Sunday, October 21, 2012

Different ways of spending money leading to different wealth outcomes

How nations spend their money will ultimately determine their wealth. Same goes for companies and individuals. I will talk about the different ways we spend money and why certain organizations fail/succeed because of the way they spend money. Before that, I confess that I am not smart to think of such a powerful, yet simple concept. This credit goes to Milton Friedman, arguably the most influential economist of the 20th century, who introduced the concept in his book "Free to Choose".

Children in western societies love Christmas because they receive gifts from adults. Children in Chinese society love Chinese New Year because they receive red packets (红包) which contain money from adults. Suppose you are free to choose, what would be your choice? For me, I am so glad to be born a Chinese :)

When your Uncle buys gifts for you on Christmas, he is spending his money on someone else (First way of spending money). He may love you very much and has the kindest intention to shower you with the best gifts. The problem is he does not know you well enough to buy what you really like. He could spend a bomb and still end up with a gift that you do not like, do not need, do not want. Worse still, he may even buy you something you already have. He could end up buying you an expensive white elephant that serves no useful purpose except take up space.

When your Uncle gives you red packets (红包), the money is yours and you can spend your own money on yourself (Second way of spending money). Nobody knows your likes and dislikes better than yourself. Since it is your own money, you will do your best to get value for money when you spend it and therefore, not overspend. In other words, you will use the minimum sum of money to extract maximum pleasure. This can best happen when you are spending money on yourself. This way of spending money leads to far superior capital allocation compared to the first one when a person spends his own money on someone else.

When you go on overseas trips with expenses fully paid by your employer, you are spending other people's money on yourself (Third way of spending money). Because it is other people's money, you do not really care how much you spend. What you really care is to extract maximum pleasure from spending the money. This way of spending money will lead to wastage but it will at least serve its purpose of being put to good use on yourself. Wastage but at least good outcome.

Suppose you are a kind, idealistic person and joins the government one day with the intention to help other people. As a government official, you are charged with the responsibility to spend taxpayers' money on taxpayers. Now, what happens? You are spending other people's money on other people (4th way of spending money). This is the worst of both worlds. Because it is other people's money, one tends to spend with less care. Because it is spent on other people who are faceless strangers, the spender does not really know what other people want and need. Therefore, chances are that the people whom the money is to be spent on do not really benefit much from it. This is going to lead to plenty of wastage without achieving good outcome. A good example of the proverb "The road to hell is paved with good intentions".

The 4 ways of spending money is a simple concept and is a useful tool to think about economic systems. The private sector does a better job allocating capital than the public sector because most people there spend their own money on themselves. Even with the best of intentions, the government is unlikely to achieve more than a group of selfish individuals pursuing their own selfish interests using their own money (read the invisible hand of Adam Smith). This is why free, capitalistic countries have succeeded so spectacularly economically compared to the socialist/communist, centrally-planned economies.

It is naive to think that most government officials are public-spirited and have the people's interests at heart most of the time. All forms of government is guilty of the third way of spending money - spending other people's money on themselves. In other words, corruption. Despite Singaporeans' numerous complaints about the government, this is one aspect that our government score very well in being relatively corruption-free. China can do everything that Singapore can from low-end work to high-end technology but it is very hard for them to copy this clean aspect of Singapore. The vested interests are too deep. Closer home, due to human nature, there is a natural tendency for Ministerial salaries to go up if set by Ministers themselves. The fact that the PM has agreed to cut his own salary as well as his colleagues' is a good sign that we have good men in charge and democracy is kicking alive here. I have actually written a letter to the PM on this issue but I doubt he will have the time to read it.

Due to the ease at which government officials can spend other people's money on themselves, it is far more important to focus on the character of the people they are recruiting than on their intelligence (1st-class honors, good academic grades etc) which our government tends to be obsessed about. Intelligent workers are double-edged swords. A smart worker in a position to steal will be able to steal more without getting caught. Who can disagree with that? Problem is it is very hard to judge a man's character because intelligent but bad people can put on a good show to show they are good people.

A more insidious form of "spending other people's money on yourselves" today are financial institutions taking excessive risks with other people's money and paying themselves very high bonuses when things go right but push the losses to taxpayers when things go wrong. When things run well, Wall Street lobbied for deregulation and that government should have the good capitalist sense to keep their hands off. In 2008, when things went wrong, Wall Street screamed for help "Save me, save me or the world will go to an end", hoping that the government will turn socialist to save them. Since taxpayers' money are at risk for too-big-to-fail institutions, there is a good case for more regulation. In fact, any institution that have taxpayers' money on the hook should be heavily regulated.

One vital purpose of Finance is optimal capital allocation which is channeling idle capital to productive uses. Ironically, allowing financial institutions to spend other people's money on themselves without adequate regulation has led to one of the worst capital allocation in living memory which culminated in the global financial crisis of 2008. The global major banks lost so much money that the government has to print money to save them. So much money was lent to people with bad credit because the bankers have repackaged the debt and sold off to other investors who are not in a good position to make credit decisions compared to the bankers themselves.

Thirty years ago, all major Wall Street investment banks were private partnerships. They were handling their own money. By 2000, Goldman Sachs became the last major investment bank to go public. By then, all of them were using other people's money to get rich, some at a leverage of 30 to 1. The risks people take with their own money and with other people's money are very different. 2008 crisis would surely not happen had investment banks remain in private hands.

The free market works best when enterprising people have maximum freedom to use their own money for themselves with minimum interference from government. If they screw up or just suffer hard luck, the free market will discipline them to ensure that poor capital allocation decisions get punished. The government should lay their hands off these enterprising people because the free market will be there to punish (or regulate) them for bad decisions/behavior. However, the free market does not work for certain groups of people (too-big-to-fail financial institutions) who have at their disposal so much of other people's money that when they screw up, society cannot give the free market total freedom to punish them without risking social chaos. Government has to step in for such cases.

As a Singaporean hoping for a more prosperous future for our country, I hope to see more of our people using their own money for themselves and get rich as entrepreneurs. Today, it is not healthy to see too many of our finest minds joining the government sector and getting rich as bureaucrats who spend other people's money on other people, however well-intentioned. It is also not healthy if a disproportionately huge number of bright minds join the financial sector and get rich in a poorly regulated environment where they use other people's money on themselves neglecting their fiduciary duties to people who entrust money to them.

On a final note, this blog is about helping your own money which is really about managing your own money yourself. If possible, always rely on yourself on money matters as very few can be trusted when it comes to handling money. There is no better incentive structure than to have a person manage his own money and invest/spend his own money for himself.

24 comments:

  1. Interesting article. Economics 101 in one single article on why capitalistic systems outperform communism and socialism.

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    1. Excellent article even a layman like me more or less understands.
      So if you are not interested in managing your own money, many people are always waiting to tell you they are. Ha! Ha! "A fool and his money are soon parted"

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    2. Hi Temperament,

      You are too humble. You are a proven investor with investment results that enabled you to retire early and still able to finance your kids' education. You have much to teach those economists with dismal forecasting track record.

      With your own track record, I am sure there is nobody better to manage your money than yourself.

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  2. partnerships are not the best stuff as well. recently i read that the lawyer partnership in US is facing problems because if they have one loss making year they will be in deep problems.

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    1. Hi Drizzt,

      You are right. On an individual level, partnerships are risky because the risks are concentrated in the hands of a few partners only and not spread around. On a systemic level, they are safer because private individuals handling their own money do not take crazy risks compared to institutions handling other people's money.

      Private individuals suffer the full downside while the incentive structures of institutions can be asymmetric - enjoy the upside but don't suffer the downside. Fund managers' incentive schemes is one example. They take a cut from the profit but suffer zero losses when they lose their clients' money, assuming they are not substantial investors in their own fund.

      Delete
  3. I like the way you use a simple idea of different ways of spending money to explain Economics. It is not only easier to understand but also much more convincing. Are you an Econs student?

    Thanks. I have bookmarked your blog.

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  4. Hi Hyom,

    Nice article and I enjoyed reading it.

    I would like to share my point of view. Your theory of the 4 ways to spend money and their outcomes is right but incomplete. Let's see.

    First way. Another person buy/give you something instead of money can lead to misallocation of capital. It is true if your uncle give you a gift instead of money. But what if it is your dad or mom who will be spending the money on your education? If the money is given to you instead, you would most probably spend it on other than education, such as games, foods or whatever you feel like buying at that moment. Do you think this is a misallocation of capital?

    Second way. Spend your money on yourself is the superior capital allocation process. Like in the first, if you do not know what you are doing, you might be wasting money rather than allocating capital effectively.

    Third way. To spend other people's money on yourself is a waste but lead to good outcome on yourself. It is not necessarily a waste. From the other people's perspective it could be a win-win situation in which he can get what he wanted by assigning you (instead of himself in which he assigns a higher time for value) the job. You too will be happier as you can extract maximum pleasure. Win-win situation.

    Fourth way. To spend other people's money on others will lead to plenty of wastage without achieving good outcomes. This too is not necessarily a waste without achieving good outcomes. Government projects which uses taxpayers money for financing are usually huge projects with high risk. For example, airports, seaports, MRT etc. These projects can benefit both the government and the publics. Should these projects be given to the private entities without government interventions, I am sure that the publics will be extorted as these private entities will be demanding a higher return for the huge risk they are taking. Even worse, the private entities will not build the infrastructure as they are short sighted.

    In conclusion, each of the four ways of spending money is double edge sword; it can lead to catastrophe or prosperity. It is no doubt that in this society, the four ways of spending money will be utilised in day to day operation of our capital. Therefore, we need to find a way to lose less and gain more within each of the four ways.

    I also think the government and the public needs to work together. Both need to realise that they are in the same boat. Should one party take advantage of the other, both will move one step back, or worse, capsize the boat. USA with the free capital system is collapsing because the private sectors have too much debt and the debt is entangling even the government. Only time can tell if USA can survive and maintain the superpower position. Indonesia with so much corruption under the Suharto era lead to mass protest and turned the country to anarchy. The Soviet with their communist system failed catastrophically and lead to the break up of the nation.

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    1. Hi Anonymous on Monday, October 22, 2012 2:35:00 PM GMT+08:00

      Thank you for sparing the time to write a long comment. No general rule can work well for all situations. You have provided the exceptional cases for the 4 different ways of spending money.

      Thanks! Your comment added value to this article.

      By the way, it is not my theory. The credit belongs to Milton Friedman who makes me appear like an ant.

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  5. Hyom,

    Nice writing!

    Personally, I would be worried if some of our brightest do not join the civil service and government. Can you imagine a civil service and government run by mediocre people? That's plutocracy as corruption favours the wealthy class.

    The ideal would be some of these brightest amongst us can first make their millions in the private sector, and they "sacrifice" in pay and privacy by joining our civil service or government at a later stage of their career for "self-actualization".

    We already have quite a few good examples in our past Chief Justices, Ministers, and even President ;)




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    1. I agree with Hyom and you. it all comes down to character, which is very hard to judge. A mediocre person with good character is better than a smart person without good character. Of course, the best is a smart person with good character.

      Given that Singapore has proven in history that she can produce that best person, I think she will continue to do that. I read somewhere if a country that has made good decision will continue making good decision. Therefore my conclusion that Singapore will continue making good decision by the people running it.

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    2. Hi Jared,

      Certainly our government must attract its fair share of Singapore's brightest. In fact, the most expensive place to have fools around is the government. When government people screw up, the entire population is affected. When private corporations screw up, only their employees, suppliers and customers are affected. I would rather have fools in the private sector than fools in the public sector. Therefore, it makes perfect sense to pay our public servants well. However, the salary they get should not be so high that they starve the private sector of talent. Given that government jobs are relatively secure, their salaries should reflect the lower risk which means they should not be paid more than higher risk equivalent private sector jobs.

      The ideal would be some of these brightest amongst us can first make their millions in the private sector, and they "sacrifice" in pay and privacy by joining our civil service or government at a later stage of their career for "self-actualization".

      We already have quite a few good examples in our past Chief Justices, Ministers, and even President ;)


      I share your opinion as well. Unfortunately, this did not happen in the last GE. The ideal candidate which fits your bill went to the opposition (Chen Show Mao). Ironically, I think the failure of PAP to attract good private sector men is high Ministerial salaries. I do not begrudge Ministers for their high salaries because I think few people would want to take up their jobs even without the latest pay-cut given the loss of privacy. However, excessive salaries will cost our leaders respect in the eyes of the people. Losing respect means losing trust. Without trust, it is hard for a leader to lead. Also, private sector people do not need the money because they already have plenty of it. If they join politics, it is for respect and the chance to do greater things to greater number of people in a greater, positive way. When politicians are perceived like greedy Wall Street bankers, no private sector guy will want to become a politician if what they want is respect and reputation, not more money. This may be a reason why PAP was able to attract private sector people in the past but no longer able to do so as can be seen in the last GE. Throwing more money at the problem will worsen the problem, not solve it.

      http://help-your-money.blogspot.sg/2012/01/letter-to-prime-minister-on-ministerial.html

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    3. Given that Singapore has proven in history that she can produce that best person, I think she will continue to do that. I read somewhere if a country that has made good decision will continue making good decision. Therefore my conclusion that Singapore will continue making good decision by the people running it.

      Hi Andreas,

      I am confident you are more likely to be right than wrong. Given that there are so many foreign countries looking to learn from our government leaders, they have definitely done more right than wrong. That's for sure. But, able as they may be, they may have blind spots that ordinary citizens can sometimes feedback. A good sign is that our leaders have become much better listeners after the last GE :)

      Delete
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    1. Hi Helle Mikkelsen,

      Thanks for reading my blog and your compliment.

      Delete
  8. Great Article. Like yourself, I manage my own money and my own investment.

    I would like to do a blog link exchange with you. Would like to show my readers of the articles that you have written.

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    1. Hi Dave,

      Please drop me an email at help.your.own.money@gmail.com after you have added the link to your blog.

      Thank you.

      Delete
  9. Just watched this documentary on Karl Marx and stumbled onto your article.

    http://www.youtube.com/watch?v=hsxfMHbLubA

    Your article gives a very simple-to-understand explanation on why the free market won over the communist system.

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  12. Thank you for the intersting article and putting rather a serious theme into simple, yet exciting word frame. I would like to know to which way of spending money will you refer loans. Is it the 3rd or the 2nd? Frankly speaking I hezitate with the answer.

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