Economics
of Risk Value

Once upon a time. Then Times change.

Before the 1980s, most construction and business was predicated upon specifications of what would most likely result in an expected outcome. Life focused on reasoned productivity. Plans were made with the goal of ensuring the desired and expected outcome. Collateral was required before expenses were incurred and risk was minimized to the greatest degree possible. Even government was expected to spend no more than was justified by any undertaking.

By the early 1980s, the U.S. economy was in a cycle of growth which was an extension of boom times which followed World War II. Prosperity which had been unimaginable before the War was now touching most areas of life. Productivity was high, wealth at all levels of society was greater than envisioned and asset holding was at the all-time high, i.e., citizens held more goods than ever before. But this was a repeat of earlier, unrecognized cycles.

Beginning in the late 1800s, there was the Long Depression (1873-1879), the Panic of 1893, Panic of 1907 and then the Wall Street Crash of 1929 ushering in the Great Depression lasting for the next decade. Each one was characterized by an over expansion of the economy either by under-capitalization of businesses or too rapid of growth without the ability to support the higher productivity or too much speculation without assets to serve as the foundation for growth.

In a play on words, the housing boom from 1950 to 1980 began as a deliberate, specified growth of an industry with each unit being built for an existing market and demand exceeding supply. Yet money remained tight and banks and government-financed programs were the only sources of mortgage financing. By 1978 the boom was speeding up with additional sources of monies available as investors saw the housing market as an easy way to make larger profits than readily accessible in other ventures. Profits made in other ventures began to be funneled into housing but now rather than a specification market it became a speculation market. Speculation is the idea that risks are manageable and profits can be higher than in the constraints of Specification. The market moves from Investment to Speculation and as such loses restraints in the quest for maximized yields. Risk is not a present concern. By the early 1980s when interest rates took double digit increases, much of the money “speculated” into the market on a “sure thing” could not be recouped. Thousands of speculators lost all of their “investments” and had no assets to show. Bankruptcy became a common escape which further depressed the market.

But, never to be discouraged, folks were soon looking for the next rising star and the market was primed for the dot.com bubble of the mid-1990s into first year of the next millennia. The investing public has a tendency to become infatuated with markets without adequate knowledge of the nature of the enterprise or what the actual asset is. With the early days of the Internet and everything related to the digital world, venture capitalists touted the possibilities available to anyone who would be wise enough to join them in the capitalization of anything to do with the wonders of the digital age. Scams were rampant and everything from online shopping channels to dot.com stocks to software, games, social media all beckoned the endless possibilities for the shrewd investor. Unfortunately, the astronomical rise (800% in five year) was not supported by real assets but rather the equivalent of vaporware or good intentions. Or less. In the following year, this segment lost 78% of its original value and most of the highly sought opportunities simply did not exist.

Another example of inflated value might be found in the concept of what became known as Cost-Benefit Analysis. Is it actual value or projected estimated speculated value? A French engineer-economist, Jules Dupuit, is credited with the creation of cost-benefit analysis in an article he published in 1848. In his original work, he sought to justify the cost of a public works project by the benefits that would be derived following its completion. The calculation proposed to take the direct cost of goods and services used in the project and ratio them to the gross benefits/savings which would accrue as a result. It was generally agreed that the benefit should have equal if not greater value than the costs. This becomes difficult to measure due to putting a value on life or consequences not apparent.

The first U.S. federal application of CBA, cost-benefit analysis, came under the Corps of Engineers when they began using it as justification of projects under the 1936 Federal Navigation Act. By the time of the 1939 Flood Control Act, CBA was the Corps’ standard measure for viability of its federal projects and other federal agencies. “…the benefits to whomever they accrue (to be) in excess of the estimated costs.” ¹

Previously, in 1933, Congress enacted the Tennessee Valley Authority Act which was “To improve the navigability and to provide for the flood control of the Tennessee River; to provide for reforestation and the proper use of marginal lands in the Tennessee Valley; to provide for the agricultural and industrial development of said valley; to provide for the national defense by the creation of a corporation for the operation of Government properties at and near Muscle Shoals in the State of Alabama, and for other purposes.” Section 13 includes the requirement that,

“The Corporation shall, not later than January 1, 1945, submit to the Congress a report on the operation… including a statement of the distribution to the various States and counties hereunder; the effect of the operation of the provisions of this section on State and local finances; an appraisal of the benefits of the program of the Corporation to the States and counties receiving payments hereunder, and the effect of such benefits in increasing taxable values…”

Section 14 continues that,

“… the Corporation must ascertain the proportional values of the assets under the Corporation to include Dam Number 2, steam plants at nitrate plants 1 and 2, cost of the Cove Creek Dam so that the costs of said assets could be allocated to 1) flood control, 2) navigation, 3) fertilizer, 4) national defense, 5) development of power…”

CBA (Cost-Benefit Analysis) seeks to justify the expense of any project by maximizing the benefits of that project. Over time CBA proponents have become adept at creating multipliers to measure indirect or unmeasurable rewards. It is not unusual for multiplier factors in the range of 3.7 and higher to be applied to expenses to create benefit composite values. The rationale is that any dollar spent on the project will result in a multiplication as that dollar spent is then recycled 3.7 times in the economy. “The laborer earns $100 which is then spent on groceries at the local store. The store then buys goods and has employees who earn the $100 and then those recipients spend the $100…” Not surprisingly, anyone who wants to justify a expenditure of resources will overlook any shortcomings of the CBA even though the benefits are not specified or an actual, quantifiable investment with specific returns but rather a speculation in what might or might not become reality.

As in the earlier housing example, when investment crosses from a specified manner of attainment of a product and becomes a speculation resting upon what-might-have-been’s, it is not investing. This is not entirely different than the Ponzi scheme where the first in are paid from the next layer coming in and yet no real asset is created equivalent to the investments made. When more goes out than comes in, it is not an investment. The famous quip of gambling is, “You have to play to win.” but the truth is you have to play to lose. Nothing pays out more than is taken in, at least legally. And consider the management fees for lotteries – the entity operating the lottery is likely taking a 10-25% fee off the top of all income. In 2023, U.S. lottery sales (value of tickets sold) was $113.3 billion while the actual payout to winners (RTP Return to Players) was $37 billion. Typically lotteries RTP is somewhere between 50-70% with the remaining 30-50% going into management, overhead and advertising which includes payments to the vendors who actually sell the cards. In Montana for instance, when the Montana Lottery was created in 1986, the premise was that “profits” after RTP and expenses would be used to fund the Teachers’ Retirement Fund, but by 1995, “profits” were redirected to the State’s General Fund. Historically, the amount actually contributed to the General Fund is in the range of 1% of total fund. But. When inaugurated the payback was greatly exaggerated and was touted as a means to reduce property taxes in the State. Since the first year through Fiscal Year 2023, the Lottery(s) have a RTP of $953 million and return of $342 million to the State General Fund(s); another $97 million has been spent on sales commissions. The year ending June 30, 2023, Montana State agencies also expensed $326,346 for services and support of the Lottery. Montana law requires at least a 45% RTP. ²

There is a social expectation that Speculation should have the same relative outcome as Investment or at least the mindset is along those lines. If the statistics are that you will lose two-thirds of every dollar you “invest” in an opportunity, or that you are speculating that the payback benefit will be 3.7 times greater than what you put into an effort or that you can multiply your assets without your own productivity, we do have schemes for you.

From a different perspective, in investing there is an expression that “you have to have a stake in the game to play” which means you have to be a participant, have to have placed something of value in the transaction before there can be any expectation of return. Simply being present or expecting you are as valuable as other participants does not give you the opportunity – you have to bring something besides expectation into the process.