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.