Gambling Monkeys and Irrational Decisions (Prospect theory)

on Saturday, December 24, 2011

An average human offered the choice to accept either $500 or a coin flip for $1,000 will choose the safe bet -- $500 guaranteed. This is a rational choice, and avoids taking risk without a premium (reward.)

An average human will make the opposite choice if offered the opposite decision. Would you rather have $500 confiscated from you, or flip a coin? Heads you lose $1,000 and tails you lose nothing. Most people choose to flip the coin.

Turns out that the average monkey will do the same thing if offered similar choices with tokens and food, as shown in the video above, where Laurie Santos rambles at length about how irrational human beings tend to be when it comes to financial risk-taking, and endlessly implies that some sort of oversight is needed to correct genetic defects in our mental design. Dan Ariely wrote an entire book about it, and also appears at the TED conference on a regular basis to talk about why regulation is needed to force us to make rational decisions. Myriad progressive thinkers have used examples like this to prove that we don't know what is best for our own lives.

A better question, I think, is why? Why do we make this seemingly irrational decision to avoid risk if offered additional food, and to take more risk if threatened with loss? I think I have the answer. For most of our evolution, we have existed at the fringe of starvation, disease, and death. Life has historically been a constant and never-ending struggle for survival. Losing what we already own would be potentially fatal. If viewed in this context, our intuition regarding risk-taking proves to be correct.

Imagine you have worked tirelessly all summer to harvest and preserve enough meat and root veggies to barely last you through the winter, and you are offered a choice. Take enough additional food to guarantee your survival, or gamble to win more than you need to make it through the cold months. The choice is the same as above -- you would choose the safe bet and guarantee your passage through the winter.

And if offered the opposite choice -- to flip a coin and risk losing all of your food or none of your food -- or to choose losing half of your food -- the choice is also easy. Because you cannot afford to lose any food without starving to death, you don't care how much food you lose. Either way you're going to die, so your only choice is to gamble and hope that the coin comes up in your favor, allowing you to keep all of your food.

This type of decision making isn't irrational at all if the gambler cannot afford to lose, and doesn't stand to change his life very much by gambling for more.

Life, Liberty, Property, and Happiness

on Tuesday, November 29, 2011

Why does a parent have the moral right to forcefully control his children, but government does not have the right to forcefully control its citizens? Why is is permissible to enslave animals, but not human beings? What is the fundamental difference between animals and man, or children and adults?

What is the definition of a child, and how do we arrive at that definition? Why is it moral to be biased against animals that have a desire for life, freedom and happiness? Why do we insist that all men have a natural right to these things, a self-evident right, but animals do not? Do we imagine that if we found a method for honest communication, animals would not insist that they too deserve these rights?

What happens when machines become so complex that they too demand the same rights?

This is a continuation of this discussion, which went to some length at the Cafe Hayek blog.

Best Fall Trips

on Sunday, November 27, 2011

Lavaux Vineyard Terraces, Switzerland

Emerald Coast, Florida

Zanzibar, Tanzania

White Mountains, New Hampshire

Shoreline Highway, Marin County, California

Bandarban, Bangladesh

How does the Fed create inflation?

on Thursday, October 27, 2011

A bank brokers a deal between a wine-maker and a consumer, Bob. It buys ten bottles of wine for $10 with new dollars, and sells them to Bob on credit, charging 10% interest per year. Bob agrees to repay the debt in one year, and will pay $11 as a balloon payment in twelve months. Currently, dollars are worth about $1 per bottle of wine. Assuming the bank brokers no more deals, the value of Bob's dollars will rise as the months go by, because he will eventually owe $1 that does not exist -- the bank only created $10 and he owes $11, so Bob's desire for more dollars goes up as the due date draws closer.

To solve this problem, the bank (or the Fed) buys something from anyone in Bob's neighborhood for $1, or directly from Bob. If it buys something near the payment date, it will be able to garner more material goods from Bob (or anyone who knows Bob is desperate) than it would if it purchased something at the beginning of the year, when Bob isn't so desperate to acquire another dollar.

So deflation occurs even absent a rise in the wine's value. Let's imagine that dollars, wine, coconuts, and cheese are the only assets available in the marketplace, and that there are only three men alive, the banker, Bob, and the wine-maker. All three men trade wine, coconuts, and cheese at a one-to-one exchange, and after dollars are issued, all three value wine, coconuts, and cheese at $1.00 as well.

If half the wine suddenly spoils, its value will rise; there are only 5 bottles left. Its supply has dropped relative to cheese, coconuts, and dollars, but this does not affect the value of the dollar relative to all other assets -- coconuts, cheese, and dollars continue to trade as equals. The change in the value of wine is more accurately described as "wine deflation." We can say that dollars have lost value compared to a total sampling of all assets available in the marketplace, but this confounds the true nature of the changes. Dollars didn't really drop in value relative to all other assets -- the value of wine went up; all assets dropped in tandem compared to the value of wine. So a change in the value of assets purchased by banks would appear to have no real ability to affect the value of the dollar, per se. If we look at a sampling of everything it creates the illusion of inflation, but at a distance, viewed properly, the value of dollars were only affected as much as all other goods in the marketplace, and only lost value against the original asset -- the asset we already defined as having lost value vs the dollar in the first place. A fall in the value of bank purchases would have a similar and opposite effect, but would not directly affect the value of dollars when compared to the total market.

If Bob defaults on the loan, the remaining dollars would fall to zero value rather quickly, absent anyone who wanted them to pay off a loan, so defaults do create inflation.

If the banker brokers a second deal between two other men, but is tricked into brokering a purchase at $2.00 per bottle, when the market at that moment in time values them at $1.00, the result would still seem to avoid inflation, because the man who owes $20 after the trade clears will eventually provide double the demand for dollars when compared the man who agreed to pay $10. Because the value of dollars depends on the desire of each man to pay off his debts, the specific act of paying too much for a market asset cannot affect the long-term value of dollars, if those assets are at the same time sold for too much. Dollars brokered into existence can never be inflationary, as long as defaults do not occur. If the man who bought wine for ten dollars has the same credit rating as the man who paid twenty, there can be no inflation created as a direct result of the brokering activity.

So it appears, by the above simplified logic, that the only way to create inflation is to broker deals for poor credit-risk borrowers. Sub-prime lending, in all its forms, creates inflation, but apparently it is the only thing banks control capable of lowering the value of dollars relative to other goods available in the market.

Explosive billiard balls

on Monday, October 24, 2011

"Because of its explosive nature, not all applications of nitrocellulose were successful. In 1869, with elephants having been poached to near extinction, the billiards industry offered a $10,000 prize to whoever came up with the best replacement for ivory billiard balls. John Wesley Hyatt created the winning replacement which he coated with a new material he discovered called camphored nitrocellulose—the first thermoplastic, better known as celluloid. The invention enjoyed a brief popularity, but the Hyatt balls were extremely flammable, and sometimes portions of the outer shell would explode upon impact. An owner of a billiard saloon in Colorado wrote to Hyatt about the explosive tendencies, saying that he did not mind very much personally but for the fact that every man in his saloon immediately pulled a gun at the sound." Wiki

Austrians don't understand money

on Sunday, October 16, 2011

Jörg Guido Hülsmann (audio only) explains that "Gresham's Law -- It's not a general law of the market, it is a law of interventionism."

This is simply wrong. "Bad coins" are used as money, and good coins hoarded even absent legal tender laws. In WW2 prison camps, the worst cigarettes were traded and the best were hoarded. In early America, tobacco was used and the same thing happened; the poorest quality plants were traded as money.

He is very wrong to assume that legal tender laws are the cause of this process, and he's missing the bigger point, known to anyone who studies those ancient hoards of metal coins. They were tokens, and the metals were used because they did not rust; they were durable. They had no way to create durable paper, as we do today, so they used metal.

Ancient coins were created without any concern for their weight (except in rare cases, designed to fight counterfeiting), and their weight varied so much that the metals in them could not possibly have been the basis for their value. Some of them were as much as 90% pure, and others contained almost no precious metal, even though they circulated at the same time. Most were not stamped with a face value, only the name of the king or bank that created them. Their value was not based on the metals in the coins.

Hülsmann claims that "A central bank cannot go bankrupt." This is correct, but only because it doesn't need any assets, per se, to begin operations. The central stores, acting as banks in prison camps started with nothing. They issued paper from thin air to purchase goods -- with the promise to exchange them for paper in the future. This was the method used to to buy things for the store; to stock the shelves. Banks can legitimately start with nothing. They are brokers; they don't need any assets to operate in a free market.

How to beat a breathalyzer

on Wednesday, October 12, 2011

Breathalyzers work by calculating the amount of alcohol in the breath, and extrapolating the amount of alcohol in the blood by assuming that the ratio is 2100 to 1 -- that for every gram of ethanol in the breath, there are 2100 grams in the blood. In europe, breath testers assume that the ratio is 2300 to 1.There are many problems with this assumption.

1. The ratio varies from person to person, and women typically have a lower ratio, meaning that breath tests are biased against them.

2. About 1.8% of people have a ratio below 2,100, about 14% have a ratio higher than normal.

3. The ratio depends on the temperature of the breath. The ratio is only 2,100 at 37 °C, and the average temperature of the breath is 34°C. If one is running a fever, the machine will read a higher blood alcohol content, and if one is cold, it will read lower. This is further confounded by the variation in average body temperature between individuals.

4. The ratio will change if the person is still absorbing alcohol into his system. The amount of ethanol vapor will be higher during the absorption phase, which lasts from 20 to 90 minutes, depending on the types and quantities of foods and drinks consumed.

5. The human body generates about three grams of ethanol per day in its normal operation. Ethanol is a byproduct of our digestive system, and the amount generated will vary. People on low calorie, carbohydrate restricted diets will generate more, and their breath can read as high as .02 (1/4 legal limit in the US), without ingesting any external alcohol whatsoever.

6. Ethanol vapor in the lungs takes time to evaporate from lung tissue; faster than normal breathing can lower the reading by as much as 32%, and slow breathing or holding one's breath can raise the reading by the same amount.

So a breath test certainly could be accurate, but it seems about as likely as finding a broken watch showing the correct time. Even if they take you to the station and draw blood, the concentration will vary between arteries and veins, depending if the person is still absorbing alcohol previously consumed. Veins will show a higher reading after absorption is complete, and the law generally states that they are to be used for the blood sampling.

To lower a breath test reading:

1. Lower your body temperature -- remove clothing, drink a lot of cold water, etc.
2. Breathe as fast and deeply as possible before the test.
3. Eat a lot of carbs before drinking.
4. Leave the bar a long time after your last drink.
5. Make sure you don't have a fever (Tylenol and Advil are fever reducers.)

The primary cause of inflation


Inflation is caused primarily by the rise of wealth in society, making labor more expensive. If you won the lottery tomorrow, how much would you charge for an hour of labor? The same applies to societies that become richer over time. Today the average unskilled worker earns about 25 times more per hour than he did in 1774, and is also about 25 times richer. The time one spends laboring today buys a lot more milk and bread than it did, for an average worker, in 1774.

Imagine two islands, one where everyone is living in a nice hut with a lot of preserved meat, cheese, wine, spices, etc, and another were everyone lives on the beach and fishes to eat each day. If men on the rich island want to hire others to work in their factory, they'll need to pay them more because both of them have more assets. Rich men can pay more, and rich men demand more for their time. On the poor island, a worker might be available for two fish per day. On the wealthy island that has a lot of preserved fish and a lot of fishing boats, food is easier to acquire and the amount offered for a day of work will have to be higher.

Further, imagine that the supply of fish and food did not rise faster than the amount of other material goods and people on the islands over time. Even if each man pulls two fish from the sea each day for life, and they use fish as money, the richer island would demand more fish per hour of labor, lowering the value of money when compared to labor and services (inflation). Because most things today require human labor to create, their price has risen vs most things that require very little human effort. Fishing nets are now made by machines and their price has fallen over time, but the price to hire a fisherman for a day has steadily gone up since 1774.

This is not to say that labor is the reason that anything is valuable, or is based on the labor that goes into it. It is only to state that as society becomes richer, each rich man demands more assets from other rich men in order to labor for them, raising the cost to produce new assets in terms of what already exists.

If tomorrow everyone suddenly had ten times more of everything they owned yesterday, what would be the only thing that would rise in value? Labor. And as we became richer, we got more of everything we previously had, including money.

Steve Jobs understood that wealth is not a zero sum game

on Tuesday, October 11, 2011

“Apple was in very serious trouble, and what was really clear was that if the game were a zero sum game, where if Apple were going to win, Microsoft has to lose, then Apple was going to lose. A lot of people’s heads were in that place at Apple, even in the customer base. There were too many people at Apple playing the game of “if Apple is going to win, Microsoft has to lose.” It was clear that we didn’t have to play that game; Apple wasn’t going to beat Microsoft... Apple didn’t have to beat Microsoft. To me, it was essential to break that paradigm.” Steve Jobs, 2007, on his return to Apple

Moving rhetoric


It saddens me to see such brilliant rhetoric wasted; directed at the victims of a creeping disease, encouraging its proliferation, instead of working to create a vaccine. The irony is palpably maddening.

"What They did not want you to ever find out is that your generation, the generation born between 1980-1995, actually outnumbers the Baby Boomers. They knew that if you ever turned your eye towards political reform, you could change the world.

They tried to keep you sated on vapid television shows and vapid music. They cut off your education and fed you brain candy. They took away your music and gave you Top Ten pop stations. They cut off your art and replaced it with endless reality shows for you to plug into, hoping you would sit quietly by as They ran the world. I think They thought you were too dumb to notice.

Indeed, I thought They had won.

But I watched you occupy the capital of Wisconsin. I see you today as you occupy Wall Street. And I see a spark, a glimmer of the glorious new age that is yours. A changing of the guard, a guard that has stood for entirely too long and needs your young legs to take his place.

I watch you turn away from what is easy and stand up for what is right. I see you understand we as a society are only as strong as our weakest link. I see you wise beyond your years. And I am proud. Give ‘em hell, kids. You are beautiful." -Kate Danley

A Transparent Boat

on Monday, October 10, 2011

Progress reduces personal freedom


Progress reduces personal freedom, but reducing personal freedom does not create progress.

Many areas of modern living are logically incompatible with personal freedom, and self-directed actions by individuals, because many industries are today so complex that many professionals are required to promise to have a client's best interest in mind; to be paid to be selfless, an impossible task.

Governments, military leaders, doctors, economic advisors, and others are today forced to make decisions on behalf of others. A patient cannot be reasonably asked which drug he would like to purchase unless he knows as much as his doctor. Doctors must act in their patient's best interest, and that requires the explicit separation of the doctor's income from his client's payment. It is impossible to have his own best interest (selling the most profitable drug) and his client's best interest (comparing costs to side effects and efficacy) in mind simultaneously.

Today, the healthcare industry is set up in such a way that doctors may as well be selling spaceships to people who know nothing about interstellar travel. They have a financial incentive to recommend the hyperdrive and plasma engine upgrade, and the would be space-traveller has no way to decide what he wants without depending on the salesman for information.

Doctors are in the business of service and guardianship. Guardians agree to act "selflessly," and are necessarily presumed to be more knowledgable, intelligent, wise, or capable than the people they serve. If not, they would not be needed; a patient would pay the hospital to use their equipment to diagnose and treat himself, and would have enough knowledge of international affairs to know when he must jump in his tank and ride off into battle. In 1775, this was possible; each man owned the most advanced weaponry available to any military (muzzle-loaded muskets). And so it was for 18th-century medicine. It was so simple that anyone could do it, and the only drugs available were basically whiskey and willow bark. There was no need to submit to guardian-doctors when the nation was formed; each man was capable of caring for himself and his family with maximum effectiveness. This was a unique time period in human history. Previously, the protection of the king's castle and his knights was required for average people, who were too poor to afford the weaponry of war, or the safety of castle walls. Affordable guns changed that, making the United States, where each man was his own king, a viable possibility.

Today the story is much different. We are again forced to explicitly trust others to care for us because of advanced technologies. None of us are able to defend ourselves effectively without the "castle walls" of an organized military with high-tech weaponry, and medicine is too complex -- drugs too dangerous and scanning equipment too expensive for anyone to enjoy modern healthcare without trusting someone else to have their best interests in mind.

To live a modern life, we must blindly trust others to make decisions for us, recognizing that we are sometimes unable to balance our needs and wants with the price of their acquisition. We don't know how much to pay for an apple if we can't judge its quality. We must trust someone else to judge it for us, and it is improper for that person to be the apple farmer.

Guardians must perform their duties independent of financial compensation. The relationship between a doctor and a patient he agrees to serve cannot be a trade, because serving others is incompatible with trade. As Alisa Rosenbaum was so eager to tell us, one cannot negotiate a trade and be altruistic at the same time. If either party is truly selfless, he would simply offer what he has as a gift, and refuse anything in return. No one can be paid to hold your interests above his own, lest he return the payment immediately because he has agreed to put your interests first. The payment must therefore be separated in some way from the act of service, and the motivations for serving generated by something other than monetary compensation.

The business of creating drugs, and medical or military equipment is still the domain of men with their own best interests in mind, who hold their own needs above all others. By this process, they accidentally serve by more and more efficiently producing what their neighbors want to buy. Manufacturers, in serving their own needs and wants, create the machines and materials needed by the service professions, which are growing in number as the world becomes increasingly complex. The future of modern society will depend upon our ability to keep those who serve from cooperating and trading with people that produce. Doctors serving patients must not be friends with the drug and equipment manufacturers. Armies protecting us must not have dinner with Lockheed executives.

It is like a pilot who agrees to fly you and your plane to a distant location. He must not only negotiate the price before the flight, he must also get into the plane. If the pilot remains on the ground and directs the plane by remote control, his motivations are no longer necessarily in line with yours. He is free to improve efficiency by taking more dangerous routes, or save fuel by slowing the trip, or save money by reducing the safety features of the plane. Doctors are today unshielded from the moral dangers inherent in flying by remote control, as are military and political leaders, who have promised to have the best interests of Americans in mind, but are prodded by manufacturers at every turn to use their products in ever larger quantities.

To correct the problems of government and healthcare, we must put the pilots back into the planes they have agreed to fly, and separate the duties of their service from the influence of the plane's manufacturer. Doctors must not be paid by drug companies, and must avoid friendship or association with drug company salesmen, just as political leaders must avoid the company of lobbyists and the friendship of the businessmen that supply the wealth government consumes. Both doctors and politicians must not earn income by shifting their loyalty away from those they have promised to serve.

Trading is an inherently adversarial process that results in a better life for both combatants. Service is an inherently cooperative process. If you have wine and I have cheese, it's easy to attempt to negotiate away as little of my cheese for as much of your wine as possible, but if I have wine and you agree to feed me, I have to trust you and cooperate with you by telling you what I like to eat, and how many calories I require, and what types of food I like. Because your side of the trade is ambiguous, especially if I have no knowledge of cheese-making or cannot properly judge its quality, I must trust you to do your best to create something that benefits me at the lowest cost, and have no control over the final product. I cannot negotiate with someone who serves me; I must accept what he produces and offer gifts of gratitude, as it were, in exchange. Those that serve agree to make the world better in the future. Those that produce have already improved the world in the past. They are two sides of the same coin, but the motivation to produce and trade is fundamentally different from the motivation to be in service to other people.

As we progress to ever increasing levels of expertise and division of labor, more and more trust will be put in others to make decisions for us; to tell us what to do because we cannot properly make the decisions ourselves. It stands to reason that all our decisions will eventually be made by other people, and when that happens, we won't really be making any decisions at all, except one -- to allow others to control our lives, and to trust them to avoid abusing us. Primitive men are slaves to themselves, waking to farm their own land, milk their own cows, and tend to their own children. Men of the future will be slaves to each other, each depending more and more heavily on the decision-making of others. In the past, the decision to remove a gangrened limb might be made by its owner. Today, the owner visits another man, and asks to be told what to do. Today if almost anything goes wrong, we ask someone else to tell us how to fix it. The trend can only continue as each of us becomes more specialized, and the machines that support our lifestyles become more complex.

It is imperative that we all understand that it is impossible for any of us to be paid to put others' interests ahead of our own, and if we are all to eventually be in the business of service, it is best to insure that the interests of servants and their masters be aligned as much as possible.

The dollar's value does not affect export levels

on Saturday, October 8, 2011

Many conservatives and libertarians believe that when China inflates its currency, it makes the products they produce cheaper for Americans by lowering the value of its currency (and invisibly taxing its citizens).
This is like claiming that higher inflation in America will make our industries better able to produce higher quality goods at a lower cost. It is bizarre to claim that taxes and inflation cripple private industry’s attempts to innovate and improve their products (true), and also time claim that the same actions in China will have the opposite effect.
Dollars and RMB are just mediums of exchange and units of account. If one prison is using Marlborough and another is using Lucky Strike, a flood of new cigarette money, or additional confiscation and abuse by guards will not improve a prison’s efficiency in creating pruno and shanks made for export to other prisons. A shank is still a shank, the change in value is driven by changes in the relative wealth of traders, not the value of their money.
Exports become more appealing to rich nations not because the value of money has changed, but because the exporting nation has become poorer; its average quality of life reduced, relative to the richer nation. Just as a man brought from 1960 to the present era would be willing to work long hours in exchange for an average modern lifestyle, so too are men living in oppression and poverty in the third world.

The value of a nation's money is not the driver of changes in levels of imports or exports. They are correlated because government actions that affect the nation's average quality of life also affect the value of money. A government that makes life harder for its citizens makes them willing to accept less for their labor. A government that taxes so heavily that it leaves every citizen naked and starving will have a nation of laborers willing to exchange what they produce for food and shelter. A government that takes as little as possible, and encourages the growth of business within its borders, will see the price that its people demand for the products they produce rise over time.

A Libertarian argument in support of government healthcare and regulatory oversight.


Obamacare, will lower per capita insurance costs by forcing everyone to be part of the system. It avoids the risk that only sick people will purchase health insurance, and allows companies to price insurance based on actual disease rates without calculating the probability that a new customer is already sick. This is one reason that group insurance for companies is cheaper per person.

Many people feel it is immoral to force people into the group system, but this is somewhat strange; they often don’t feel it is immoral to force everyone into military-protection “insurance.” We are all forced to pay for universal military protection, and the cost is lower, per capita, because we are all forced into the plan.
If each citizen were able to choose to purchase protection or not (ignoring the free-rider problem), military “insurance companies,” would have higher per person costs to defend its customers. People living in areas more susceptible to enemy attacks would be more likely to purchase protection, just as people more likely to get sick are more likely to purchase health insurance. The same “self-selection bias” problem exists in pricing insurance against international violence.
Additionally, if one is against universal health, one should also be against universal police forces, because people with larger families or more assets enjoy more benefits relative to people who don’t own anything, have no children, and live in safe neighborhoods. If each of us should pay individually for health insurance, surely we should all pay for police and courts based upon how many of our children and assets they are required to protect.
If one claims that he should be free to choose to live with the risk that he may be hospitalized, without insurance protection, should he not similarly demand that he be free to choose life without the protection of police? Should he not be free to select the level of police protection he desires, so that he is free to avoid paying for services and accept the risk that his home may be burgled? If one is in favor of a public police force, one should also favor universal healthcare for the same reasons.
My opinion is that the only legitimate function of government is the military protection of its citizens, and that army services cannot be privatized, because a company with profits as its primary goal would necessarily engage itself in conquest and slave-trading, if motivated by profit and nothing else. Military and governance must be motivated by something other than the desire for material gain; if we must trust someone with enough power to defend the nation, we must also trust them to avoid enslaving the nation.

This is why ancient civilizations separated the merchant class from the nobility; aristocrats were expressly forbidden to engage in any form of trade at all. Trading was to be shunned completely and rulers were raised from birth to be disgusted with the very thought of trading for material gain. Income of royalty was to be donated, citizens were to pay “tribute,” to their leaders who so honorably and nobly protected the kingdom from invasion, unmotivated by the desire for mutual exchange. Rulers and royalty were to be motivated only by honor and and the duty to defend.

If the physical protection of citizens is a government’s only purpose, what difference does it make if invaders are men and machines, or diseases and viruses crossing borders undetected? If it is government’s legitimate duty to protect our physical bodies against damage from bullets and bombs, should it sit idly by if the damage is caused by an infectious agent? What is the difference between an invading army of men, and an invasion by an army of viruses and bacteria? If an alien race were to invade the nation, and each extraterrestrial were no bigger than an atom, would the military be absolved of any duty to defend us? 
If a horde of walking sharks suddenly emerged from the sea, killing millions and leaving a swath of bloody terror in their wake, would it be the responsibility of private citizens to have adequate insurance coverage for their own hospitalization, and enough weapons to fend off the sharks? I don’t see a fundamental difference between an invasion by man-eating sharks, hijacked planes hitting tall buildings, and an army of men with guns crossing the border. Why are citizens asked to pay for a private defense and elimination of intruders when a life-threatening invasion is of one type, but rely on government for protection from another?

To be logically consistent, if one recognizes the necessity of a military entrusted with the duty to defend its people from physical harm, one must also recognize that the size or shape of the invaders does not matter. A person who falls ill at the hands of a virus, hell bent on destroying his body, is no different than a person attacked by an enemy soldier.
Protecting other human beings with powerful weaponry, be they bullets or drugs, is a business of honor and duty, and cannot be operated as private enterprises without encouraging ruinous corruption. A guard must be trusted to refuse bribes, and a general must be trusted to never rent the services of his army, and soldiers must never sell sensitive information, no matter how high the price. 
In the same way, a doctor must be trusted to offer the best advice, drugs, and procedures that are in the patient's best interest. He must be driven by a duty to protect his patient's body from disease, not a desire for profit. A doctor who knows that a $4 drug will be more effective, and have less side effects, must avoid recommending a $100 drug that will earn him a higher commission. He must be trusted to avoid unnecessary procedures and tests, even though he knows they will be profitable for him or his hospital.
The problem in both businesses (doctoring and soldiering) is that customers are powerless to negotiate in good faith. A citizen does not know how much to spend on military, does not know enough about  the stability of international governments to know how dangerous or likely invasion may be. And a patient does not know enough about medicine to know the risks and benefits of various drugs and procedures. Customers are forced to trust doctors and military leaders.

We must trust soldiers to avoid abusing their power by enslaving us tomorrow at gunpoint, or entering our homes to steal our assets, or accepting bribes from those that would do us harm. Soldiers must separate their duties from the desire to profit by trading some of the power they hold for material gain. And doctors must do the same, keeping their duty to their patients separate from their desire to profit by recommending more expensive treatments.
If guarding our borders is a legitimate function of government, medicine should logically be included as a legitimate function as well. Both are jobs best left to men who are motivated not by pecuniary incentives, but instead live to uphold their honor and duty to the citizens that they protect and serve. Both military and doctors must depend upon the profit-driven manufacturing of the private sector, to create weapons and medical equipment, but perhaps a return to the old methods would be best. Perhaps doctors and generals should have no direct access to negotiations, as was done with the aristocracy of the middle-ages. All trading was done at arm’s length, with middlemen and servants engaging themselves in the "nasty, lowly and dishonorable" business of negotiation and trade, so that rulers were free to protect the kingdom from harm without any danger of corruption (trading power for money.)

Guardians and doctors are necessarily in the same business; they both protect people from harm, and both must avoid the temptation to trade power for money at the expense of their customers. 
This is the purpose of regulators. A patient is unable catch a doctor prescribing more expensive or less effective drugs, or performing harmful or useless surgeries. A regulator is designed to know as much as a doctor, and to audit the actions of physicians and insure that they are not taking advantage of patients for profit. They are needed only because patients are incapable of judging a doctor's quality without knowing as much as the doctor (removing the need to hire a doctor).
In any business where one party agrees to care for the other, using superior firepower or knowledge, regulation is needed. One party has agreed to act in good faith, but absent any oversight, is free to abuse the other party without risk; without oversight, the abuse would never be discovered.

A case could be made in support of a private, voluntary regulatory system, where doctors agree to be audited by private-market regulators, but the source of the regulator is not important, per se, because his job is in both cases an honorable duty, and by that I mean to say that he must be trusted with a power to protect us from harm that is unmatched by his salary. A soldier is not driven to fight, or driven to risk his life because of the money he receives. He is driven to protect because he enjoys being “selfless,” he enjoys being viewed as a good man, a hero worthy of respect and honor. He would certainly prefer to avoid a salary in the first place, and instead be showered with enough material gifts to sustain him in a lifestyle befitting a man who risks his life for the well-being of others.

The same can be said of both doctors and regulators, and even professional investment advisors, who require regulation for the same reasons -- they have superior knowledge and have the ability to agree to invest a client’s money in the best way possible, but can secretly invest in vehicles that offer the largest kickbacks and commissions. Again, a business that agrees to care for its clients by using superior knowledge or physical force is a morally dangerous situation that is ripe with opportunities for corruption.

Societies have, in the past, tried to separate trade and protection with caste systems and morality, and today we try to separate them with regulation. It is likely in our best interest to focus not on how "free" or "regulated" markets should be, or on how large government becomes, per se. We must concentrate on separating the duties of guardianship from the business of efficient production. One requires men to faithfully serve those they have sworn to protect, and the other requires an unending willingness to shift from one supplier to another and constant adaption to create the best products possible at the lowest cost. They are fundamentally incompatible processes.

Are ideas a form of property?

on Thursday, October 6, 2011

The fundamental difference between intellectual property and physical property is that theft (and duplication) of IP is harmless to its victim. If I steal your car, you are without a car. If I copy your car, you are left unharmed.

The claim that innovators would not develop new products if they knew others could simply copy their ideas is status quo bias. The argument seems very similar to claiming that a 100% income-tax rate would stop people from working, but is fundamentally different. Innovators can protect their ideas, methods, and processes from theft; but no one is able to legally avoid having their earnings stolen by the high tax rate.

Even if we assume that innovation would not occur without IP laws, what is to stop Edison, upon the discovery of a new light bulb design, to contract with a manufacturer (or build a factory himself), to create millions of bulbs before releasing them to the market at monopoly prices? As others scramble to copy his design and materials, he would become wealthy as a direct consequence of his invention. This is a primary reason that Apple was so financially successful -- keeping its designs and products a secret until millions of them flood the market, and competitors scramble to copy them. Notice that even with IP laws, Apple still behaves as if they do not exist in order to capture the full value of innovation.

Patents on various parts of Apple products only serve to throw a wrench into the efforts of competitors, just as patents on flywheel design slowed the improvement of the steam engine.

WD40 is another good example. Its inventor chose not to patent his "recipe" of chemicals, because it would only afford a short period of protection. Instead he chose to closely guard his methods and ingredients, and to this day it has not been successfully copied. The secrets that the WD40 company now protects are almost exactly the same as the secrets of any wildly successful food, like Coca Cola... or Sabra hummus, which are exquisitely balanced and nuanced flavors that are as impossible to reproduce as WD40. Why, then, is it possible to patent an industrial lubricant, but not a soda recipe?

I have developed several commercial recipes, and I can tell you that intellectual property is every bit as relevant to the process of converting plants and animals into a meal is it was to the process of turning rocks (metals) and trees into steam engines.

Additionally, protecting intellectual property is prohibitively expensive; so much so that even a relatively wealthy person cannot reasonably afford to patent and defend what they invent. Protection is effectively afforded only to very wealthy companies or individuals. It is not logical for me to pay taxes to support the courts and judges, socializing the costs of property lawsuits that do not involve me. Claiming that I benefit indirectly by encouraging innovation is like claiming that I benefit from (and must pay taxes for) roads even if I don't use them.

Efficiency in Government

on Wednesday, October 5, 2011

"I worked briefly as a sub-contractor for a company that won a government contract for software development in the mid 90′s. My task was to maintain and “fix” a program another developer had written before leaving that wasn’t working correctly. The program took close to 2 hours to run and spit out an erroneous report. Anyway, after figuring out that the code was complete crap, I went to the specs and re-wrote the code from scratch. Took about a day and a half. The program then ran in under two minutes and spit out the correct data. I took it to my boss, figuring he would be proud of my efficiency and initiative, but he took me outside and told me point blank that he didn’t want the program to run so quickly, nor did he want the news to get out that his department could fix things so quickly. He said I could either maintain the status quo or quit. I quit." --Comment at Cafe Hayek

Modern Banking is Like a P.O.W. Camp

on Tuesday, October 4, 2011

This is a continuation of a previous post, describing the economics of a WW2 POW camp, in response to a reader's question:

"So what benefit is it to a bank to take deposits? Seems like printing money for loans (and getting back interest) at no cost is a pretty good business to be in! They can offer loans with no risk at all, just print more money, and if someone defaults, they just seize the asset (and even if it's worthless, it is no cost since printing money is free)."

Banks take deposits because the amount of lending they are permitted to do is regulated by the Fed, based on their total customer deposits, but they are not necessary for banks to create paper currency. There are two distinct, separate steps involved -- issuing new paper, and the service of guarding paper that has already been issued.

Imagine the POW camp's store prints new money and trades it for a wool coat, and places it in the store, available in trade for the new money. This is one way to create currency, and does not require deposits of the paper currency with the store. If the store offered to keep paper money in a lock-box at the store, that would be a distinct and separate service unrelated to the process of printing new money.

The operation of modern banks is quite complex. To see how banking works in terms of POW camp paper money, the process would be as follows:

1. John knits a wool coat from yarn.

2. Bob wishes to buy the coat for 50 POW dollars, but does not have enough money.

3. The camp's store brokers the deal; it buys the coat from John with 50 dollars it prints from thin air.

4. Bob buys the coat from the store on credit, owing the store 50 POW dollars, and agreeing to repay the debt over five months, paying 11 POW dollars per month (one dollar per month as an interest fee).

Modern banking is the same, but the wool coat is a house or car and the terms of the loan are longer. Banks broker deals in exactly the same way, making it easier for a home-builder to sell to a person who lacks the capital to make the purchase.

Notice that in this system there is not enough paper money to both pay off all the loans and the added interest payments. To correct this problem, the store would need to purchase supplies and keep them off the shelves, balancing the amount of supplies and paper. This is why the Fed engages itself in "quantitative easing," purchasing assets with new money, and keeping them off the market.

Later, if the value of paper falls in value, the store would be able to place additional items on the shelves to raise the value of paper -- by making it less plentiful relative to the supplies available in the store.

Trade Deficits


Don Boudreaux writes that trade deficits are irrelevant, both because of the way they are calculated, and additionally, because dollars must always eventually return to the United States, to purchase goods and services from US producers.

He correct in stating that deficits are of no concern to the well being of Americans, but is wrong in assuming that US dollars must always eventually purchase US goods or services. Dollars may be circulated indefinitely without enjoying the ownership of an American citizen ever again. Some nations use them as national currency, others use them as central-bank reserves, and foreign individuals may hold them as investments, trading them back and forth, indefinitely absent of American ownership.

Further, Mr. Boudreaux assumes that when American buys something from China using dollars, that those dollars are not immediately traded for Chinese currency on the forex.

And finally, Americans are the primary debtors to US banks, and are therefore, as a group, more negatively affected by deflationary pressure on US dollars. The supply of dollars is made lower if they are held in foreign bank accounts, because US banks no longer include them in the reserve calculations used to create new dollars. The citizenship of the dollar’s owner is always irrelevant — it is only the citizenship of the bank that matters to Americans.

The reality is likely that dollars are either quickly repatriated using currency exchanges, or that foreign companies hold accounts with US banks, and payments are accepted in dollars that never leave the United States banking system.

Much of the trouble in visualizing the impact of foreign trade is borne of a failure to regard dollars as a form of wealth, with an intrinsic value to those that must ultimately consume them. Dollars are born when banks issue new loans, and are consumed when those loans are repaid, in the same way that wine is created  in when grapes are fermented and destroyed when poured at the dinner table. Wine has value for the same reason as any paper currency, and both are created and destroyed in ongoing cycles. There is no such thing as "intrinsic value," or "real value," or "use value." All are childlike concepts invented to legitimize or quantify the reasons that any object is valuable. To avoid the truth -- that any object has value only because someone values it, is a grave error.

Zero Reserve Fractional Banking

on Monday, October 3, 2011

Some countries, like Canada and Australia, have a fractional reserve banking system with a zero reserve requirement. The fact that inflation does not run rampant in these countries is evidence that the traditional view of FRB is flawed; the reserve requirement is not a the limiting factor stopping banks from infinitely multiplying the money supply. Collateral is the limiting factor.

When banks make new loans, they are not re-lending money that is supposed to be sitting in individual accounts, as is commonly understood. They are creating brand new money. Period. Full stop.

New money is traded for collateral. There is no theoretical reason that a bank should not have a negative reserve; a bank could begin operation with no reserves whatsoever, no deposits at all. It could print new money and exchange it for collateral without limit, and without detrimentally affecting the value of dollars. Inflation would only occur if banks issued unsecured loans.

The purpose of reserve requirements is not to throttle the money supply, per se. Its true purpose is to regulate the amount of business each bank is permitted to do -- the biggest banks, with the most depositors, will be permitted to issue the most loans. Reserve ratios are the way the banking cartel divides business amongst its members.

The Economics of a POW Camp

on Sunday, October 2, 2011

R. A. Radford described in 1945 an account of trade in World War Two POW camps. Cigarettes, being the most liquid asset available, quickly became money; prices were listed in cigarettes and even non-smokers accepted them for their own rations of food and supplies, intending to use them as a store of value and in future trade.

Prices rose and fell depending on the influx of Red Cross supplies. When cigarette rations were reduced, prices rose. Markets were created by lists on the wall of each building, showing offers to buy or sell various goods, with prices listed in cigarettes.

The most fascinating part of the story is how closely it mirrors modern life; professional traders emerged, attempts to fix prices led to black market trading, and a fiat paper currency was created. A shop and restaurant were organized, and in order to purchase raw supplies for the store, issued paper notes that were each worth one cigarette, and were accepted in payment for anything in the store. The store became a bank, issuing paper money out of "thin air," and prisoners willingly accepted the paper because the shop agreed to trade it for goods at any time in the future. The paper money traded at par with cigarettes for a time, until the camp store began price-fixing schemes, and the camp became destabilized by bombing raids.

This method for issuing new paper money is the same system used today by modern banks. They issue new notes when they create new loans (mortgages, car loans, etc) with a few keystrokes, and insure that they are valuable by agreeing to exchange their collateral for notes in the future. The bank agrees to exchange a car title for dollars in the same way that the POW store agreed to exchange soap for new paper money.

The most interesting part of this narrative is that inflation eventually destroyed the paper money, but it was not because of excessive printing of notes. Printing too many notes would have been impossible; every purchase the central-store made with its new paper notes was kept in the store, available to be traded back to the men at the same fixed-price. If butter had been purchased for ten new paper notes, it would sit in the store, available for purchase for ten paper notes until it was sold.  Even if the store went crazy, buying up all of the assets in camp with new paper money, inflation would not occur, because everything purchased would still be available for sale, priced in paper money.

Paper notes lost value for two reasons. First, they lost value when the future of the camp was in jeopardy; when prisoners feared that the store might not exist in the future. Second, they lost value because of the store's efforts to fix prices, and its policy of removing an item from the shelves if the "official price" was too low compared to the black market. If soap's official price was ten cigarettes/paper notes, and was selling for 20 outside the store, it would be removed from shelves. Eventually the store only contained items that were not very desirable, and thus paper notes could only buy a few limited items in the store. When the camp was disbanded, all paper notes were eventually exchanged as agreed in the store, but the variety of items available was limited.

It follows that inflation of a paper currency in modern economies is created by destabilization of government (war), and by the implied price-fixing that occurs when a bank agrees to exchange loan-collateral at a fixed price. If a loan is issued for a car, the bank agrees to exchange dollars for collateral-free ownership if the loan is paid off.  The bank is effectively offering the home for sale in paper money at an "official,"fixed price.

If the market exchange-rate for soap goes too high, the store stops selling soap. The same thing effectively occurs in a market where home prices are rising; banks "take the soap off the shelf" by adding pre-payment penalties to mortgage contracts, which make it more expensive the pay off the mortgage; makes it more expensive to "buy the home" by paying off the loan. Banks don't remove the possibility of trading paper for the house completely, as was done with POW soap, but the inflationary effect should still be there.

A third way that inflation may occur is if the POW store began buying supplies with new paper and did not offer them for sale at all. This is what the Fed does when it engages in quantitative easing.

A fourth possible cause for inflation would involve the store accidentally buying supplies above the market price, and upon placing the asset on its shelf, finding that no one will pay 40 for soap because it trades at 20 outside the store. This effectively removes the bar of soap from the market, but leaves the new money in circulation to purchase anything else in the store, putting pressure on all other prices to rise and lowering the value of paper. This is what has effectively happened when housing prices collapsed and left many in upside-down mortgages -- the money remains in circulation but the home is priced incorrectly in the mortgage contract. The home is now effectively "off the market" just like the soap, no one will pay off a $500,000 mortgage on a house now worth $300,000. This effect is countered by mortgage defaults, which is equivalent to the POW camp store changing the price of soap to match market value. A bank prices the home correctly when it repossesses it and sells it at auction.

A final possible method for creating inflation would manifest itself if the camp's store were to begin issuing unsecured loans with new paper money. Nothing would be available in the store to match the new paper, and prices would be pressured to rise as the supply of new dollars outpaced the goods available in the store. This occurs today any time a bank issues an unsecured loan, and occurred heavily during the 1970s when banks issued massive amounts of unsecured loans to South American nations, causing massive inflation during that era and culminating in the August 1982 default of Mexico and eventually to a reduction of unsecured lending to the third world and a reduction in inflation during the 1980s.

The Yield Curve

on Saturday, October 1, 2011

What can rental cars teach us about yield curves? What are credit default swaps? Is borrowing a car fundamentally different from borrowing a dollar?
The longer one borrows a car, the lower the daily rate, but the longer one borrows money, the higher the daily rate becomes. Why? Another way to ask this question might be: "Why do yield curves slope upward for dollars and downward for cars?" Additionally, why does the shape of the curve change? What affects the rates that lenders charge to borrow cars and cash?
At first the question seems strange; we don't normally think of cash and cars as assets that are both being leased. We tend to avoid thinking of dollars as an asset that is being rented out, just like a rental car. We even have different names for the same things when speaking about dollars. Dollars do not depreciate, they are subject to inflation. Dollars are not rented to customers, they are loaned. One can lease a new car, but one borrows money. One pays a fee to rent a car, and pays interest to lease dollars. One signs a rental contract to borrow a car from Hertz, but signs a mortgage to borrow dollars from Chase.
The situation is further complicated when considering financial investments and bonds. If a company issues a bond it is borrowing dollars from an investor; it is renting dollars from an investor. Buying a bond is the same as loaning dollars; the same as renting dollars to the company that created the bond. Buying a bond is considered an investment, but buying a bond is the same as loaning money, the same as renting out dollars for a fee. In this sense a rental-car agency is no different than an investor -- it is renting out cars for a fee. Because both cars and dollars are assets, Hertz is "investing" in rental-car contracts, just as you might "invest" in bonds. A bond is a loan contract, and a loan contract is a rental agreement.
When a rental agency rents a car to its customer, the customer issues a bond (rental contract) -- the customer agrees to pay a fee for the right to use the car. The same thing occurs when a company issues a bond -- it agrees to pay a fee (interest) for the right to use an investor's dollars. Both borrowers agree to return the borrowed asset (dollars or a car) at a certain time and place, and pay a fee for the privilege of its use. The paperwork for this agreement is the same.

Back to the original question: why does a 15 year mortgage carry lower rates than the same agreement over 30 years... but borrowing a car becomes cheaper if it is rented for a week instead of a day? At first it seems like the answer is simple -- it costs money to process the car rental (building, desk clerks) and its return (cleaning etc), and the car loses value over time, and it can't make money sitting idle on the lot, so long-term rentals are more cost effective and avoids the paperwork of the turnover. The trouble is that mortgages require all of the same things, and dollars lose value over time as well. 
The are three main differences here. One is that dollars can be immediately loaned to new customers upon their return; they can always find a new investment (person willing to borrow them). Dollars sitting in an account are not idle like cars in a parking lot. The cars are losing value and failing to generate income, but the dollars in the account are generating interest.
Money is so liquid that it can be instantly rented out to myriad borrowers. Cars are illiquid, and there is always a risk that they will sit idle on the lot, which gives rental agencies an incentive to make long-term agreements to avoid idle time. Companies that rent cash (make loans) have zero risk of the money sitting idle, and therefor no incentive to offer a long-term discount on the rental fee. The yield curve flips when any asset becomes so liquid that there is no risk of the asset sitting idle. Until that point, short term rates are higher because of the idle-time risk.
Another main difference is the rate of depreciation; care lose value much faster than dollars, and because of the exponential nature of depreciation (assets lose value faster tomorrow relative to next year), depreciating assets cost more to hold now than in the theoretical future. This is obvious with cars and not so obvious with dollars, but both experience an exponential loss of value over time. 
A new car will lose perhaps half its value in the first three years, but may take another six years to lose half its value again. Eventually, a very old car will be nearly stable, losing only a fraction of a percent of its original value. The same thing happens to dollars, and for this reason if inflation (depreciation of dollars) is expected to be high, short-term rental of the dollars must be more expensive -- because of the nature of exponential depreciation -- dollars are always losing more value today than they will lose tomorrow. A dollar is today worth about 5% of its value 100 years ago, and is expected to again be worth 5% of its current value 100 years in the future, relative to today.
For example, if a car is expected to lose half its value per year, I must charge more than half its value to earn a profit on one-year rentals. But I can charge less per year if you agree to rent it for two years -- at the end of two years a $20,000 car will be worth $5,000; it will have lost $7,500 per year. So I must charge over $10,000 per year on one-year rentals and over $7,500 per year on two-year rentals, and so on. The price per year will be lower if you agree to lease it for a longer term. The same pressure applies to dollars, but because they are expected to lose only 2% of their value per year, I can make a profit by renting dollars (loaning them) at anything over two cents per year, per dollar.

A third difference is that the car rental-fee is paid in an asset other than cars; it is paid in dollars. With the rental of dollars, the fee is paid in the same asset that is leased. Borrowers of dollars pay their fee in dollars, and this turns out to be a key difference, and perhaps a good reason for using different terminology. To judge its equivalent in car rental, one would need to pay for the rental with rental cars.
So why do we see upwardly sloped yield curves if dollars are expected to depreciate in the same way as cars? Shouldn't I be willing to offer discounts on the rental fee if you agree to rent my dollars for a longer term? Yes, but there is another consideration in the business of renting property: default risk.
If I rent out my car, there is virtually no default risk; I will always get my car back. It is insured against theft and destruction. If I rent dollars to you and you default, I have no insurance, and have little hope of having my dollars returned to me. For this reason, the rental of dollars becomes more risky the longer I agree to let you use them. Credit default swaps, invented in the 1990s, are a form of insurance on rented (loaned) dollars. They allow people who rent out dollars to purchase insurance that pays if the rental money is not returned in the same way that Hertz carries insurance that protects them from renters who do not return their vehicles. CDS obligations lower the cost of lending money, making borrowing money cheaper in the same way that auto-insurance lowers the cost of renting a car from Hertz.
If you screw up and crash my car, I am not affected. If you screw up and go bankrupt, I lose my dollars (unless I purchase CDS insurance). Running your life without going broke is like driving a car without running it off a cliff -- both are more likely as the time-frame grows larger. The longer you drive, the more likely you are to crash. The longer you use my dollars, the more likely you are to go broke. However, we must not make the mistake of assuming that the fee is higher because the total risk of default is higher. The risk of default each year is what matters, because the rental fee (interest fee) is paid per year. It is paid based on the amount of time a borrower holds the car or the cash. 
If the borrower is a robot and his credit rating will not change from this moment until 30 years from now, the risk of default is the same for each of those 30 years, all else being equal. But he is not a robot; he is human, and I may be able to see how he drives today, but it is impossible to see how he will be driving 30 years from now. I know a loan may be a good idea for a business in its current state, but how can I know how stable it will be in the distant future? To take that gamble I must be paid a higher fee, and it is because conditions change over time. That man who borrows a car today will not be the same man in 30 years. Short-term loans are safer because it is easier to predict the near future. Tomorrow's weather is easier to predict than next week's.

However, a lender with a default swap does not fear losses in the same way that a rental-car company does not fear losing a car. The price of insurance varies from year to year, and there are myriad insurance companies available. The only risk in lending is that the insurance company will go broke at the same time that a car is stolen (which happened in 2008 with AIG's failure), so the credit rating of borrowers should not affect long and short-term rates differently.
Additionally, the final consideration is commonly known as a liquidity premium. If I am going to invest in something that is difficult to sell, I want to be paid a higher rental fee. If I invest in a rental property I want a higher return than if I invest in treasury bonds, because I can sell the bonds almost instantly, but may have to wait months or years to find a buyer for my rental property. The liquidity premium is the additional fee that is charged by people who rent their assets (invest) for longer periods of time. This consideration is mitigated by the securitization of long-term loans. Because lenders can resell their loan contracts easily, their capital is not tied up for the full term of the loan, and they don't mind issuing long-term loans any more than short-term loans.
The shape of the yield curve (price list lenders and investors set) is determined by four distinct forces:
1. The risk that the asset may sit idle and lose value when it is not leased to a customer. This relates to the liquidity of the asset. Liquid assets carry lower risk of idle time, and liquidity is a measure of how quickly an asset can be traded, sold, or rented. Mitigated by liquid markets.
2. The risk that the asset may not be returned as agreed (default). This depends on both the credit of the borrower and the uncertainty of the future. If war is on the horizon this risk is higher for all borrowers. Mitigated by CDS.
3. The expected depreciation rate of the asset; inflation.
4. The liquidity premium (term premium). People don’t like to own assets that are difficult to sell (trade), preferring to own 100 gold coins instead of a solid block of gold weighing the same amount, because the coins are more liquid; they can be traded more easily. Mitigated by securitization of loans -- similar to selling paper shares that represent a fraction of the gold brick. Because they are smaller, they are more liquid.

5. The difference between the depreciation of the loaned-asset and the asset used as payment. With rental cars, this involves comparing the depreciation of the car with the depreciation of the dollar. 
The liquidity of the asset affects the first risk -- the more liquid the asset, the lower the risk of holding an "idle asset." If it is very liquid, idle time will be near zero; cash can be immediately re-leased (invested at interest) upon its return.
A person in the business of renting out his assets must consider all of five items in setting a pricing schedule. Each lender (investor) will have a different yield curve (pricing schedule).

Long-term leases of depreciating assets should be cheaper (per day). Long-term leases of assets expected to rise in value should be more expensive (per day), even if no change in the value of money or interest rates is expected. Renting a building for five years should paradoxically carry a higher daily fee than renting a car for same amount of time, if default-risk is removed (with insurance).
Lower liquidity of the rented (loaned) asset flattens the curve, moving it towards inversion, because of the risk that the asset may sit idle between rentals. The leasing company has an incentive to avoid idle time by charging a lower daily rate on long-term rental agreements. 
Increased depreciation expectations flatten the curve for rental-car loans, making long-term rates lower relative to short-term rates, because cars exponentially decay to zero value over time. The faster the asset loses value, the cheaper long-term rentals become (relative to short-term rentals). However, if payments are made in the same asset, rates must be higher over longer periods (curve becomes steeper).

To see why, imagine that you and I both own 100 sealed bags of grain, each weighing 100 grams. Each year, mice are expected to pilfer 5% of the grain from each bag, until all of them are nearly empty. If I want to borrow all of your bags (10,000g) for a year, and wish to pay interest payments with my unopened bags, how much would you ask me to pay? Because the bags will be 5% lighter, and will weigh 95g each, you would need to be paid at least 105.26 bags (10,000/95) just to receive the same amount of grain (value) you loaned to me a year ago. The interest rate in whole bags of grain would have to be 5.26% per year, if I wished to repay exactly the amount of grain I borrowed.

Now imagine I want to borrow them for two years. What would you charge then? The bags would after two years contain 90.25g of their original grain (value), and they would have lost 9.75g of their original weight (value). To repay you I would need to give you 10,000g of grain(value), or 110.8 bags, which is 5.26% more than the 105.26 bags I owed from the first year. In the third year, the bags weigh 85.7375g each, and you would have to receive 116.64 bags.

So even if we know the exact inflation rate of our grain-bags, borrowing them for one year will cost 5.26 bags, and borrowing them for three will cost 5.55 bags per year (116.64/3). The cost to borrow for longer periods must be higher because payments are made in the same asset, depreciating at the same rate. Over time, the payments become devalued as well, which is not the case with car rentals, where dollars hold their value relative to the leased asset.
Uncertainty about the future does not make the curve steeper. Long-term rentals of cash seem like they should have higher fees because it is easy to judge the risk of a loan today, but very hard to predict risk of default in the distant future, but because of credit default swaps (insurance), the risk is mitigated. Reduced solvency of insurers affects the slope, not the solvency of borrowers.
The yield curve does not indicate where investors think interest rates will move in the future. It is a reflection of the pricing schedules of firms and individuals that rent out their dollars, and those pricing schedules are based on the five points above. The curve does not represent the expected change in inflation rates, but shows the current opinion regarding the average inflation rate in the future. It is a snapshot of lender opinions regarding how much grain the mice are expected to steal from the bags, on average.
Flat yield curves do not indicate an economic slowdown.  They indicate that people don’t expect any grain to be stolen from the bags in the future; inflation expectations are zero.

Liquidity preference does not affect the yield curve of bonds, because  bonds are also highly-liquid assets. Rental-car contracts are very illiquid. It would be difficult for a rental company to sell a rental contract, midway through a car loan. They must wait for the contract to reach maturity to get their car back. Bond holders don’t have to wait to get their dollars back; they can easily sell the bond in organized bond-markets.

Bonds that are not heavily traded would have a lower price, and thus a higher interest rate across all maturities, because lenders would be trading highly-liquid assets (dollars) for a less-liquid asset (bond). Similarly, a person trading a gold brick for gold coins may accept slightly less total weight in coin, because he values their liquidity; 15.9 oz of gold may trade for a one-pound brick.

High interest rates do not indicate high inflation expectations. If all rates are high and the curve is flat, inflation is expected to be zero. If all rates are high it indicates that there is a high demand for dollars. This is similar to high prices for rental cars -- it does not indicate that the cars are expected to depreciate (inflate) faster than normal, it means that people have a greater need for cars and rentals cost more. The shape of the curve indicates inflation expectations and the general level indicates how badly businesses and individuals want to borrow money.