Saturday, July 31, 2010

What You Need to Know About Present and Future Value (FV)

What do deflation and inflation mean in terms of our mortgages and investments? We turn to the concepts of present and future value for answers.


Discussions about the impact of future deflation or inflation tend to be quasi-ideological rather than pragmatic. Today we look at the consequences in numbers we can all understand. Frequent contributor Harun I. has kindly provided an explanation of the key concepts here: present value and future value. Extending the consequences of mortgages and bond yields 30 years is a real eye-opener-- or should be.


Here is Harun's commentary:

Why is it important to understand Present Value and Future Value?

By understanding these concepts we can determine the risk/reward involved in debt, how inflation or deflation, incidence or expectation, effect risk/reward. We can also understand whether inflation or deflation who wins or loses and why. Understanding who loses and why also gives us a prelude as to how market participants can be expected to behave.


I highly recommend reading Steve Keen’s Roving Cavaliers of Credit, and watch Chris Martenson’s Crash Course. These treatises will help you to understand that


1) we have a Credit Money system


2) there is always more debt than there is money


3) because of points 1 and 2 the system is inherently leveraged and inflationary. (Leverage cuts both ways; if leveraged 40:1 a 2.5% decline wipes you out)


Any loan that is written, the lender has to factor in what will the money be worth when I the principle is returned--the inflation risk--and what is the risk that principle will not be returned--the default risk. Both concerns are based on assumptions--in essence speculations about the future, which can and do get fairly complex.


For simplicity’s sake, I will be using a risk-free rate of return of three percent to calculate Future Value (FV) and Present Value (PV). In my opinion, the risk-free rate of return is the expected rate of inflation, meaning that when your principle (factoring interest payments) is returned it will have the same purchasing power as when it was loaned.


Given in the chart is the FV of $250,000 at inflation rates of 3-6%.


So, referring to the FV chart, $250,000 at a risk-free rate of 3% per annum will be worth (or more accurately, equivalent to) $606,815 in 30 years. If this were the cost of a home and it indeed appreciated at the rate of inflation, you know what the home will cost in 30 years.

If, however, you as the lender are wrong and inflation was at 4%, the rate of depreciation of money was greater than you anticipated and therefore you would need an additional $204,033 to have the equivalent purchasing power of your original $250,000. If this happens the mortgagee wins. (emphasis added: CHS)


If at period 30 the owner wishes to sell his home, he can put it on the market at its 4% equivalent of $250K ($810,849) and pocket the difference. This concurs with one of the greatest threats to bond holders: inflation risk. And, as can be seen in columns A70, B70, and C70, the effects of being off on our speculation by just one percentage point are large indeed.


Conversely, if the risk-free rate of return was 4% but deflation of 1% actually occurred, the mortgagee would eat the difference because (assuming he didn’t default) he would only be able to put his house on the market for $606,815 versus $810,849. For the mortgage bondholder this is acceptable because he now holds a bond with an attractive rate (4% vice 3%), which if he chose to sell would fetch a premium.


Put another way: the Future Value (FV) of $250K today at 3% annually in 30 years is $606,815.62. Cell A70 is the difference of being wrong by 1 percentage point (3%-4%). B70 is the difference of 4%-5% and C70, 5%-6%.


Both lender and borrower need to understand how changes in interest rates affect PV and FV because it affects current yields and yields at maturity. This directly affects the ability to unwind the position or sell the debt or asset.


This is a very simplistic example and can get complex once risk is factored. The reason I refer to the cost of a home is because I constantly hear people comment about how they paid for their house twice once interest was factored. Well, it just happens that prices double every 30 or so years.


Bond buyers would not lend money so freely if they knew the inevitable outcome would be a loss of purchasing power. In other words, if one generally accepts that bond buyers want an income stream plus the guaranteed return of their principle, what would be the point if that fixed income stream yielded increasingly declining purchasing power to a point that the overall investment when the principle is returned is a net effective loss?


So, in a deflationary environment someone who is concerned about an income stream and safety of principle may consider lending to the Treasury at 0%. With no inflation, he doesn’t have to worry about the solvency of a bank, FDIC limits, or the loss of purchasing power--that is, if the solvency of the Treasury is not in question. If prices decline faster than income there is still a net positive outcome.


One last thing that should be obvious: achieving the risk-free rate of return, that is, achieving nothing more than the rate of inflation on your savings may yield more nominal dollars but it does not increase purchasing power. I say this because some may be over enthused about watching $250,000 go to over $600K in 30 years. No wealth has been gained; it just requires more dollars to purchase the same items. (emphasis added: CHS)


The implications of PV and FV are important. I highly recommend watching the four videos at the Khan Academy website.


Here is another chart of present value. Referring to the areas highlighted in red:


At 3% interest or inflation the PV of $250,000 projected 30 years out is $102,996.69. You can see the results of 4%, 5% and 6%. If you put $250K under your mattress for thirty years and gave up a risk-free return of 3%, or inflation progressed at 3%, your $250K lost purchasing power. Higher interest rates destroy the PV of money; this has an effect on how much I can or must borrow. At 3% $250K has a PV of $103K, at 6% $250K has a PV of only $43K.

The calculations are simple but when one spends some time thinking about these concepts, the implications are very important.

Thank you, Harun, for a very insightful commentary. I will be extrapolating some of these insights in future entries.


In essence, mortgagees (borrowers) benefit in inflation, and bond holders (lenders) suffer potentially massive declines in the value of their asset (the mortgage or bond).


In deflationary periods, the bond holders (or owners of the mortgage note) gain while the borrower loses as the value of his home deflates while the interest and principle payments on his loan remain fixed.


The concepts of PV and FV help us understand why a government bond paying an absurdly low rate of return (1%) might be an excellent investment in a deflationary environment, and why debt is a catastrophic "investment" in deflationary times.


What are the risks going forward for borrowers and lenders? Ah, if only we had a crystal ball. But lacking that, we can take our cues from the the current deflationary currents and avoid debt and high-risk speculations alike.




"What the heck, it's only the cost of a latte" $2.99 Kindle book sale: Here are quick descriptions of each novel's plot, genre and theme.


Claire's Great Adventure ($2.99)


Of Two Minds ($2.99)


Kama Sutra Cadillac ($2.99)


Survival+: Structuring Prosperity for Yourself and the Nation ($9.95)


Survival+ The Primer ($5)


Weblogs & New Media: Marketing in Crisis ($5)


If you're going to buy the new $139 Kindle Reader (6" Display, U.S. Wireless, shipping August 27), please do so through my site as I earn a modest commission which costs you nothing.




If you would like to post a comment where others can read it, please go toDailyJava.net, (registering only takes a moment), select Of Two Minds-Charles Smith, and then go to The daily topic. To see other readers recent comments, go to New Posts.





Order Survival+: Structuring Prosperity for Yourself and the Nation and/or Survival+ The Primer from your local bookseller or from amazon.com or in ebook and Kindle formats.A 20% discount is available from the publisher.


Of Two Minds is now available via Kindle: Of Two Minds blog-Kindle


Thank you, Sam R. ($50), for your awesomely generous donation to the site-- I am greatly honored by your support and readership. Thank you, William L. ($20), for your extremely generous contribution to the site-- I am greatly honored by your support and readership.


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Friday, July 30, 2010

Gardening Break, "What the Heck" Kindle Book Sale

We take a break from analysis to view our garden and announce a "what the heck?" Kindle sale on my novels and other books.


I call this Kindle book promo a "what the heck?" sale, because $2.99 is a "what the heck, I'll give it a look" price. I chose $2.99 because this is roughly the cost of a latte or other specialty coffee (don't forget the sales tax!) in much of the country, and since few people seem to give that $2.99 much thought (at least those who are still employed) then snagging one of my books for $2.99 might also qualify as a "what the heck" purchase.


I've dropped the price of three novels to $2.99 each, the cost of Survival+ to the magic $9.95 price point, and Survival+ the Primer and Marketing in Crisis: Weblogs and New Media to a flat $5 each.


Here are quick descriptions of each novel's plot, genre and theme.


Survival+: Structuring Prosperity for Yourself and the Nation ($9.95)


Survival+ The Primer ($5)


Weblogs & New Media: Marketing in Crisis ($5)


Claire's Great Adventure ($2.99)


Of Two Minds ($2.99)


Kama Sutra Cadillac ($2.99)


Due to the contract with my publisher, my first novel I-State Lines remains $9.95.


My "adult themes" books remain in print only:

Verona in Spring For My Daughter


If you're going to buy the new $139 Kindle Reader (6" Display, U.S. Wireless, shipping August 27), please do so through my site as I earn a modest commission which costs you nothing.


As a break from the monotony of charts and analysis, here are some photos of our modest garden. I am a lazy gardener, hence the weeds, general disorder, etc.




Sunflowers in foreground, zucchini behind.




Cilantro flowering on the right, strawberries and parsley, new lettuce on the left.




Ripening peaches.




Trellised scarlet runner green beans.




From the garden to the wok to the dinner table.




Many of the seeds used in our garden come from our site sponsor, Everlasting Seeds. Please give the ES website a look--it's not too late to plant fast-growing greens, etc.




If you would like to post a comment where others can read it, please go toDailyJava.net, (registering only takes a moment), select Of Two Minds-Charles Smith, and then go to The daily topic. To see other readers recent comments, go to New Posts.





Order Survival+: Structuring Prosperity for Yourself and the Nation and/or Survival+ The Primer from your local bookseller or from amazon.com or in ebook and Kindle formats.A 20% discount is available from the publisher.


Of Two Minds is now available via Kindle: Of Two Minds blog-Kindle


Thank you, Zachary M.. ($20), for your second most generous donation to the site (and your kind words of encouragement)-- I am greatly honored by your support and readership. Thank you, Sriram E. ($50), for your stupendously generous contribution to the site-- I am greatly honored by your support and readership.


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Thursday, July 29, 2010

The Next Golden Age, Part II

The Next Golden Age will bloom once the high cost structures of the U.S. economy implode in insolvency.


Part II of my series which addresses the positive future that potentially lies beyond devolution and collapse focuses on the high cost structure of the U.S. economy which dooms it to insolvency.


Yesterday, in The Next Golden Age, Part I, I laid out why the Savior State and its sprawling fiefdoms (both domestic and global) are unsustainable and thus will inevitably devolve/collapse.


Based on the historical accidents of plentiful cheap energy, global dominance via the destruction or marginalization of competitors and favorable demographics, the Savior State and its global Empire arose to reach the present extremes of marginal return: treasure, blood and effort are thrown at "problems" even as the returns sink to negative territory.


Exponential growth of State revenues and debt (public and private) is unsustainable, yet the status quo will immediately implode without borrowing on a vast and rising scale (the Savior State currently borrows 11% of GDP every year, a sum sure to rise).


We can thus look forward to the demise of the entitlement mentality:


The entitlement mentality is a prison of resentment, self-absorption and complicity in the "project" of enlarging the Central State and its Power Elites' share of the resources, output, wealth and income of the nation and the world.


Now I would like to focus on the pragmatic result of marginal return and protected fiefdoms: an intrinsically high cost structure in the U.S. economy.


I have addressed this many times over the past few years:


Lowering the Cost Structure of the U.S. Economy (August 29, 2008)


Is Higher Education Worth a Lifetime of Debt? (August 26, 2009)


What Won't Be Changing (February 2, 2009)


This Week's Theme: The Coming Great Depression (November 24, 2008)


Has Capitalism Failed? (December 19, 2008)


The key dynamics of high cost structure are:


A. Marginal return: as the returns on investment plummet to zero, the status quo attempts to "solve" the "problem" by borrowing and throwing ever-larger sums of money at the "problem." Thousands of pages of legislation add more complex layers of bureaucracy to systems already groaning under a crushing complexity and resulting inefficiency. Returns soon drop to negative.


B. Cost of borrowing rises: One way to think of this is to recall the physics of corn ethanol: consume a barrel of oil producing the ethanol and get 2/3 of a barrel of equivalent energy as a result. The 1/3 loss is filled by borrowed money, which masks the loss and shunts the burden forward, but with the added cost of interest. Thus marginal return which is cloaked by borrowing merely doubles the burden going forward: not only is good money being put after bad, but the money is borrowed, leaving futere taxpayers/citizens with an ever-rising burden of interest to service. The economy loses not just in the malinvestment but in capital and national income being diverted to pay interest on the money squandered in the misallocation/ malinvestment.


C. Cost of energy rises: All sorts of inefficiencies, fraud, predatory skimming and waste could be covered up by the unequaled benefits of cheap, abundant energy. Once energy is no longer abundant or cheap, then the true costs of our national high cost structure and profligacy will be revealed. Higher energy costs will act as an economy-wide tax, pulling income out of every household and enterprise, and thus complicating the Savior State/global Empire's project of extracting ever-larger sums from the national income.


D. Full spectrum defense of the Status Quo fiefdoms: Those who have garnered enough wealth and assets to dictate State policy will naturally defend their share of the swag to the death. The nation itself will be picked clean as each fiefdom-- sickcare, the National Security State-within-a-state, the military-industrial complex, the parasitic banking (and shadow banking) sectors, etc.--goes for broke (double entendre intended) to protect every last dollar of its swag.


In so doing, each fiefdom guarantees that the tax burden on the dwindling class of productive citizenry and enterprises will rise, increasing the cost structure of the nation.


National insolvency and the writedown of uncollectable/unpayable debt will clear the decks for a low-cost structure economy. Prosperity flows not just from higher productivity but from higher productivity in a low-cost structure economy. If the structural ("overhead") costs of the economy are rising faster than output and productivity, then the citizens become poorer with every passing day. That is our fate until the entire high cost structure of the Savior State/global Empire and its insatiable fiefdoms tumble into insolvency and all the accumulated debt is written off and renounced.


From the ashes of the shadow State and shadow banking system's leverage, fraud, and exponential debt will arise the "cash is King, productivity is Queen" economy which favors productive labor and investment over parasitic capital and its partner, the Savior State.




If you would like to post a comment where others can read it, please go toDailyJava.net, (registering only takes a moment), select Of Two Minds-Charles Smith, and then go to The daily topic. To see other readers recent comments, go to New Posts.






Order Survival+: Structuring Prosperity for Yourself and the Nation and/or Survival+ The Primer from your local bookseller or from amazon.com or in ebook and Kindle formats.A 20% discount is available from the publisher.


Of Two Minds is now available via Kindle: Of Two Minds blog-Kindle



Thank you, Michael T. & Carrie P. ($20), for your much-appreciated generous donation to the site (and your book order)-- I am greatly honored by your support and readership. Thank you, Alex V. ($100), for your outrageously generous contribution to the site-- I am greatly honored by your support and readership.


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Wednesday, July 28, 2010

The Next Golden Age, Part I

The Next Golden Age will blossom without the burden of the Savior State and its Elites and fiefdoms.


I recently received this insightful challenge to address the positive future that potentially lies beyond devolution and collapse:

Good morning sir, I love your writing I read it everyday. You focus so much on the coming collapse and not at all the inevitable rebirth and the beginning of the next 80-year cycle. Would you spend some time speculating about the new golden age beginning in 2021 or so? Your glass half empty pessimism is sometime overwhelming.
Thank you,

Sgt C., U.S. Marines

Thank you, Sgt C., for suggesting the challenge of imagining not just collapse (all too easy) but a positive rebirth from the ashes of the present unsustainable status quo.


In a way, I've already tried to address this with my book Survival+, but with the focus on individual, household and community actions. What I will attempt in this occasional series is to describe future large-scale changes: financial, cultural and material.


1. The reduction of complexity and the end of marginal return. The chief characteristic of the U.S. economy and society is marginal return: ever-larger sums of money, energy, human effort, etc. are dumped into a "problem" while the return on that prodigious investment diminishes to less than zero.


The reasons are not complex: one is complexity itself, fed by entrenched fiefdoms protecting their payrolls and perquisites, the pernicious effects of the entitlement mentality and an organizational bureaucratic sclerosis which can be defined as a focus on process over results.


In the post-collapse-of-the-status-quo future, all the wasted motion will be lost. It will no longer be affordable, so it will go away.


Results will matter, process won't--the reverse of today's cultural worldview. Nowadays, by following procedure you CYA--protect yourself from criticism--and also evade responsibility for the outcome.


My favorite illustration of this may be apocryphal. Someone goes to Thomas Edison's laboratory and asks about the enterprise's regulations. "Regulations?" Edison is said to have retorted. "We're trying to get something done here." Precisely.


The ultimate luxury and waste is a CYA focus on procedure to avoid responsibility for poor results (or negative results). That luxury will be gone.


Let me illustrate the reduction in complexity and process with one example we can all relate to: going to the doctor. In the New Golden Age, everyone will pay for healthcare with cash. There may well be some limited forms of catastrophic coverage, but the entire mindset of entitlement ("healthcare is a right," etc.) will be gone.


You choose the doctor, and he/she agrees to offer care for a sum (just like in the "old Golden Era" of the 1950s). You receive the care/treatment, and then pay the doctor in cash or equivalent.


Currently, it is estimated 40% of the $1 trillion we spend on Medicare/Medicaid is squandered on shuffling paperwork/electronic files and fraud. Another 40% does not actually help the patient or is needless (defensive medicine, tests given for profit only, etc.). The opportunities for fraud in the sprawling bureaucracy are endless.


Now compare it to the Next Golden Age. Where is the opportunity for fraud when care is paid for in cash? A "bad check" slipped in lieu of real money? Perhaps, but in general the staggering waste and fraud of the current system vanishes.


How much of this transaction is "overhead," paper-shuffling, filing of insurance claims, arguing over who pays for what, etc.? Very little. If the doctor overcharges (i.e. charges more than other equivalent services) then his/her business will decline.


What about poor people who can't pay for care? In at least some cases, "poverty" is at root mismanagement, carelessness and perhaps a self-destructive worldview. These people will either learn to manage their money better or they will have to wait for whatever care is offered by charity.


In today's environment of Savior State entitlement, that sounds harsh. But the reality is the Savior State will implode or devolve to irrelevancy, regardless of whether your like it or not (see below for the inescapable reasons why).


Charity was and continues to be a vibrant, important part of American society. To belittle it as unequal to the task is to misunderstand the reality that the Savior State is unsustainable. The material wealth of the nation--the actual output--will be declining, and the Savior State, which only knows how to grow and wrest an ever larger share of the national income, will implode.


In the New Golden Age, our rights will be simple: life, liberty and the pursuit of happiness. The Savior State will have dissolved in insolvency or shrunk down to irrelevancy. There may be all sorts of entitlements offered and promised, but no one will be offering those services for free.


This reality will be familiar to those who have declared bankruptcy. Bankruptcy eliminates all the wasted motion in an organization; all the support staff, the layers of management, the meetings--all that disappears because there is no longer any money to sustain that wasted motion. In a household, the unsustainable mortgage, fancy car payments, etc. are all gone, and debt-serfdom has been thrown off.


The enterprise which emerges is stripped down to its productive core. If it isn't, then it will wither and go extinct. No group, enterprise or State can live beyond its real output for long. The U.S. has been using the artifice of its currency, the hegemony of the U.S. dollar, and its soaring borrowing, to paper over the yawning gap between what the nation produces and what it spends. Eventually, reality intrudes and spending declines to match output.


There is a great freedom of movement, purpose and innovation in a stripped-down enterprise. The bankruptcy blows off all the dead weight and sclerosis, the obsession with process/procedure and keeping up appearances. After a household, enterprise or nation loses its useless complexity, it can be energized by the freedom of no longer supporting the impossible burdens.


Indeed, the argument presented in the excellent book The Upside of Down: Catastrophe, Creativity, and the Renewal of Civilization is that productive people simply grow tired of supporting an economy suffering from terminal marginal return. Empires don't collapse as much as they are abandoned by the productive citizenry who must shoulder the rising burdens. At some point the "benefits" of Empire no longer outweigh the Empire's costs and constrictions.


2. The end of the entitlement mentality. Being entitled is taken as a wonderful thing in today's crumbling status quo, but upon examination we find that entitlement is intrinsically bound up with resentment and passivity/complicity. The act of feeling entitled brings with it a latent resentment: against others who may be getting more, and against the authorities who now wield power over the entitled.


If the Empire stripmines productive citizens and other lands, the entitled don't care; they are focused on "getting what's mine" and whatever evils and costs are perpetrated to obtain the swag that flows to the entitled are ignored, marginalized or dismissed as irrelevant.


Everyone wants something for free, but few seem to notice that whatever is given free is squandered, unappreciated, and endless demands for more soon follow.


The entitlement mentality is a prison of resentment, self-absorption and complicity in the "project" of enlarging the Central State and its Power Elites' share of the resources, output, wealth and income of the nation and the world.


One of the key benefits of the disappearance of the entitlement prison is that people will start realizing the benefits of believing they have something positive to contribute to their community and nation. That is a powerful self-affirming idea. People will begin to feel better about themselves.


Why will the Savior State implode/shrink to irrelevancy? Here are five inherent reasons which cannot be "solved" or massaged away:


A. The accident of favorable demographics goes away as the citizenry age. Endless entitlement paid by "somebody else" or future generations seemed plausible when there were 10 workers for every retiree. At two workers for every retiree, it is revealed as impossible. You cannot support 100 million retirees on the backs of 100 million workers, as well as a global Empire and various vast fiefdoms such as the National Security State-within-a-state, a parasitic shadow banking sector, etc.


B. Exponential growth cannot be sustained. The Savior State must grow by 3-5% annually while the economy will fluctuate around zero growth or even decline. Please go to Chris Martenson's site and view The Crash Course for the end result of exponential growth.


C. The hegemony of the U.S. dollar is not permanent. In the current status quo, the U.S. issues endless trillons of government bonds denominated in dollars, and the rest of the world is more or less beholden to accepting this phantom promise in exchange for real goods. Once the forward value of the promise is eroded, then this prop under America spending more than it makes will crumble.


D. The underlying economy produces goods and services worth a certain amount in dollars, gold, quatloos, oil or whatever measure you choose. The status quo requires that the nation spend trillions of dollars more than the nation's output to support the Savior State, its Elites/fiefdoms and its global Empire. At some point gravity will take precedence over fantasy and the nation will have to live within its means. The Savior State already requires 11-12% of the GDP be borrowed every year to maintain the flow of swag/redistribution of the nation's income to favored hands. That percentage will rise as the underlying economy devolves and "the end of work" shrinks the taxpaying workforce.


E. The entire project of the Savior State was dependent on cheap, abundant energy. When that goes away, so does the Savior State.


What replaces the Savior State? Nothing. There may well be a Central State devoted to smaller, less complex projects such as national defense (as opposed to global Empire), but the Savior State which sends checks to 100 million citizens and supports vast complex systems like Medicare will no longer function.


Most people seem to feel the implosion of the Savior State is something to dread, yet the nation survived quite well without a Savior State or global Empire circa 1781-1941. The Savior State only arose because of three specific circumstances: favorable demographics, World War II and the vast supply of oil which happened to exist within the national borders. Its passing cannot be stopped so why mourn it?


In losing the false god of the Savior State, we will turn once again to community for security, to productive focus on results rather than procedure, and on resilience rather than exploitation.


Sgt C., I apologize for not replying, but I am too cheap to pay $20 for a digital signature--please use an unsecured email system to email me next time. Thank you.




If you would like to post a comment where others can read it, please go toDailyJava.net, (registering only takes a moment), select Of Two Minds-Charles Smith, and then go to The daily topic. To see other readers recent comments, go to New Posts.





Order Survival+: Structuring Prosperity for Yourself and the Nation and/or Survival+ The Primer from your local bookseller or from amazon.com or in ebook and Kindle formats.A 20% discount is available from the publisher.


Of Two Minds is now available via Kindle: Of Two Minds blog-Kindle



Thank you, Douglas C. ($50), for your fabulously generous donation to the site-- I am greatly honored by your support and readership. Thank you, Joe H. ($100), for your magnificient financial contribution to the site--and for your many intellectual contributions. I am greatly honored by your support and readership.


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Tuesday, July 27, 2010

Natural Selection, Finance and Extinction

The current U.S. financial sector has been selected to reap enormous profits off a very narrow ecology of speculation, credit, risk and leverage. That parasitic specialization makes it highly vulnerable to extinction.


One of my projects is to integrate the insights offered by the processes of natural selection into the Survival+ critique and recommendations.


This line of inquiry has led me to ask: is the current financial system as robust and resilient as its many backers claim, or beneath the hype and propaganda, is it actually acutely vulnerable to collapse?


From the point of view of selection, we would start by considering the ecology the system has evolved in, and ask how specialized the system has become--in other words, how dependent is the financial system on narrow and potentially vulnerable sources of energy?


In nature, species which go extinct often do so when they have become increasingly specialized to exploit a narrow source of sustenance. Such species evolve that specialization in order to exploit the windfall offered by a food supply that has fewer (or even no) competitors.


This lack of competition offers the species rich rewards for specializing (long beaks maximized to fit certain flowers, etc.) even as they increase the species' vulnerability to a breakdown or collapse in the limited source of food they have been selected to exploit.


The narrower the base of food and the greater the specialization, the more vulnerable the species will be to reductions in that food source. Thus a plant disease which wipes out the specific flowers will drive the bird with a highly specialized beak to extinction unless it can adapt quickly enough to another food source, or leave that ecology for one with a new source of similar flowers.


The U.S. financial system has already exploited the standard ecologies of capital and lending. How profitable is originating and holding plain-vanilla mortgages? Not very profitable at all, compared to the vast profits generated by securitizing mortgages and writing derivatives against those bundled and tranched loans.


The U.S. financial system in effect stumbled into a new ecology of profitable windfalls that no one else had ever seen or exploited: extremes of leverage and securitization were not just possible in this new environment, they were rewarded with vast profits.


It seems to me that the U.S. financial system, dominated by highly profitable money-center and investment banks, is akin to a species which has adapted to exploit a very specific ecology of finance: a world in which leverage is unlimited, and assets, liabilities and risks can be gamed and cloaked in a "shadow banking system" free from competition and interference.


But unbeknownst to the members gorging on the windfall exploitation of this newly discovered "financial innovation" ecology, the system had become precariously dependent on ever-rising leverage, securitization, credit expansion and the "shadow banking system" which enabled this exploitation.


Were this ecology to collapse, so too would the financial system which had become dangerously dependent on this source of profits.


It seems that is one way to describe precisely what happened in 2007-2008 when the system's source of profits--the highly specialized ecology of ever-rising credit, leverage and derivatives--collapsed.


The old environment of originating mortgages and business loans with modest margins is full of competition and thus not very profitable; there is no way for the U.S. financial system to reap the kinds of staggering profits it has become accustomed to from "old style" banking, credit creation and lending.


Thus the Central State's political leaders are trying desperately to do the impossible: to limit the opportunities for profitable windfall exploitation without undermining the entire narrow financial ecology upon which all the sector's huge profits depend.


Exquisitely sensitive to the possibility that limiting the sources of profit--the shadow banking system, the leverage, the derivatives--might end up killing off the highly specialized species of finance which feeds their re-election campaigns, the politicos have engaged in a convoluted facsimile of reform which leaves the ecology open for exploitation by money-center and investment banks even as it attempts to rein in the most extreme exploitation.


But the foundation of the financial sector's gigantic profits are not broad--they are very narrow. The financial sector does not depend on the sprawling U.S. economy for most of its profits--it depends on a narrow slice of fecund financial territory that would wither under transparency and strict regulation.


The irony is that State manipulation and a studied lack of oversight enabled the blossoming of this highly specialized species of profit, and now State manipulation threatens to undermine it.


But Nature itself may foil the plans of both the supremely specialized financial sector and its State toadies. The financial sector is now so specialized and so dependent on dwindling sources of profit that even State manipulation cannot broaden its withering supply of financial fodder.


The financial system cannot go back to the slow-growth, unleveraged transparent financial environment and retain its vast profits. So as it clings to the dwindling ecology of leverage, risk and shadow banking, the system is selecting itself for extinction.


Given its parasitic, predatory nature and the little value it adds to the real economy, that extinction of the shadow banking system would be a highly positive prospect for everyone but the parasites themselves, who can always choose to become lower-paid bankers doing traditional, transparent low-profit banking.




If you would like to post a comment where others can read it, please go toDailyJava.net, (registering only takes a moment), select Of Two Minds-Charles Smith, and then go to The daily topic. To see other readers recent comments, go to New Posts.





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Monday, July 26, 2010

Things Fall Apart: But Not Just Yet

Even as the global financial system becomes ever more fragile and vulnerable to distruption, feedback loops will maintain the Status Quo for awhile longer.


The best analogy to describe the global financial system may well be "skating on thin ice." Despite all the "fixes" and "reforms," the ice continues thinning for a variety of reasons which are not fixable in the current State/Plutocracy-dominated Status Quo: massive overindebtedness, both public and private, and a declining ability to service that ever-rising debt.


Thus it is natural for many observers to see the current crisis-du-jour (Gulf oil well blowout, China's real estate bubble, sovereign debt/banking insolvency in Europe, etc.) as the "straw that will break the camel's back," that is, the crisis which will trigger a phase transition or tipping point to the global collapse which is already inevitable: demographics, exponential debt and resource depletion all render the status quo Neoliberal Capitalist Globalized system unsustainable.


The concepts of phase transition and the related "stick-slip hypothesis" play key parts in the Survival+ critique, as they describe the process of a system reaching a "critical point": the sand pile suddenly cascades, tectonic plates shift, causing an earthquake, or the buying of bundled debt (such as mortgage-backed securities) suddenly drops to near-zero.


But other forces are constantly striving to maintain the Status Quo, and as such they resist the dynamics pressing the global financial system to the breaking point. These are negative feedback loops, and the major Central States have deployed powerful monetary and political tools to stave off collapse.


Here is a diagram of a positive feedback loop in which recession reduces housing equity which then further reinforces recession, which further depresses housing, and so on:



This chart illustrates how capital declines feed additional declines:



At the critical point, the positive feedback overwhelms the negative feedback and a death spiral ensues. This diagram charts how raising taxes in a contracting economy to feed public unions and other tax-dependent fiefdoms creates a "death spiral" which ends in the bankruptcy of local government.



But the last two years have shown how those with enormous stakes in maintaining the Status Quo have thrown all their resources into staving off or deflecting the crises. The Full-Spectrum Defense of the Status Quo is generally a facsmile of reform, a facade of "change" heralded as the "fix" to all our most pressing problems, or merely propaganda, i.e. a travesty of a mockery of a sham.


Nonetheless, we would do well not to underestimate the tenaciousness and reserves of those benefiting from the Status Quo, or the depth of their commitment to doing whatever it takes to defend their perquisites and power.


But in addition to feedback loops, there are also long-wave cycles which have tended to play out over history. Nothing is written in stone, of course, except the endless repetition of human folly, and thus those who dismiss all cycles as mesaningless do so at their peril.


This chart from Weblogs & New Media: Marketing in Crisis illustrates four primary cycles which are set to coincide in the 2010-2022 time frame:


1. The 80-year ( four-generation) cycle of U.S. history--a major transformative crisis occurs about every 80 years (1781, 1861, 1941, 2021), as described in The Fourth Turning.


2. The Fisher wage stagnation/price inflation cycle documented by David Hackett Fischer in The Great Wave: Price Revolutions and the Rhythm of History; (no precise length, but wages have stagnated and prices have been rising since the early 1970s)


3. The credit expansion/bubble-bust cycle (i.e. the Kondratieff cycle)


4. The depletion of oil and other non-renewable resources (lithium, uranium, etc.; see The Long Emergency: Surviving the End of Oil, Climate Change, and Other Converging Catastrophes of the Twenty-First Century and Financial Armageddon: Protecting Your Future from Four Impending Catastrophes)


As a lagniappe, there is fifth cycle possibility conjectured by Elliott Wave Theory, the Grand Supercycle (not shown), the last of which led to the 1720 South Sea Bubble collapsing and a 50-year long depression, and a sixth relating to warfare, as wars also tend to cycle, as shown in The Rhythm of War (recommended).



As an example of how Status Quo resistance/feedback loops can lengthen the unsustainable longer than seems possible: many of us knew housing was in massive bubble as early as late 2003, yet the bubble continued expanding for over 3 years, finally popping in early 2007. The insolvent black hole known as Fannie Mae continued sporting a share of price of $65-$70, even as its obvious value was near-zero. (I know, because I lost a lot of money betting that the supposedly infallible "market" would eventually pole-axe the fraudulent Fannie's share price. The value of Fannie's shares didn't fall until the entire house of cards was in full-blown collapse.)


Thus I fully expect the U.S. Central State to continue borrowing and squandering $1.5 trillion a year to maintain the Status Quo and the American Empire, with few if any visible consequences, as the Chinese Central State and other exporting nations will desperately continue propping up low interest rates to keep their mercantilist fantasies (that the U.S. will continue to be the dumping ground for the world's massive oversupply of exports) alive for another year.


The Fed will persist in its manipulations and machinations to prop up the housing market and the stock market, as those facades are the critical elements in the propaganda campaign to convince the fast-crumbling middle-class that all is well and the Plutocracy is not only firmly in charge, but it's doing a darned fine job of it.


But the heat of insolvency is not dissipating, as much as it is merely being cloaked; the ice is thinning every day, and the global financial system is becoming more brittle, more fragile, more vulnerable, more unstable and less resilient. Meanwhile, obfuscation, misdirection, and outright propaganda have been normalized as "news," the illegitimate (shadow banking, shadow National Security State, etc.) have been legitimized and those who challenge the Status Quo or act as whistleblowers are quickly discredited or marginalized.


My best guess: the wheels won't really fall off the wobbly global cart until 2012-2013, with the possibility that it all hangs together (against ever-longer odds) until 2014. After a near-collapse experience, things will seem to improve for a few years, setting up the real collapse in the 2020-2022 time frame. Just a guess...to be revised as events unfold.




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Saturday, July 24, 2010

Four Factors Affecting Millennials (and the rest of us)

Correspondent Charles M. illuminates four primary factors affecting the Millennial Generation.


I have been covering Millennial and other generational issues from the very inception of this weblog. To note but two:


Boomers, Prepare to Fall on Your Swords (June 2005)


Trends for 2009: Generational Optimism (January 5, 2009)


Correspondent Charles M. read one of the more recent entries, An Open Letter to the Millennials/Gen-Y, and responded with an excellent overview of four related factors which are generally left unaddressed.

First, let me say that I enjoy reading your blog, and couldn't agree more with many of its points. I've found them to be quite elucidating on many levels, and often parallel my own ponderings on modern economics.

I was taking a break from writing my PhD thesis and read a number of recent posts today, one being An Open Letter to the Millennials/Gen-Y: Where Are You? (June 23, 2010). I have some thoughts I'd like to share regarding Gen Y as to possibly why we don't see the heroics or leadership you noted of your friends and in general for previous generations.



1) Everyone's a terrorist. Post 9/11 I have watched as the U.S. created the biggest scapegoat in all history, and has used the fearmongering to justify ridiculous expansions of government power, massive unchecked increases in military spending, and the creation of the incompetent DHS/TSA. Remember in your younger days how high school students could stage a good old-fashioned prank and get everybody laughing, despite probably causing grief to some people? Nowadays, kids of Gen Y who do similar things are sent to jail (or at least strongly threatened with it) -- sometimes under the guise of anti-terrorism laws (a stink bomb would be labeled a terrorist weapon).


The heroics you mention regarding your lifelong friends would have been classified as terrorism in today's world. A quick review of Russian history under Lenin and Stalin would show the alarming parallels. Simply threaten the masses with strict criminal penalties, make very public examples of a few people, and you will get complacent and orderly people who will not do anything heroic.


2) Some of this push to silence the masses began well before Gen Y. I'm part of Gen X, and I distinctly remember with disgust how the 9th/10th grade campus of my high school was built like a fortress which had large sliding metal gates that were used to lock the kids in during the day. It was almost as if it was indoctrination to prison life. However, this high school was not located in a violent area -- just a normal suburb. Fortunately, I found a loophole by which I could get out for part of the day, as my drama class was held on the 11th/12th grade campus, which was nice and open. I grew up during the time when the "get tough on crime" movement gained much of its momentum.


It's the same thing as #1 above, but it was its precedent: labeling normal human behavior as criminal and maximizing the penalties (3 strikes, etc.). There was little focus on actual rehabilitation and self reflection at the society level. I'm sure there are larger examples that better highlight this point.


3) Make everyone too busy to get involved. This is another trend I've seen in the U.S. The 40-hour workweek has gone from being full-time to being nearly considered part-time. Most people I encountered during my 10 years of corporate employment worked 50 hours a week or more (it's a far different argument for self-employed, as they directly reap the benefits of all the extra work, in good years and bad). I lived in Dallas, and saw how numerous people thought nothing of spending 10 or more hours per week commuting between work and home. The average workday for most people begins with getting up at 5:30-6 a.m.; out the door by 6:30-7; arriving at their desks around 7:30-8; then leaving work around 5:30-6 p.m.; arriving back home by 7; eating dinner around 8; then going to bed by 10. There's little free time during the week under that kind of schedule, and the weekend is often when the accumulated chores get done. Under such a schedule, there is certainly no time to thoroughly research political candidates, dig up scientific information on consumer products, attend local council meetings, pick fresh food from a local farm, etc.


Information gets reduced to simple soundbites because that is all people have time to digest. From Gen Y's perspective, if this is all the information that older generations base weighty decisions on, why should they pick up any more information themselves? The older generations have shown Gen Y that life is meant to be a rat race of massive consumerism -- yet Gen Y sees that there are no rewards in overworking (today the company appreciates you, tomorrow you are laid off), so escapism (Facebook and so on) becomes an outlet.


4) Opportunities have been stripped down. I read a recent article in the NY Times about good opportunities being elusive for Gen Y (American Dream Is Elusive for New Generation). The article seemed to focus on the young kid's expectations against the success of other members of his family -- but I couldn't help but notice the details of the father and grandfather. The grandfather had no training as a stockbroker, yet after WW2, got directly hired by a friend's father and trained on the job. Nowadays, one couldn't even get a call in for an interview without full pre-existing qualifications. The father walked into a manufacturing job and became a manager.


Had either of those men been put into today's job market, they would discover the "I can learn, give me a chance" air of optimism just doesn't cut it. Even though I grew up learning that same attitude from my family, it never once got me a job.


As I am finishing my PhD and re-entering the workforce, I am encountering the same situation in my new career field. I left a 10-year career in I.T. because despite working hard to acquire new skills and performing well in each job I had, year after year I got the same sob story during my performance reviews. Money was tight (and this was well before Recession '08!), we just had to lay off a few people, here's more responsibilities to add to your job, and we have managed to be able to give you a 2% raise. Meanwhile, I knew how to read financial statements and could see the companies I was at actually performed rather well during those years, and the executives had all kinds of fantastic perks on top of 6-figure bonuses.


On a different level, I saw the same thing you have pointed out in your posts about the reshuffling of wealth in ways that rob the peasants blindly. As my salary had not grown at all during my 10 years in I.T., I could see the writing on the wall -- it simply wasn't going to grow no matter what work ethic I had. I embarked on a career change to become a scientist. In my ignorance of the post-doc market, though, I did not realize that there was a glut of PhDs in the U.S., enough to reduce post-doc salaries down to the mid $30s.


In generations past, one would be expected to get a PhD, work for a couple of years in a post-doc position, then accept a tenure-track position at a university and have a career for life. That, too, is no longer the case. Many people are now doing post-docs for 5 years or more.


So those are my main points that I think tie in to the discussion on Gen Y (hopefully I haven't rambled too terribly). As the world becomes more complex, mobility significantly decreases. Most any job ad nowadays lists very specific skills sought in applicants. Those whose skills do not match that specific list don't stand a chance, whether it be I.T., finance, or science. I don't think there is any non-scam job offer posted anywhere that simply states, "job with decent pay looking for hard-working individuals, willing to train."


Gen Y is going to have to be far more creative to find job opportunities as rewarding as what previous generations enjoyed. Nobody wants to keep looking over their shoulder for the next layoff or a company's imminent collapse due to reckless management. At the same time, if one goes through the trouble of gaining skills to fit a particular job, in the time it takes to get those skills, they or the job could become obsolete. Everything in today's world moves quickly -- but there is no royal road to learning. University education now carries with it far more risk (debt, in particular, but wasted time also).


About me: I have a bachelor's in Russian (great subject to study -- absolutely useless in the job market), a master's in applied physics, and am completing a PhD in chemistry (materials science). I have been to Russia 3 times, once for an extended period of 5 months. My 10 years in I.T. (even surviving the dot-com bust) was due to self-taught programming skills I acquired over the years, and I continued working full time in I.T. while pursuing my master's degree in the evenings.


I am getting my PhD in Australia, because I could not get anything that amounted to a decent scholarship in the U.S. At the university where I got my master's, I could have received a PhD stipend of $13K/year, and the mandated student insurance would have eaten $600/month. Just as with the dismal job market I dropped out of, I refused to play the losing end of such an economic game. Once I am done with my PhD, my wife and I will be moving permanently to Canada so that we will continue to have time to enjoy life and our families.

Thank you, Charles, for an insightful commentary. I would add these comments:


1. These trends also affect the other generations as well. Boomers and Gen-X have to be just as wary of challenging authority or the Ruling Elite as Gen-Y. In general, the less entrenched/dependent you are on the Powers That Be and their institutions/cartels, the more freedom you have to challenge mainstream orthodoxies.


2. Gen-Y, like previous generations, in being enticed to join the Ruling Elite: question nothing, accept the Status Quo, and maybe you'll be granted the security of a plump position in the shadow State or shadow financial sector. As alternatives dwindle, then the implicit pressure to game the system and become complicit grows ever more persuasive. Correspondent Chad D. sent me this essay which I recommend as a refreshing look at the Power Elites and the technocratic Upper Caste which enforces their rule: America's Ruling Class -- And the Perils of Revolution.


3. As I suggested in "National Security:" A Global Police State-Within-a-State, the "shadow government" and its private sector partner, the shadow banking/financial system, have poisoned the entire culture: resistance is either "domestic terrorism" or delegitimized, etc.


4. The government sells its control of the economy and every aspect of civil life as the solution to all problems: no matter what the issue, the solution is always more government control and a greater share of the dwindling national income being diverted to, and redistributed by, government and its Power Elite cartel contractors.


5. Regardless of one's age or generation, the first step to is to avoid becoming a debt-serf who is then beholden to the government and its 3,000-page statutes controlling payment of debt and other obligations to its Fiefdoms and favored private-sector cartels.


A high cost structure based on ever-rising debt forces participants into the killing lifestyle Charles M. describes: killing levels of debt, servitude to corporations or the government in order to "afford" "the good life" funded by debt, complicity in global Empire and rule by the Plutocracy lest you lose your share of the State/cartel swag, and the destruction of family life via long commutes, constant overtime, medication-nation "fixes" for a very natural alienation from what passes for "lifestyle" in the U.S., the attractions of distractions via 24/7 "entertainment" and social media, etc.


6. When sacrifice, trade-offs and accountability are anathema, then so too is liberty.


All of this flows from the Survival+ critique.






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Friday, July 23, 2010

No Wonder Home Sales Are Plummeting: Look Who Was Buying

We need look no further than the temporary nature of recent buying in residential housing to understand why that buying has dried up.


The reason buyers have become scarce in housing is simple: the three pools of buyers which drove recent sales are drying up.



The cliché has it that "all real estate is local," and while that is certainly true in a broad-brush way, it's equally true that some trends cut across local and even regional markets. Though some of the evidence is anecdotal, the national market appears to be subdivided into three categories of buyers:


--Middle-income households who took advantage of the Federal tax credits to buy homes in good neighborhoods at prices under the FHA ceilings for conventional loans.


--"Bottom fisher" investors who snapped up distressed properties for cash.


--Overseas investors seeking to put their capital to work in distressed U.S. real estate.


The price and sales spike was driven by supply and demand: an artifically low supply (a vast shadow inventory was held off market) was snapped up by buyers seeking to exploit a one-time credit and/or "bargain prices" set by massive numbers of foreclosures.


High-value, high-demand locales saw substantial spikes in price while lower-value areas (with high unemployment and low wealth creation) saw prices continue their slide.


This is supported by the latest S&P Shiller-Case Index, which found that prices in San Francisco have risen 18 percent while home values in hard-hit Las Vegas are still declining.


Analysis of sales by zip codes and price levels by Doctor Housing Bubble found that sales in areas with prices below the FHA conventional loan caps—$271,050 in many parts of the country and as high as $729,750 in pricey zip codes—rose sharply between January and May 2010 as buyers took advantage of Federal tax credits.


Homes priced well above the FHA guidelines that require hefty down payments and jumbo mortgages are not doing as well. Indeed, the percentage of seriously delinquent $1 million-plus loans rose to 13.3% in February, 50% higher than the 8.6% overall delinquency rate.


While sales have surged in lower priced homes in desirable areas such as San Diego--inventory fell to a mere 2.6 months earlier this year--higher end homes are languishing: it would take 12 months to move the homes above $1 million at current sales rates in san Diego county, and three years to unload the inventory of homes above $2 million.


Cash buyers--a code-phrase for investors rather than regular home buyers--accounted for fully 30% of all sales in the huge Southern California metropolitan market in February of this year. Cash buyers have driven up prices in beaten-down markets such as San Diego by up to 14%.


Much of this cash buying has centered on foreclosed properties--REOs (real estate owned) in real estate parlance. In the first quarter of 2010, sales of REOs accounted for fully 31% of all residential sales.


To put that in context: there were 1.2 million foreclosure sales in 2009, more than 25 times the amount logged just four years earlier in 2005 at the top of the housing bubble.


Ironically, as prices rise in response to this investor demand, the number of "bargains" available diminishes.


What remains to be seen is if these cash buyers plan on "flipping" their investments for a quick profit--a plan which depends on prices continue to rise and inventory staying modest--or hold them as rentals.


According to reports from heavily-discounted markets such as Miami, foreign investors are still buying condos for cash. Condos which once fetched $190,000 can be had for $75,000 to $100,000, and European-based buyer Leroy Jean Francois bought 47 condos this year alone for clients in France and Switzerland.


Going forward, the question "What happens to home sales after the tax credit ends?" has been definitively answered: they tank.


Now that the euro has fallen from 1.60 to 1.25-1.30, it remains to be seen if that 20% increase in the cost of everything priced in dollars (such as Miami condos) will cool off foreign buying of U.S. real estate.


As for cash-heavy American bottom-fishers: that pool is not unlimited, and now that prices and sales are receding once again, there will be fewer investors betting for quick profits from flipping foreclosed houses.


Investors who bought homes to rent out will soon find (if they haven't already) that generating positive cash flow from rentals isn't as easy as they might have thought.


If all three pools of buyers are shrinking, then what new cash-rich cadre will appear to pick up the slack? There is precious little evidence that millions of qualified buyers are gearing up to buy the hundreds of thousands of U.S. homes and flats sitting on the market or languishing in the shadow inventory.




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Thursday, July 22, 2010

Facebook Is a Utility Which Can't Charge Its Users

Facebook will never be very profitable, for it is a utility which will never be able to charge its users. Its free functions are more valuable to marketers than its advertising, hence it will never generate big ad revenues.


Why am I not surprised to read that Facebook has the same customer satisfaction ratings as hated cable providers and the I.R.S.?

A new study by ForeSee Results and the American Customer Satisfaction Index finds that U.S. consumers regard social media sites Facebook and Myspace as lowly as they regard cable providers, airlines and the I.R.S.

Facebook is in essence a utility like cable providers, but with one important difference: it can't charge its users. Users view Facebook as a free utility, and tolerate it because it's free.


Even global corporations prefer its free functions to actually paying for adverts. In a dynamic peculiar to the Web, Facebook's very ubiquity as a platform for free marketing and networking make those features much more powerful than paid advertising. Thus advertisers will inevitably be drawn into exploiting the free aspects of Facebook rather than pay a premium for adverts which are ignored.



The big hype in social media is exploiting the trust implicit in "friending" for profit. This will degrade the very trust the marketing seeks to exploit. So not only is Facebook unable to charge its users or charge a premium for adverts when its free services are so much cheaper and more effective, the "platform" itself will intevitably be degraded by the relentless counterfeiting of "friends," "likes," etc. which have created its supposed "value" as a platform.


As the chart above illustrates, most Web users disregard banner adverts, and this poses a problem to both the social media companies and their potential advertisers: how can they break through the marketing clutter which most users tune out? If social media companies fail to offer adverts which actually work for their advertisers, then they won't be able to charge premium rates for ads.


Facebook collects significant revenues from purveyors of online services and games such as Zynga's FarmVille, but the big money is in advertising--a field that both Twitter and Facebook are still exploring.


Facebook is attempting to make use of its vast user base in tailoring ads which are not just contextual to the content but to their social context.


When somebody writes about their mortgage on their blog or Facebook page, then the search engine will place an advert for mortgage rates on that page: that's contextual placement.


The social-context ads, which Facebook introduced about a year ago, are based on data it collects on the "likes" and networks of friends of its users. These social-context adverts appear on the right side of a user's homepage, and along with the ads are the names of any of the user's friends who previously clicked that they like the brand or advert being displayed. Users can then click a button to add their "like" to the ad or brand.


The basic idea is to enable the gold standard of marketing: word-of-mouth. Despite all the studies, metrics, and innovations, successful marketing campaigns are still largely based on good old word-of-mouth. Thus the hope for social media companies and their advertiser alike is that the global networks of friends and colleagues assembled in Twitter, Facebook and other social media leaders can be used to spark successful word-of-mouth campaigns.


Two challenges have emerged to this "stimulate word of mouth" strategy: one is the inherent ambiguities in tracking the effectiveness of any such campaign, and the second is that marketers and promoters are busy exploiting the trust and loyalty which are the foundations of social networks.


The metrics of online media is so important to the Web that an industry has arisen to fulfill that mission, and a professional conference, the International Conference on Online Media Measurement, was recently held in Lisbon, Spain.


One attendee was David Tiltman, a journalist who has covered the field for years. Tiltman concluded that the industry has no standard metric to measure "buzz" (word-of-mouth) or effectiveness and thus advertisers are bombarded with terms such as "engagement" and "conversation" rather than meaningful metrics.


A number of companies have sprung up to measure the "buzz" created by ad campaigns on social networks. According to Tiltman, "When one delegate asked five different word-of-mouth measurement companies to track his Superbowl ad, he got five different responses. These services sell themselves as tracking tools, but actually they are hugely reliant on human input to categorize brand mentions on social media."


In other words, counting friends or clicks is not a very useful metric.


Canny marketers are also busy inserting counterfeit "friends" and product placement into social networks, undermining the very trust they seek to exploit.


One way marketers seek to influence social network users is to inflate the number of "friends" and Twitter followers by purchasing thousands of friends and followers online.


They also deploy Sponsored Tweets and paid referrals—users are paid to re-tweet Tweets promoting some brand or advert—to create what is in effect a fake word-of-mouth campaign that will supposedly ignite a real word-of-mouth buzz.


This dilution and exploitation of social networks may well cause users not to trust any marketing they see on social networks, which would lower the value of social media to advertisers and marketers.


Tiltman described a conversation with a big-name advertising client who was wary of such a metric-free, easy-to-game environment: "Without a proper currency online that allows some sort of comparison between media, he cannot advise heavy spend in digital."


Companies deciding between traditional advertising campaigns which funnel revenue to the social media companies like Facebook and "viral" word-of-mouth campaigns waged via Tweets and inserting product placement in conversations between friends have little to go on.


"It fundamentally comes down to why people are there on social networks. They are not there to read our ads. They are there to talk to each other," says Scott Monty, the respected head of social media at Ford Motor Company.


Rather than spend millions on traditional ad campaigns displayed on Facebook, Ford uses the site's free options to assemble networks of fans who share photos and stories about their Ford vehicles online.


The net result: potential advertisers will simply use the free tools these networks offer to market their products and services, leaving the social-media companies with little big-dollar advertising.


Bottom line: Social media may be wildly popular but never wildly profitable.


If you would like to post a comment where others can read it, please go toDailyJava.net, (registering only takes a moment), select Of Two Minds-Charles Smith, and then go to The daily topic. To see other readers recent comments, go to New Posts.





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