Monthly Archive: February 2015

Most people have a fixed idea about the meaning of the word ‘capital’.  They tend to think of it strictly in materialistic terms as money or goods that allow a business owner to produce products and earn a profit.  A factory filled with machines or a bank brimming with money to loan comes to mind.  Of course, there is nothing wrong with that definition as far as it goes – it simply doesn’t go far enough.

The word ‘capital’ is defined variously by Webster’s dictionary (3^rd definition) as:

• A stock of accumulated goods,
• accumulated goods devoted to the production of other goods,
• accumulated possessions calculated to bring in income,
• net worth,
• advantage or gain,
• a store of useful assets or gain,

the general theme knitting all these definitions together being that capital is a set of assets or advantages (things of net worth) that promote the accumulation of other assets or advantages of the same or different kinds.  So, the commonly held view of capital is correct but limiting.

Why does it matter how capital is defined?  It matters because, as a society, we continuously craft political structures and laws that limit what can be done with one type of capital while allowing other types of capital unfettered reign.  We are also in a better position to understand the motivations and the accompanying behavior of others if we can perceive what marketplace they are actually engaged in and what capital they are trying to accumulate.

In the rest of this post, I am going to explore the two most common types of hidden capital: reputation capital and political capital.

Reputation Capital

How familiar is the following scene?  The latest sports news comes on the radio or television and the announcer coolly states that so-and-so has just signed with some-such team for millions of dollars, making him the highest paid player at his position.  A friend of yours turns to you and says “how much money does one man need?”  Another friend responds by saying something like “It’s not about the money!  He just wants more than the other guys.  He just wants to be known as the best player in world.”  What the player in question is doing is building reputation capital.

Alex Rodriguez is a prime example of this.  His early success as a baseball player garnered him a reputation as a great ball player.  That reputation, in turn, garnered him a chance to play in bigger venues, which in turn grew his reputation.  The money was a secondary affair as his fame was really the means to the end.  It opened doors for him, the entire country talked about his contract, his lifestyle, and his legacy.

This is all innocent enough, and A-Rod’s celebrity fame and eventual infamy did not actually shape the economic or political sphere very much.  Outside of his influence on America’s pastime and popular culture, his mark will soon disappear.

Much more interesting and worthy of a skeptical eye are the so-called ‘paragons’ of society in whom is invested a lot of trust.  Journalists and scientists fall squarely into these categories.

Take the recent fall from grace of NBC’s pride and joy, Brian Williams.  Whether you call his fabrications exaggerations or outright lies, it is clear that he has played fast and loose with the truth.  But why did he do it?  I think his behavior is best explained by the model that he was trying to build his reputation as a gritty journalist.  His fantasies related to his time in Iraq or his encounters with dead corpses and armed gun men in New Orleans in the aftermath of Hurricane Katrina were meant to build capital with his viewers.  He intended his audience to regard him as an objective journalist who would back down before nothing and no one.  From such a position, he wielded great power and basked in the adoration of fans and the admiration of his colleagues.  He achieved assets and advantages that mere money could not buy.

University professors and academics engage in their own unique marketplace.  They are first and foremost tradesmen whose primary focus is to sell their ideas to each other and to society as a whole.  Journal articles, published books, and television and radio appearances are their currency, and their academic reputations are their capital.  Their wealth is measured in terms of the number of times their article is cited by peers, or how many of copies of their book were sold, or how many tweets and postings their TV appearance generated.  As their reputation grows, so does their power, even though very little in the way of money changes hands.

Political Capital

No matter where you work or volunteer, there are always a few people who are at the center of the institution.  These are the people who get things done by pulling strings, facilitating compromises, and horse-trading between one group and another.  These people engage in the marketplace of political capital, and the favors they give and receive are the currency.  They hold and wield power in the institution, and the larger the institution the greater the power, political capitalists in governmental positions being the most influential.

Political capitalists in government fall into two classes depending on whether they are elected or appointed and in the public eye (e.g., John Boehner or Samuel Alito), or they are far removed from general scrutiny (e.g., the head of the EPA).  In both cases, even though their assets and advantages are never translated into a monetary value, these people are able to buy and sell for goods and services just the same.  The public only thinks about this marketplace when an elected official grossly abuses their capital, as in the case of Bob McDonald, who was recently convicted of corruption for ‘selling access’ to his political capital in exchange for financial compensation.  In other words, the public doesn’t seem to care when the bartering is done strictly in terms of political favors – even though such bartering may lead to material gain on all sides – but only seems sensitized when political capital is turned into cash directly.

Regulating Marketplaces

As I alluded to above, the major reason to care about how capital is defined is to level the playing field when it comes to how different types of capital are accumulated, spent, or exchanged.  As a society, we tend to regulate and focus on financial or monetary capital and ignore reputation and political capital.

I’m not objecting to the capitalists that trade in either of these marketplaces, nor am I objecting to their accumulation of assets and advantages.  I do object to the thoughtless position that fears the business man and his accumulated financial wealth but embraces the celebrity and his dominating reputation.  I’m against laws that limit the modes of speech and the exchanges of ideas because they are purchased by money but leaves unfettered the speech and exchange of ideas that are bought through political favoritism.  I don’t understand why society is willing to be suspicious of one and not the others.

I’m skeptical across the board.  The accumulation of capital is not a bad thing, in and of itself, and I am willing to give the person who has acquired any type of capital the benefit of the doubt that he has earned it.  But the use of that capital is no less corrupting if it is based on reputation or political connections than if it is based on cold hard cash.

What do the terms ‘greedy capitalist’ and homo economicus have in common?  Both terms are used, albeit with different connotations and by different groups, to describe a member of a society who pursues his own rational self-interest, trying to maximize it with each decision made.  But what is rational self-interest?  How do you define it? What is being maximized? And is the pursuit of one’s own self-interest necessarily incompatible with being a good neighbor? At the crux of these questions is the definition of rational self-interest.

Traditional economic analysis tends to view self-interest solely within the material context.  Much like playing a board game, the success that you have had in maximizing your personal self-interest is completely judged by the amount of stuff you’ve accumulated.  Cars, houses, jewelry, and money are all victory points that allow a person to rank themselves.  You can declare yourself to have arrived at the good life when your house is bigger, your car more expensive, your jewelry more gaudy, and your bank account larger than the Joneses' down the street.  In this view, a rational person never fails to make a decision that increases his material wealth.  This, then, is the definition of homo economicus – an individual who tries to maximize his utility when he is a consumer, and his profit when he is a producer. You can go one step further in this description if you believe that the wealth one person enjoys is often or always at the expense of another.  In this case, you would characterize a person pursuing his self-interest as a ‘greedy capitalist’.

But is this really how people act?  It is true that we can find excellent examples of miserly, parsimonious, and bitter old men in literature.  Scrooge in Dickens’ A Christmas Carol and Old Man Potter in Frank Capra’s It’s a Wonderful Life come immediately to mind.  And certainly there are people who take materialism too far, but does that mean that the system as a whole is corrupt or corrupting?  I think not.

There is a fascinating game, in the sense of game theory, that is often used to determine the degree to which people will tend to maximize their utility by following their own rational self-interest.  It’s called the Ultimatum Game.

It works essentially like this.  The game begins when the game administrator (shown in blue below) approaches two random people with a pile of cash and invites them to play.

The rules are simple.  The administrator will randomly designate one of them as the proposer and the other as the responder.  The administrator will give the proposer the money and the proposer will decide on a split between himself and the responder.  The responder’s only move is to decide to accept the proposal or reject it.  If the responder accepts the proposal, they both get to keep the money in the proportions defined by the proposer.  If the responder rejects the proposal he and the proposer walk away empty handed.  The administrator emphasizes that the proposer gets only one chance to make an offer – there are no negotiations – and that this is the only time they will be playing this game.

Assuming that both players are homo economicus, the results of the game are easy to predict.  The proposer should keep most of the money for himself and give only a small percentage, nearly zero, to the responder, because the proposer realizes that the responder will rationally maximize his own utility and will take any money offered.  This way the responder will leave with more money than he had before the game began.  The responder may lament the fact that the mere luck of the draw separates him from the proposer, but money is money, and free money is free money, and so he accepts.

When this game is run experimentally, the results are quite different.  The responder accepts the split only when it is close to 50-50, and often rejects when the offer strays to far from an equal split.  Furthermore, the proposer, without having the benefit of playing this game before, often offers a split close to the 50-50.  Why do both participants often behave unlike homo economicus?

In practice, the experiment is done with more care and in a double blind fashion, as explained by the Foundation for Teaching Economics’ lesson plan found here.  But the results remain the same.

• The mean split is 60-40 (proposer gets 60% and responder 40%)
• Most common split is 50-50
• About 20% of the offers that fall outside the ‘fair’ range are rejected.

How does one explain the proposer’s generosity?  How does one understand why the responder ‘cuts off his nose to spite his face’ when the split is too low?  As discussed in great detail in the accompanying appendix to the lesson plan, this game has been applied in a variety of circumstances where variations in age, gender, background and other factors have been examined and controlled.  There appears to be no confounding variable that allows the administrator/experimenter to pre-determine when the participants will behave like homo economicus.  Even the amount of money has been varied. Relatively vast amounts were brought to the developing world, where people subsist on only a few dollars a day, and the results remained the same.

A much more cogent explanation is that the definition of rational self-interest needs to be expanded from the materialistic realm to consider things like reputation, human compassion and altruism, and wisdom.  And that these traits act to balance the purely materialistic instincts.

Virtue in the ancient world was defined not by a super-abundance of a trait but rather as the correct amount or a balance.  A warrior who acted reckless and drove into battle with an overly great amount of physical courage was no more lauded than the coward who sat in the corner timidly, wanting for danger to pass by.  The correct balance between caution and courage was the virtuous position.

Here in the ultimatum game, I see reflections of these ideas of virtue.  The game results provide ample evidence that a human being engaged in a free market does not necessarily become selfish.  The free exchange of goods and services is not inherently corrupting to those who participate, and they are no more likely to be preoccupied strictly with material possessions than if they had  not engaged. The free market, like any tool, can be misused and can create an injustice, but it is not intrinsically flawed.

Lord Acton is famously quoted as saying “All power tends to corrupt; absolutely power corrupts absolutely”.  I wonder what he would say about the Ultimatum Game. I’m not sure, but I like to believe that he would recognize the free marketplace as a place where people can come together to trade without the threat of coercion.

Well, the January jobs reports are in and the economy created a reported 257 thousand jobs in January.  Hurray for the US economy!  This comes hard on the heels of job growth numbers for the November and December of 423 and 329 thousand, respectively.  The news is certainly welcome and the trend is encouraging, but not all of the results are likely pleasing to either the current administration or the American public at large.

The fly in this particular batch of ointment is that the unemployment number has ticked up one tenth of one percent.  Of course this is to be expected.  As I discussed in an earlier post, when consuming the job statistics, one has to make a sharp distinction between the unemployment rate and the workforce participation rate.  Some of the folk who had dropped out of the workforce entirely are now, no doubt, coming back in as job openings become available.

Indeed, Bloomberg’s lead article on the January numbers, entitled Jobs Report Crushes It, agrees with this idea saying that

The article goes on to say that

And there is the rub.  The American people, by and large, do not understand the distinction between good and bad rises in the unemployment rate.  The public’s inability to make these distinctions is mostly due to the low economic literacy and discourse of many of the institutions that proclaim themselves as the guardians of the working man.  Primary amongst these are the media, who gush and dance in sound bite and spin, about any ‘favorable’ movement in an indicator whether or not it is actually good.  Also culpable are the schools, which employ teachers less economically literate than my butcher.  After all, public school teachers don’t have to worry about producing a product the public wants since the government will make sure the bills get paid and the lights stay on no matter how many students show up.  My butcher, on the other hand, needs to show just where the beef is.

So, the public is likely to get restless as the unemployment rate rises.  As public sentiment goes, so goes the administration, which will likely leverage political pressure of the Federal Reserve to lower unemployment.

For those who don’t know, the Federal Reserve (or the Fed, as it is affectionately known by everyone – even themselves) is charged with control of the monetary policy of the United States.  As the nation’s central bank, it has only three arrows in its quiver:

• Open Market Operations – buying or selling of bonds to basically create or delete money from the economy. Buying bonds will increase the money available in the economy and selling decreases it.
• Reserve Requirements – sets the percentage of deposits that a bank must hold in reserve. Lowering the reserve requirement frees up more money to be loaned and raising the reserves limits the amount.
• Discount Rate – fixes the interest of a loan from the Fed to a bank.

The effect of each of these is to raise or lower the interest rate that banks charge each other for bank-to-bank loans (federal funds rate), which then trickles down to the end consumer as the rate to borrow.  These three arrows are shot at two distinct targets with the intent of keeping inflation fairly constant at about 2% per year and keeping unemployment also fairly constant at about 5% per year.

The Fed has even gone to the trouble of creating a web-based video game in which the player can pretend to be the Fed Chairman.  The rules of the game are succinctly summarized when you are appointed chairman and are now in charge.

The simulation, while visually appealing, is primitive in its fidelity and doesn’t inform the player what model is used to determine how the simulated economy will respond to the changes he makes.  But considering that this is meant to be an educational tool, my guess is that the rules are really simplistic.  The following snap shows one of my attempts at managing the economy.

I suppose the Fed’s intent is to make it clear how hard it is to do their job and, perhaps, have us show a little gratitude for their steering an ocean liner successfully through troubled waters.

And maybe I should be grateful, but I can’t help but think that the Fed can’t possibly do a credible job of controlling inflation and unemployment by essentially adjusting the federal funds rate.  This particular jobs report is a perfect case in point.  One of the rules of the game states that ‘you can lower unemployment for a while and push up inflation by setting the federal funds rate close to, or even below, the inflation rate.’  That rule can only be true if something else, say the workforce participation rate, remains constant.

In this particular case, keeping the federal funds rate low, as it currently is, is actually raising the unemployment rate, and that is a good thing.  Capable people who had fled the workforce need to come back in and swell the ranks, even if they are just looking for jobs at this point.  It also isn’t a given that inflation needs to rise as these workers find jobs and begin to gather paychecks.  That point of view only makes sense if one only assumes that the output of goods and services remains low so that ‘more money is chasing few goods’.  But the recent decline in gasoline prices that has pushed inflation down (at least in practical if not statistical terms) is due to the industry of workers flooding into the energy sector.

So, what does the Fed do?  I suspect that they will coax the federal funds rate to rise and that, in the process, they will smother what is a good thing.  I mean, what else can they do when they are trying to achieve fine control using the crudest of tools?

Time is money. From our earliest years to the twilight of our lives, each of us hears that sentence over and over again. It slides across the page in print and pounds our ears in radio, film, and television. It’s usually uttered by some ruthless wolf of Wall Street or miserly business man with no heart. It’s a cruel phrase that weighs profit in one hand and people in the other and finds the human side of the equation wanting. It’s the proverbial elephant in the room that we fervently wish to be false but fear is true – that the almighty dollar rules our life, exactly as we are warned in that classic song by the O’Jays (and as brillantly portrayed in the opening sequence of the movie For Richer or Poorer).

But how many of us really understand what that sentence is all about? Is money really the evil necessity that prevailing wisdom warns us about? How might our attitude towards money be different if we simply turned that old trope around to read: Money is time?

Let’s start our discussion of what money really is by looking at its origin. It’s common knowledge that, prior to the invention of currency, bartering was the only way of trading goods and services. We've all learned that in school (at least we should have), and there is that Schoolhouse Rock song

that tries to explain how money arose from the bartering system. The song is catchy but its message is muddled. Money wasn't invented to make it easier to carry goods around or to make change. It was invented to save the most precious commodity a human has: his time.

Living with currency of all sorts (paper and electronic) makes it easy to ignore just how time consuming barter must have been. A typical scenario might have looked just like this. Let’s suppose that Charlie lives in an agrarian society where there is division of labor but no currency. Charlie raises chickens and since he can concentrate on their breeding and rearing, he can produce far more chickens in a unit of time than he could if he didn’t specialize. Having more chickens than he needs, he is willing to trade some of his for sheep that his neighbor Steve breeds. He is also willing to trade with Pam for some of her pigs or William for some of his wood but not with Fran or Harry since Charlie dislikes fish and has no use for hay.

Problems arise when Charlie wants pigs but Pam is unwilling to trade because she wants hay. Unfortunately, Harry won’t trade with her because he wants sheep. Steve, however, doesn’t want hay because he needs wood to fix his house. Steve’s willing to trade with William, but William has his mind on the nice fish tacos he could make if only he had some fish. Fran won’t trade with William, even after William has offered his finest oak lumber, because Fran is dreaming of a nice chicken sandwich but is lacking the main ingredient. By visiting each in turn, Charlie is able to piece together a plan of action, and he proceeds to make four transactions that he doesn't want to make, to finally arrive at the one he does. First he trades chicken to Fran in return for fish. Next he takes the newly acquired fish and gives them to William in exchange for some nice wood. And so on. The figure below shows the whole wacky scheme.

Charlie not only has to spend his time moving goods around this vicious circle but he also needs to spend time learning enough about all the other goods so that he knows how much his chickens are worth relative to them. Failure to know what his chickens are worth will prevent him from bringing home the bacon and, instead, will cause them to come home to roost.

Many of us don’t relate to farming unless we are playing Harvest Moon or Farmville. Fortunately for us, this idea of horse trading from A to B to C and so on is kept alive in sitcoms. My fondest memory of this kind of show is the episode of M*A*S*H entitled ‘For Want of a Boot’ in which Hawkeye tries to get a new boot by making a chain of transactions. Of course, it blows up in his face just as he’s about to achieve his goal, as the last person reneges, setting off a chain reaction that sets him back at square one with only a long useless day to show for his efforts.

Obviously, Charlie's situation would be greatly improved if there were a central entity with whom everyone could transact business and who also knew the relative worth of each person’s goods. Fortunately for our little farming village, money is such an entity.

The invention of currency allows for a single transaction between each seller and buyer, saving a lot of time. The market where the money and goods are exchanged provides the framework for determining the relative worth of each good.

The adoption of currency also allows our little group to preserve the worth of their goods in a non-perishable form. Fish may spoil and wood may rot. The chickens may die and the sheep grow old. The hay may get moldy and the pigs may get skinny. But the value of each good is secure once it is traded for currency. Money also allows for the expansion or contraction of the economy when a new member arrives (Tim with his tools) or an existing member leaves (Steve and his sheep head to greener pastures).

To summarize these benefits, we say that money:

1. Acts as a medium of exchange
2. Sets relative worth via the prices paid for each good
3. Holds the value for future use.

In all of these benefits, the aim is to provide more time for everyone involved to live life and enjoy. So, the next time you see Time is Money and you cringe, turn that expression on its head and remind yourself that the correct way to read that is Money is Time and that it is time that really counts.