage: The option for catastrophic insurance has evaporated. The few plans that apply to students or the self-employed are either too expensive or offer too little coverage to be useful. The number of patients relying on Medicaid or charitable care keeps growing.

How does the President's proposal attempt to address these problems?

The centerpiece of the bill is the “public option,” a government-run health insurance policy offered as an alternative to private health insurance. The theory is that if a lower-cost alternative is available, private insurance companies will be forced to lower their premiums in order to retain their customers. The public plan would also offer a policy at reasonable cost to those who are excluded by existing options.

The trouble with this proposal is that it does little to reduce the actual costs of providing healthcare. If healthcare costs remain high then insurance premiums must also remain high. Some of the president's spokespeople have promoted the public option as a method to “break the monopoly” of existing health insurers. With dozens of existing insurers large and small there certainly isn't a monopoly. And if there was one, the right approach would be to use antitrust law. Consumers and HR directors have put great pressure on the insurers to keep premiums down and yet premiums continue to rise. This can only mean that the actual cost of health care is rising consistently across all insurers.

The only way a public option can offer the same benefits for lower cost than private insurers is if it is subsidized or receives some preferential treatment under the law. Private insurers cannot compete with artificial advantages like these. Therefore they would be driven to bankruptcy leaving the public option as the only option.

To be fair, the president's plan does include some cost-saving measures such as centralizing and standardizing medical records and attempting to streamline the claims process. However, I don't think these will save enough to overcome the cost of a new government bureaucracy. The records proposals also raise serious privacy concerns.

What to I propose?

The focus of a proper reform process needs to be cost reduction. By its nature this eliminates any programs that add government offices, staff or oversight. That's because government is always less efficient than the private sector. So, we start with the requirement that any reform has to be budget-neutral as far government spending is concerned.

That limits government action to regulatory changes. Here's what I suggest:

Tort Reform: It has been estimated that lawsuits and liability defense account for 20%-30% of the cost of healthcare. We can't eliminate malpractice suits entirely but a ceiling should be put on that liability. Alternatives to lawsuits, such as public record of physician performance, could be used to maintain physician oversight while reducing the number of malpractice suits and the size of the awards.

Restore the Catastrophic Insurance Option: There aren't any proper catastrophic insurance policies available. Such a policy would only kick in when medical costs exceed some, relatively large, deductible. I have read that this has gone away due regulations making catastrophic insurance illegal but, unfortunately, I don’t have a good reference. Regardless, regulations should be changed to restore this option.

Make Health Savings Account Legislation Permanent: A health savings account is a tax-free savings account that can only be applied toward healthcare. HSA's are usually combined with catastrophic insurance. The HSA covers normal health care needs and the catastrophic insurance picks up in bad cases. This reduces the costs of healthcare in two ways. First, the consumer becomes aware of health care costs and is more selective in determining what procedures, drugs or tests are to be performed. Second, insurance claims only have to be filed in big-ticket situations thereby reducing the paperwork costs both at the provider's office and at the insurance company.

HSA laws exist but they haven't caught on very well because the backing insurance is too expensive. Also, existing laws are set to expire and companies aren't interested in investing in programs that may disappear.

Eliminate Group Health Plans: An insurance company should be required to offer the same plan to all customers regardless of their employer or other group membership. This would level the field for the self-employed, students and so forth.

Create an Electronic Claims Submission Standard: Much of the cost of processing insurance claims is dealing with different processes and standards at each insurance company. A consortium of insurance company representatives should create a standard format and process for electronically submitting claims.

Create an Independent Source of Drug Information: The pharmaceutical lobbies drive the dissemination of treatment information to physicians and patients. An independent evaluation would offer unbiased information leading to greater use of lower-cost treatments. Since I've precluded government funding for such an option I suggest that it would be funded by a consortium of insurance companies (that are motivated to reduce costs).

 

Variations on most of my proposals exist in some of the bills being considered. There's still hope that a proper healthcare reform package can be assembled. But this will only happen if our politicians are willing to ignore the lobbyists, set aside their personal agendas and serve the people who elected them.