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Economic Battleground A Fish Story Part 1

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1 Economic Battleground A Fish Story Part 1
By John P. Bott, II

2 Full service Houston-based brokerage firm founded in 1986
Fixed income specialists Success is built upon long-standing client relationships based on trust, honesty, and quality service

3 John P. Bott, II Chairman of Tri-Star Financial
GP of Parallax Investments, GP& CIO of Parallax Capital Partners, LP Hedge fund and Portfolio Manager of Parallax Investments

4 The talking points, ideas and images for this presentation come from the book “How An Economy Grows And Why It Crashes” by Peter Schiff.

5 Keynesian Economics vs. Austrian Economics
John Maynard Keynes Carl Menger and Ludwig von Mises Government Intervention Free Markets Fiat Currency Gold Standard Debt Savings Consumption Investment Bailouts Let Inefficient Companies Fail

6 Keynesian Economics is generally the more popular school of thought
Keynesian Economics is generally the more popular school of thought. Why? Individuals like it because they get to avoid the pain and difficulty of a more serious recession or bust cycle. Politicians like it because they can promise to increase employment and boost economic growth without necessarily raising taxes. Financial Institutions like it because they can make a larger spread with easy money and lower interest rates. Educational Institutions began teaching Keynesian economics because that is what employers preferred.

7 An Idea Is Born Able, Baker and Charlie lived alone on a desolate island with only fish to eat. One fish would feed one man for a day, however because they had no nets it took all day to catch that one fish by hand. Their entire island economy amounted to wake, fish, eat, sleep. Every fish that was caught was eaten. Nothing was saved, exchanged or leant. Able wonders, what if more fish could be caught in less time? Such a device could give him more time to make a home, make clothing and begin growing crops. But he would have to go a day without eating in order to make a net because there were no loans or savings he could rely on. At the end of the day Able had no fish to eat but he had his net. Through self- sacrifice if the net is successful he created capital.

8 Economic Principles Underconsumption Risk taking Capital
Underconsumption – Able forgoes income (the fish) that he otherwise would have eaten. His demand for the fish did not go down but he deferred that consumption for the potential of more in the future. Risk taking- Able took a risk because he did not know that the net would work to catch fish more efficiently. He is risking that his investment in net making will compensate him with more fish in the long run. Capital – a piece of equipment which is not useful on its own but is used to for making or acquiring something else which is wanted. Able does not want the net, he wants the fish. If the net can get him more fish, then the net (capital) has value.

9 An Idea Is Born The next day Able caught two fish instead of the one Baker and Charlie each caught. By making the net Able has increased his productivity and can produce more goods than he needs to consume. Being able to catch a fish for tomorrow has creating savings on the island. Spare production is the life blood of a healthy economy. In most species economics really only boils down to day-to-day survival. They are constantly in search of food, water and shelter, which leaves little to no room for innovation and increases in capital.

10 Economic Principles Simplest definition of economics – the effort to maximize the availability of limited resources to meet as many human demands as possible. Tools, capital and innovation are the keys to this equation.

11 Sharing The Wealth Now Able only has to fish every other day in order to feed himself. Baker and Charlie ask to borrow the net on the days Able was not fishing. But Able has many concerns about loaning out his net. What if they break it? What if they don’t give it back? Why should I take the risk of losing my capital for no return? When Able shot down that idea Baker proposed another. Ok how about you loan us the extra fish you catch so that we can make our own nets and not starve? Then we will pay you back with the extra fish we catch from our nets? Able again had concerns. He was still putting up a lot of risk for no return. He was giving them his newly found savings and not getting anything back for it. Their nets might not even work and he would have given up his savings for nothing. He also risked that they would just sit on the beach all day rather than make their nets in order to pay him back. Again he said, it is not worth the risk for the return. Fig

12 Sharing The Wealth Finally Baker approached Able with a financial idea. For every fish you lend us we will pay you back two fish. Able liked that idea because he could easily double his fish and not do any additional work. But Able was also weighing his other options. He could hold onto his fish for future use, which is the most secure option. He would not have any losses but his savings also would not grow. He could eat his fish and consume his savings. He could build a net rental company. He could use his surplus fish to make 2 extra nets and charge ½ a fish a day rental. Able only has 5 options of what he can do with his surplus: Save Consume Lend Invest Combination Able decides to loan the fish to Baker and Charlie. Now Baker and Charlie each have nets they did not have before. Fig

13 Economic Principles Demand is needed in order to spur economic growth, but is not what achieves it Only by increasing supply can people actually get more of what they demand Lenders benefits only if the borrower benefits The economy has doubled in size from 3 to a 6 fish capacity a day. Their hunger also, known as demand, spurred them to want more fish. But their demand did not give them the ability to increase the islands capacity. Demand comes in many forms; the demand for more capacity, time, fun, choices all of which require capital. With their extra fish they can now eat more than one fish per day. But the economy didn’t grow because they consumed more. They consumed more because the economy grew. Most economists think that demand can be increased by giving people more money to spend. But that does not change real demand, just how much people can spend on items that have been produced. Only by increasing supply can people actually get more of what they demand. The Lender benefits only if the borrower benefits: Some may think that Able was selfish by not giving the fish for free. However they must realize that they both benefited from the transaction. Able was able to gain extra savings without any extra work and Baker and Charlie were able to build their net without decreasing their consumption. If Baker and Charlie do not build the nets and use the fish to sit around all day then Able will have wasted his savings and Baker and Charlie are no better off than they were before. The lender only benefits if the borrower benefits.

14 Economic Principles Why not give the fish to Baker and Charlie?
Evil Capitalist? Type of loans Business Consumption Loans Emergency Can you really expand credit? Why not give the fish to Baker and Charlie? Sure this is the generous thing to do but if Able gives them the fish with no requirement to pay it back then more than likely they will spend their time being leisurely. This leisure time while likely deserved and good does nothing to increase the economy of the island. The bottom line is anything that leads to more fish catching benefits the islands economy. The more fish there are the more free time to pursue other innovations, eat more or have more leisure time. Evil Capitalist? The fact that there are different degrees of wealth is often seen as unfair. Rich are often perceived as having gained their wealth by taking wealth from others and creating the poor. The reason the rich get risk is because the service they provide is of value to others. Type of loans: Business Loans – the best use of savings because they tend to increase production. However there is the risk that the business loan will not result in any increase in production if the venture fails. These failed loans waste societies savings and diminish productive capacity. Outside forces (government) which encourages or demands savers to make loans that do not take into account the likelihood of repayment are far more likely to fail and are a waste of societies savings. Consumption Loans – If Able gave Baker and Charlie a loan but they used it to go on vacation instead of building a net then they would not have increase their productive capacity. They can still only catch one fish a day and so would have to cut their consumption in order to repay him for the loan. Loans to consumers that do not improve production capacity are a drag on both the loaner and the borrower. Emergency Loans – If Baker and Charlie were to become very ill and unable to fish Able can use his savings to keep them nourished while they recover. While the likelihood of repayment is low the risk of not making the loan is higher. If they perish from not receiving the loan the overall production of the island drops. This loan would not have been possible if he had already exhausted his savings through unproductive loans. Can you really expand credit? During economic contractions most politicians and economist encourage banks to expand credit by making more loans available. But how can these banks loan more money than they have in their savings? The islands total supply is limited by the number of fish it has saved. The imposition of government in between savers and borrowers separates the cause and effect of lending. This leads to inefficient allocation of savings. Private lenders generally lend when they feel they can make a profit lending to a stronger company more likely to repay the loan. This leads to a Darwin effect where the stronger companies survive and create a stronger economy. When loans are made based on reasons other than their ability to repay the loan no innovation or expanded capacity is created. These loans to weaker companies, which do not improve the economy, tend to weaken the overall economy by wasting the supply of savings.

15 Economic Expansion With Baker and Charlie’s successful net making complete they have now drastically increased the islands production. With each catching 2 fish per day they have more time for leisure and to make other innovations. Able made clothing, Baker collected coconuts and Charlie made the islands first hut. Baker devised another fish catching device which if successful could catch fish 24 hours a day and almost eliminate the need for fishing. In order for this project to succeed he would need help from Able and Charlie for an entire week. This would greatly reduce their savings and was a very large risk if it didn’t work. They decided the benefit was worth the risk and consumed their savings to work on the contraption. Success! The fish trapped caught 30 fish a week with only some small maintenance. With all of their extra time they built a second fish catcher and now had more fish than they had ever imagined. They began spending their time doing many things, Able was able to make enough clothing for himself and other islanders, Charlie created a surf board to make a fun leisure activity and Baker started working on a canoe to improve the islands transportation issues. sfddddddddddddddddddddddddffffffffffffffffffffffffffffffssssssssssssssssssssssssssssssssssssssssssssssssssssssdddddddddddd And we are to be say hay trend set pit lit how road

16 Economic Principles Savings do not just allow for increased spending of time or money The Keynesian theory views savings as detrimental to an economy because it removes money from circulation and decreases spending. Why does government use spending to track the health of the economy? Savings do not just allow for increased spending of time or money. It is also a means to buffer the economy from the unexpected. If a storm wipes out the two fish catchers they need enough saved to rebuild after the drop production. Although most economists consider natural disasters to stimulate an economy they actually destroy wealth and diminish living standards. The Keynesian theory views savings as detrimental to an economy because it removes money from circulation and decreases spending. Policy makers which have been influenced by these ideas have made laws to encourage spending and penalize savers. As a result Americans have spent more than we have earned. In the island economy this would be impossible but with international markets and magical printing presses have made it possible… temporarily. Why does government use spending to track the health of the economy? The purchases do not necessarily create any value at all and yet they increase the GDP. If you buy $1 million worth of air that looks like genuine activity even though it has no impact on the prosperity or value of the country. So why does spending really matter, everything produced is eventually consumed (at the right price). It is production that adds value thus a dollar saved is more valuable because it creates capital that allows for the expansion of production.

17 Prosperity Loves Company
Word of all of the surfing, mass fishing and luxury clothes spread to other islands. Soon they were migrating to the island to live this luxurious life style. Some immigrants took over tending the mega fish catchers, others borrowed the extra fish to clear the land for farming and others took out loans for other trades. Society has become so good at producing food and tools that some people didn’t need to produce anything physical to survive. Thus the service sector was born. Chefs, hut builders, surf instructors, etc created a need for a currency system to pay these service providing people. Previously bartering was used but this is inefficient because a chef may want surfing lessons but a surf teacher may not want a professionally cooked fish meal. And how many meals are equal to a surf lesson anyway? Since everyone ate 1 fish a day the value of a fish was universal across the island and could serve as money. All wages and prices were based on fish and therefore was related to the real (or intrinsic) value of fish.

18 Prosperity Loves Company
Specialization increases production, which in turn raises living standards. Making a canoe takes most islanders 5 days; therefore we could consider it would cost them 10 fish if they were fishing with a net. One islander, Duffy, is better at carving canoes and can do it in 4 days. So he can split the difference and charge 9 fish then Duffy makes a profit of 1 fish and the buyer of the canoe saves 1 fish. Now suppose because he specializes in making canoes he comes up with an innovation allowing him to create a canoe in 2 days. This allows him to sell his canoe for $6 which give him a profit of $2 and a whopping $3 savings for the buyers. Win Win! A product which was once a luxury item is now available to more islanders.

19 Prosperity Loves Company
As the island society became more complex islanders began working for other people by trading their labor for wages. Each worker is free to choose from three options Underconsume to build a net Take out a business loan to buy a net Work for someone who already has a net Most workers choose the third option and specialize in something. Finnigan, a big burly man makes his fish by transporting fish from the fisherman to their market and he charges 2 fish a day for 100 fish moved. Murry took a business loan to build a fish cart where he can move 300 fish and charge 3 fish a day. Murray’s cheaper price and higher profit margin allow him to hire Finnigan who because of his strength can move 400 fish a day netting 4 fish a day. He pays Finnigan 3 fish (1 extra) and keeps one as profit towards making another cart and hiring more workers. Reduced freight costs will also bring down costs of fish for all islanders. At aid and band At aid and band last fast

20 Economic Principles The vilification of deflation has led to governments enacting policies to push prices back up when deflation hits. But why? It’s not the spending but the production that counts! People do not need to be persuaded to spend. If society doesn’t want to buy something its either no good or too expensive. The vilification of Deflation (the overall decline in prices over time), has led to governments enacting policies to push prices back up when deflation hits. But why? In the US from the late 1700s to 1913 some of the fastest economic growth was recorded along with deflation because of increased efficiency. Increase efficiency can decrease prices AND strengthen the economy. Henry Ford made a fortune, had some of the highest paid workers and brought down the price of cars. The computer industry is booming with falling prices all the time. Why is deflation only ok if confined to one industry? Most economists assume that spending drives growth, and that when deflation is present people tend to defer purchases (to allow prices to fall); and when they do spend, the diminished price makes less of an economic impact. IT’S NOT THE SPENDING BUT THE PRODUCTION THAT COUNTS! People do not need to be persuaded to spend. If society doesn’t want to buy something its either no good or too expensive. Saving or deferring the purchase instead of spending is good for the economy as a whole. The best way to increase spending is to allow prices to fall naturally to affordable levels. Sam Walton made millions with this concept. Ex: Plasma TVs

21 Put It In The Vault As the island became more prosperous peoples savings of fish increased. They had to keep their fish in their huts and robbers began stealing their hard earned savings. Many would like to invest in businesses but did not have the time or knowledge to pick a good business for investment. Max Goodbank, after years of protecting his own fish and seeing many neighbors’ fish stolen and burned by slick fish borrowers knew there had to be a better way to store savings. So he built a super strong building with the toughest guys on the island to guard his ‘bank’. But he didn’t want to just charge a storage fee, he could use the savings to loan out with interest returned going to pay his investors, his employees and keep the profits for himself. He started the bank for his own personal gain, but he also helped solve the islands problem of savings, credit and theft. Requirements Keep his loan business profitable by carefully screening borrowers, collect interest and foreclose on collateral when loans fail Keep investors happy through regular interest payments Attract more borrowers to keep they cycle going Make decisions based on dollars and cents not on personal history, family relationship and emotions

22 Put It In The Vault Lending Rate - lower for most secure borrowers and higher for those more questionable to repay the loan. Interest paid – the lending rate determines the interest paid; also longer term lessened the risk of a fish so the longer the term the higher the interest rate Large gains in productivity can result in large deposits of fish in the vault and not enough loans made to balance. Lower the lending rates on loans in order to attract more borrowers. The bank is counting on the healthy economy to provide a fertile environment for the new businesses they are loaning to (encourages borrowing) Decrease the interest rate they will pay depositors (discourages savings)

23 Put It In The Vault dsffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffggggg When savings dip (dangerous for an economy) things that encourage savings come into play Goodbank is extra careful with loans because a default loan could be critical Charges a higher rate to borrowers (discourages borrowing) Offers higher interest rate to depositors (encourages savings) Interest rates that stabilize the market are created by Banks desire for maximum returns on bank deposits Banks fear of losing capital on risky investments Individuals time preferences for consumption Some investors want higher returns than Max Goodbank was willing to offer. To make higher returns Manny Fund, a flamboyant fish tycoon, used his depositors funds to invest in more risky businesses which were more likely to fail but also had a higher return when they succeeded.

24 Economic Principles When the Federal Reserve sets the federal funds rate the banks use this rate to determine the rate loans are made to individuals. Flaws with the Fed’s logic We have created a nation of spenders instead of a nation of savers and the Fed has a tendency to hold the rates too low for too long and not raise them high enough. When the Federal Reserve sets the federal funds rate the banks use this rate to determine the rate loans are made to individuals. In that way the Fed determines the general movement of the market to keep the economy on track by determining the optimal interest rate at any point in time. Boom time – a time when overconfidence leads to foolishness the Fed increases interest rates to deter borrowing Bust time – a struggling economy gets a boost from low interest rates so loans are more attractive Flaws with this logic Assumes the small group of people at the Fed know better than the marketplace The Fed does not suffer if the loans go bad and thus do not suffer the repercussions of bad loans made in a bust time Fed decisions are determined by political instead of economic considerations – politicians want the economy to appear stronger and encourage lower interest rates Savers are the only group which would favor higher interest rates but are not well organized in the political arena so are never heard Rates that are too low relative to supply of savings send false signals to borrows about the health of the economy leads to false booms followed by spectacular busts

25 Disclaimer The preceding presentation has been prepared for informational purposes only. It does not constitute an offer, recommendation, or solicitation to buy or sell, nor is it an official confirmation of terms. The above is based on information generally available to the public from sources reasonably believed to be reliable. Note that for any collateralized mortgage product, (CMO), the yield and average life will fluctuate depending on the actual rate at which mortgage holders prepay the mortgages underlying the CMO and changes in the current interest rates. Past performance is not indicative of future returns. Tri-Star Financial makes no representations or warranties, express or implied as to the accuracy or completeness of the above information or that any returns indicated will be achieved.

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