Wednesday, October 22, 2008

Open Source Code

I came across this wonderful statement on the ideology behind the Open Source revolution from an interview, in Mint, with Bob Young - one of the founders of Red Hat:

"Only in the software industry, the vendor had control over the way the consumers use the product. Imagine you buy a car, and the dealer who sold you the car had the key to the hood of the car. If your engine starts making a noise, he can say that it is not a bug, but a feature."

Brilliant! Read the whole article here. I particularly like the way he says that he is not a free software exponent, but a free market exponent!

Monday, October 20, 2008

What is bound to happen...

This is a simple explanation of the financial crisis and the current response towards it.

Illustration 1 shows the global financial system as it existed until very recently. The lenders deposited with retail banks which gave them back interest on the capital. The retail banks invested in the stock markets where the investment banks underwrote stock equity for the various businesses and also made loans out of the capital invested with it. The central banks and government officials had a significant say in the whole system; they dictated the interest rates (kept them low => Caused a bubble) but they also followed a misguided monetary policy based on fiat currency and fractional reserve banking. Life went on; but behind the balance sheets, the investment banks were betting on toxic assets, and the retail banks were making loans to individuals and organizations with bad credit histories.

Illustration 2 shows what has been happening in the global financial markets since early September 2008. The investment banks and retail banks are going bankrupt because of toxic assets - that they have been bundling and selling - on the stock market, not giving them any returns. The stock market has crashed. Lenders are spooked and are diminishing in confidence and are unwilling to lend money to banks hence causing a credit crunch, which is impeding the way retail banks function. Now, the government official's and central bank's role in the economy is large; they are continuing the misguided monetary policy and still 'banking' on fractional reserve banking and fiat currency systems. They are now buying assets in toxic and underperforming businessess and financial institutions, while still knowing that they are worthless assets. This is having no impact on the confidence of the retail investor who still does not trust his money with the banks, further worsening the credit crunch. His assets are also wiped out in the stock market fall denying him the ability to even lend back to the banks if they regain his confidence.

Illustration 3 shows what is expected if the increased role of the Central bank continues the way it is. The nation will become a toxic asset and this would have been caused by none other than the most toxic asset of them all, which is called 'Government Intervention'

Don't believe my prediction as depicted in illustration 3? Why not atleast listen to the scholar who knows more than any one alive about monetary history - the 92 year old Anna Schwartz! Here is an article where she has made the simple arguement,

"Everything works much better when wrong decisions are punished and good decisions make you rich."

Tuesday, October 14, 2008

Capitalism - Still an Unknown Ideal

While I was chatting with a friend on the phone this past weekend I was asked a question. "Has Capitalism failed? Now that everyone is questioning the lack of regulation which has led to the near collapse of the global economies, isn't it time to rethink the primacy of Capitalism?" Both of us - let me mention upfront, are laymen; salaried employees who are not experts at economics. But ,we have studied economics and its many theories as part of our MBA course. Both of us are still students of economics and are learning to appreciate the many nuances which each theory in economics poses to the interested mind. But when it comes to the debate between which solution - Free Market Capitalism, Keynesian Economics or Communism should be at the helm of the commanding heights of the economy, one of us - me, is not open for debate. The solution has to come from Laissez Faire capitalism. I may have doubts about how a free market solution can be achieved to a particular problem, even profess the need for certain degree of policy regulation, but it is irreconcilable to me that such a solution can be better than one which a free market can provide - in the long run.

The problem, I think, which leads people to end up believing that Free Market Capitalism is bound to fail, or has failed is the undue importance to human greed which people attribute to an unregulated economy. It is common to hear people say of the collapse of Lehman Brothers that "Isn't it obvious? When you let people indulge their greed unabatedly, there is bound to be such failures. We should restrict their blatant freedom!". But this is a knee jerk reaction. One which casts a doubt over a system based on the symptoms of the affliction ailing it, and not the cause. This is beautifully described in an article by Quinglian He, a chinese economist. When asked "Does The Free Markets Corrode Moral Character" she replies "No" and rightly points out -

"Ofcourse, the market economy is not a perfect system. But the market's flaws stem from the actions and motivations of its human participations rather from its design"

Free markets allow us to be what we are. It gives all of us a playing field where we compete based on merit and the rewards are directly proportional to the level of risk we are willing to take based on the merit of our judgements and capability. Free markets nurture the individual's rights and allow him to pursue his goals. It is also a test to his character and as Tyler Cowen points out,

"By placing more wealth and resources at our disposal, [free market] tends to boost and accentuate whatever character tendencies we already possess."

Ayn Rand wrote in her book "Capitalism: The Unknown Ideal" about the form, nature and purpose of government as being a means to protect man's right - protecting him from physical violence. It is from the person who is bound to utilize the unregulated free market for personal corruption and greed, that the government needs to protect others from. Not regulate the system itself. Any other interference by the government in the functioning of the market is detrimental. But most people find this line of reasoning a hard pill to swallow. Today when governments around the globe are bending backwards to come up with plans to 'bail out' underperforming financial institutions, it seems a far cry for anyone to keep believing in the merits of 'unabated capitalism' and the extent of greed of people who are not regulated.

But, this is again a case of assigning blame to the symptom and not the cause. It is a mistake to point blame at the capitalist ideaology for the current financial industry meltdown, because it is not under a purely capitalist system that these financial institutions functioned. Observe the conditions of pseudo-capitalism which has been at the commanding heights of every major economy in the world today. There is always an ever present creditor of final resort which each of these countries have - a central bank. As rightly pointed out by this article,

"Additionally, the only reason why the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac were able to guarantee nearly $5 trillion in home loands with merely $100 billion in net equity is that both their management and other market operators knew that the government would step in if things took a turn for the worse. Acting as lenders of last resort, the Federal Deposit Insuarance Corporation (FDIC), the treasury department, and the Federal Reserve Bank fueled the crisis by encouraging a decade of careless lending"

A classic case of a Moral Hazard where the proper functioning of a free market does not happen because the players are tempted to risk more than what their judgements and analysis lead them to believe, because a pseudo net is ever apparent to cushion their fall. Free markets punish those who make unwise decisions and reward only those who take calculated risks. Free market success stories are those which exhibit fundamental growth and true value creation as against a 'sentiment' based growth.

There are many opinions about the bailout plans which are unfolding around the world - most, even pro-libertarian ones are saying that maybe a bailout was inevitable. But interventionist solutions are unfortunately never better than what a free market can come up with - in the long run. It is almost uncanny to see how the 'bailouts' have started popping up across the world after the US Treasury department came up with the $700 billion plan. It is seen as the repercussion of the failure of the 'capitalist bastion' of United States of America and leads many an undecided mind to disbelieve the essential efficiency of a free market.

To such doubters, I can only say - please observe where you cast the shadows of your doubts. The world may not be facing this problem in the first place had the true ideals of Free Markets been adhered to. The question of greed and favouritism does not hold too much merit in a free market economy because, like Milton Friedman said,

"In a capitalist society, it costs money to discriminate, and it is very difficult given the impersonal nature of market transactions"

Viva Liberty!

Wednesday, October 08, 2008

Co-opetition, collusion and free markets

Co-opetition is when traditional competitors in a market form a pact and offer a single product, service or an experience to the consumers in order to avoid splitting the market shares. It is optimal when the market is saturated and further fragmentation is not beneficial to the players involved.

Can co-opetition be a good solution all the times?

Consider the case of the flower vendors outside Dadar railway station in Mumbai. The small lane where the sell their flowers is a key artery which all the pedestrians use to get to the railway station from workplaces in the Dadar area. Come a festival season, this street is so crowded that getting to the station for commuters is nearly impossible! Now, assume that people who regularly use this street all decide to work out a deal with the flower vendors.

Assume that deal is simple - the flower sellers will sit only on one side of the road thereby allowing the commuters to freely use the other side of the road. In return, the flower sellers who are displaced could be incentivized monetarily or sell their daily quota to other flower sellers who sit on the side of the road where they are not displaced at prices slightly higher than what they would sell to consumers. All these transactions are facilitated by a small association formed with participation from the flower sellers and commuters. There is no involvement from the law enforcement agencies or the government.

Unfortunately, although I am a firm believer of free markets and voluntary regulations (like the one mentioned above), the following concerns pop into my head immediately:

  • The above system will work when the monetary incentive which the displaced flower sellers get is more than what they can make in the free market. It won't be business sense to be party to such a scheme if the flower seller ends up making a loss. Hence, the value of the incentive would essentially need to be above the profit of the most profitable flower seller. A threshold price which will need to be borne by the commuters.
  • How would the consumers distribute the cost of bearing the incentive given? As the commuters are not a homogeneous community and there would be many who would not be willing to partake any financial cost and not mind the madness.
  • Where does co-opetition end and collusion begin? The displaced and not-displaced flower sellers can soon start forming cartels and look to make profits in the arbitrage thereby offsetting the commuter's costs.
And the problems I can forsee are many more. Some trivial and some profound. What about enforcing the framework of the law on those who default? It is when I see such situations where the market is so dense and players innumerable that I feel that regulation from the government is the only feasible way out. One overarching rule which all people have to abide by and enforced by the government. Although I hate myself for admitting this, I doubt free market mechanics to be able to handle such a situation when the market players are compelled to make a profit by any means possible, so that one can feed oneself the next day.

One mega solution would be to privatize the entire suburban railway system in Mumbai. This would force the private company to make the surroundings, entries and exits to the station commuter friendly to keep up business. This would involve costs, which eventually would have to be borne by the commuter, atleast initially - and given the fabric of current Indian society, such a plan would face severe opposition. So we are stuck in between a rock and a hard place. Bold plans like privatizing the suburban railway system in Mumbai would never get off the ground because of the opposition, and even small bottom up approaches like voluntary self imposed regulations by the people who are involved in the matter is also doomed to fail because of the immense number of variables. One would need to impose a very strict 'Police Raj' to see that all these variables are harnessed - which is defeating the very premise that it is a voluntary.

What really bugs me is, how then can a society like that of India be, even gradually moved towards a free market economy from its current socialistic bent of mind. Top down, mega projects would fail because they would never get off the ground and would have to be championed, ironically by the government itself, and bottom-up approaches which would act as shining examples of how efficiently a voluntary free market regulation can work, showcasing it so that it can be adopted in other situations, also are doomed to fail due to the sheer number of hurdles it needs to overcome!
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