Milton Friedman, 1912 - 2006

Today marks the anniversary of the birth of Milton Friedman, born on July 31, 1912.

Dr. Friedman was one of the clearest voices for freedom in the twentieth century, and in fact of all time.

Among his many accomplishments was his articulation, along with Anna Schwartz, of the principles of monetarism, in the revolutionary Monetary History of the United States, 1867 - 1960. That paradigm-shifting text argued that the Great Depression was largely caused by the Federal Reserve's misguided monetary policies. The book correctly outlined the connection between the quantity of money and price stability, and had a profound impact on the way monetary policy would be understood from that point forward.

Along with his wife Rose Friedman, Dr. Friedman put forth brilliant and straightforward arguments for the connection between economics and freedom, in works such as their book Free to Choose, which was also made into an outstanding television series. There, as well as in other works promoting freedom, they argued that economic freedom was an indispensable means of achieving political freedom, and that the great advances of civilization have never come from centralized government.

The power of his arguments on this subject of human freedom can still be heard, in his own voice, in the television version of Free to Choose, which is available in its entirety both in the 1980 series and in the 1990 series, at Idea Channel TV. We strongly encourage all of our readers to make it a goal to watch those series, which cover a subject that never becomes outdated.

Dr. Friedman's work was also notable for the gentleness and the humor with which he framed his arguments -- a quality that is sadly lacking in many of the voices arguing over such matters today.

We urge all people everywhere to become familiar with Milton Friedman's work, and his arguments on behalf of economic and human freedom. Please pass this message along to your friends and family.

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The Bandwidth Revolution

Over a year ago, we linked to an article entitled "Unleashing the 'Exaflood'" by Bret Swanson and George Gilder, which discussed the ramifications of the probability that internet traffic will likely surge one hundred fold by 2015.

According to data presented in that article, the volume of data sent over the Internet in the year 2006 amounted to about 10 exabytes of data. A single exabyte is 1 x 10^18 bytes, or the amount of data present in the entire Library of Congress multiplied 50,000 times (a single 400-page book amounts to about a million bytes of data, or a megabyte). By 2015, the data volume is predicted to reach 1,000 exabytes.

The "pipes" that handle the traffic of the internet are simply not big enough at present to handle that enormous volume.

Now, signs of the strain are starting to become evident -- for example, in the recent hullabaloo over the decision to deny access to Google Voice over the iPhone. Google Voice is an application in which voice data** is routed through the internet, similar to other voice-over-IP services such as eBay's Skype, with a variety of distinguishing features including the ability to initiate and receive calls from regular landline telephones and mobile phones, rather than from computers or special computer devices*.

Recently, AT&T and Apple denied iPhone users the ability to access Google Voice from Apple iPhones and iPod Touch devices, fueling speculation that the restriction was enacted because AT&T is having trouble handling the enormous bandwidth strain created by iPhone users*.

That may or may not be the actual explanation. However, AT&T and Apple also recently limited iPhone users' access to SlingPlayer Mobile, a service from Sling Media which enables users to consume video on their mobile devices, suggesting that bandwidth usage by iPhone owners may indeed pose a problem for AT&T's "pipes." We interpret these developments as validation of some of the themes we have been following now for many years.

The implications of the enormous increase in internet volume are critical for investors to understand. Currently, most voice data is not sent over the internet -- if all voice data today were sent over the internet, it would amount to a volume of about 30 exabytes per year all by itself. Video data, which is much more bandwidth intensive, is also flooding the internet, and promises to create massive changes in the way we consume visual entertainment.

The demand for such services -- not only by consumers but also by businesses -- is going to create a "Bandwidth Revolution," as we argued in a previous post called "The Unstoppable Wave." That demand will necessitate an enormous expansion of the existing network infrastructure -- the "pipes" that will route this greatly expanded volume of data traffic. In spite of this, much of the discussion you hear from financial channels about "technology" is still focused on makers of PCs or on technology names that were in focus in the 1990s.

Investors who understand the classic growth stock philosophy of investing that we have articulated in this blog will understand the significance of these developments.

* The principals of Taylor Frigon Capital Management do not own securities issued by Google (GOOG), Apple (AAPL), AT&T (T), or eBay (EBAY).

** Special technical note added 07/30/2009: Some readers have expressed the view that Google Voice is not actually a VoIP service. They are correct that there are some important differences between Google Voice and traditional VoIP services. We in fact noted in our post that it has "a variety of distinguishing features" from other VoIP services. However, Google Voice does use voice-over-IP technology. A user's call goes to a carrier with which Google has an agreement, and at that point the voice call is transferred to data packets, which are then routed using Internet Protocols (IP). Thus, it is technically correct to describe Google Voice as a service which routes voice traffic over IP. The larger point is that it adds to the volume of data traversing through the "pipes" of the network infrastructure (immaterial of AT&T's and Apple's actual reasons for dropping Google Voice, which may have had to do with any number of business-oriented decisions other than pure bandwidth, since Google Voice calls actually come into an iPhone the same way that any other call would, and use minutes purchased by the user just the same as any other phone call). The significance of the projected massive increase in this traffic volume is the important point for investors to understand.

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The Fed's oversteering and the wreckage of the past decade

With a strong rally today, the general stock market roared back . . . to a level it originally reached twelve years ago.

Meanwhile, Fed Chairman Ben Bernanke in testimony before Congress earlier this week and in a Wall Street Journal article he published on Tuesday declared "accommodative policies will likely be warranted for an extended period."

As an excellent editorial in the same Wall Street Journal pointed out the next day, "we’ve been here before — specifically, in late 2003 when Mr. Bernanke was a Governor at Alan Greenspan’s Fed. Despite an expansion that was already well under way, Mr. Bernanke argued at the time that the Fed needed to keep the fed funds rate at 1% for an 'extended period' in order to reduce unemployment."

We would argue, and have argued before, that the economic wreckage of the past decade has the fingerprints of Fed over-steering all over it. As the Journal's editorial board point out above, Fed over-steering in 2003 led directly to the housing and mortgage bubble that exploded in 2007 and 2008 (for evidence of that one need look no further than the graph in this blog post).

Fed over-steering was also culpable in the Nasdaq bubble of 1999 which collapsed in 2000-2002, as we explained in "The long shadow of the Y2K bug" and "Revisiting the 'New Economy.'"

In short, the Fed's attempts to both "promote economic recovery and price stability" (as Mr. Bernanke put it in his testimony before Congress this week) has led to widespread and unnecessary economic suffering for countless individuals. By trying to steer the economy and "promote recovery" the Fed creates boom and bust cycles of volatility that are far worse than would be the case if they simply focused on price stability and let businesses create the recovery.

How long will this Fed volatility continue? It appears to be with us for the foreseeable future. Currently, the Fed is in a very accommodative posture and Mr. Bernanke's stated belief in the "output gap" is likely to keep it accommodative long enough to cause inflation and/or another bubble somewhere.

Investors must be acutely aware of this phenomenon, which we believe is responsible for much of the pain they have felt over recent years.

The best response to this oversteering Fed, in our opinion, is to avoid chasing after faddish speculations (such as last year's commodity bubble and currency speculation, both of which we warned against at the time). Instead, investors should build the foundation of their future purchasing power on innovative, growing companies -- the only vehicles that over time have shown the ability to stay ahead of the dangerous swerving Federal Reserve.

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The Investment Climate: July, 2009.

We recently published "The Investment Climate: July, 2009" in the commentary section of our website.

In it, we summarize the current situation and provide some perspective on where we stand today.

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Apollo 11

Today is the fortieth anniversary of the magnificent achievement of landing a man on the moon, on July 20, 1969.

There are many important and weighty lessons that we can ponder as we look back at that historic day.

One that is certainly appropriate is to remember that during the 1960s, the space program was very much seen by the entire world as a contest between two nations with very different views about the best way to allocate limited resources.

One of those nations believed that the best way to organize society and reach goals was through centralized government planning.

The other believed that the best way was to enable individuals to make their own choices, through free enterprise, the rule of law, and respect for private property.

During the 1960s (and even afterwards) there were many who believed that the first notion -- the organization of resources by central planning -- was the wave of the future, and that any society that failed to get in line with this new reality would be left behind.

The history of the twentieth century should have put that fallacy to rest forever. The ability of the United States, a country whose economy and resources were reliant upon free enterprise, to place a man on the moon before the end of the 1960s was a clear sign that the centrally-planned state was not the real wave of the future.

The successful landing on the moon by the Apollo astronauts was a very visible sign of the strength of a free country. We would probably do well to think about that more often.

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The healthcare black hole

Today, the Cato Institute published an article by Michael Cannon entitled, "Let Customers Control the Money and Market Will Cure Health Care." We believe he is right on track, and in very good company.

In 2001, the late Milton Friedman wrote an exceptionally clear explication of the economics behind the problems with health care in the United States.

In 2006, the Hoover Institution at Stanford University, where Dr. Friedman was a fellow, published a shorter version, entitled "How to Cure Health Care" -- an excellent resource for anyone who wants to know how we got to where we are today, and how to fix the problem.

In the article, Professor Friedman repeats a simple truth that he brought out over and over in his Free to Choose television series (both the 1980 and 1990 versions of which are available in their entirety on the Internet here). That truth is "that nobody spends somebody else’s money as wisely or as frugally as he spends his own."

The article demonstrates that over fifty percent of healthcare costs are already subsidized by the government in the US, when the tax deduction for health insurance costs available to employers is considered as what it is: a government subsidy.

This hybrid structure -- halfway private and halfway public -- leads to the conditions we have today, in which the cost of healthcare is paid for by employers.

Because of this government-induced situation, citizens in the US spend more on healthcare than they would if they were paying for it directly themselves (17% of the national income -- no other nation in the world comes close), in which the costs of medical treatment have increased by an astronomical 3,900% in the fifty years from 1946 to 1996 (while the cost of other economic goods such as automobiles and electronic technology went down even as their quality went up over the same timeframe), and in which more people are without health insurance* than otherwise would be (because the market for health insurance is artificially skewed towards employers, making it much harder to obtain for those who work for themselves or who are in between jobs -- data shows that 63% of uninsured workers are self-employed or work for small firms).

In fact, the convoluted situation of the past sixty years -- in which freedom to choose has been taken out of the individual's hands -- follows the pattern of Gammon's Law, after British physician Dr. Max Gammon, who formulated it after extensive study of the British medical system in the 1960s. Dr. Gammon determined that when freedom to choose is trumped by government bureaucracy, the result is like a black hole. He said that in any "bureaucratic system [. . .] increase in expenditure will be matched by fall in production. [. . .] Such systems will act rather like ‘black holes,’ in the economic universe, simultaneously sucking in resources, and shrinking in terms of ‘emitted production.’"

Friedman found Gammon's Law operating in many other areas of life in which freedom to choose had been overtaken by government bureaucracies, such as the school system. In fact, if you watch this video of Friedman's 1980 discussion of the problems with the US school system, you will be struck by how many parallels exist between it and the US healthcare system.

The most important lesson from Professor Friedman's piece is the central role that government interference has played in creating the problems in the US healthcare system we have today, because it takes away the individual's freedom to choose. The real solution to the problem will be to pull back from the black hole by restoring the freedom to choose, rather than diminishing it more and plunging even further into the black hole.


* One additional point on the number of uninsured: data shows that the numbers often thrown about for the number of Americans who "can't get healthcare" are grossly overinflated. This piece from the Wall Street Journal cites evidence that demonstrate that about half of the people without insurance are either eligible for public insurance or could afford insurance on their own, but for their own reasons elect not to do so.

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Seeing beyond a huge false dichotomy

This little exchange (see video above) between Professor Jeremy Siegel of Princeton's Wharton School and Barry Ritholtz of Fusion IQ brings out an important misconception that plagues many investors and which, unfortunately, was not directly addressed by any of the participants in the conversation during the discussion.

In the video, host Larry Kudlow asks whether a young person today, having observed the stock market carnage of the last decade, should invest in stocks "for the long run," using the phrase made famous by guest Jeremy Siegel in his Stocks for the Long Run, first published in 1994.

Guest Barry Ritholtz says, "They should buy stocks, but the caveat is they shouldn't just buy them and put them away; they should buy them and engage in risk management; they should use stop-losses --"

"You wanna trade them!" interjects host Larry Kudlow.

"No, no, I don't mean aggressively trading -- I mean you use a trailing stop-loss. You can own any stock in the world, including Enron, and as long as you have a stop-loss fifteen percent below that . . ."

The conversation continues along those lines pretty much for the rest of the segment, with Professor Siegel arguing that attempts to market time lead to increased transaction costs and taxable events, as well as the difficult problem of determining when to come back in if you get stopped out of all your holdings, and Mr. Ritholtz making the point that if you owned companies that were heading towards bankruptcy, you don't need to worry about taxable events, because all you will have are total losses.

Unfortunately, nobody in the segment took a step back and pointed out that the conversation is a huge false dichotomy, and since this is an important point for investors (as well as an argument that plays itself out over and over in cocktail parties, bars, and backyard barbecues across the land), we will try to step back and point it out here in the Taylor Frigon Advisor.

We advise investors to follow a course that neither holds companies forever nor trades them based on market-driven signals. A stop-loss order (in which the investor places a trade order to sell shares of a holding after the price hits a certain trigger below its current price) is a market-driven signal, dependent upon the moves of the market, rather than a business-driven decision based on the underlying business prospects of that company.

This is the distinction that all of the participants of the above discussion overlooked. Instead, we advise investors to follow a different path:
  • We advise owning good businesses through multiple economic cycles. Jeremy Siegel and Larry Kudlow were on the right track when they noted that jumping in and out of a company whenever its stock suffers a market-based reversal is a losing proposition in the long run, as we explain in previous posts such as "Ownership of businesses through multiple economic cycles."
  • However, it is important to realize that companies themselves have life cycles. As we explained in an important post entitled "Remaining calm without being blind and obstinate" the very term "growth investing" came from the observation in the 1930s by the late Thomas Rowe Price that "corporations have life cycles similar to those of human beings." Investors should seek to own companies during the growth phases of those life cycles, and sell their ownership in those companies when it becomes clear that they are no longer in the growth phase of their business life cycle.
  • Market-driven triggers such as the ones that Mr. Ritholtz was discussing in the above video are not the only alternative to buying and holding forever, although from most discussions you hear on this subject you might get that impression. We explain in some detail the sell discipline that we follow and that we recommend investors follow in "The importance of a proper sell discipline."
Finally, we believe that investors should always think of investing as an act of matching capital with innovation. This is the important thought that was not brought out in the exchange of ideas captured in the film above.

It enables those who understand it to see beyond the folly of trying to trade back and forth based on market movements (or based on complex computer algorithms that watch market movements -- as we have explained here and here, no algorithm can predict where the next unexpected innovation will arise, because innovation by definition is unexpected).

It also enables those who understand it to see beyond the "buy and hold" mentality, because they will realize that companies do not typically continue to bring about what Clayton Christensen calls "disruptive innovation" to their industry forever.

We hope that this discussion helps investors to see beyond the widespread confusion on this important subject.

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Air Vulgaria

National Public Radio recently weighed in on the economics of government health care with a metaphor that was so widely panned by listeners the producers ended up trying to apologize for it.

In a piece called "What does 'public plan' mean in health debate," NPR postulated that "President Obama wants all Americans to get to 'Healthyville'" and that private plans are like private airlines, but that since not everyone can afford those planes to Healthyville, "the President wants to create, say, 'Government Air': it's just as sturdy as those other guys, probably a 737, but it might lack a few of the perqs. It might be a little more crowded, and there will probably not be free meals on the public plane, but you will have a seat, and you will get to your destination: Healthyville."

The NPR editor narrating this story, April Fulton, then engaged in a bit of economic analysis, speculating that the current carriers (private planes to Healthyville) will begin to get worried, but "like good capitalists the current carriers must start cutting their prices to attract their customers back. Because demand is high for lower prices, the market will produce lower prices! And then perhaps the cost of healthcare stops skyrocketing into the stratosphere, which was President Obama's hope, all along."

This ham-handed attempt to portray government-run healthcare as a plane to Healthyville that will bring down prices without the loss of anything but a bit of legroom and heated towels for your face (actual examples used in the NPR metaphor) backfired so strongly with listeners that NPR ran a sort of apology two days later which condescendingly explained that "it was not clear to listeners what the piece was attempting to do" and that because the piece was not introduced properly, "it was not clear what the piece was trying to convey" and that therefore "it's easy to see that some listeners might interpret" it the wrong way.

To the contrary, it was quite easy to see what the piece was trying to convey, as even a cursory listen to the actual broadcast will demonstrate. The problem was that the metaphor was terrible and the economic analysis ludicrous.

April Fulton's statement that if "demand is high for lower prices" companies will have to provide lower prices is simply a gross misinterpretation of Economics 101. Prices are a result of the intersection of the supply curve and the demand curve. You cannot dictate that it will be lower without affecting either the supply or the demand (or both). What she is really saying is that she would like to see the government dictate that the price will be lower, and that this will make it happen. What will actually happen, however, is that supply will fall, or that the government will have to restrict demand through forcible rationing.

We'd like to note, however, that the metaphor could be fixed, as demonstrated in the video above, from the classic movie Chitty Chitty Bang Bang (based on a children's story written by Ian Fleming, a former British Naval intelligence officer and World War II commando and the creator of James Bond -- someone who knew a thing or two about countries that sharply restricted economic and human freedom).

In that wonderful little clip, the freedom-loving Englishman who is hijacked by Baron Bombast of Vulgaria is along for the ride involuntarily, and his trip conditions are somewhat less rosy than those depicted by Ms Fulton in her imagined public plane to Healthyville.

Most striking, of course, is the necessity of throwing a few things overboard -- including two passengers! While the NPR story tried to employ economic terms like "demand" and "produce" to support their metaphor, the actual function of supply and demand to bear in mind in this scenario is that whenever something good (in this case, healthcare) is offered for free, the amount that is demanded will be infinite. Because there is not an infinite supply of this good, the most likely response at that point will be the restriction of the demand (in this case, by stopping people from asking for it).

This truth has been well documented in countries that have tried to provide healthcare using government control rather than market controls. The Wall Street Journal recently ran an article detailing the restrictions on access to medical procedures enacted in the United Kingdom, which include refusal to provide biotech drugs that prolong the life of patients with forms of stomach cancer and breast cancer, as well as limitations on biotech drugs which halt macular degeneration. In the case of the macular degeneration treatments, about one in five patients can actually have access to the drug, but only for one eye -- the other eye must be sacrificed for the sake of cost.

If the image of the dictatorial Vulgarians throwing passengers over the side of their airship and into the ocean isn't a good metaphor for the kind of medical treatment documented in that story, we don't know what is.

It is also worth noting that the drugs mentioned in that Wall Street Journal article were developed in the United States, by private biotech company Genentech (recently acquired by Roche*). Treatments like these are rarely -- if ever -- produced in countries dominated by government control of health care, because there are no market incentives to reward the tremendous cost and risk that go into discovering such drugs. This is yet another economic reality ignored in NPR's one-sided story.

In fact, many of the problems with access to and cost of health care in the United States today are the product of extensive government intrusion into the industry, which eliminate choices for providers and potential customers.

The parts of the healthcare system in which such choice takes place demonstrate this truth. For example, the cost of LASIK eye surgery (which is not covered by Medicare and where the government does not control the market) has fallen rapidly, and the availability of this procedure has risen dramatically. Compare this to the example of Magnetic Resonance Imaging, a market in which the government does regulate reimbursement. The cost and availability of MRIs have not budged in ten years.

The entire fiasco with NPR's embarrassing airplane piece is itself a good metaphor for the problems with government intrusion into industries that should be left to free enterprise. NPR is a market participant that is supported by tax revenues, and therefore does not have to worry about quality the way a free enterprise would have to do. The results, unfortunately, are sadly predictable.

* The principals of Taylor Frigon Capital Management do not own securities issued by Roche.

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Dangerous media distractions

Typical of some of the recent "sky is falling" economic angst roiling the markets lately is this recent opinion piece by New York Times columnist Paul Krugman (pictured above).

Since the disappointing June jobs report issued Thursday, those who were certain we are in a repeat of the Great Depression and those who are certain we need more government stimulus (Krugman fits both categories) have stepped up their alarms that the illusion of recovery is a false one and that we are actually on the brink of economic armageddon.

In Krugman's piece, he begins by saying "OK, Thursday's jobs report settles it," and then goes on to warn of possible "descent into Japanese-style deflation" and the likelihood of "savage budget cuts" in the states. He finishes by warning that without drastic action, we are heading straight to an economic repeat of 1937. Other recent commentators focused on foreclosures and the effect that lower home prices have on consumer spending.

We have addressed many of these concerns in previous posts, pointing out our view that the recession was the result of a technically-induced banking panic and that direct comparisons to the Great Depression such as those Paul Krugman makes in his recent piece are inappropriate (see for example "It's a panic, not a Great Depression," from January 21, 2009).

We have also pointed out the economic data from numerous fronts which indicate that a recovery is indeed underway, including sharp "V-shaped" turns upward in the ISM Manufacturing Index, the Empire State Manufacturing Survey, the Baltic Dry Shipping Index, the Bloomberg US Financial Conditions Index, the Port of Los Angeles' outbound shipping containers records, and other measurements of economic activity, which are depicted in an earlier post entitled "A picture is worth a thousand words." Jobs data is notoriously volatile, and is well-known to be a lagging indicator -- businesses typically begin expansionary activity and then they hire new employees, rather than the other way around.

As for calls for greater "government stimulus" such as the one with which Paul Krugman ends his piece, it is quite possible that the recent struggle in the markets have less to do with fear that the economic recovery is an illusion than with fear that there will be more government intrusion around the corner (including recent talk of a "second stimulus"). We have given reasons previously for our belief that such stimulus plans do nothing to actually stimulate the economy and in fact are actually harmful in that they can unbalance it further.

The important point for investors in this debate is that we believe the myopic focus of much of the media over the past few days on the question "Are we really going to avoid the Great Depression II?" can obscure the tremendous changes on the horizon that are beginning to take shape but that almost nobody is talking about.

We are referring to the paradigmatic shift in bandwidth capabilites that we highlighted in previous posts such as "The Unstoppable Wave," and the tremendous impact that it will have on everything from the way that visual content is delivered for entertainment (a model that has profoundly shaped our culture for over fifty years and which is about to change radically) to the way that people monitor their health, the appliances in their homes, and even inanimate objects such as the socket wrenches and torque wrenches in their garages.

We have also explained that, due to recent increases in unnecessary and counterproductive government intrusion into the business landscape (to say nothing of calls from individuals like Paul Krugman for more such intrusion), investors will have to be unusually discerning in the years ahead when it comes to selecting individual businesses for the investment of capital. Simply "owning the market" may well be inappropriate. We have developed this concept further in posts such as this one and this one.

Having a true perception of what is taking place in the larger picture is critical for successful investing. The media can sometimes be a tremendous distraction towards gaining that kind of vision. One of those times may well be right now.

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What Benjamin Franklin can teach us about free enterprise

Benjamin Franklin was one of the Founding Fathers of the United States of America, and a brilliant inventor, author, businessman, and statesman.

Among his many inventions were bifocal lenses for glasses, the lightning rod for houses, and the concept of the public library. He discovered and articulated the principal of "conservation of charge" in electricity, which is foundational to even the most modern technological computing inventions.

He was one of the committee who drafted the Declaration of Independence and one of its signers.

Franklin is depicted on the US $100 bill, and as such is featured in an illuminating joke about economics, brilliantly explained in a recent weekly commentary by noted economist Brian Wesbury.

In the joke, two economists see a $100 bill lying on the ground, and pass it by -- saying to one another, "It can't possibly be a real $100 bill, or else somebody else would have already picked it up!"

As Wesbury insightfully notes, this joke illustrates a blind spot in economic theory: it treats the world "in terms of very impersonal forces that sum the actions of all people" and entirely overlooks the unexpected. In this mistaken way of thinking, there can never be any new inventions or businesses or new value to add to the world -- "if it could be done, someone would already have done it," the typical economic theory seems to say.

We have stated more than once before that this is exactly what is wrong with most economic theories and models -- they have no way of predicting the next unexpected innovation that will change an industry or add to human knowledge and happiness. This is a tremendously important concept for investors -- and entrepreneurs -- to understand.

Benjamin Franklin himself is a wonderful example of this principle, through his numerous innovations and inventions and businesses that added value to his customers -- and through his thoughts and writings on human liberty, which added tremendous value to future generations and ultimately to the world.

Free enterprise allows every individual to add to his own happiness and that of others, by being free to provide as much value as he wants, and thereby make money when others voluntarily pay for it. This is a fundamental human freedom, and we discussed it in our previous post on free enterprise.

We also can't help but note that Franklin was the fifteenth of seventeen children of Josiah Franklin. As such, he is also a wonderful refutation to the zero-sum idea that (in the words of the United Nations Population Fund) there is a "link between population and poverty." As we explained in this previous post on the subject, every person is a potential asset, not a potential liability, because every person is a potential inventor, innovator, or contributor to the good of not only himself but of others.

The next time you look at a $100 bill, or celebrate the Declaration of Independence, take a moment to think about Benjamin Franklin, and the many ways he illustrates the best principles of the concept of free enterprise.

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Free enterprise vs free markets

The Fourth of July is all about political and economic freedom and inalienable individual human rights, and in honor of those themes we'd like to discuss the important distinction between "free markets" and "free enterprise."

Although it may not be a distinction drawn by economists, we like to make a distinction between the terms "free markets" and "free enterprise."

By enterprise, we mean the practice of providing value to others by offering goods and services that they need or want.

Enterprises (or businesses) offer their goods and services in the marketplace, and thus the expression "free markets" is often used as a synonym for free enterprise.

But there is a subset of the word "markets" which refer to the institutions by which capital is matched up with business enterprises -- the exchanges where shares of those businesses are bought and sold, the banks through which those businesses raise capital through loans and other offerings, and all the other mechanisms which surround the process of pairing investment capital with corporate activity. In America, this entire landscape of capital-matching mechanisms is often referred to as "Wall Street."

While we are strong supporters of free markets in the sense that the phrase is used to describe the freedom of businesses to offer their goods and services in the marketplace, we acknowledge that the second sense -- dealing with capital markets -- requires a series of rules and regulations in order to ensure smooth and orderly operation and the ability of all parties to evaluate and compare different capital investment opportunities, much the same way a game of basketball requires rules to enable the game to take place.

These rules involve accounting standards by which companies are evaluated by others, and standards governing all the ways in which transactions are ordered and executed. Government has a proper role in ensuring these boundaries are in place and that they make sense, just as government has a role in ensuring the roads are properly marked with stop signs, center lines, and appropriate speed limits.

We would argue that much of the problem of the past ten years, including the market crashes of 2000-2002 and 2007-2009 as well as the housing bubble and the misallocation of capital that we have highlighted in previous discussions, was a market problem. In large degree, the most recent market panic was related to problems with the accounting regulations (such as FAS 157, which we discussed at length in various posts) and with changes to longstanding short-selling rules. It was also a government problem, with interference in bank lending through the CRA and other legislation, as well as manipulation of interest rates in order to stimulate borrowing and lending.

The reason this distinction is important is that proponents of "free enterprise" and "free markets" (in the sense that the term "free markets" is used as a synonym for "free enterprise") can be caricatured as being against any government role in providing reasonable rules for "markets" in the second sense (the "Wall Street" sense).

While the events of 2008 have caused many to correctly conclude that the rules governing markets were broken (although few of them realize that important rules such as mark-to-market and the uptick rule were altered in 2007, right before the biggest problems began), this should not cause them to lose faith in free enterprise.

By free enterprise, we mean the ability of anyone to start a business without the permission of the government and to compete against other businesses without interference from the government, as long as they do so without practicing actual violence or fraudulent deception. Of course, free enterprise also requires the Rule of Law and the enforcement of contracts, which is a legitimate and necessary role of the government. However, in many other countries an individual cannot start a new business without permission from the government, and the ability to compete against existing businesses is prohibited by a system of cronyism and legal prohibitions on competition.

We don't believe that faith in free enterprise is going away in this country, and that is very important. We would encourage our readers to be advocates for free enterprise within their own circles of influence, and not to let problems with markets derail their own faith in this important component of human freedom.

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