Thursday, March 25, 2010

The Foundation of Economies

I’ve been talking a lot to people lately about the rule of law and how important it is to the foundation of our economy. It is THE critical element, without it, no functional economy. You can have massive human and natural resources, but without the rule of law, you will not have capital formation and you will not have an economy that works.

The basis of a functioning economy is a rule not of man, but of nature. It is natural because man can attempt to manipulate or bypass the process, but man will lose every time they stray outside of the rules. The same rules win out every time they are tested, just like gravity. The basis of economies are ruled by the same rules of mathematics and of physics, it is bound and limited in its construct by both. Create a system that is not harmonious with those bounds and well… welcome to exponential math and the limits of the physical world.

Sometimes when what you’re doing isn’t working, it’s best to get back to the basics. Allow me to start with a most fundamental concept, one that many people are aware of but may not be able to verbalize real well. I call it BE – DO – HAVE. The concept is simple. In order to have, you must first BE, then DO… THEN you can HAVE. Take, for example, the lotto winner. They skip right over BE and DO and proceed straight to HAVE. This is what people are attempting to do every time they gamble, every time they buy that ticket at the 7-11.

And what happens to those lucky enough to win, do they hold onto their wealth? Of course not, they failed to first BE and then DO. Thus they do not HAVE for very long.

My point? The same thing is true for nations. This is the root of socialism and WHY it is not harmonious with nature. Sharing the wealth destroys work ethics, it undermines BE and DO. It is an attempt to HAVE from the efforts of others. I was in the Soviet Union at the height of the cold war, I saw the lack of work ethic first hand. I saw how it impeded the progression of mankind – it was like stepping back in time 50 years or more. Innovation? Forget it. Security? No way. Freedom? Hardly.

Of course Plutocracy, rule by the rich, is hardly efficient at advancing humankind either. That doesn’t work because it too eventually destroys work ethic, serfs and slaves forced to give away all their productive efforts will eventually give up.

A Dictatorship, Mr. Chavez, is also an attempt to proceed directly to HAVE while skipping over BE and DO. This is why dictatorships do not last; they too are not harmonious with nature.

So let’s take a look at the basis of a healthy and functioning economic system, one that is built upon a solid foundation.

Pyramid of national wealth:



Note that the first bricks of the foundation are built upon the rule of law. They are not built upon money and they are not built upon human or natural resources. The rule of law comes FIRST, without it the others are meaningless.

If you attempt to head straight to wealth, you are skipping over BE and DO. This is the current method, it is top down, not bottom up. This is why money printing fails, it is not real wealth, and it is the “solution” being offered. It is destined to fail in exactly the same way that the gambler is destined to die broke.

Think that our nation can just go straight to creating jobs? Never happen, will never work without first starting at the foundation and building your way up to it. Think you know the answer to job creation? Build this project, build that project? If you think that you can just fire up job creation, you are mistaken.

Large projects and infrastructure building, real wealth, cannot be stolen, it cannot be dictated. In order to create jobs, the rule of law must be in place, a system of exchange and way of providing capital must work, there must be human resources at the appropriate level, there must be natural resources available, and THEN you can HAVE jobs that build wealth.

THE RULE OF LAW:

The rule of law is necessary FIRST because without it capital will not be formed, it is not attracted, it will not concentrate. Would you give your money to Hugo Chavez as an “investment?” Would you lend your money to someone who is constantly changing the rules of the game? Would you put your money to work by giving it to a lazy person with no work ethic? Would you lend your money to someone who spends three times what they earn?

NO? Neither would I. Capital, you see, is free to come and go as it pleases, it is a part of nature and it cannot be contained, not in the long run.

Lawmakers skipping over and creating new procedures to pass healthcare? Is that the Rule of Law? Bailing out bankrupt companies, is that the Rule of Law? TARP, Quantitative Easing, Mark to Fantasy accounting, government buying of mortgage paper, are those the things that comprise the rule of law? Private individuals charging people interest to use their own money system, is that the Rule of Law?

These things are gouging huge holes in the foundation of our economy. They are causing capital to flee. This is a part of why so many do not have jobs, and why we are becoming less wealthy as a nation. It begins at the foundation. Who is responsible for maintaining the rule of law, the foundation? It is WE the People.

MONEY/ EXCHANGE SYSTEMS:

Money and exchange systems are necessary to provide working capital. Want to build a nuclear power plant? Where’s the capital coming from? Capital concentration is completely necessary to the advancement of human kind. A person and his capital can accomplish little things. Combine capital with several partners and you have the basis to accomplish something greater – the core of a simple partnership or business.

Want to send wooden sailing ships across the ocean without risking ALL your capital? Better have some limited liability, the foundation of corporations and the next level of capital formation that was necessary to advance humankind.

Want to accomplish something larger than is capable by a corporation? You will need capital that is directed and formed by government. That capital, however, will not last long if it is manufactured or not formed in accordance with the rule of law.



Let’s go back and visit the way in which capital is free. You may recall from the following diagram from my article Asset Classes and Capital Flow…



There are 5 principal asset classes:

1. Currencies – for capital to flow from one asset to another, it must first be exchanged for currency.

2. DEBT – Debt, because our money is backed by debt, it is as large an asset class as currency. Yes, debt, although likely a liability to you is an asset to someone else. An asset to someone, like say, the central bank who issues an instrument of debt when YOUR money is created.


3. Equities – Providing working capital for corporations is an essential process for capital formation. This is, in case you have forgotten, the reason that we have stock markets. No, they do not exist for the pleasure of market makers, quants, banks, or gamblers in derivatives.

4. Real Estate – Sections of the earth. Under our current rule of law, by the way, you don’t really own, you rent.

5. Commodities – Things of the earth.

It’s a fascinating study watching money pour from one asset class to another. The equity bubble in technology leading up to the year 2000… pop, into currency, into real estate… pop, into DEBT, pop… and now which asset class do you see capital flowing to?

New home construction lowest level on record. No, not there, keep looking. Meanwhile, with each cycle the DEBT piles higher, our money system adds on another three zeros. We are forgetting the basics, it’s time to head back to the fundamentals.