In a brief posting today, I just wanted to point out that the term "fossil fuel" is really nothing but a theory. There is no absolute proof that oil derives from dead dinosaurs or other ancient biomass. In fact, there's a fair bit of evidence that oil is created by geologic processes deep within the earth's crust. Thomas Gold wrote about this alternative theory before knowing that the Russians had already come up with it themselves. That's what he claimed anyway, some people think that he plagiarized. Gold predicted that this theory would show microbes living deep within the earth, and recently more evidence in support of that keeps appearing.
If Gold and the Russians are correct, then oil may be extremely plentiful at layers below the crystalline basement, extractable by deep drilling. Russia sure has been successful at finding new oil in strange places. More reading on the subject here.
By making us all believe that oil is limited and is reaching a peak in production, the oil conglomerates can keep the "black gold" speculators on board thus keeping oil prices high and protect their obscene profits. They will likely seek to squash any information or theories which tend to make oil possibly be much more plentiful than they want us to think.
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Wednesday, May 28, 2008
Tuesday, May 27, 2008
Estates and Probate Fees
Another blogger asked me recently to take up the subject of estate planning and probate fees. I am not a lawyer (IANAL) but I have been the executor of one estate that managed to avoid probate and associated with another estate that also managed to avoid it as well. First off, let's examine what it means to probate an estate. In general, when a person dies, their assets are all frozen. In order to release the assets to the next of kin, an estate has to be probated. Probate means getting a court to agree that an executor has the legal right to do so. It is often just a rubber stamp, that comes along with the court demanding a small cut of the gross amount of assets that are frozen. In Ontario, it is around 1.5-2%. In Alberta, it is virtually nothing. Lawyers' fees are on top of this as well. On an estate worth close to a million dollars in Ontario, the government wants the value of a new car in order to deliver its stamp.
Keep in mind that in Canada there are no inheritance taxes, or taxes on gifts for that matter. People receiving estate money, or large amounts of gift cash from a relative do not have to worry about any tax consequences. This is important in terms of understanding the strategy.
One way around probating an estate is to put everything you own into a trust. The trust is set up such that you control everything, but the trust doesn't freeze when you die. The articles of the trust stipulates what happens in that event. Trusts don't get tax deductions like individuals do, so it gets complicated fairly quickly. People who are significantly wealthy may go this route and have lawyers and financial advisors take care of all of this complexity for them. This is about all I'll say on this particular topic.
For the rest of us, what we want to do is to make as much of our assets as possible not freeze upon our death. One way to do that is to make sure that all bank accounts, GICs, etc. be joint with someone who can be completely trusted such as a child, with right of survivorship explicitly stated. Then upon the death of one party, the other has complete unfettered access to the money. There's no income tax consideration here either as all income from the investments can be split in any way between the parties. So if you're joint with your parent, then the income can be accrued to them until their death. Then it starts accruing to you.
Upon death however, all income (from non-joint assets) received by the dead individual from that moment on, has to go into what's called an estate trust. As executor, you cannot disburse money from an estate trust (with a few exceptions as we'll see) unless you probate. As such, you want to minimize what has to go into the estate trust. For example, the CPP death benefit pretty much has to go in there. Life insurance payouts (without a living beneficiary listed on the policy) has to go into the estate trust. Without having a certificate of probate, as executor you can direct the bank to disburse money from this account (or any frozen account) to a funeral home to pay for the funeral. They will also allow other disbursements to pay utility bills etc. on a home if it would cause hardship to the survivors. But the key here may be to work with the funeral home to pay a little way down the road via directed disbursements through the bank. What you want to do here is to drain the frozen estate accounts all the way to zero without going through probate. Another approach to getting frozen accounts drained is to not pay all the income tax owing on the estate. Yes, you'll be hit with penalties and interest but you can direct the CRA to the frozen accounts and hound them to seize the balance. As executor you're still personally on the hook to ensure that all taxes are paid including interest and penalties. So hound them until they seize the accounts.
If the deceased owned a house when they died, then it is very hard to avoid probate. They could gift the house to somebody before they die, but if that new owner doesn't live there, then there is likely tax consequences to the new owner. Cottages or other non-primary residences will likely trigger a large tax bill for the owner if they give it away to next of kin, since it will be a deemed disposition.
One thing, however, to keep in mind is that jointing assets can cause all kinds of problems if the next of kin don't get along with each other. Sometimes probating a will is a good thing, even though it may cost a lot more. This way, the court makes sure that assets are divided according to the wishes of the deceased. If the next of kin are few, and get along well with each other, then jointing assets may well save a lot of money.
So to sum this whole thing up:
Another thing to keep in mind is that if you ever agree to be an executor to an estate, you are personally responsible for getting the taxes paid. I would recommend avoiding agreeing to be executor if you think the estate may be complicated with respect to taxes.
If you have a mentally infirm parent in a nursing home, and have their power of attorney (POA), then you can use that to joint yourself on all the accounts if you haven't already. The POA dies with the parent, don't expect to be able to use the POA after the fact. The POA may have limited power to change beneficiaries on life insurance policies though. Talk to your bank regarding RRSP beneficiaries.
Keep in mind that in Canada there are no inheritance taxes, or taxes on gifts for that matter. People receiving estate money, or large amounts of gift cash from a relative do not have to worry about any tax consequences. This is important in terms of understanding the strategy.
One way around probating an estate is to put everything you own into a trust. The trust is set up such that you control everything, but the trust doesn't freeze when you die. The articles of the trust stipulates what happens in that event. Trusts don't get tax deductions like individuals do, so it gets complicated fairly quickly. People who are significantly wealthy may go this route and have lawyers and financial advisors take care of all of this complexity for them. This is about all I'll say on this particular topic.
For the rest of us, what we want to do is to make as much of our assets as possible not freeze upon our death. One way to do that is to make sure that all bank accounts, GICs, etc. be joint with someone who can be completely trusted such as a child, with right of survivorship explicitly stated. Then upon the death of one party, the other has complete unfettered access to the money. There's no income tax consideration here either as all income from the investments can be split in any way between the parties. So if you're joint with your parent, then the income can be accrued to them until their death. Then it starts accruing to you.
Upon death however, all income (from non-joint assets) received by the dead individual from that moment on, has to go into what's called an estate trust. As executor, you cannot disburse money from an estate trust (with a few exceptions as we'll see) unless you probate. As such, you want to minimize what has to go into the estate trust. For example, the CPP death benefit pretty much has to go in there. Life insurance payouts (without a living beneficiary listed on the policy) has to go into the estate trust. Without having a certificate of probate, as executor you can direct the bank to disburse money from this account (or any frozen account) to a funeral home to pay for the funeral. They will also allow other disbursements to pay utility bills etc. on a home if it would cause hardship to the survivors. But the key here may be to work with the funeral home to pay a little way down the road via directed disbursements through the bank. What you want to do here is to drain the frozen estate accounts all the way to zero without going through probate. Another approach to getting frozen accounts drained is to not pay all the income tax owing on the estate. Yes, you'll be hit with penalties and interest but you can direct the CRA to the frozen accounts and hound them to seize the balance. As executor you're still personally on the hook to ensure that all taxes are paid including interest and penalties. So hound them until they seize the accounts.
If the deceased owned a house when they died, then it is very hard to avoid probate. They could gift the house to somebody before they die, but if that new owner doesn't live there, then there is likely tax consequences to the new owner. Cottages or other non-primary residences will likely trigger a large tax bill for the owner if they give it away to next of kin, since it will be a deemed disposition.
One thing, however, to keep in mind is that jointing assets can cause all kinds of problems if the next of kin don't get along with each other. Sometimes probating a will is a good thing, even though it may cost a lot more. This way, the court makes sure that assets are divided according to the wishes of the deceased. If the next of kin are few, and get along well with each other, then jointing assets may well save a lot of money.
So to sum this whole thing up:
- Make sure that anything that allows a beneficiary such as life insurance and RRSP accounts have at least one living beneficiary listed. If the number of equal next of kin is small enough, then list them all. The establishment will divide the payout equally for you.
- Anything else should get jointed with right of survivorship. The primary residence and other real estate may be an exception here, talk with a lawyer/financial planner.
- Try to minimize any money landing in estate bank accounts. Those accounts cannot be jointed. Remember that you can drain this money out, via the bank, to pay funeral homes. CRA can seize these accounts (to your benefit) to pay outstanding taxes. After all that is done, any money left in an estate account will have to be obtained through probate. Do the math, probate may be cheaper anyway once CRA penalities and interest is factored in.
- Die in Alberta. ;)
Another thing to keep in mind is that if you ever agree to be an executor to an estate, you are personally responsible for getting the taxes paid. I would recommend avoiding agreeing to be executor if you think the estate may be complicated with respect to taxes.
If you have a mentally infirm parent in a nursing home, and have their power of attorney (POA), then you can use that to joint yourself on all the accounts if you haven't already. The POA dies with the parent, don't expect to be able to use the POA after the fact. The POA may have limited power to change beneficiaries on life insurance policies though. Talk to your bank regarding RRSP beneficiaries.
Sunday, May 18, 2008
Scotiabank's New "Bank the Rest" Savings Program
Perhaps you have heard about this nifty new "savings" program that Scotiabank is offering to its customers. It's called "Bank the Rest". The way it operates is like an electronic change jar. Every time you do a debit payment, such as when you buy groceries, it can round up your purchase amount to the next dollar or five dollar level and transfer that additional amount into a savings account. The way Scotiabank spins this, is that by spending money you can actually end up saving a bit, and will hardly notice that little extra amount per transaction.
Well, what is really going on here? Banks exist to make money, often by taking it away from you without you realizing it. Hmmmm. Out of the goodness of their hearts they are creating a way for you to transfer a bit of money over to an account where they are going to pay you more interest. At first blush, it sounds like the bank is going to lose money on this scheme while helping their customers save a bit of money. Well, let's dig into this a bit further.
To whom is this savings scheme really targetted? Well, it really is a nickel and dime approach to getting a tiny bit of money set aside. Is somebody with a fat bank account going to bother doing this? Is somebody who already knows how to save 10% or more of their paycheque going to bother doing this? The answer is a resounding no. This scheme is targetted at people who normally drain their bank accounts all the way to zero or close to zero between pay periods. They're led to believe that they can get ahead by tossing aside a bit of money into another account where they won't have easy access to spend it. But what is happening here is that a large number of these people have their accounts drifting into overdraft between paycheques as it stands today. This extra bit of so called savings is really coming out of their overdraft where they are paying a bit over 10% per annum interest. And it goes into an account where the bank is paying them just 2.75%. The bank itself is pocketing the approximately 8% difference on this money. Even though the "bank the rest" amount will not be taken once the account is in overdraft or will send the account into overdraft, don't be fooled. It's all about grinding the accounts down to the overdraft limit faster in a clandestine way.
Let's crunch a few numbers just to get a handle on this. Let's say the average person using this scheme saves about $20 a month. Over the course of a year, the pot ends up at say $250 to make the math easier. For the sake of the calculations, assume that it all comes out of overdraft. It doesn't really, since the user's regular chequing account will drift in and out of overdraft as paycheques arrive and payments come out (ie. the 10% overdraft rate isn't being paid all the time), but for the sake of the numbers just say it all comes out of overdraft. How many such customers might the bank sucker into this so called savings scheme? Well, the country has 35 million people in it, let's say that Scotiabank has a million customer chequing accounts. It's probably a conservative number but let's go with it. Let's say that of those million customers, they can convince 5% (all overdraft drifters) to go with this scheme. So that's 50,000 chequing accounts that are likely in overdraft for quite a bit of the year. So $250 x 50,000 accounts = 12.5 million dollars. At 8% (difference between overdraft rate and the savings rate) that amounts to exactly 1 million dollars per year. This also doesn't take into consideration the juicy service charges when overdraft is triggered in accounts that wouldn't normally hit overdraft except for these greater amounts now coming out. It also doesn't take into consideration all the new services charges that will be triggered out of the new savings accounts. If you look into those new "Money Master" savings accounts you can't dip directly into them via ABM or direct payments without it costing you $5 per transaction. You can transfer to your chequing account for free, but how many of these customers are going to bother to do that or accidentally trip over the fee the first time?
So, Scotiabank, you found a new way to pull at least a million dollars out of your poorest customer base by spinning it as something good. Wow, way to go, you are my new hero. Pat yourselves on the back.
Well, what is really going on here? Banks exist to make money, often by taking it away from you without you realizing it. Hmmmm. Out of the goodness of their hearts they are creating a way for you to transfer a bit of money over to an account where they are going to pay you more interest. At first blush, it sounds like the bank is going to lose money on this scheme while helping their customers save a bit of money. Well, let's dig into this a bit further.
To whom is this savings scheme really targetted? Well, it really is a nickel and dime approach to getting a tiny bit of money set aside. Is somebody with a fat bank account going to bother doing this? Is somebody who already knows how to save 10% or more of their paycheque going to bother doing this? The answer is a resounding no. This scheme is targetted at people who normally drain their bank accounts all the way to zero or close to zero between pay periods. They're led to believe that they can get ahead by tossing aside a bit of money into another account where they won't have easy access to spend it. But what is happening here is that a large number of these people have their accounts drifting into overdraft between paycheques as it stands today. This extra bit of so called savings is really coming out of their overdraft where they are paying a bit over 10% per annum interest. And it goes into an account where the bank is paying them just 2.75%. The bank itself is pocketing the approximately 8% difference on this money. Even though the "bank the rest" amount will not be taken once the account is in overdraft or will send the account into overdraft, don't be fooled. It's all about grinding the accounts down to the overdraft limit faster in a clandestine way.
Let's crunch a few numbers just to get a handle on this. Let's say the average person using this scheme saves about $20 a month. Over the course of a year, the pot ends up at say $250 to make the math easier. For the sake of the calculations, assume that it all comes out of overdraft. It doesn't really, since the user's regular chequing account will drift in and out of overdraft as paycheques arrive and payments come out (ie. the 10% overdraft rate isn't being paid all the time), but for the sake of the numbers just say it all comes out of overdraft. How many such customers might the bank sucker into this so called savings scheme? Well, the country has 35 million people in it, let's say that Scotiabank has a million customer chequing accounts. It's probably a conservative number but let's go with it. Let's say that of those million customers, they can convince 5% (all overdraft drifters) to go with this scheme. So that's 50,000 chequing accounts that are likely in overdraft for quite a bit of the year. So $250 x 50,000 accounts = 12.5 million dollars. At 8% (difference between overdraft rate and the savings rate) that amounts to exactly 1 million dollars per year. This also doesn't take into consideration the juicy service charges when overdraft is triggered in accounts that wouldn't normally hit overdraft except for these greater amounts now coming out. It also doesn't take into consideration all the new services charges that will be triggered out of the new savings accounts. If you look into those new "Money Master" savings accounts you can't dip directly into them via ABM or direct payments without it costing you $5 per transaction. You can transfer to your chequing account for free, but how many of these customers are going to bother to do that or accidentally trip over the fee the first time?
So, Scotiabank, you found a new way to pull at least a million dollars out of your poorest customer base by spinning it as something good. Wow, way to go, you are my new hero. Pat yourselves on the back.
Saturday, May 17, 2008
The Housing Market
If you've been checking out the mainstream media lately, the softening Canadian real estate market has been making headlines. After years of crazy price increases some sanity appears to be finally creeping back in. Let's explore some concepts behind real estate and perhaps also explore where the market may be going.
First off, let's look at some historical data on real estate. According to Yale economist Robert Shiller, real estate prices historically just track inflation. Inflation is just the dilutive growth in the money supply from more money being created out of thin air. This creation of money is driven by borrowing. Borrowing, in my opinion, is primarily driven by population growth. So housing prices ultimately, over time, track growth in the population. This makes sense and should come as no shocking surprise to anybody. Here's Robert Shiller's chart on historical housing prices in the US, priced in constant dollars. Constant dollars already have the dilutive effect of inflation factored out of them. Given that real estate only tracks inflation, many people would say that buying a house is not really an investment, it should be seen as just an inflation hedge. I'd just like to point out that back in 2006, that graph shows a massive bubble in prices. Fast forward 2 years later and that bubble, driven by speculation and sales based on subprime mortgages, is finally bursting. How low will prices go? In my opinion, markets always over correct, be it to the upside or to the downside. The chart refers to the US housing market, but I'm told that Garth Turner's book "Greater Fool: The Troubled Future of Real Estate" has something similar which covers Canada. Essentially, if you're currently renting but are thinking of buying a home, you probably want to just continue to sit on the sidelines building your downpayment and watch prices come down to something sane.
So if buying a house is really nothing but stuffing an inflation hedged mattress with your money, why do it at all? Well, in general, you have to live somewhere and isn't it better to be stuffing your own mattress rather than a landlord's? Once your house has been completely paid for, that frees up a lot of monthy cash that you can use elsewhere, be it for retirement savings or just enjoying life. Also, the inflation gains on your money are tax free when you eventually sell, if the house is your primary residence. My advice, when shopping for a first house, is to buy primarily based on your needs, not your wants. Keep it affordable so you can pay it off faster! You can feed your "wants" and upgrade sometime in the future when you've already paid off your first home. Keep in mind that the bigger the mortgage, the longer it is going to take to pay it off and hence more interest money flows out of your pocket in the process.
Another point about real estate is that it costs a lot of money to simply possess. Municipal taxes can be as high as 1-2% of the value of your home. Also, homes "rot" if not maintained. Somewhere around $1000 per year or more should be set aside for maintenance fees not including landscaping costs. Condo fees can easily exceed $200 per month for a modest townhome, to over $400 in a highrise situation with elevators and a swimming pool to maintain. But to be fair, some utilities may be included in those fees. My point is, what other so-called "investment" has such a high cost of ownership? Sure, precious metals may have some safe keeping fees associated with them and some actively managed mutual funds have high MERs, but the "money pit" aspect of home ownership should be understood and not ignored.
A fully stuffed inflation hedged mattress can be a wonderful thing to have as lenders will fall all over themselves to loan you money using your home as collateral. If you invest that borrowed money (certain rules apply) the Canada Revenue Agency will let you write the interest off your regular income. If you're in a high marginal tax bracket, this can come close to cutting the cost of borrowing this money in half. Personally, I'm not a big fan of doing this, but some people do swear by it. As always, your mileage may vary. This may be a good future topic for other bloggers who have experience with some of these borrow-to-invest type of schemes.
Update: I just came across a fairly recent paper by Shiller exploring the speculative bubble aspect of the housing market.
First off, let's look at some historical data on real estate. According to Yale economist Robert Shiller, real estate prices historically just track inflation. Inflation is just the dilutive growth in the money supply from more money being created out of thin air. This creation of money is driven by borrowing. Borrowing, in my opinion, is primarily driven by population growth. So housing prices ultimately, over time, track growth in the population. This makes sense and should come as no shocking surprise to anybody. Here's Robert Shiller's chart on historical housing prices in the US, priced in constant dollars. Constant dollars already have the dilutive effect of inflation factored out of them. Given that real estate only tracks inflation, many people would say that buying a house is not really an investment, it should be seen as just an inflation hedge. I'd just like to point out that back in 2006, that graph shows a massive bubble in prices. Fast forward 2 years later and that bubble, driven by speculation and sales based on subprime mortgages, is finally bursting. How low will prices go? In my opinion, markets always over correct, be it to the upside or to the downside. The chart refers to the US housing market, but I'm told that Garth Turner's book "Greater Fool: The Troubled Future of Real Estate" has something similar which covers Canada. Essentially, if you're currently renting but are thinking of buying a home, you probably want to just continue to sit on the sidelines building your downpayment and watch prices come down to something sane.
So if buying a house is really nothing but stuffing an inflation hedged mattress with your money, why do it at all? Well, in general, you have to live somewhere and isn't it better to be stuffing your own mattress rather than a landlord's? Once your house has been completely paid for, that frees up a lot of monthy cash that you can use elsewhere, be it for retirement savings or just enjoying life. Also, the inflation gains on your money are tax free when you eventually sell, if the house is your primary residence. My advice, when shopping for a first house, is to buy primarily based on your needs, not your wants. Keep it affordable so you can pay it off faster! You can feed your "wants" and upgrade sometime in the future when you've already paid off your first home. Keep in mind that the bigger the mortgage, the longer it is going to take to pay it off and hence more interest money flows out of your pocket in the process.
Another point about real estate is that it costs a lot of money to simply possess. Municipal taxes can be as high as 1-2% of the value of your home. Also, homes "rot" if not maintained. Somewhere around $1000 per year or more should be set aside for maintenance fees not including landscaping costs. Condo fees can easily exceed $200 per month for a modest townhome, to over $400 in a highrise situation with elevators and a swimming pool to maintain. But to be fair, some utilities may be included in those fees. My point is, what other so-called "investment" has such a high cost of ownership? Sure, precious metals may have some safe keeping fees associated with them and some actively managed mutual funds have high MERs, but the "money pit" aspect of home ownership should be understood and not ignored.
A fully stuffed inflation hedged mattress can be a wonderful thing to have as lenders will fall all over themselves to loan you money using your home as collateral. If you invest that borrowed money (certain rules apply) the Canada Revenue Agency will let you write the interest off your regular income. If you're in a high marginal tax bracket, this can come close to cutting the cost of borrowing this money in half. Personally, I'm not a big fan of doing this, but some people do swear by it. As always, your mileage may vary. This may be a good future topic for other bloggers who have experience with some of these borrow-to-invest type of schemes.
Update: I just came across a fairly recent paper by Shiller exploring the speculative bubble aspect of the housing market.
Tuesday, May 13, 2008
Money, Time, and Inflation
Have you ever stopped to wonder how money and capitalism actually work together to provide prosperity? One of the big reasons is simply time. I said in my last posting that money can be seen as a kind of insurance product. Insurance generally has a time limit or deadline on it, and money does too. Money is a lot like electricity, it does no work unless it is flowing, meaning changing hands for the provision of goods or services. Money stuffed into your mattress does no work, and it will actually decline in purchasing value or useability over time. It may as well simply not exist. This decline in purchasing value is what we call inflation, and it is primarily due to more money being created over time, thus diluting its potentcy.
Inflation is actually very good for capitalism. It means that you just can't sit on your money. Your money will rot over time, unless you can get it invested so that you can grab a piece of the dilutive new money being created. Another alternative to keep it from rotting is to buy an inflation hedge which is generally some physical asset whose value tends to keep up with inflation such as land. While mild inflation is good for capitalism, high inflation is quite bad. When inflation is high, investment returns (production) can't keep up with the dilution. People are also incented to spend their money rather than invest it as they watch prices climb. Individuals on fixed incomes end up suffering as the dilution outruns their ability to save and invest. So what we want is inflation that's high enough to incent people to invest yet low enough to allow production returns to keep up. This is what the Bank of Canada and Fed in the US try to accomplish through setting the overnight interest rate which translates into what you and I are charged to borrow money. Borrowed money gets created out of thin air and is the source of inflation/dilution which I mentioned earlier. In this author's opinion, population growth is at the root of money supply growth.
So what happens if the population stops growing? In such a non-growing modern society with a high standard of living, the amount of borrowing doesn't exceed the amount of money already in existence. No growth in money supply means no inflation. In fact, taken a bit further, that society can be facing deflation. Deflation is when the money supply starts to shrink. Loans are paid back and that money isn't reborrowed by anybody. Money just sitting there and not flowing, as I said earlier, may as well not exist. It can be seen as simply disappearing. As the money supply shrinks, and there is less in circulation, it becomes worth more in terms of buying power. Prices start to decline. Money no longer rots if it isn't used, so people just sit on their money and don't spend it as they watch prices decline. This can cause an awful downward spiral in an economy and the term deflation can cause an economist to have nightmares.
Japan is an example of a society facing this right now. They have tried lowering interest rates all the way to zero at one point to try and get people to borrow money. To get older people to borrow money they have created the concept of multi-generational loans. But this hasn't really worked all that well to up the borrowing. So the government decided to just start printing money and fed it into the economy via social spending and bad loan bailouts. Businesses that can't properly sustain themselves are being kept on government life support to preserve jobs. Japan's government debt levels are now so high as a percentage of GDP that there's serious worries about a possible Bank of Japan collapse. Artificially fueled inflation is nothing but a time bomb. Japan has to import so much stuff that it can ill afford other nations or banks to no longer want to accept its currency.
So what are we capitalists going to do down the road when the population stops growing as the laws of physics eventually dictate? I do not know. All I know is that no generation wants to be the one left holding the bag. We can already see this slowly approaching as interest rates slowly decline as the baby boomer cohort ages. Immigration certainly helps, but can it be stepped up to the point where it can compensate for the low birth rate and the eventual accelerating death of the boomers?
One way to simulate population growth is to have other people in the world willing to borrow your nation's money with, of course, a demonstrated capability to pay it back. The dilutive effect of this borrowing has to be seen by your nation, meaning the money has to flow back in to purchase things such as production equipment. Perhaps the way out of this mess is to become bankers to the second and third world. Maybe there is method to the madness of creating the "Amero" and getting it slowly adopted by Central and South America as well as North America. It wouldn't surprise me to see, in the further out future, the Euro getting adopted by small third world nations as the EU tries to manage to keep away the deflation demon. Whether this scheme will work or not, who knows?!?
As a final note, what I've written here is extremely simplified as it doesn't, for example, address the impact of foreign exchange and foreign trading. Countries don't exist in isolation.
Inflation is actually very good for capitalism. It means that you just can't sit on your money. Your money will rot over time, unless you can get it invested so that you can grab a piece of the dilutive new money being created. Another alternative to keep it from rotting is to buy an inflation hedge which is generally some physical asset whose value tends to keep up with inflation such as land. While mild inflation is good for capitalism, high inflation is quite bad. When inflation is high, investment returns (production) can't keep up with the dilution. People are also incented to spend their money rather than invest it as they watch prices climb. Individuals on fixed incomes end up suffering as the dilution outruns their ability to save and invest. So what we want is inflation that's high enough to incent people to invest yet low enough to allow production returns to keep up. This is what the Bank of Canada and Fed in the US try to accomplish through setting the overnight interest rate which translates into what you and I are charged to borrow money. Borrowed money gets created out of thin air and is the source of inflation/dilution which I mentioned earlier. In this author's opinion, population growth is at the root of money supply growth.
So what happens if the population stops growing? In such a non-growing modern society with a high standard of living, the amount of borrowing doesn't exceed the amount of money already in existence. No growth in money supply means no inflation. In fact, taken a bit further, that society can be facing deflation. Deflation is when the money supply starts to shrink. Loans are paid back and that money isn't reborrowed by anybody. Money just sitting there and not flowing, as I said earlier, may as well not exist. It can be seen as simply disappearing. As the money supply shrinks, and there is less in circulation, it becomes worth more in terms of buying power. Prices start to decline. Money no longer rots if it isn't used, so people just sit on their money and don't spend it as they watch prices decline. This can cause an awful downward spiral in an economy and the term deflation can cause an economist to have nightmares.
Japan is an example of a society facing this right now. They have tried lowering interest rates all the way to zero at one point to try and get people to borrow money. To get older people to borrow money they have created the concept of multi-generational loans. But this hasn't really worked all that well to up the borrowing. So the government decided to just start printing money and fed it into the economy via social spending and bad loan bailouts. Businesses that can't properly sustain themselves are being kept on government life support to preserve jobs. Japan's government debt levels are now so high as a percentage of GDP that there's serious worries about a possible Bank of Japan collapse. Artificially fueled inflation is nothing but a time bomb. Japan has to import so much stuff that it can ill afford other nations or banks to no longer want to accept its currency.
So what are we capitalists going to do down the road when the population stops growing as the laws of physics eventually dictate? I do not know. All I know is that no generation wants to be the one left holding the bag. We can already see this slowly approaching as interest rates slowly decline as the baby boomer cohort ages. Immigration certainly helps, but can it be stepped up to the point where it can compensate for the low birth rate and the eventual accelerating death of the boomers?
One way to simulate population growth is to have other people in the world willing to borrow your nation's money with, of course, a demonstrated capability to pay it back. The dilutive effect of this borrowing has to be seen by your nation, meaning the money has to flow back in to purchase things such as production equipment. Perhaps the way out of this mess is to become bankers to the second and third world. Maybe there is method to the madness of creating the "Amero" and getting it slowly adopted by Central and South America as well as North America. It wouldn't surprise me to see, in the further out future, the Euro getting adopted by small third world nations as the EU tries to manage to keep away the deflation demon. Whether this scheme will work or not, who knows?!?
As a final note, what I've written here is extremely simplified as it doesn't, for example, address the impact of foreign exchange and foreign trading. Countries don't exist in isolation.
Friday, May 9, 2008
Insurance
Inspired by Michael James' posting on insurance today, I'll add my 2 cents on the subject.
Let's go back to basics. Just what is insurance? In a nutshell, insurance is simply hedging the future. It's about being able to obtain something with better certainty down the road. Since time is always moving forward, the notion of the future permeates our entire existence. As such, insurance is everywhere. In its simplest form, anything with a future promise attached to it is insurance. Reach into your wallet and pull out some paper money. What is that? It's insurance. It is a promise to provide a good or service in the future. Without it, you will have a harder time obtaining that good or service. It is a form of a promise, or a contract if you will. This contract we call money mitigates your trading risk in not being able to obtain a good or service.
So what exactly is risk? Risk is about the future not unfolding the way you need it to occur. It exists because the future is not predictable with absolute certainty. What is one of the least predictable things that has the biggest impact on mankind? The weather. Can you buy weather insurance? Of course you can. The agricultural industry relies upon it. Farmers buy crop insurance all the time. Your house is likely insured against catastrophic weather damage. You have heard of the futures or commodities market, right? That's a bunch of people trading a form of agricultural insurance. By insuring themselves against supply abundance and demand collapse, farmers can plan and successfully run a business. The futures contract removes his risk of not getting enough money for his crop. Removing risk is a valuable service, and thus insurance costs money, often big money. Insurers are usually quite sneaky about hiding the real cost of it from you. Also, most insurance has a date or other condition on which it ends, and thus usually becomes less valuable as the end condition approaches in the absence of the insured risk.
You can find insurance embedded in almost everything. Did you buy something with a warranty attached to it? Insurance. Did you take out a loan with a fixed interest rate? Insurance. Sports gambling can be seen as happiness insurance if you bet against your team. Many credit cards have insurance products built into them as well. Service insurance, unless it involves money refund and a impartial ombudsman, can be somewhat useless. If somebody screws up performing a service (eg. a haircut) are you likely to give them another chance even if it is free? If they have somebody else who is competent to fix the problem, then perhaps.
How do you put a value on insurance? Well, if you're an insurer, it is all about calculating the risk, and putting a value on the potential payout. Then they'll add a profit margin on top of that, the amount of which depends on supply and demand curves for the insurance product, basic econ101 stuff. The risk calculation can be extremely complex, involving intricate mathematical models with closely guarded markov chains. The potential payout is also subject to complex calculations potentially obfuscated with all kinds of exclusion clauses.
What do you, as a consumer, need to know about valuing insurance? Well, if the law requires insurance, such as car insurance, then you have no choice. Shop around, and potentially raise the deductible to the maximum amount you can afford should the worst happen. But in general, don't buy insurance if you can afford to deal with the bad future event actually happening. Extended warranties, especially on electronics, are seldom worth buying. If they cover accidental damage and you have young children, then perhaps you do want to consider them since the odds of payout will be high. If you feel that your circumstances are different from most consumers such that the odds of payout (check exclusions!!!) is quite high in your favour, then perhaps you should buy the insurance. Also, look at insuring yourself. Be it for a mortgage (see my previous post) or for insuring electronics, put the extra payments into a savings account and use it for repairs or replacement. Also by insuring yourself, you don't put a deadline on when your insurance would expire. Your money remains with you and is not lost.
Let's go back to basics. Just what is insurance? In a nutshell, insurance is simply hedging the future. It's about being able to obtain something with better certainty down the road. Since time is always moving forward, the notion of the future permeates our entire existence. As such, insurance is everywhere. In its simplest form, anything with a future promise attached to it is insurance. Reach into your wallet and pull out some paper money. What is that? It's insurance. It is a promise to provide a good or service in the future. Without it, you will have a harder time obtaining that good or service. It is a form of a promise, or a contract if you will. This contract we call money mitigates your trading risk in not being able to obtain a good or service.
So what exactly is risk? Risk is about the future not unfolding the way you need it to occur. It exists because the future is not predictable with absolute certainty. What is one of the least predictable things that has the biggest impact on mankind? The weather. Can you buy weather insurance? Of course you can. The agricultural industry relies upon it. Farmers buy crop insurance all the time. Your house is likely insured against catastrophic weather damage. You have heard of the futures or commodities market, right? That's a bunch of people trading a form of agricultural insurance. By insuring themselves against supply abundance and demand collapse, farmers can plan and successfully run a business. The futures contract removes his risk of not getting enough money for his crop. Removing risk is a valuable service, and thus insurance costs money, often big money. Insurers are usually quite sneaky about hiding the real cost of it from you. Also, most insurance has a date or other condition on which it ends, and thus usually becomes less valuable as the end condition approaches in the absence of the insured risk.
You can find insurance embedded in almost everything. Did you buy something with a warranty attached to it? Insurance. Did you take out a loan with a fixed interest rate? Insurance. Sports gambling can be seen as happiness insurance if you bet against your team. Many credit cards have insurance products built into them as well. Service insurance, unless it involves money refund and a impartial ombudsman, can be somewhat useless. If somebody screws up performing a service (eg. a haircut) are you likely to give them another chance even if it is free? If they have somebody else who is competent to fix the problem, then perhaps.
How do you put a value on insurance? Well, if you're an insurer, it is all about calculating the risk, and putting a value on the potential payout. Then they'll add a profit margin on top of that, the amount of which depends on supply and demand curves for the insurance product, basic econ101 stuff. The risk calculation can be extremely complex, involving intricate mathematical models with closely guarded markov chains. The potential payout is also subject to complex calculations potentially obfuscated with all kinds of exclusion clauses.
What do you, as a consumer, need to know about valuing insurance? Well, if the law requires insurance, such as car insurance, then you have no choice. Shop around, and potentially raise the deductible to the maximum amount you can afford should the worst happen. But in general, don't buy insurance if you can afford to deal with the bad future event actually happening. Extended warranties, especially on electronics, are seldom worth buying. If they cover accidental damage and you have young children, then perhaps you do want to consider them since the odds of payout will be high. If you feel that your circumstances are different from most consumers such that the odds of payout (check exclusions!!!) is quite high in your favour, then perhaps you should buy the insurance. Also, look at insuring yourself. Be it for a mortgage (see my previous post) or for insuring electronics, put the extra payments into a savings account and use it for repairs or replacement. Also by insuring yourself, you don't put a deadline on when your insurance would expire. Your money remains with you and is not lost.
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