Cupcakes and Bubbles

Cupcakes and Bubbles – no, that’s not the two new women at the Body Shop on Sunset. It’s just two ways of thinking about the economy. It’s easy to deal with the Body Shop, the most famous all-nude-girls-all-the-time gentlemen’s club in the world – it’s just down the street, two short blocks. It’s harder to deal with the economy. The economy is everywhere, and nowhere, and in the last year it has collapsed. Unemployment is now nearing ten percent, and if you count those who have just given up looking for work, unemployment is well over sixteen percent. The housing market has collapsed too, of course. And commercial real estate is next – a good discussion of that from Daniel Gross here. The bubbles burst, and cupcakes are next – but more on that later.

Many have been wiped out, and investment banks, like Lehman Brothers, are gone, and the government now pretty much owns GM and AIG, the largest insurer in the world. We’ve propped up the major banks, without saying we’ve nationalized them, but smaller banks go under at the rate of six or seven a week – the FDIC just shuts them down, covers the bad debt, and lets some other slightly more solvent bank run the shop. And there’s this:

The names of 111 institutions landed on the FDIC’s “problem list” at the end of June, adding to the 305 banks already being watched by the agency. These 416 institutions, thought by the FDIC to be at risk of collapse, represent about 5 percent of the nation’s banks. A year ago, there were only 117 names on that list.

Things are getting worse. But if you watch the financial gurus on CNBC, America’s business channel, you should cheer up – things are getting worse at a slightly slower rate each month. That’s a good trend. Imagine you’re dying of cancer and your major organs are failing one by one. Of course you would be encouraged if, say, your liver were disintegrating a bit more slowly than it was the week before. That’s progress, if you’re not too picky about defining the word.

This is what the financial wizards on your television call “green shoots” – of course the economy is collapsing, but now it’s collapsing a slight bit more slowly, and if you do a simple linear extrapolation, and assume nothing else bad ever happens again at all, then there must be a point in the future when the collapse will end and the economy is flat. That’s only logical. And if we can get back to break even, growth will surely follow. What could go wrong?

They say these things and stocks soar, and then they don’t. Investors remember things are still collapsing. They sell and take their short-term profit and hunker down. And Larry Kudlow and the CNBC crew go off looking for more green shoots. One thinks of those highly-trained pigs in Southern France snuffling around in the forest undergrowth for those rare and exotic black truffles. Keep that image in mind – it makes watching CNBC more bearable.

But you are watching the free-market supply-side folks do their thing – Milton Freidman meets Ronald Reagan, two dead guys telling you that the market is a primal force in and of itself. You see, if the government would get out of the way, and stop regulating things, and stop taxing everything, and end welfare and unemployment benefits, then the economy would right itself. Greedy people would do anything and everything to make money, and we’d have boom times as they did, as they’d hire staff. And the Invisible Hand of Competition would create the greatest good for everyone – prices would come down as the greedy competed for our business, and they’d have to offer good stuff or we wouldn’t buy it, and we wouldn’t do business with anyone we discovered was screwing us over, so the bad guys would fail. Problem solved. The law didn’t have to deal with Bernie Madoff. Sooner or later people would have figured out what he was up to and stopped doing business with him. The market knows best.

There’s a whole school of economics that thinks this way, and these guys, with their mathematical models for how to play the market for maximum profit, have been in charge in America for the last eight or more years. That things haven’t gone well at all is, for them, proof that the markets weren’t free enough. We didn’t try hard enough. That must be it. These are the smart guys, after all.

The other school of thought, the Maynard Keynes folks, thought they were just as smart, and argued supply-side utterly-free-market policies just got us into mess after mess, into one foolish bubble after another. The demand side mattered just as much – have the government pump money into the economy when it stalls, even if you have people painting WPA-style murals or repairing roads in obscure corners of West Virginia, or even picking up trash, so they have cash to buy things and get things moving again. And that means collecting taxes from those still making oodles of good money to fund the effort. It’s intervention.

The Freidman meets Reagan crowd hates that whole idea of intervention, calling it socialism or heresy or treason or whatever, but we seem to be trying that now. So we have the Battle of the Economists – a grudge match where two economic theories duke it out on your television every night, while you worry about whether you’ll be living in a cardboard box under a freeway ramp this winter.

Should you listen to economists and financial gurus and the captains of industry at all? Their track record isn’t that good, and in late August, Paul Krugman wrote an item in the New York Times magazine on just how economists got everything so wrong – “As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.”

Up in Berkeley, the Clinton economist, Brad DeLong, is fine with that:

The big lesson, I think, is that Wall Street is much less sophisticated than we imagined it was: Goldman Sachs simply did not do any of the due diligence it needed to do to understand the AIG-specific risks it was assuming, Citigroup was unable to manage its own derivatives book to understand what “liquidity put” risks it was assuming, and as for Bear Stearns, Lehman Brothers, Merrill Lynch – hoo boy…

What? These guys don’t know anything? Kevin Drum says oh my, yes:

Wall Street bankers are smart, and rich, and experienced, and knowledgeable – but they aren’t sophisticated. They are hairless apes a few gene mutations removed from the savannah who only think they’re sophisticated.

So what to do? Krugman thinks the Great Recession will affect macroeconomics about the same way that black body radiation affected physics: it will uproot it completely. Markets are no longer plausibly efficient, neoclassical economics plainly doesn’t work, and market agents are far more irrational than anyone thinks.

Well, that is what Krugman said:

So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection – that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit – and this will be very hard for the people who giggled and whispered over Keynes – that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.

Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: “There is always an easy solution to every human problem – neat, plausible and wrong.”

Drum suggests this may be a good time to become an economist, as there is work to be done. And he mentions that Max Planck’s solution to the black body radiation problem in 1900 was the starting point of quantum mechanics, which uprooted all of classical physics – and apologizes for being obscure. Hey, it happens.

But modern market (neoclassical) economics has become a joke. And Douglas Rushkoff in Edge argues that’s because, as much as folks like to think economics is a natural science, it just isn’t:

The marketplace in which most commerce takes place today is not a pre-existing condition of the universe. It’s not nature. It’s a game, with very particular rules, set in motion by real people with real purposes. That’s why it’s so amazing to me that scientists, and people calling themselves scientists, would propose to study the market as if it were some natural system – like the weather, or a coral reef.

It’s not. It’s a product not of nature but of engineering. And to treat the market as nature, as some product of purely evolutionary forces, is to deny ourselves access to its ongoing redesign. It’s as if we woke up in a world where just one operating system was running on all our computers and, worse, we didn’t realize that any other operating system ever did or could ever exist. We would simply accept Windows as a given circumstance, and look for ways to adjust our society to its needs rather than the other way around.

It is up to our most rigorous thinkers and writers not to base their work on widely accepted but largely artificial constructs. It is their job to differentiate between the map and the territory – to recognize when a series of false assumptions is corrupting their observations and conclusions.

And if Richard Dawkins, Sam Harris, and Christopher Hitchens can “challenge the widespread belief in creation mythologies” by defending secular rationalism – what others call atheism – it may be time to ask hard questions about this other religion. The idea seems to be that believing the talking snake who promotes apples or the mysterious Invisible Hand that creates the greatest good are both kind of odd, and irrational. The “underlying premise of our corporate-driven marketplace as a precondition of the universe” is just that, a premise, or pure faith in what could be nonsense:

Whether it’s being done in honest ignorance, blind obedience, or cynical exploitation of the market, the result is the same: our ability to envision new solutions to the latest challenges is stunted by a dependence on market-driven and market-compatible answers. Instead, we are encouraged to apply the rules of genetics, neuroscience, or systems theory to the economy, and to do so in a dangerously determinist fashion.

In their ongoing effort to define and defend the functioning of the market through science and systems theory, some of today’s brightest thinkers have, perhaps inadvertently, promoted a mythology about commerce, culture, and competition. And it is a mythology as false, dangerous, and ultimately deadly as any religion.

Go to the link for detail, but note this history:

The economy in which we operate is not a natural system, but a set of rules developed in the Late Middle Ages in order to prevent the unchecked rise of a merchant class that was creating and exchanging value with impunity. This was what we might today call a peer-to-peer economy, and did not depend on central employers or even central currency.

People brought grain in from the fields, had it weighed at a grain store, and left with a receipt – usually stamped into a thin piece of foil. The foil could be torn into smaller pieces and used as currency in town. Each piece represented a specific amount of grain. The money was quite literally earned into existence – and the total amount in circulation reflected the abundance of the crop.

Now the interesting thing about this money is that it lost value over time. The grain store had to be paid, some of the grain was lost to rats and spoilage. So each year, the grain store would reissue the money for any grain that hadn’t actually been claimed. This meant that the money was biased towards transactions – towards circulation, rather than hording. People wanted to spend it. And the more money circulates (to a point) the better and more bountiful the economy. Preventative maintenance on machinery, research and development on new windmills and water wheels, was at a high.

And that started it all, with the natural push-back:

Feudal lords, early kings, and the aristocracy were not participating in this wealth creation. Their families hadn’t created value in centuries, and they needed a mechanism through which to maintain their own stature in the face of a rising middle class. The two ideas they came up with are still with us today in essentially the same form, and have become so embedded in commerce that we mistake them for pre-existing laws of economic activity.

The first innovation was to centralize currency. What better way for the already rich to maintain their wealth than to make money scarce? Monarchs forcibly made abundant local currencies illegal, and required people to exchange value through artificially scarce central currencies instead. Not only was centrally issued money easier to tax, but it gave central banks an easy way to extract value through debasement (removing gold content). The bias of scarce currency, however, was towards hording. Those with access to the treasury could accrue wealth by lending or investing passively in value creation by others. Prosperity on the periphery quickly diminished as value was drawn toward the center. Within a few decades of the establishment of central currency in France came local poverty, an end to subsistence farming, and the plague. (The economy we now celebrate as the happy result of these Renaissance innovations only took effect after Europe had lost half of its population.)

Of course there’s more, but it comes down to this:

We ended up with an economy based in scarcity and competition rather than abundance and collaboration; an economy that requires growth and eschews sustainable business models. It may or may not better reflect the laws of nature – and that it is a conversation we really should have – but it is certainly not the result of entirely natural set of principles in action. It is a system designed by certain people at a certain moment in history, with very specific interests.

And Rushkoff is not impressed with all the talk of how man is competitive in nature, as are all life forms, and as it’s a dog-eat-dog world, that should be the axiom upon which economic theory of any kind is built. He notes you can prove that cooperation as a primary human social skill, mentioning Harvard biologist Ian Gilby’s research on hunting among bats and chimps that “demonstrates advanced forms of cooperation, collective action, and sharing of meat disproportional to the risks taken to kill it.” It’s not all self-interested battle for survival of the fittest.

And that’s just a part of it. The whole thing is fascinating.

And it is time to rethink things. See Dana Stevens’ review of the documentary film American Casino (Table Rock Films):

American Casino gets its schadenfreude out of the way up front. During the opening credits, the late Blossom Dearie sings “The Party’s Over” as the camera swoops through the canyons of New York’s Financial District, zeroing in at last on the Lehman Bros. building. In its jargon-filled but instructive first half-hour, the documentary takes up euphemistic terms like “complex financial instruments” – remember last fall during the bailout negotiations, when every other sentence out of Henry Paulson’s mouth seemed to contain the words complex financial instruments? – and lays out what they actually were: bald-faced scams in which, for example, banks submitted bundled subprime mortgages to credit ratings agencies, which then rubber-stamped the loans, collected a large fee, and handed them back to the bank, having run no financial analysis whatsoever. An internal e-mail at the ratings agency Standard & Poor’s put it this way: “We rate every deal. It could be structured by cows and we would rate it.” An honest bovine broker would have been preferable to these vultures, who, among themselves, were quite open about the havoc their greed was about to wreak; in another internal e-mail from late 2008, an S&P analyst writes, “Let’s hope we are all wealthy and retired by the time this house of cards falters.” A former Bear Stearns executive addresses the camera anonymously, visible only in silhouette, his voice electronically distorted – the same treatment documentary filmmakers traditionally give to child molesters.

Just when you’re getting ready to sharpen your scythe and head to Wall Street, the film abruptly cuts to the boarded-up row houses of Baltimore, where a young black schoolteacher and father of three, Denzel Mitchell, has just lost his home. Mitchell’s story, and those of other minority homeowners who were hoodwinked into subprime mortgage deals, are heartbreaking enough as isolated anecdotes. But later in the film, when a financial reporter points out Mitchell’s mortgage on a computer screen listing bundled Goldman-Sachs assets, the viewer gets a chilling sense of the scale of this transfer of wealth from bottom to top. As another financial talking head puts it, some infinitesimal percentage of Hank Paulson’s $600 million worth of Goldman stock came directly from profit on Denzel Mitchell’s subprime loan.

The Invisible Hand gave us every one of us the finger. And then there is Daniel Gross explaining the Cupcake Bubble:

The current recession, which started in late 2007, laid the groundwork for the recent proliferation of cupcake stores in American cities. Lots of people know how to make really tasty cupcakes, which are simple products with cheap basic ingredients. Baking cupcakes doesn’t require a large amount of capital investment, and it’s relatively easy to scale up without hiring lots of workers. It takes about as much labor to produce three dozen cupcakes as it does to make one dozen. Meanwhile, storefronts in heavily trafficked areas became cheaper with the decimation of local retail. And so in the past year, casual baking has turned into an urban industry.

The trend started, as most trends do, in Los Angeles and New York. In Los Angeles, Sprinkles, which bills itself as the first cupcake bakery, has expanded from its base in Beverly Hills to five locations in California, Texas, and Arizona – with 16 more outlets in the works. Crumbs, started six years ago on Manhattan’s Upper West Side, is up to nearly two dozen locations: five in Los Angeles, and 18 in chi-chi zones of the New York metro area – New Canaan, Conn.; Westfield, N.J.; East Hampton, N.Y. – with three more on the way. Magnolia Bakery, immortalized in Sex and the City, has three locations in Manhattan. Washington, D.C., is getting in on the act, too. As the Washington Post notes, “at least half a dozen cupcake bakeries have opened around Washington in the past 20 months, and more are on the way,” with Georgetown Cupcake and Red Velvet out front.

Gross has no problem with this – “They’re peddling a product that is simple, obvious, and generally affordable.” And any of it is better than the crap pastries at Starbucks, of course. But we have a bubble forming:

The first-movers get buzz and revenues, gain critical mass, and start to expand rapidly. This inspires less-well-capitalized second- and third-movers, who believe there’s room enough for them, and encourages established firms in a related industry to jump in. In New York, the Crumbs is joined by a cupcake truck, Sweet Revenge, Babycakes, and Sugar Sweet Sunshine. The Post notes that in D.C., “established bakers such as CakeLove, Just Cakes, Furin’s, Best Buns and Baked & Wired are all in on the act.” Operating in what is essentially a commodity market newcomers try to distinguish themselves by offering twists on the familiar formula. Hello Cupcake, conveniently located near Slate’s D.C. office, specializes in organic, seasonal, and local ingredients. Babycakes offers vegan cupcakes. Coming soon to a precious storefront in a gentrifying neighborhood of Brooklyn: sustainable cupcakes made of flour ground from organic wheat raised in Prospect Park, served in wrappers recycled from old copies of the New York Review of Books.

Greed, and everyone wanting in, creates certain widespread failure. The Invisible Hand, like Elvis, has left the house. And the product does the opposite of improving:

What’s more, cupcakes aren’t so cheap. With tax, many of these cupcakes run close to $4 a pop. Pair a high-end cupcake with a coffee and your snack costs the equivalent of a satisfying sandwich. Crucially, the sugar rush that $4 buys lasts only as long as it takes to walk back to the office. By contrast, an expensive latte can keep office drones humming for the whole afternoon. And while cupcakes doubtless offer good margins, a baker has to sell a lot of them to make real money. That will surely tempt many entrepreneurs to start mass production. But the minute you start baking at a central location and trucking to the goods over long distances, the value proposition inherent in the product can grow stale, as Krispy Kreme found.

If you can extrapolate from one commodity, cupcakes for example, to the economy in general, you can see there is something terribly wrong in how as a matter of faith, we believe things work. It would be better to just observe, to fall back on something like secular rationalism. But on the other hand, maybe it would be better to walk down the street and check out Cupcakes and Bubbles in Hollywood.

About Alan

The editor is a former systems manager for a large California-based HMO, and a former senior systems manager for Northrop, Hughes-Raytheon, Computer Sciences Corporation, Perot Systems and other such organizations. One position was managing the financial and payroll systems for a large hospital chain. And somewhere in there was a two-year stint in Canada running the systems shop at a General Motors locomotive factory - in London, Ontario. That explains Canadian matters scattered through these pages. Otherwise, think large-scale HR, payroll, financial and manufacturing systems. A résumé is available if you wish. The editor has a graduate degree in Eighteenth-Century British Literature from Duke University where he was a National Woodrow Wilson Fellow, and taught English and music in upstate New York in the seventies, and then in the early eighties moved to California and left teaching. The editor currently resides in Hollywood California, a block north of the Sunset Strip.
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