Potential Smartism #4: Uber vs. City Governments Is a Stylized Free Market vs. Regulated Market Argument

There’s a great story recently of a market regulating itself without influence from a big central regulator. For the most part they’re doing it with happy participants, a much lower cost, and, for the meantime, no explosion of risk and abuse. No I’m not living in a Libertarian fantasy land, I’m talking about Uber. As a frequent enjoyer of Uber I’ve been following the debates / riots (really France?) a lot recently. Fundamentally, I totally understand the objections to Uber:

City governments make a lot of money from cab companies who pay them for the right to effectively have a monopoly on providing services. It makes sense that cabs would lobby to protect this monopoly. It also makes sense that cities would react favourably to this lobbying to protect that revenue stream.

In response to this, Uber (particularly the Uber X service) has essentially come in and said to the cities “hey, we can do this better, cheaper, and get your citizens around more efficiently than the current system. Isn’t that what you want?” In order to avoid outright saying that protecting a revenue stream is a large consideration, governments have been forced into PR contortions to justify continuing Uber resistance. These range from totally legit (Uber doesn’t operate rurally) to pretty silly (Ubers don’t get inspected bi-weekly like city cabs).

This is where this story gets interesting for me: Uber essentially crowdsources regulation and lets the market participants regulate themselves. If an Uber driver is creepy or drives like they’re in Grand Theft Auto, they get down rated (rating is mandatory) and either given less work, or removed from the rotation entirely. If their car squeaks and is poorly maintained, same thing. Passengers are rated as well to protect drivers. So while there isn’t as much up front checking, though they do background checks, there is a consistent, frequent, and motivated “regulating body” of riders and drivers afterwards. Most importantly this regulating body is free (!) and the savings are passed along to consumers and drivers.

I completely understand that giving an Uber driver a 0 star rating isn’t going to be much comfort in the worst case scenario, but incidents with licensed cab drivers / cabs aren’t exactly unheard of either. Uber also provides the advantage of having all your interactions tracked and logged via the app, vs. cabs, where you are effectively anonymous other than your pickup location. I would say that at worst, Uber is as safe as cabs.

Anyways, this isn’t a treatise on why Uber is better, but on why it has the ability to be cheaper than traditional cabs. This cost advantage subsequently gives them the ability to bludgeon cities with rhetoric that by banning Uber they are increasing costs for their citizens. Uber’s financials aren’t public, nor are most cab companies, but here would be my guess on why the cost differential arises (from largest to smallest):

  1. Regulatory outsourcing (no mandatory maintenance checks, no drug and alcohol testing / programs, no partitions, no cameras, no training programs, no fuel efficiency requirements, no mandatory downtime for cars or drivers etc etc)
  1. Technical improvements (no human dispatch, more flexible pricing, more efficient use of cabs)
  1. Legit gripes (drivers use personal insurance vs. commercial insurance, don’t have to pick up disabled passengers, aren’t required to subsidize mandatory rural service with downtown fares)

With regards to Uber, the people have spoken. Price and convenience is king and they are willing to either a) trust that the “crowdsourced” regulation is sufficient or at least that b) any additional risk is offset by lower prices. However, Uber is a simple “free market” example that is easy to get your head around. Any potential additional risks are easy to understand, and the benefits from accepting those risks are readily apparent.

It is much more complicated when scaled up to an entire financial system. There are a number of regulatory bodies that need to agree, a ton of regulations that often conflict (see Potential Smartism #2 for a discussion of the difficulty of de-regulating conflicting policies), and the benefits are more challenging to observe, but the concept is the same. Rather than one governing body making the “risk decisions” for all participants at a high cost, participants make the risk decisions on one another at a lower cost. These participant risk decisions are made on a regular and constantly updated basis. They are also made by players who are more directly incentivized and potentially more capable. When it is framed in an additional risk vs. reduced cost manner, the free market decision can become much easier to analyze.

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Potential Smartism #3: Whose Casa? A Different Look at the Rent vs. Buy Real Estate Decision

Potential Smartism #3: Whose Casa? A Different Look at the Rent vs. Buy Decision

An attempt to take the emotion out of the decision and look at what you need to believe to buy a house in the current Canadian Real Estate market.

Goes through taking into account the intangible benefits to owning vs. renting, how much people need to make to “safely” carry mortgages of various sizes, whether the divergence between rent and buy over the last 10 years could be based on fundamentals (vs. solely based on debt), some discussion on what has caused the mortgage boom, and some case studies on rent vs. buy for Toronto properties.

This was made as a PPT to be delivered to some friends, but I figured I’d throw it up here as well. I’ll try to come back and write a post on this as well.

H/t to Ben Rabidoux for the Real House Price chart (and for fighting the housing bear fight) and to The Holy Potato blog for spurring me to think about this topic deeper, digging up the census numbers as well as creating the Rent vs. Buy  model that some of the conclusions are based on.

Potential Smartism #2: The Spinning Top Theory of Financial Regulation

Regulation sets the underlying playing field for everything we know and understand about finance. Yet regulation seems to generally follow a pattern: something happens, regulation is put in place to stop that thing from happening. Something else happens, something else is put in place to stop that other thing from happening. Little thought seems to be given to whether the regulation from the first thing caused the second thing (“were always fighting the last war” syndrome). I’m not cynical enough to think that regulators really don’t think of the bigger picture or realize that there are unintended consequences to regulations, but there have been curious decisions made. I wanted to take a Modigliani and Miller approach in terms of thinking of everything as frictionless, open and perfect first, then layering real world impacts on top of this theory world.

The Theory

In a nutshell this theory is that there is a spinning top on a flat table. There are a ton of moving parts and forces in play, but as long as it’s on a perfectly flat surface, it’s stable. That’s the market with no frictions and perfect transparency. When frictions are introduced they create either lumps, which move the top towards a certain subsection in the market at the expense of others, or they create holes, which trap the market at a sub-optimal level. Regulators then take actions to either prop up these holes or tamp down these lumps. Often these actions have unintended consequences and overcompensate, creating new lumps / holes elsewhere to ensare our fragile spinning top.

Spinning Top - Flat Table

The perfectly flat table involves no saving of any institutions no matter how large (though no bankruptcy costs either), no restrictions on mergers, no deposit insurance, no leverage limits, no interest rate changes from central banks, no lobbying for laws to be changed to benefit financial institutions, no minimum wage, no government set consumer protection standards on mortgages, no government insurance for mortgages etc. If you want to sell a crappy mortgage that’s fine, but you’re responsible for the loan. If you want to securitize it that’s fine too. But in a world of rational actors who understand the inherent risks, you will need to pay interest commensurate with the risk and only get the transaction spread. Everyone will completely understand risk and their own tolerances and think in 50 year increments and unicorns will explode from the treetops in their majestic glory. It’s my theory I can have what I want in there. Point is, we’re in theory land here and this flat, completely unregulated market is a good place to start.

Then one day, into theory land comes a shady dude named Todd (no one awesome is named Todd). Todd has some insider information, say knowledge of an impending merger, and elects to trade on it. Suddenly our market isn’t perfectly transparent anymore and our table isn’t flat it’s got a lump in it! A lump that is shooting our top towards stupid Todd!

Spinning Top Model - Todd #1

Now in a properly functioning regulatory system, an independent, rational body would take steps to restore transparency to the market. Let’s consider two options:

  1. Force all merger talks to be held in a public setting. No more non public merger information for Todd to trade on! Todd lump removed! But clearly this creates a whole other bunch of lumps (or holes). For instance giving away competitive secrets, minimizing any bidding tension, messing with employee morale, etc etc. There are many good reasons that merger talks are held in the strictest confidence and legislating that they all be public would effectively kill the merger market, which is a huge part of the efficiency of our perfect flat table up there. But then you can’t have a moribund merger market! You need to do something to stimulate it! Maybe we lower interest rates? Maybe we offer a government backstop on bridge loans to spur demand? Etc etc. You get the point.Spinning Top Model - Todd #2 (Hole)
  2. Make insider trading illegal. If the threat and enforcement is believable, the market should have faith that everyone is trading on the same information. This introduces monitoring and enforcement costs, people might get around it and it might reduce liquidity, but overall there seems to be a way to detect it and a way to stop it. The Todd lump is removed, with limited additional lumps / holes created.Spinning Top Model - Todd #2 (Lump)

Obviously choice #1 is the better way to return the market to its flat state right? But we’re assuming regulatory independence and rationality here (remember our 50 year time horizons and perfectly rational actors? ….and unicorns?).

Consider a politician who is up for re-election. Rather than trying to explain to voters how an insider trading law would work and how that would protect them (complicated!), they blamed the Todd lump on “shady corporations making back office deals to get richer! Why do they need secrecy if they have NOTHING TO HIDE?!?!” (simple!) Whether the politician is just pandering for votes or truly believes that rhetoric themselves is up for debate, but ultimately irrelevant if the policy gets enacted. So for an independent, omnipotent, economically rational regulatory body, the decision is simple. But when real world limitations and politics get thrown in, anything can happen (and then un-happen……then happen again…..).

Real World Application

Now think of a full regulatory system like the US. Ever since they turfed the centralized Second Bank of the United States in 1836 they’ve ended up with a fragmented, state level, individualistic banking system. With this comes a ton of conflicting regulatory bodies. They also have very aggressive politics that can tend towards populism. They’ve also regulated and partially deregulated in a dizzying cycle since the formation of the country. I can’t even begin to imagine how far away they are from our perfectly flat table up there, but we gotta start somewhere!

Let’s look through a real world example in terms of “the narrative” and also in terms of our Spinning Top Model here. We’ll use Glass Steagall and its subsequent repeal.

The enactment

Glass Steagall was introduced in 1932 in reaction to the perception that investment banks, when combined with commercial banks, took on too much risk and caused the 1929 melt down (this is the super summary version). It was comprised of two parts:

1. Legislation that broke up the banks and forced investment banks to operate independently of commercial banks.

Narrative: The banks are too powerful and too ingrained in the economy. This would restrict investment banks from using retail deposits to fund risky operations. With a lower capital base, the investment banks would have to reduce their scope of operations and risky activities.

Spinning Top Model: The transparency of the market had been compromised by a network of extremely connected bankers who sat on everyone’s boards. Insider trading was rampant and the resulting lump moved the market towards certain financial institutions and people. Forcing the investment banks to be smaller would help reduce some of their influence by reducing the number of companies they were involved in, but this seems to be an ancillary effect rather than a direct one. Though not explicitly part of Glass Steagall, insider trading laws enacted in 1934 helped tamp down on this lump as outlined above (with loser Todd).

The interesting part is that, assuming a perfectly flat and transparent table with equal upside and downside, there doesn’t seem to be any other lump that needed to be solved by breaking up the investment and commercial banks. If consumers recognize that their deposits are being used for risky activities they can either demand to be compensated more for their deposits, or move them to a traditional commercial bank that doesn’t undertake those activities. These retail deposits can be taken out on demand so there is no reason for them to be loyal to an institution. As the investment banks take on more risk, the supply of capital should reduce commensurately and in a short period of time. (Note: fully recognize this is a simple treatment of an extremely complex and touchy topic).

What removing this source of funding from investment banks DOES do though, is make them artificially small. Artificially small intermediaries have an artificially small amount of capital that can be put into activities necessary to our perfect flat table up there. These are activities like underwriting IPOs, doing bond issuances and re-distributing risk. With this artificially restricted capital, deals that are economically viable may not get done and you create a hole in the table.

2. Glass Steagall created the Federal Deposit Insurance Corporation, which guaranteed commercial bank deposits up to a certain threshold.

Narrative: This would guarantee the solvency of banks and prevent any future runs on the bank. Banks will be secure and you can sleep at night knowing your money is safe.

Spinning Top Model: Panics created by runs on banks were distorting the perceived level of risk upwards causing much greater economic pain than necessary given the conditions. This would create a hole, which the top falls into. The FDIC pushes up this hole so that ideally there is no excess loss, only what is economically rational.

However the FDIC also creates lumps in that consumers no longer face a symmetrical return profile. They get all the upside with no downside so there is no incentive to monitor the institutions they put their money into (moral hazard). There is also no incentive for the institutions to manage their risk, knowing that people will never remove their capital from their bank (moral hazard). This creates lumps that tilt the top towards the banks and depositors and away from the tax payer.

So recognizing this tension, the line of questioning becomes:

Is the hole created by panic bringing down healthy institutions bigger than any potential future lumps / holes brought on by the moral hazard introduced from the FDIC?

If it’s not then is there a better way to counter the excess economic loss problem with either no negative externalities or at least ones that don’t outweigh the benefits?

If not then can we politically do nothing and let the occasional panic take down a healthy bank?

Banking is a confidence industry. If an institution inspires so little confidence that people are lining up in the streets to demand their money back, then maybe that bank should change the way it runs its operations?

We’ve forced banks to be small and local so maybe we should remove the restriction on interstate banking so that banks can have cash flows from all over the country instead of being totally reliant on one area?

That reduces the potential hole from panics, but what new lumps or holes would interstate banking bring on? Potential oligopoly concerns if they grew too big?

Etc etc etc

I obviously wasn’t there, but I doubt that this was the kind of dispassionate conversation that was taking place in 1932 in teh depths of the great depression. Again here the narrative (your money is safe!) is much easier to sell to the public than understanding the underlying lumps and where new ones form if you squeeze out the obvious ones. Plus the FDIC fixes things now (within your term of office), while the pain from moral hazard will take decades to come home to roost.

The Repeal

Fast forward now to 1999 and the official repeal of Glass Steagall. Though Glass Steagall had been getting chipped away for years, the Graham Leach Bliley act officially wiped it out in 1999. Investment banks were free to own commercial banks again, but the FDIC persisted…. (cue the ominous music)

Narrative: Look at how free market we are, we’ve gotten rid of these restrictions!

Spinning Top Model: The separation of commercial banks and investment banks created small investment banks and relatively risk averse, traditional commercial banks. Inefficient and keeping the top in a hole, but relatively safe. The moral hazard lumps created by the FDIC didn’t have a huge impact because there generally wasn’t that much risk that needed to be managed by consumers / the FDIC insured institutions.

Now though, investment banks were able again to purchase these commercial banks AND their federally insured deposits. Prior to Glass Steagall a consumer was responsible for monitoring their deposits and either demanding higher interest rates or withdrawing their money if the activities of the institution got too risky. The FDIC removed this incentive. By doing so they  created a system where investment banks had essentially risk free, taxpayer backed funds to collateralize the riskiest (and most profitable) of activities (derivatives, proprietary trading). The reunification of investment and commercial banks unleashed the moral hazard issues and created a lump that tilted the top towards the banks and away from the tax payer.

Fast forward to the aftermath of the 2008 crisis and the narrative becomes “you never should have repealed Glass Steagall! Look at what it caused!! De-regulation is the worst let’s re-regulate everything!”. This would be partially right, but it’s not that de-regulation itself caused these issues, it’s the stuff that was left over from previous regulation. If you create a lump (moral hazard from FDIC), then create an opposite force that tamps that lump down (separating IB and CB), but then only repeal one of them….. you can kinda see where the spinning top ends up.

This type of thinking can be applied to the housing crisis as well. The government started backstopping mortgages for lower income families for political reasons, then never removed the punchbowl and ended up artificially distorting the risk downwards for an entire mortgage market. A full narrative vs. Spinning Top model treatment for housing would be a worthwhile undertaking. This actually ties in with my Potential Smartism #1 theory on bubbles: they need a lump to get started.

Overall this is a massive simplification of a controversial, complex century of American legislation and politics, but sometimes simplifying and starting from nothing allows you to cut down to some interesting issues!

Potential Smartism #1: The champagne glass theory of economic bubbles

Alright here we go. This is a site essentially to house my working theory’s on economics, finance, sports, incentives, morality, Dr. Pepper, puppies, why brussel sprouts are gross (I know right?) etc. It will probably be a mile wide and a couple inches deep, but with time, OH YES WITH TIME, hopefully it can grow into a grand unified theory on how awesome everything could be.

The quest to universalize and diagnose bubbles has been a “holy grail” of policy making since the Dutch Tulip Mania. Ben Bernanke and Alan Greenspan thought they had it solved in the early 2000s with “the great moderation”, where volatility had dropped and recessions were much less severe for a roughly 20 year period. They were under the opinion that financial theory and regulation had gotten so effective and the markets so efficient that there could no longer be bubbles! Of course this was proven false.

Here is my take on bubbles. Something happens to distort normal market incentives and the risk / return framework (could be regulatory related see Potential Smartism #2: the Spinning Top Theory of Regulation). Smart people (rational actors) recognize and take advantage of the distortion. They are followed by sillier people (irrational actors) who see profits but not risks. Rational actors exit the situation when the distortion is corrected or systemic issues add enough risk to balance the equation. Irrational actors remain in and often lever up to recapture profits from boom time. Then there is a catalyst, the bubble bursts and irrational actor’s exuberance turns to panic to get out. Rinse repeat. Similar to how champagne glasses produce bubbles because of imperfections in their surface, it is when there is an imperfection in the symmetrical risk / return framework that bubbles occur in economies. If we try and minimize distortions and leverage then we should be able to minimize the impact of these bubbles.

Champagne Glass Model

There is a symmetrical risk / return framework that in an open market setting generally holds. If you are equally exposed to the upside and the downside of any investment then it stands to reason that the riskier the investment the more you will need to be compensated for it. The supply of investable capital should logically decrease as the risk increases and the capital able to tolerate that risk wanes. This, in theory, should keep a leash on the riskiest parts of the market. It’s when there is a distortion in this risk / return framework that things go crazaaayyyy.

Initially, whatever the distortion is, you are generally able to earn larger rewards than the risk should entitle you too (or the same rewards for lower risk). In the lead up to 2008 there were two distortions:

1. Banks could earn high interest from lending to risky subprime lenders, but the downside risk was trimmed by federal backing (both explicit and implicit). If you can get all of the reward, yet lay off the risk onto the government (read: taxpayer) then you have a distortion. It has long been a political aim to increase the home ownership rate in the US, so you can see the motivation for introducing this distortion into the market.

2. There were unnaturally high ratings on the Mortgage Backed Securities eventually created from these mortgages. These unnaturally high ratings allowed banks to borrow against them at a low rate, while selling them at a high rate. The high ratings arose from misaligned incentives stemming from the issuer pays model of rating. If the person paying you is asking for a AAA rating, the incentive system is there to not do a full independent analysis to ensure future business. Add to this the fact that the US government mandated that pension plans invest in only AAA assets, which effectively gave a seal of approval to the ratings agency ratings. After all if the government mandates that we follow these ratings, they must be right, right?

When the distortion is identified, smart players (fancily termed: rational actors) understood that there were excess profits to be made in this distortion and they endeavoured to do it over and over and over again in a linear programming, maximization type equation. Less smart players (irrational actors) see profits being made and follow suit, not necessarily understanding the distortion or the underlying incentives and motivations of the rational actors, but making money regardless.

A rational actor would cease this action once the excess profits are no longer there and the distortion is corrected. This could happen either from returns being reduced, or from risk being increased. One way that the distortion could have been resolved in 2008 was for the government to reduce its role in the housing market and return to a market focused approach, that didn’t happen. What balanced the equation was systemic risk that arose from the fact that the size of this market was overwhelming the governments ability to backstop it. If everyone was rational then when this systemic risk balanced the return, this would be where the bubble ends. Housing prices would remain elevated and it wouldn’t be great, but this would seem to be a “non-cataclysmic” type bubble.

In real life though, at this tipping point not everyone exits the market (see Michael Lewis: The Big Short for a cool treatment on really seeing the difference between rational and irrational in a case like this). The irrational actors see what used to be outsized profits receding and, lacking the ability to find their own distortions, proceed to use the only mechanism they know how to regain their profits: leverage.

This last stage is the most damaging portion of the bubble. The rational actors would acknowledge that adding leverage to an investment that already wasn’t earning excess profits anymore would earn them an economic loss, but the irrational actors keep fuelling. They can fuel for quite some time depending on the distribution between rational and irrational and the amount of leverage available. Finally, some catalyst punctures the bubble, leveraged losses start to pour in, and the irrational actors flood to the exits en masse creating panic and severe downturns.

Given that governments have a) the ability and b) the political desire to distort markets, the largest bubbles seem to form from government intervention. In 2008, the distortion was from the government combined with the rating agencies[1].  In the South Sea bubble of 1711, the British government debt exchange program provided a massive source of demand for the South Sea Company’s shares. This demand, done to try and reduce crown debt, caused enormous price appreciation independent of the underlying economics. Initially everyone made money as the returns were artificially high, however at a certain point it was unsustainable and the rational actors cashed out while the irrational actors sold their houses and took on debt to buy more shares. It all ended in tears.

It does not need to be government made though. In the tech bubble of 2000 the distortion was the completely incomprehensible impact of the internet, which distorted the perceived return potential for a given level of risk. Perceptions change quicker than government actions though, so when people realized that “eyeball share” did not equal cash, we saw a much quicker, and less severe boom/bust cycle.

In terms of policies that could limit the damage of bubbles, the largest one is to NOT enact policies that create these excess profit potentials and keep the upside and downside symmetrical. This is understandably difficult as regulation is very complicated and there will always be tradeoffs. We cannot legislate risk tolerance or prudence, but we can legislate leverage restrictions on the intermediaries that transmit these distortions around, namely financial institutions. This would have the effect of at least containing the ability of the largest irrational actors to continue to inflate after the systemic issues have eliminated excess profit.

It’s not perfect (still not sure what the hell people were doing in the tulip bulb mania in Holland), but its an interesting way of thinking about bubbles and what pushes them through the cycle. I’m interested in looking back at other bubbles and seeing how they fit into this model.