Friday, August 01, 2008

The danger of paper profits

The unregulated financial organizations (UFOs) have one after the other stopped paying out monthly amounts to participants, starting with Cash Plus last year. What is even more evident is that many of the over 20 UFOs, identified by the FSC, seems to be “genetically” linked, leading to the collapse of many at one time. This no doubt has led to significant fall off in the income levels of many Jamaicans, and will no doubt affect industries such as the motor vehicle and real estate sectors.

I have been speaking with some people who have been severely affected by the fallout, as many have not only placed the great majority of their savings in these schemes, but also borrowed money to secure assets based on the income flow they expected to continue in perpetuity. The decision to rely on “risky” investments to maintain a lifestyle of course is one grounded in stupidity, as even if a risky investment is legitimate the fact that it is such a high risk means that one cannot prudently expect it to continue forever.

Foreign currency trading
I have always indicated that foreign currency trading is a well established trading activity, and people do make significant returns from trading currency. Within the global context, foreign exchange trading accounts for over US$2 Trillion traded daily, and is much larger than any single traditional investment type. On the other hand I have always been at pains to point out that there is a high degree of risk associated with this type of activity, and just as one wins big, one can lose big also. So even if high risk investments are regulated in many instances they will make huge losses and go out of business, causing much pain to those who have invested. In fact one legitimate hedge fund in the US last week reported that it was going out of business as it had lost some US$3.2 billion on oil longs when the price of oil futures significantly fell off.

There are of course methods that can be used to minimize losses but on average a hedge fund may last for around five years and then usually suffers significant losses because of its risky nature. The lesson though is that anyone who significantly upped their lifestyle based on risky returns should not only see a psychiatrist but also a neuro surgeon to see what part of their brain was not functioning when they made that decision.

The bigger picture for Jamaica though is that these returns were nothing more than paper profits. And the problem with paper profits is that there is no productive asset to back it up, so what it creates is a fall sense of wealth for the country with no productive base. As a country this is not a strange phenomenon for us, as in the 1990s because of a high interest rate policy we did create a “paper profit” economy also, which effectively killed the productive sector, and on its way helped to create that monstrosity we call FINSAC.

What paper profits do is that it creates a notional return that cannot be backed by the creation of any goods for consumption. So wealth is created by means of money on paper, and is unsupported by an increase in assets, which eventually leads to inflationary pressures. When these inflationary pressures are created it has the effect of either pushing up prices or in order to keep prices stable we will have to either (i) push up interest rates; (ii) borrow money to be able to buy more goods for consumption; or a combination of both. So when paper profits were being created by high rates of interest on government paper in the 1990s in order to prevent the inflationary pressures from pushing prices up we borrowed money to create an illusion that there was real stability when all the time we were only setting up ourselves for the pain that comes with debt repayment. This was not the result of any unregulated scheme, but was the design of legitimate government policy, which had the same effect as the collapse of the UFOs. The only difference was that in the 1990s taxpayers bailed out those that would have lost their investments and today those that invested directly will lose out.

Pyramid economy
So in the 1990s we created a regulated “pyramid economy”, which we are still suffering from today. The following simple example shows the effect that paper profits have on the economy.

1) Assume that the value of goods in the economy is at $100 and income levels are at $100, then there is a 1:1 relationship between goods and income.
2) We can also assume that the savings rate is 20%, so that $20 out of the total income of $100 is in savings accounts and $80 is used for consumption. So that the relationship between goods and income is $80 divided by $100, resulting in each unit of good being valued at $0.80.
3) If one invested in a piece of paper (government instrument or UFO) paying 10% per month, by using the savings of $20, then you would theoretically generate an additional $2 per month, and in a year one would generate an additional $24 of income ($2 times 12 months using simple interest for ease of calculation).
4) If this additional $24 goes into consumption then consumption income increases to $104.
the effect of this is:
a) The price of goods goes up, as no new goods are produced, as the returns are just based on paper profits. So price per unit moves from $0.80 to $1.04 ($104 / $100). In contrast if $24 worth of goods were created price would only go to $0.83 each.
b) There is no new investment in the economy as the savings, which in economics equals investments, is gone into paper.
c) Because the investment is in paper then what is being used to pay the investors are the savings of $20 and in addition $4 must be borrowed by the government or the pyramid to pay the investor. This will mean getting new monies in from new entrants, who are outside of the economy as the entire income of the country will have been used in consumption.

It is this effect that helped to create the financial crisis in the economy in the 1990s and that contributes to inflation, low productivity, and low economic growth. The positive from the fallout of the UFOs is that inflationary pressures will be eased, as the price of items such as motor vehicles and real estate will fall, as the total income falls and more goods are now available for consumption as the secondary market for goods grow. What it also means though is that growth will be negatively affected (the quantum to be determined) as there is less savings for investment purposes.

This dilemma is at the heart of Jamaica’s problem. It is the inability to grow productivity that has caused the lack of economic growth. In fact what we have seen is that productivity has been declining. Unless we can turn around this problem then there will be no meaningful growth and creation of real wealth. In the immediate future, with current global conditions, and our own local situation, the best bet for us is to reduce consumption activities especially in relation to energy. This of course means that fiscal measures will have to be a key ingredient of our near term economic strategy.


Jorge said...

Hola amigo: quería invitarte que visites el blog que estoy realizando con mis alumnos de segundo año de la secundaria sobre LA DISCRIMINACIÓN.
Tema arduo e interesante.
Seguro será de tu agrado.
Te invitamos que leas lo que gustes de él y hagas una opinión sobre el mismo.
Tu aporte será valioso.
Un abrazo desde la Argentina.

Anonymous said...

Appreciate the recommendation. Will try it out.

Also visit my blog post ... weight loss calculator

Anonymous said...

My spouse and I stumbled over here coming from a different
page and thought I might check things out.
I like what I see so now i am following you. Look forward to checking out your
web page yet again.

Also visit my webpage: waist to height ratio ranges

Anonymous said...

I think this is among the most important information for me.
And i am glad reading your article. But wanna
remark on few general things, The web site style is wonderful,
the articles is really great : D. Good job, cheers

Feel free to surf to my blog how much should i weigh for my age and height

Anonymous said...

An intriguing discussion is worth comment. I do think that you need to publish more about this topic, it may not be a
taboo matter but usually people don't discuss such topics. To the next! Many thanks!!

Feel free to surf to my webpage :: diets that Work for women

Anonymous said...

I’m not that much of a online reader to be honest but your sites really nice, keep it up!
I'll go ahead and bookmark your website to come back later. Many thanks

Feel free to visit my website; healthy diet plans for women

Anonymous said...

I read this piece of writing completely on the topic of the comparison of latest and earlier technologies, it's awesome article.

My webpage ...

Anonymous said...

Currently it sounds like BlogEngine is the top blogging
platform available right now. (from what I've read) Is that what you are using on your blog?

My page; bmi chart male

Anonymous said...

I pay a visit daily a few blogs and websites to read articles,
however this blog offers quality based articles.

Feel free to visit my web site: diets that work fast for women

Anonymous said...

It's wonderful that you are getting ideas from this piece of writing as well as from our dialogue made here.

Feel free to surf to my site: Buy Veluminous

Anonymous said...

Awesome site you have here but I was wanting to know if you knew of any forums that cover the same topics talked about in
this article? I'd really love to be a part of group where I can get advice from other experienced individuals that share the same interest. If you have any suggestions, please let me know. Many thanks!

My webpage :: beauty care

Anonymous said...

Do you mind if I quote a few of your posts as long as I provide credit and sources back to your
website? My blog site is in the exact same niche as yours and my users would truly benefit from a lot of the information you provide here.
Please let me know if this okay with you.

Thanks a lot!

Feel free to surf to my weblog; Order Vydox

Anonymous said...

constantly i used to read smaller content that as well clear their motive,
and that is also happening with this piece of writing which I am reading

My web-site; Buy Nuvocleanse

Anonymous said...

I don't even know how I ended up here, but I thought this post was great. I do not know who you are but definitely you are going to a famous blogger if you are not already ;) Cheers!

Have a look at my webpage: Rvtl Anti Aging Solution

Anonymous said...

Today, I went to the beachfront with my kids. I found a sea shell and
gave it to my 4 year old daughter and said "You can hear the ocean if you put this to your ear." She placed the shell to her
ear and screamed. There was a hermit crab inside and it pinched her ear.
She never wants to go back! LoL I know this is totally off topic but I
had to tell someone!

Feel free to visit my web page :: acoustic guitar a chord

Anonymous said...

It's perfect time to make some plans for the future and it is time to be happy. I've read
this post and if I could I desire to suggest you some interesting things or
suggestions. Perhaps you can write next articles referring to this article.
I want to read even more things about it!

my page; raspberry ketones reviews

Anonymous said...

I comment when I like a post on a site or if I have something to contribute to the discussion.
Usually it's triggered by the passion displayed in the article I looked at. And after this post "The danger of paper profits". I was actually excited enough to leave a thought :-) I actually do have a few questions for you if it's okay.
Is it only me or do some of the responses come across like they
are written by brain dead individuals? :-P And, if you are posting at
other online social sites, I would like to keep
up with you. Could you list all of your social
pages like your Facebook page, twitter feed, or linkedin profile?

Here is my homepage diets that work fast

Anonymous said...

I was suggested this website by my cousin. I'm not sure whether this post is written by him as no one else know such detailed about my problem. You are incredible! Thanks!

Also visit my site :: skin cream

raybanoutlet001 said...

michael kors handbags outlet
nike huarache
jordan shoes
ralph lauren outlet
golden state warriors jerseys
nike roshe
gucci sito ufficiale
reebok shoes
michael kors uk
ugg outlet

郑佳颖 said...

stephen curry shoes
ultra boost 3.0
james harden shoes
nike dunks
michael kors handbags
adidas eqt support adv
adidas yeezy
curry 3
adidas ultra boost
adidas stan smith

jeje said...

chrome hearts outlet
nike air max 2017
kobe 9
tory burch shoes
true religion outlet
links of london
nike air max 2018
michael kors
kobe basketball shoes
nike huarache