Naked Economics Wheelan, Charles (books to read for 13 year olds TXT) 📖

Not every transaction is a winner, of course. Just as individuals make investments they later regret, the capital markets are perfectly capable of squandering huge amounts of capital; choose your favorite failed dot-com and think of that as an example. Billions of dollars of capital flowed into businesses that didn’t work. The real estate bubble and the Wall Street meltdown did the same on an even bigger scale. Adam Smith’s invisible hand has hurled a lot of capital into the ocean, never to be seen again. Meanwhile, some potentially profitable enterprises are starved for capital because they have insufficient collateral. Economists worry, for example, that too little credit is available for poor families who would like to invest in human capital. A college degree is an excellent investment, but it is not something that can be repossessed in the event of default.

Still, the financial markets do for capital what other markets do for everything else: allocate it in a highly productive, albeit imperfect, way. Capital flows to where it can earn the highest return, which is not a bad place to have it flowing (as opposed to, say, into businesses run by top communist officials or friends of the king). As with the rest of the economy, government can be enemy or friend. Government can mess up the capital markets in the same ways it can mess up anything else—with overly burdensome taxes and regulations, by diverting capital into pet projects, by refusing to allow creative destruction to work its harshly efficient ways. Or government can make the financial markets work better: by minimizing fraud, forcing transparency on the system, creating and enforcing a regulatory framework, providing public goods that lower the cost of doing business, and so on. Once again, the wisdom lies in telling the difference.

Obviously the current crisis has presented some teachable moments. The financial regulatory system needs to be patched up, if not completely overhauled. The challenge will be to protect what a modern financial system does best—allocating capital to productive investments and protecting us from risks we can’t afford—while curtailing the excesses—stupid bets that enrich the folks making them before eventually leaving a mess for the rest of us to clean up.

All that is well and good. But how does one get rich in the markets? One of my former colleagues at The Economist suggested that this book should be called Are You Rich Enough? His logic was that most people would answer no and rip the book off the shelves. Sadly, I’m not a big believer in surefire strategies to trade your way to riches. Just as miracle weight-loss programs violate nearly everything we know about health and nutrition, get-rich-quick schemes violate the most basic principles of economics.

Let me begin with an example. Suppose you are shopping for a home in the Lincoln Park neighborhood of Chicago. After many weeks of searching, you find that a three-story single-family brownstone will cost you somewhere in the range of $500,000. Some homes are listed for $450,000 but they need work; others are listed for $600,000 because they have extra amenities. Just when you begin to despair that you will have to spend $500,000 for a home, you find a brownstone listed for $250,000 that meets all of your specifications. When you investigate, you learn that this home is every bit as nice as the ones you’ve been looking at—same location, same size, same structural integrity. Still wary, you ask your real estate agent for her assessment. She assures you that this house is indeed a remarkable bargain and should be selling for $500,000. In her professional opinion, there is no doubt that you could buy this house for $250,000 and sell it only months later for $500,000 or more. Then you see the final piece of evidence. An article on page 3 of Crain’s Chicago Business has a screaming headline: “Bargain of the Month: Lincoln Park Brownstone Listed for $250,000.”

So you snap up the house for $250,000. Sure enough, six months later you sell it for $500,000—doubling your money.*

How many things are wrong with this story? Quite a few. A reasonable person might begin by asking some of the following questions:

If this house was really worth $500,000, who was the moron selling it for $250,000? Was this person not willing or able to do the three minutes of work necessary to determine that comparable houses in the neighborhood were selling for twice as much? If not, wasn’t there a family member or a real estate agent—whose commission is based on the sale price—willing to point out this enormous discrepancy?

Maybe not. In that case, why hasn’t my real estate agent bought this house for herself? If this house is a “sure thing” to double in price, why is she working for my 3 percent commission when $250,000 is staring her in the face?

Perhaps my real estate agent is a moron, too. In that case, where are all of the other buyers looking for bargains, especially after this house is featured in Crain’s Chicago Business? If this brownstone is a tremendous bargain—and has been widely advertised as such—then presumably all kinds of people are going to want to buy it. A bidding war would result, with potential buyers offering larger and larger sums until the price reached its fair market value, which is around $500,000.

In other words, there is virtually no chance that you will find a Lincoln Park brownstone (without some surprise lurking in the basement) for $250,000. Why? Because of the most basic idea in economics. You are trying to maximize your utility—and so is everyone else. In a world in which everyone is looking to make profitable investments, no one is going to leave $250,000 sitting on the table. Yet people assume the stock market works like this all the time. We believe that after reading about a “hot stock” in BusinessWeek, or reading a Wall Street analyst’s buy recommendation (offered to all the firm’s clients), we