The Efficiency of Auctions

A Globe and Mail article describing the auction processed used to sell houses in Australia distracted us from our holiday celebrations and hockey tournaments. The article argues that an auction drives prices higher than the ask-offer system commonly used in North America. (Click here for article)


Markets are most efficient when there is a large number of both buyers and sellers all dealing with a homogeneous product. This is typically not true in real estate. Properties are heterogeneous; there is only one seller and multiple buyers. There is also an asymmetric information problem in that the seller knows everything that is wrong with the property and the potential buyer doesn’t. In the North American system, the seller offers the property for sale at a price that is higher than the minimum price they will accept. The potential buyers make offers below the maximum price that they are willing to pay.

Then comes the game. The seller wants to get the highest price that any of the potential buyers would be willing to pay. The seller responds to one of the offers by changing their terms, letting all potential buyers know that there are multiple offers. None of the buyers knows the terms of the other offers. If the sellers can’t come to suitable terms with the first potential buyer, they are free to negotiate with another. Typically, the seller will settle for a price that is less than their initial asking price, and above the initial offer. More importantly, the price will likely be below the highest price that a potential buyer would have been willing to pay. The seller’s agent is supposed to help get the highest price, the buyer’s agent is supposed to help get the lowest possible price. A seller’s agent is considered successful if the property is sold, not if it sold for the maximum price. The marginal benefit to the seller’s agent of getting an extra $1000 for the seller is less than the marginal cost of getting that $1000 and there is no benefit to the buyer’s agent attaining a $1,000 reduction in price. This process is inefficient for both seller and buyer.

An auction works differently. The seller sets a reservation price and multiple buyers bid against each other. The auctioneer is the seller’s agent and works to get the best price possible. As the price rises, potential buyers drop out until two are left. The winning bid will be just above the maximum price of the buyer with the second highest willingness to pay, but below the maximum price that the winning bidder was willing to pay.

The article suggests that the auction process is responsible for the rising prices in the Australian market. People don’t like to lose and therefore bid up prices in a frenzy. This argument requires that bidders behave irrationally on average. We normally assume that individuals maximize utility, or personal welfare. That implies that they know the maximum price that they are willing and able to pay and that rational individuals will not go above this price. An auction increases the price and benefit to the seller, whereas the bid-offer system does not.

Beating the Market

Yesterday, we quoted a Globe and Mail article that commented on a book Zombie Economics: How Dead Ideas Still Walk Among Us by John Quiggin. (Click here for article). That quote read:

"Nothing in the (efficient market) hypothesis can explain the frequent bubbles and busts, strange stock valuations or the inconvenient truth that some shrewd investors do outperform the market." (emphasis added)

Our previous blog sought to illustrate that a "shrewd investor" could beat the market purely by luck. The evidence of investors outperforming the market is not sufficient to dispell the efficient market hypothesis. Today, we take a stab at what "outperforming the market" means, and what is should mean. By most accounts, beating the market implies creating a portfolio that generates a return, after transaction costs, that exceeds the return of a benchmark index i.e. TSX 60, DJIA, SP500, FTSE 100, CAC40, DAX, Nikkei, Hang Seng, MSWI etc.

There are some problems with this method, however, in that simply comparing the rate of return to a market index does not compensate for the risk of the portfolio. In general, the greater the risk, the greater the return. So, for  example, if we create a portolio using only the 30 riskiest stock in the TSX 60, we are likely going to beat the TSX.

There are at least three measures of return that do compensate for risk, and beating the market should be evaluated using one or more of these measures.

The Sharpe measure can be used for sufficiently diversified portfolios and is the ratio of the portolio return minus the risk free rate of return divided by the standard deviation of the portfolio return. This ratio is then compared to the same ratio for the benchmark. The Sharpe measure looks to see if the portfolio lies above or below the capital market line. Above indicates that the porfolio beat the market after compensating for risk.

The Treynor measure can be used for single securities as well as a portfolio and is the the ratio of the portfolio or asset return minus the risk free rate of return divided by the beta of the asset. Beta is a measure of risk relative to the market risk. The Treynor measure looks to see if the portfolio lies above or below the securities market line.

Finally the Jensen measure, or alpha, is similar to the Treynor measure in that is makes a comparison based on beta. Alpha is calculated by taking the difference between the actual rate of return of a portfolio minus the return predicted by the capital asset pricing model (CAPM). If alpha is positive the portfolio beat the market on a risk adjusted basis.

Yesterday, we showed that beating the market can be a matter of pure luck. Today, we showed that beating the market may be a result of taking on excess risk. Our intent is to show that having some shrewd investors that outperform the market is not sufficient to dismiss the EMH.

Probabilities and the Efficient Market Hypothesis

An article in the Globe and Mail got us interested in a book entitled Zombie Economics: How Dead Ideas Still Walk Among Us by John Quiggin. (Click here for article) We currently have the book on order from Amazon and will report back once we have read it in full.

In the meantime, we thought we might do a few blogs on the efficient market hypothesis and this one is based on a single line from the Globe and Mail article that suggests the EMH must be false because:

"Nothing in the hypothesis can explain the frequent bubbles and busts, strange stock valuations or the inconvenient truth that some shrewd investors do outperform the market." (emphasis added)

A little experiment. If you flip a fair coin, what do you believe the likelihood of it coming up 'heads' 10 times in a row? If it did, would you suggest that the coin wasn't balanced properly? Most people would. Now, however, lets start with 1024 people and ask them all to flip a coin. Those that come up tails must leave, and those that come up heads can stay. After the first toss, we should have about 512 people left. Repeat a second time and about 256 people should be left. On each successive toss, about half will be tails and half will be heads. After three tosses 128 people are left, then 64, 32, 16, 8, 4, 2 and finally, after ten rounds, only one person is left. That person just tossed 10 consecutive heads. (The probablility of doing that is one in 1024)

Lets do the experiment again with 1024 "shrewd investors" who build a portfolio by choosing any 59 stocks in the TSX 60. The one stock they don't hold is chosen by throwing a dart at the list. If the stock they omit underperforms the TSX then their portfolio will outperform the market. The omitted stock is chosen at random and thus has a probability of beating the index of approximately one half. After one year, those investors that beat the index can stay, they rest leave. At the beginning of each year, the survivors choose a new portfolio in the same manner. By the same logic as the coin game, after 10 years one of those "shrewd investors" beat the index 10 years in a row ... by throwing a dart.

According to the Chartered Financial Analyst Website, there are currently 90,113 individuals that hold the CFA designation. These are the people that manage portfolios and are well trained in what they do. If they all build portfolios in the game above, 88 will beat the market 10 years in a row, and one will be expected to beat the index for 16 consecutive years.

The existance of investors that outperform the market is not a sufficient reason to dismiss the efficient market hypothesis. As just shown, even with efficient markets, given a big enough pool, it is possible to beat the market entirely by luck.

Next time we look at the meaning of "beating the market".

Price controls and black markets

Something that Venezuelan President Hugo Chavez has never understood is the economic effects of the price controls that he imposes - or if he does understand them, he ignores them. The latest incident is reported in the Miami Herald. (Click here for article)

Price controls are implemented to prevent prices from rising to market equilibriums. At prices below equilibrium, the amount that people want to purchase exceeds the amount that firms want to sell. Normally, this would cause prices to rise inducing firms to produce more and consumers to want less until the market was in balance. When prices are held below the equilibrium price by government decree, a black market is created. A shortage of the product exists and buyers bid the price up above the equilibrium price, to the black market price, where the number of buyers is equal to the production amount that is legal.

In resource markets, the price will normally be equal to the value of the marginal product (the additional amount of output from one additional unit of input multiplied by the price of the output) Efficiency requires that resources are used in the most productive way possible.

President Chavez has subsidized the cost of urea, a chemical fertilizer, in an attempt to increase food production which is subject to price controls. In neighbouring Columbia, there are no price controls on the production of coca, the plant from which cocaine is derived. As a result, the value of the marginal product of urea is higher in the Columbian coca fields than it is in the Venezuelan corn and rice fields.

Not surprisingly, Venezuelan subsidized urea is not available to the rice and corn farmers of Venezuela, but appears to be available in sufficient quantities to satisfy the demands of Columbian coca farmers. Like it or not, Sr. Chavez, markets will prevail.

Articles on the European Debt Crisis

One day after I post my thoughts, the newspaper articles all show up. Here are a few of interest:

From the New York Times: Speculators vs the European Central Bank.

From Deutsche Welle: Is the bailout fund large enough to save the euro?

From Reuters: Higher yields on German bonds and the arguments against joint euro zone bonds.

From Bloomberg: Bank exposure to sovereign debt and stress tests

From Bloomberg: Yield spread between US and european bank debt and the cost of credit default swaps

From the Daily Telegraph: Iceland and Ireland

Thoughts on the euro

Ireland looks like they will be able to pass a budget that will allow them to pay down their international debt although Irish citizens will be paying the price. Greece still appears to be in denial with protests every time a politician even thinks about raising taxes (or enforcement) or cutting government transfer payments. Portugal is hanging on … just. Spain has a 20% unemployment rate and will find it difficult, if not impossible to pass a contractionary budget. Italy? Well, same story, different language.

Portugal will be the next country to need a bailout, and Spain won’t be far behind. Of the two, Spain is much larger and a much bigger threat to European stability. Angela Merkel, Chancellor of Germany, has rejected any notion of increasing the size of the bailout fund. What happens next?

First, Portugal accepts a bailout and the bailout fund runs dry. The cost of credit default swaps on Spanish debt, and Italian debt, starts to rise. The rest of the world starts unloading debt of the weaker European countries and, afraid to reinvest in France or Germany, move the money out. This puts downward pressure on the euro. This increased supply drives bond prices down increasing yields and further exacerbating Spain and Italy’s refinancing problems. A falling euro increases the cost of imports for France and Germany which slows their economies and kindles inflation. The European central bank must raise interest rates to fight the inflation, but at the same time needs to buy up sovereign debt to prevent a run on any particular country. The quantitative easing is, itself, inflationary.

Eventually, Spain can no longer refinance their debt and must seek assistance. German taxpayers will revolt at the thought of taking on the debt of Spanish taxpayers and Spain defaults. Negotiations will occur and Spain will refinance their debt at 60-70 cents on the euro with restrictions on fiscal policy. This will mirror Iceland’s solution wherein the bondholders are forced to bear some of the loss.

Spain’s banks will be some of the larger holders of Spanish sovereign debt as a form of reserves. A devaluing of the debt will reduce the asset side of their balance sheets and lower their capital ratios. Some may become insolvent. With any luck, the banks will have purchased credit default swaps and with a little more luck, the counter parties will be solvent. Banks in other countries will also be holding Spanish debt and these banks will also have reduced assets and capital ratios.

When Spain defaults, all the world’s banks will be in jeopardy. Spanish banks are linked to German banks which are linked to English banks which are linked to US banks all through the swaps market. It is the counterparty risk that will cause the contagion.

England and the US will be able to support their banks, in a worst case scenario, by guaranteeing the debts, just as the US did in 2008. The numbers will be staggering. England and the US can do this because their central banks have the unlimited authority to print pounds and dollars respectively. Germany and France, on the other hand, have no such authority to print the euro.

There appears to be no mechanism available to force the fiscally liberal nations to abide by the deficit-to-GDP and debt-to-GDP restrictions that they agreed to ten years ago, nor does there appear to be a mechanism to evict them from the euro currency zone. For Germany and France to save the euro, they will be required to guarantee the debt.

There is, however, a different scenario. France and Germany could voluntarily leave the euro and reinstitute the franc and mark respectively. Their debt would immediately be repriced in their own currencies. The remainder of the fiscally conservative countries could follow with the reinstatement of their own currencies. The remaining users of the euro could vote to inflate the debt away. Once the debt has shrunk to a manageable level in real terms, the euro is abandoned and so endeth the single currency experiment.

Peter Bissonnette, welcome to the rent-seekers' club

It's been a while since we found a suitable inductee into the rent-seekers' club. Previous invitations have gone to Heather Reisman and Dr. Antoinette Dumalo. A rent-seeker is an individual or corporation that attempts to influence government policy to generate monopoly profits for themselves.

Mr. Bissonnette is the president of Shaw Communications. He is trying to pursuade the CRTC, the regulator of Canadian broadcasting, that Netflix needs to be regulated in Canada. The argument is that Netflix does not have to incur the costs of broadcasting Canadian content and thus have an unfair advantage over broadcasters like the Shaw-owned Canwest Global. See the article in Canadian Business.

Netflix is Blockbuster or Roger's video without the bricks and mortar. Instead of going to the store to rent a movie, we can now order it online for immediate deliver. Shaw did not object to the existance of Blockbuster, why Netflix?

Our guess is that using Netflix uses up Shaw's bandwidth and that may slow their internet service. Regulating streaming video reduces Shaw's infrastructure costs. Funny that a company wants to charge for unlimited internet usage, as long as you don't use it.

Notice that Roger's has been silent on this issue since they provide both cable/internet and DVD rental.

More on Sovereign Debt Pricing

In a previous blog, I suggested that the pricing of sovereign debt did not accurately reflect the implications of Too Big to Fail. (Click here for blog) If my logic is correct, the appropriate investment strategy is to buy sovereign debt of Portugal, Italy, Ireland, Greece and Spain since they overstate the default risk, and short the sovereign debt of the countries that would likely have to bail them out: Germany, France, Sweden, Denmark and the Netherlands to be sure, England and the U.S. likely, Canada, Australia and New Zealand perhaps.

A pricing correction along the lines I suggested would increase the price of the PIIGS' debt and reduce the price of the other major nations. The bonds in play would be the 10-year maturities. T-bill prices aren't very sensitive to interest rate changes due to their short duration. 30-year bonds just aren't liquid enough.

Some 10-year bond yields courtesy of the Bloomberg app on my iPhone:

Tomorrow we look at the effect of these changes on banks' balance sheets.

The Economics of Prostitution

An article in the Globe and Mail delves into the economics of the sex trade, particularly the government's intention to decriminalize and regulate prostitution. (Click here for article) There are so many things wrong with the government's plan that we're not sure where to start. The article's author, Professor Marina Adshade from Dalhousie University, delves on some of the more obvious points.

Any time a government institutes regulations, production costs rise. When costs rise, producers have an incentive to move away from the regulated market and into the 'black' market. This is true for all firms. We see this in the home renovation business where a large number of people work strictly for cash, without permits.

So, if I understand the government's logic, sex trade workers will be required to collect GST/HST and submit their quarterly forms. They will also be required to file income tax returns. Revenue Canada will be required to figure out just what deductions will be allowed as "legitimate business expenses". Will mandatory testing for STD's be covered by the medical system? I'm not sure I even want to know how they intend to enforce mandatory condom use. Stop a driver to check for DUI, but stop a sex act to check for a condom?

Then there is always the "lemons" problem. Sex trade workers that fail the STD test must return to the street. Asymmetric information then suggests that street workers have failed the STD test and therefore must lower their prices, increasing the willingness to accept riskier proposals.

Once again, we find that politician have completely ignored the economics of their social policies. Of course, we're getting use to it.

“Too Big to Fail” and the pricing of sovereign debt

There is a notion amongst politicians and those with investable capital that, in the name of market stability, some corporations are “too big to fail”. The argument seems to be that the bankruptcy of very large corporations will have such large detrimental effects on the economy, that governments must bail them out when they get into financial trouble. We have seen this in Canada and the United States with the massive loans to GM and Chrysler, and in the US financial markets with the TARP bailout of AIG, Citigroup, and Bank of America. We have also witnessed the same situation in Iceland and Ireland with the bailout of the banks.

Whether or not governments should or should not bail out large corporations is a normative question and is not subject to economic debate. No government will ever possess the intestinal fortitude to try the experiment and let a company like General Motors fail.

What we are more interested in is the inefficient pricing of corporate and sovereign debt in the market. For example, Fitch Rating currently has a default rating of ‘BBB’ on AIG’s unsecured senior debt securities. This is the lowest possible rating in the investment grade category. If AIG is deemed TBTF, the appropriate credit rating should be that of the issuer that will bail them out. The US currently has a debt rating of AAA. In this scenario, AIG debt is underpriced and it’s yield too high to reflect the true probability of default. A Reuters article found on Huffington Post makes just this argument about pricing new bank debt. (Click here for article)

The problem extends to sovereign states as well. An article in the Globe and Mail makes a good case for letting the weaker European states default on their debt inflicting losses on the owners of their bonds. (Click here for article) The investors did, after all, receive higher yields to compensate them for their risk. Today, for example, the Irish 10-yr bond is trading at 633 basis points above the German 10-yr bond. If, as expected, the other euro-nations and the IMF offer Ireland the bailout that they need, the debt will be assumed by taxpayers in Germany and France. The yield on Irish and German debt should be the same as they are being paid from the same tax base. Either German bonds are overpriced (yield too low) or Irish bonds are underpriced (yield too high) or both. Ireland got into this problem by treating Irish banks as too big to fail. Now Ireland has become too big to fail. The UK, not a member of the eurozone, is in favour of the Irish bailout since a large number of investors in the Irish banks are residents of the UK. Germany and France will also commit to a bailout of Ireland, for if they don’t, panic will spread to Portugal and then Spain. An article on the Australian website The Age explains the logic of this. (Click here for article)

Markets are not efficiently pricing debt. If a company or a sovereign nation is too big to fail, and investors are not required to take a loss in the event of bankruptcy, then the debt should trade at the same price as the saviour, and the interest rate on the saviour’s debt should reflect the risk of financial bailouts.

The HST caused some prices to rise, but is not inflationary

The Bank of Canada has, as its stated policy, an inflation target of 2% annually, plus or minus 1%. Today’s announcement that year over year changes in the Consumer Price Index (CPI) was 2.4% might lead to speculation that the Bank will act to reduce inflationary pressure. Details are in a Globe and Mail article (click here for article)

The main culprits for the increase in prices are energy prices, automobile insurance premiums in Ontario, postal rates and the introduction of the HST in Ontario and BC. Of these, only energy prices are likely inflationary, and those prices are always volatile. The reason that the others are not inflationary has to do with how inflation is calculated and the definition of inflation.

Inflation is a sustained increase in prices and is measured as the percentage change in the consumer price index. One time increases in price cause the CPI to rise but, because they are not sustained increases, they are not inflationary. The automobile premiums have risen due to the poor performance of the stock markets. Premiums have to increase as a result. This problem is not likely to continue, therefore it is not inflationary. The HST has caused the price of those goods not previously subject to the provincial sales tax (PST) to increase. Again, this is not inflationary.

Mark Carney, Governor of the Bank of Canada, will keep careful watch over the CPI and the inflation rate. When the inflation rate rises as a result of sustained increases in the demand for goods and services, expect the interest rates to rise. Until then, nothing much should happen.

Economy perking up? Don’t bet on it.

Macroeconomic data is difficult to assemble, and is never contemporaneous. Deciding whether or not a recession is over is, therefore, a tricky call. Sometimes, however, microeconomic information that is available much faster can be used as a proxy for macroeconomics data.

The demand for any particular product is determined by price, consumer tastes, the price of other related goods, number of consumers, income and expectations about future prices and income. Over relatively short periods of time, tastes and prices are relatively constant as is the population. That leaves incomes and the expectations of future incomes as the main driving forces. The income elasticity of demand measures the responsiveness of consumers to changes in income. Luxury goods tend to be more responsive than necessities and since a large number of estimates exist on the income elasticity of products, we can use those to gauge the economy.

For example, sales of luxury goods are the first to fall during a recession and also quick to return in a recover. Watching the sales of toothpaste won’t help, since a consumer’s purchases of toothpaste are terribly insensitive to economic conditions.

An article in the Huffington Post (click here for article) provides a guide for budding economists. Watch sales of lingerie at Victoria’s Secret. “Miraculous” bras, priced between $49.50 and $250 have been selling out. Most would consider these bras as luxury items, perhaps indicating that the economy is on the rebound.

In a previous blog, What Happens in Vegas, Stays in Vegas, we cited a journal article that suggested the short run elasticity for gambling was 1.85. Gambling is very responsive to changes in income. An article from BBC News indicates that the initial public offering (IPO) for Harrah’s Entertainment, owners of Caesar’s Palace and other casinos has been cancelled due to continued losses as a result of economic uncertainty. (Click here for article)

Either gambling is more elastic than lingerie, or lingerie is being bought on credit. If the former is true, the economy is recovering. If the latter is true, the economy is on its way to recovery. Either way, things are looking up.

What is an artificial rate?

Canada is a small open economy with free capital flows and a flexible exchange rate. This shouldn’t be news to anyone, least of all those professionals that work in the financial markets. You might imagine how surprised we were to find an article in the Globe and Mail quoting Warren Lovely of CIBC World Markets in a comment on foreign buying of Canadian securities. (Click here for article)

“But could this foreign buying spawn a new style of crowding out, displacing some domestic investors by driving yields and spreads to artificial and unattractive levels?”

As a small country, we are unable to affect the world price of anything. This includes the price of loanable funds – the interest rate. In its attempt to prevent deflation the US Federal Reserve Board has been flooding the market with US dollars. Countries such as China that have current account surpluses end up holding these dollars. Eventually these dollars move around the globe seeking positive yields.

According to an article in the Economist, one of the biggest recipient thus far seems to have been Brazil. When international investors try to buy Brazilian bonds, whose yields are 112 basis points above equivalent US bonds, they must first purchase Brazilian Reais. This increase in demand causes the Reais to rise, reducing their exports and increasing their imports. This slows their economic growth. The increase in demand for Brazilian bonds increases the price of these bonds and reduces their yields. The capital inflow continues until yields are equated on a risk adjusted basis. The reduction in interest rates should increase domestic consumption and investment spending. Brazil has recently imposed a tax on foreign holdings of Brazilian bonds in an attempt to slow capital inflows. (Click here for article)

An article in Bloomberg Businessweek shows that Mexico is experiencing the same situation as Brazil. Money flowing into Mexico has increased the value of the peso and central bank Governor Agustin Carstens has indicated that he may reduce borrowing costs to offset the reduction in exports. (Click here for article)

Canada is now experiencing the same phenomenon. Money is flowing in from international markets driving up the Canadian dollar exchange rate and the price of Canadian bonds. As with all open economies, yields in Canada must be equal to the rest of the world on a risk adjusted basis.

Debts and Deficits. Do politicians know the difference?

On a recent trip to England, I caught a bit of a documentary that was talking about the national debt in the UK. The journalist chose 7 MPs at random and asked them how big the national debt was. Five of the 7 indicated that it was between 150 and 160 billion pounds, one said he left that stuff to the economists and one said that, while she listened to all the debates surrounding the nation’s finances, she couldn’t really understand it. The current debt is about 1.6 trillion pounds and if you include the unfunded pension liabilities of the civil service, the debt is estimated at 4.2 trillion pounds. This year’s deficit is 155 billion pounds. At least that is according to the journalist.

Why is it that we trust our nation’s finances to politicians that seem to have absolutely no idea what they are doing? This problem is not unique to the UK, but is prevalent in the US and Canada as well.

Ladies and gentlemen of the governing class, today’s lesson is the difference between the debt and the deficit. The deficit is the difference between this year’s tax revenue and this year’s government expenditures, when expenditures exceed revenues. The debt is the sum of all previous deficits, minus any surpluses.

Too complicated? The deficit is how much you charged on your Visa this month. The debt is this month’s balance. Clear? For those politician’s in the UK, you just charged 155 billion pounds, and this year’s balance is 1.6 trillion pounds. Interest charges amount to 42 billion pounds. The good news is, if you stop using your Visa today, and start paying 64 billion pounds per year, you will have the Visa bill paid off in just over 200 years. Of course that assumes that interest rates remain at 4% for the next 200 years and that none of the civil servants collect their pensions.

For UK voters, this formula requires a combination of tax increases and government spending cuts of 219 billion pounds per year. For US voters, better hope that the Republicans cut out more than just earmarks. No worries for Canada, we’ll just sell Vancouver Island to the highest bidder.

Christmas Tree Taxes ... Is Nothing Sacred?

Christmas trees are homogeneous goods, with many sellers, many buyers and no barriers to entry. Sounds like perfect competition to me. So why is it that Christmas tree sellers can't figure out why they aren't making as much money as aircraft producers?

An article from McClatchy newspapers tells us that the US Department of Agriculture is going to levy a 15 cent tax on all fresh Christmas trees and use the $2 million for an ad campaign promoting real trees over artificial trees. (Click here for article). The intent is to stop the decline in market share for real trees. The USDA used the same strategy in their "got milk" campaign.

Need a smarter economist to help me out here ....

Each grower in a perfectly competitive industry faces a perfectly elastic demand curve, so the incidence of any tax falls solely on the producer. The advertising campaign will promote the benefits of real trees over artificial trees, and therefore increase the market demand for real trees. An increase in demand raises market prices. So to be beneficial to growers, the market price has to rise by 15 cents to offset the tax. Unlike milk, real Christmas trees have a near perfect substitute, fake trees. Since the price of fake trees is not changing, we might sceptically suggest that the best outcome is that real tree prices will, at best, return to the long run equilibrium.

The environmental half of us might suggest that natural trees should be subsidized since they remove carbon from the atmosphere and artificial trees should be taxed since they are made with oil products. This would change the relative price in favour of real trees.

Cotton Rises - One Dumb Economist's Students are Worse Off

One dumb economists is very sad having just read an article in the New York Times. The source of the sadness is indirectly floods in Pakistan and droughts in China. Only indirectly because of floods and the drought have destroyed the cotton crop. Not that we really care about the cotton crop, but when the supply of cotton goes down, the price of cotton goes up. And again, we don't really care that much about the price of cotton except that cotton is a major input into the production of my Levi's jeans. (Click here for article)

When the price of an input goes up supply the product goes down. And when the supply of the product goes down its price goes up. And when the price of a product goes up consumer surplus goes down. And anyone that knows me knows that I live in my Levi's. So when the price of Levi's goes up my consumer surplus goes down.

Consumer surplus is the difference between the value received in the amount paid into purchase. So, for example, if you value an item at $50 and the price of the product is only $40 then when you purchase it you capture a consumer surplus of $10 you are $10 better off by making exchange. If the price rises to $45 you will still make the exchange but you will only capture five dollars in consumer surplus. A reduction in consumer surplus makes consumers less happy.

So this one dumb economist is now worse off and has to make up exams for his classes. And now his students will be worse off just because of floods in Pakistan and droughts in China. Unless, of course, his intermediate students can figure out what an compensating variation is.

Keynesian ... or Kenyan

From Huffington Post (click here for article) we can never be sure what goes on in the minds of the lunatic fringe. President Obama was born in Hawaii, his father was born in Kenya. There are still some people that believe that the President was born in Kenya which would make him ineligible to be president. However, the current policies of this administration are definitely Keynesian.

Keynesian fiscal policy dictates deficit spending during a recession in an attempt to stimulate aggregate demand. The neo-classical school suggests several reasons why such a policy is likely to be ineffective. Perhaps that is why the democrats just lost control of Congress. That is the economics part.

Kenyans are known throughout the running world as some of the best long distance runners. So much so that you will often see signs stating "You're all Kenyans" while running a marathon. The currrent men's olympic gold medal marathon champion is Sammy Wanjiru of Kenya, the Commonwealth Games gold medalists are John Ekiru Kelai and Irene Kosgei both from Kenya. This year's Athens Marathon, commemorating the 2500th anniversary of Phidippides' inaugural run, saw Raymond Bett and Edwin Kimutai finish first and second ... and yes, they are both from Kenya.

All things considered, I'd rather be Kenyan, than Keynesian.

Proposition 19 and the price of peppers in BC

Proposition 19 is the ballot initiative in California that, if passed, will legalize the possession and cultivation of small amounts of marijuana for personal use. As economists, we get to ignore the ethical and political implications and focus only on the impact on markets. The Globe and Mail published and interesting article on Saturday about the implications for BC (click here for article).

There are some issues in the article that we believe need clarification. The first has to do with the increase in demand and supply of pot in California if Proposition 19 is approved. We agree that the cost of marijuana will fall, but only because of the reduction in risk, not due to economies of scale. Marijuana would still be illegal under the Federal Controlled Substances Act and thus, large scale facilities are not likely to emerge due to the threat of federal prosecution. There are roughly 37 million people living in California and there aren't enough DEA agents to arrest all users, only commercial growers. The demand for marijuana is not likely to increase if it is legalized. We need only look at the number of people that speed, run red lights, use cellular phone and refuse to buckle up to know that people don't obey laws. If the benefit exceeds the cost, people will break laws. The penalty for possession of small amounts of marijuana is trivial so the risk is not likely to change. The price of marijuana will almost certainly decrease (depending on the tax) and usage may increase.

Secondly, the author makes some claims about the economic effects on BC. There will be no reduction in BC's GDP, only because the marijuana trade is illegal and not included in GDP in the first place. Likewise, the people employed in the marijuana industry do not show up on Statistics Canada employment numbers and those wouldn't change either. The article implicitly assumes that all marijuana cultivated in BC is shipped to California. The US has a population of 310 million. (On a recent trip to Florida, I was golfing with some gentlemen from Baltimore. When the learned I was from BC, they commented that we grew great bud ... I don't think they meant beer)

If, and when marijuana is legalized in California, BC would stand to benefit by also legalizing the cultivation of marijuana. We have several greenhouses that currently grow bell peppers that retail at $1.99/lb. Enterprising  greenhouse owners would remove those crops and replace them with marijuana. That would be the short term response. The long term response would be the construction of more greenhouses and an expansion of the industry, taking advantage of the economies of scale. GDP in BC would rise (now legal) as would the tax revenue of the provincial government.

The downside is that with the removal of the pepper crops, bell pepper prices would rise in BC.

Two out of three ain't bad

Economists are a strange bunch to be sure. You just never know what we are going to research. We are currently working on a paper that attempts to explain why college business instructors, and economics instructors in general, don't often serve on committees and don't rise to administrative positions. The topic for the next Economists Cafe at our institution is "Why duelling was an efficient way to solve disputes" presented by a colleague from SFU.

Today, however, the Globe and Mail reported on a working paper that caused us to shake our heads. Three Ontario based economists have written a paper on what characteristics affect the salary of university professors. (Click here for article) The usual suspects are present: rank (professor, associate, assistant), experience, age, sex, field (yes, economists are among the top earners) and quality of university. But the most unusual attribute ... number of chili peppers on Rate My Professor. (click here for working paper)

The results? Top earners are hot, male, economists.

Income Inequality: Too many causes to ignore

A recent article in the New York Times tackled the issue of income inequality and suggested that it had been growing over time and that it was now "too big to be ignored". (Click here for article)

We will acknowledge that income inequality has been increasing throughout the world. What we take exception to is the following paragraph:

"Yet many economists are reluctant to confront rising income inequality directly, saying that whether this trend is good or bad requires a value judgment that is best left to philosophers. But that disclaimer rings hollow. Economics, after all, was founded by moral philosophers, and links between the disciplines remain strong. So economists are well positioned to address this question, and the answer is very clear. "

First, there are many causes of income inequality. While all men (and women) are created equal ... that is only under the law ... not in economics. We all have different endowments. Some are tall, some are fast, some are intelligent, some are born into wealth, some are lucky. Income equality would first require equality at birth.

Second, not everyone has the same tastes. Personally, I greatly value my leisure time, so I am on the backward bending portion of my labour supply curve. Steve Jobs apparently has a labour supply curve that is always positively sloped. Surprise!! He earns more than I do. Income equality would require that everyone has the same tastes and behaves in exactly the same way.

What is unfair is to suggest that Steve Jobs should pay higher taxes to support me, just because we view leisure diffferently.

Third, welfare measures used to create income equality on a moral basis often rely on the assumption of diminishing marginal utility. And by that argument, the utility lost from a $10,000 decrease in income when income is at $2 million is less than the gain in utility from a $10,000 gain in income when income is $10,000. And therefore, society is better off when we take $10,000 from a rich person and give it to a poor person. The problem with this argument that, while it is true that a person values $10,000 more when they have $10,000 than when they have $2,000,000, we have no way of examining utility ACROSS individuals. No one, to my knowledge, has ever suggested that utility functions are cardinal, only ordinal. We can say that individual A gets more utility from two hotdogs than one, but we cannot say that A gets more utility from hotdogs than person B.

Redistribution of income always makes one person worse off. In that sense it cannot be a Pareto improvement, and that is the way most economists measure the welfare effects of social policy. And that is the reason we leave it to philosophers to argue the point.

Chinese Auto Market

A recent Business Day article outlines overcapacity concerns in the Chinese car manufacturing industry. Sales have boomed as China’s auto market overtook the U.S in 2009 as the world’s largest due to the emerging middle class and rapid increase in per capita incomes. The demand for cars far exceeds supply at the moment.

This year, up to 17 million vehicles are expected to be sold – an increase of 25-30% after last year’s 46% surge. This has caused manufacturers to increase production at a rapid pace, leaving analysts seriously concerned. The auto market has huge potential in China, a country with a massive population but relatively low percentage of car ownership.

The article reports that international joint ventures do not hold enough current capacity to meet the huge demand, resulting in new investment decisions.
Nissan, Toyota, Hyundai, Volkswagen and FAW to name but a few, have recently announced openings of new production facilities in mainland China. This increase in the supply-side capacity of the car industry seems to be at risk of too much inward investment.

Some concerns of the National Development and Reform Commission, China’s powerful economic planning agency claims:

“Serious overproduction capacity will lead to negative market competitiveness, a loss in enterprise efficiency, factory stoppages and other problems.”

Perhaps this should serve as a reminder of elasticity of supply in a rapidly growing sector. As a general rule for the resposniveness of producers to changes in the price of their goods, if prices rise then so does supply. But we know that cars are a normal good. So long as your income is rising, you will purchase more. Which leads to our next point...

Forecasting is difficult in the auto industry and adding new plants takes time. Our readers will recall a previous blog on the devaluation of the yuan (see below). We would like to point out that just last week The People's Bank of China said it was raising benchmark rates by 25 basis points in an effort to curb persistent inflation. An increase in the interest rate is designed to slow investment. The Business Day article is evidence of this inflation. We could likely be seeing too much capacity in a few years when markets have cooled.

For more on the People's Bank click here.

The Wok Calling the Kettle Black

We have previously blogged on the dispute between China and the rest of the world regarding the pegged value of the yuan. In short, China refuses to let the yuan rise to it's equilibrium value. By keeping their currency artificially low, they encourage exports and discourage imports. The U.S. has tried to get China to abandon this policy to no avail. In the last month, the Federal Reserve in the U.S. has undertaken a policy of quantitative easing - increasing the money supply. The result is a decline in the value of the US dollar against most other currencies and gold prices hitting record highs (in US dollars).

You can't blame us for being a little surprised that China would actually criticize the US for actively depreciating the dollar given that the yuan has been undervalued for years. (Click here for article) China argues that the quantitative easing will lead to inflation and upward pressure on the yuan. The only way that China can maintain the relative price advantage is to continuously purchase the US dollar and issue yuan. The result of this action, as we previously explained, is inflation in China.

The depreciation is starting to spread. Brazil, Indonesia and Japan have already started to impliment policies to lower their currencies. Looks like we may have a race to the bottom. The first one with a valueless currency wins.

Rolling back to recession

A little macroeconomic lesson from the chief thinkers at Walmart.

An article from Time magazine online edition dated Oct 5 (click here for article) indicates that Walmart will reduce its Rollback program in an attempt to increase sales revenue. During the recession, Walmart had reduced prices in an attempt to increase sales. Why didn’t the discounts help, and why the change in policy?

During a recession, disposable income falls and consumption in general falls. Demand for normal goods decreases and sales fall. That is something Walmart can’t fix, but they may not have known it. There is an information problem when using macroeconomic data to make microeconomic decisions. While Walmart surely knew that its same store sales were down, they had no way of knowing, in real time, whether the decline in sales was due to a decline in GDP or whether customers were shopping at their competitors. The government statistical agencies typically take months to produce accurate macro data, and it wasn’t likely that Target and Fred Meyer were sharing their sales figures with Walmart.

Since Walmart can’t fight the recession all on their own, they did what they could, they dropped prices trying to get customers back in the door. The customers, however, did know that the recession was the reason they were not shopping. Because of that, consumers stalked up on the 40 oz bottle of ketchup and the 50 oz bottle of Tide. The demand for these products is inelastic meaning that consumers don’t use more when prices fall, and total expenditure falls as price falls. When consumers expect prices to rise, as they will after a temporary sale, they will buy at the low price. This just shifts the pattern of spending, not the total spending.

Abandoning this plan, Walmart is now raising prices. Paradoxically, that will increase sales revenue, unless of course, Target and Fred Meyer drop their prices.

Drought in Kazakhstan, steak prices rise in Vancouver

In our principles classes we try and show the interdependencies of different markets in different countries. We know it happens, but journalists aren’t normally cooperative in giving us articles we need to demonstrate this ... until this week.

An October 11 article from the Globe and Mail (click here for article) and an October 12 article from the NY Times (click here for article) provide just the kind of obscure relationship that we’ve been looking for.

The story starts with a catastrophic drought in Russia, Ukraine and Kazakhstan, countries that normally grow a large amount of wheat. As the supply of wheat falls, the price of wheat will rise. Since corn is a substitute for wheat, the demand for corn then begins to rise. Shift the focus 6,500 miles west to the American Corn Belt where there was too much heat and too much rain. The weather in the USA reduced the supply of corn. Go another 6,500 miles west and we find that China has been importing American corn. The increase in demand from China and the increase in demand due to the increase in wheat prices together with the decrease in supply from the weather have caused corn prices to rise.

Now turn around and head 7,000 miles west to Texas where they raise cattle. Corn is used as feed stock and, since corn prices are rising, the cost of raising cattle rises. The supply of beef decreases and beef prices rise, including the price of steak in Vancouver.

Next, we`ll head 1,300 miles north to Saskatoon, where they produce potash. Potash is used in the production of fertilizer. When the price of corn increases, the quantity supplied increases. Farmers try and grow more corn. They do this by planting in areas less suitable and use more fertilizer. The demand for fertilizer is a derived demand – derived from the demand for corn. The demand for fertilizer rises and the demand for potash rises. Therefore the price of potash rises.

As potash prices rise, the profits of potash producing companies, such as the Potash Corporation will rise. If profits are expected to continue to rise, and/or the firm is not maximizing profits, they may become a takeover target. Another firm may attempt to purchase most or all of the outstanding shares of the company.

That brings us to the last stop on our trip, 9,000 miles southwest from Regina to Melbourne Australia, the home of BHP Billiton. BHP has recognized the upside potential for potash and has made an unsolicited $38.6 billion hostile bid for Potash Corp.

Our story is complete. From the wheat fields of Kazakhstan, 30,000 miles to the corporate offices of BHP Billiton we have seen the interdependence of markets.

A little Congested

A recent report by the Campaign for Better Transport has released its findings for the M6 Toll. Click here for the article in BBC News.

The M6 Toll is a 27-mile privately-financed motorway that runs around the north west of Birmingham, between junctions 3a and 12 of the M6. It opened in December 2003 and was intended to relieve congestion on the busiest section of the M6 by providing an alternative route.

For those unfamiliar with toll pricing, here is a little review.
What price to charge for the toll may have been decided by considering a number of factors:

•The cost of building the road
•The expected usage of the road and therefore the time taken to 'break even'
•The cost of maintaining the road
•The price elasticity of demand for road use
•The cross price elasticity of demand for other roads

The report however, finds that the UK’s only private motorway toll has not significantly cut congestion. The owners (Midland Expressway) are losing close to £26million a year since the toll opened. In order for the toll to work, enough people have to be persuaded to use the new motorway even though by doing so they will incur some private cost. Charge too high a price and people will avoid using the road, too low a price may not generate enough revenue to make a profit.

The main reason for the lost revenue to Midland Expressway is that again, tolls only work if there is an incentive for people to pay them. If the marginal benefit to me (in terms of travel time, reduced discomfort and so on), is worth the £5 per car to use the M6 then I will gladly be willing to pay.
In truth, the journey times on the M6 are only slightly better than before the toll opened. As a driver, this does not equate MB=MC and there is no value to me in paying to use the toll road. Added to which, the toll for users has risen well above inflation each year.

We think Midland Expressways may need to go back to their economics 101.

For more information on the M6 Toll click here for their website.

A Burning Situation

A fire broke out at a baker's in the City of London on September 2nd, 1666. This lead to The Great Fire of London which burned for 4 days consuming 436 acres, including 80% of the City. Out of the ashes of this ruin came a new business; the competing for-profit fire insurance companies, each one of which also owned a fire brigade. For the next two centuries London held this form of protection.

History tells us that in the earliest days of insurance, companies gave plaques to policy holders who would display them on their homes. This showed them to be covered. The brigades would refuse assistance to those homes not holding a plaque. Further, an insurance company would extinguish a fire only if it was in a home insured by that exact company, so a house with the plaque of a different company would receive no assistance.

In present day Obion County, homeowners must pay $75 annually for fire protection services from the nearby city of South Fulton. Residents in the rural area of Obion had no fire protection until the county established the $75 fee in 1990. If they did not pay the fee and their home caught fire, they do not get fire protection services under any circumstances. Someone must always learn the hard way.

An article found here, describes how a man’s home caught fire last week and he called 911. Having not paid the $75 fee, he was offering to pay all expenses related to the Fire Department’s response. He was refused service. Firefighters did however come out when the man’s neighbour (who had paid the fee) called 911, worried that the fire might spread to his property. Once there, members of the fire department stood by and watched, acting only when the fire reached the neighbour's property. What did the man have to say for himself?

"I thought they'd come out and put it out, even if you hadn't paid your $75, but I was wrong."

This quote captures the “free rider” problem perfectly. Many economics textbooks discuss fire protection with respect to public goods. Economists define public goods in terms of non-rivalry and non-excludability. Non-rivalry is when a good can be used by one person without affecting the use of the good for another person. Specifically, the marginal cost of an additional person enjoying the good is zero. Non-excludability occurs when it is impossible to exclude anyone from the benefits of a particular good. A pure public good is one that has both absolute non-rivalry and absolute non-excludability.

The supply of pure public goods requires government involvement in order to be efficient. A free-rider problem often arises due to the non-excludability, meaning no one person has any incentive to provide it. Thus private provision of these goods leads to production of an insufficient level of consumption or supply. Many goods may have only a degree of non-rivalry and/or non-excludability. These goods are sometimes called “impure” public goods. Fire protection falls in this category.

According to Joseph Stiglitz, in his Economics of the Public Sector, fire protection is similar to a pure public good in that the marginal cost of use is very low. The article from Obion, states that the firefighters were at the scene and had all the equipment available to put the fire out.

However, the ease of exclusion for fire protection is similar to that of the pure private good. If fire companies cannot discriminate between the insured and uninsured, a significant free-rider problem will exist. Without discrimination, no incentive would exist for people to pay fees like the one for $75. With fire companies only interested in protecting those who paid the fees, they had no incentive to help burning uninsured houses. So there you have it, fire protection possesses attributes of both a public and a private good.

From Economics of the Public Sector:

'Most of the time, fire fighters are not engaged in fighting fires but are waiting for calls. Protecting an additional individual has little extra cost. Only in that rare event when two fires break out simultaneously will there be a significant cost to extending fire protection to an additional person. But even here, matters are more complicated: if we want to protect the building next door which has paid for fire protection, it may be necessary to put out the fire in the building which has not paid for protection – exclusion may not really be feasible (Stiglitz, 2000, p. 134).'

In another article by Levy, which hits closer to home for this blog, the idea that buildings would be allowed to burn in a fee-based system was suggested. We would encourage those interested to read it.

Stiglitz, J. (2000) Economics of the Public Sector, 3rd edn., New York: W. W. Norton & Company.

Levy, J. (1995) Essential Microeconomics for Public Policy Analysis, Westport, CT: Greenwood Press.

Ireland Update

Ratings agency Fitch cut Ireland's credit worthiness Wednesday, downgrading it to A+ from its previous AA- rating follows a similar move earlier this week by rival agency Moody's.
However, both Moody's and Standard & Poor's still rate Ireland at the higher grade of AA2 and AA-, respectively.

This had an immediate negative impact on Ireland's borrowing costs on international bond markets. The interest rate, or yield, that investors demand to buy Ireland's 10-year bonds rose to 6.4% Wednesday.

Next month Ireland will publish a 4 year deficit plan and will then unveil a 2011 budget that reduces debt by at least 4 billion euros, which could depress Ireland's already deflated economy.

“The downgrade of Ireland reflects the exceptional and greater-than-expected fiscal cost associated with the government's recapitalization of the Irish banks, especially Anglo Irish Bank,” said Chris Pryce, director of Fitch's government debt group. “The negative outlook reflects the uncertainty regarding the timing and strength of economic recovery and medium-term fiscal consolidation effort.”

But Fitch said Ireland has enough cash stockpiled (more than 34 billion eruos, including its national pension reserves) and borrowing capacity to ride through the crisis, with full funding for government spending already secured through mid-2011. Excluding the bank bailout costs this year, Ireland's 2010 deficit is projected to reach 11.9 per cent, “a more appropriate measure of the underlying fiscal position.”

To read the full story, click here for the article.

Principal Agent Problem - or what we should now call the Jerome Kerviel Problem

Jerome Kerviel , ex-trader for Société Générale, was found guilty and convicted in what is now history’s biggest rogue trading scandal. Breach of trust, forgery and entering false data into computers all linked to covering huge stock bets, he was sentenced to at least 3 years in prison and must pay his former employer damages of 4.9 billion Euros. That was not a typo.
His illicit stock bets are estimated to have cost France’s 2nd largest bank about 5 billion Euros in losses.

Let’s take a look at a quote from the article in yahoo news;

“Kerviel maintained that the bank and his bosses tolerated his massive risk-taking as long as it made money - a claim the bank strongly denied.”

This is an example of the principal agent problem. The principals (bank) hire an agent (Kerviel) to perform tasks on their behalf but they cannot ensure that the agent performs them in exactly the way the principals would like. The actions and decisions of the agent are impossible or very expensive to monitor and the agent and the principal may have differing incentives.

This lack of information was a costly failure of information and bank office controls and systems. It was reported that Kerviel had taken speculative positions on selected stocks without the knowledge of the bank. Société Générale has already been fined four million Euros after admitting to lax financial controls.

It is also reported that “The bank says Kerviel made bets of up to 50 billion Euros - more than the bank's total market value - on futures contracts on three European equity indices, and that he masked the size of his bets by recording fictitious offsetting transactions.”

The principal agent problem stems in part from a separation of principal from agent, where the agent (trader) acts in their own self-interest, not in support of the aims of the principal (bank), the incentive problem we listed above. Much has been published and written in recent years about the incentives to cheat.

Typically, the incentive to cheat is greatest when given the chance to “play” with other people’s money (no real sense of ownership leads to risk loving). The Kerviel case shows just how risky this can be for huge financial organizations if there is a failure of control over the trading floors.

It was calculated that, based on his current salary of 2 300 Euros a month as a computer consultant, it would take Kerviel 177, 536 years to pay off his damages. Spokeswoman Caroline Guillaumin called the verdict "an important ruling that acknowledges the moral and financial harm done to the bank and its staff."

More on Fiscal Policy

There are just too many stories to ignore, so once again we blog on fiscal policy. Our previous blogs were a story on the Quebec City arena, and examples of stimulus spending in the U.S.


Today we want to look at infrastructure spending in general and a baseball stadium in particular. Our first article comes from the St. Petersburg Times and looks at the benefits of the spring league to the state of Florida. (Click here for article) The article quotes a study undertaken by The Bonn Marketing Research Group that suggests the economic benefit to the State is $752.3 million annually. (Click here for study) This has prompted government spending to maintain, or increase the number of MLB teams that hold spring training in Florida. The alternate destination is Arizona. In the article, Professor Philip Porter from the University of South Florida is quoted as saying that the study is flawed – having used inappropriate methodology. We have to agree with Prof. Porter. The study looked at benefits, but not costs. This is definitely a shoddy way to do economic analysis. We look at net benefits, not gross benefits.

That brings us to our second article, taken from Bloomberg. (Click here for article) This one deals with the decision by Lee County officials to borrow $81.2 million to build a training center outside of Fort Myers, Florida for the Boston Red Sox and the Minnesota Twins. In this case, an economic analysis could be undertaken. Not all the relevant numbers are presented in the article so some research would be required. To decide whether the County has an economic case for building the stadium, we would look at the capital cost and the annual operating costs of the stadium and compare that to the benefits derived from the stadium, including lease revenues, concession and parking revenues as well as the benefits to the community. All values would have to be discounted to take account for the time value of money. This is known as net present value analysis and is similar to what a profit maximizing firm would do. The difference between public and private analysis is the inclusion of external benefits. If the article is accurate and the stadium would account for $41 million in tourist revenue, a legitimate business case might be made.

Our third article comes from the Washington Post. (Click here for article) In this article, the author argues that the U.S. government should borrow $2 trillion (that’s $2,000,000,000,000) and spend it on infrastructure including roads, railroads, runways, water systems, schools and levees. The argument is that there is so much labour and so much material available due the recession and the fact that interest rates are so low, that the costs will never be lower. Once again, the analysis is flawed. Current interest rates are, in fact low. There is no guarantee that they will stay low. Most of the demand for bonds is currently at the short end of the maturity spectrum. This usually happens when rates are expected to rise. The article does say that current government spending needs no cost-benefit analysis and is completely political. Does it not make more sense then, to initiate broad based tax cuts and let individuals decide what is cost effective? Just a thought.

What Happens in Vegas, Stays in Vegas

At least that's what the rest of the U.S. is hoping.

A New York Times article on the state of the Nevada economy reports that the unemployment rate in Las Vegas is now 14.7 percent, compared with a national average of 9.6%. (Click here for article). In addition, Nevada has led the nation for 44 consecutive months in housing foreclosures.

Nevada has two problems, the first is the downturn in gambling activity in Las Vegas. Gambling is a form of entertainment and, as such, we should expect that demand is very sensitive to changes in income. A 2008 article entitled:

The Income Elasticity of Gross Casino Revenues: Short-Run and Long-Run Estimates by Mark W. Nichols & Mehmet Serkan Tosun

published in the National Tax Journal (Vol. LXI, No.4, Part 1) suggests that the short run income elasticity is about 1.85. What that means is that a 10% drop in income causes a 18.5% drop in gambling expenditures. The two year recession in the U.S. has been particularly deep and widespread and the effect on Vegas has been more severe than the rest of the country. Las Vegas gets a lot of its clientele from nearby California, but California's unemployment rate is 12.4%. Airlines have cut back flights to Las Vegas in an attempt to keep their revenues up, so even though the planes are full, there are fewer of them.

With fewer people gambling in Las Vegas, the casinos and hotels have been laying off staff. This contributes to the unemployment rate. Nevada residents are generally not a large source of income for the casinos, but an increase in the unemployment rate causes a decrease in the demand for housing. This is the second problem. Housing is a derived demand, derived from the number of residents and their incomes. When the economy was expanding, from 2002-2007, construction in Las Vegas was booming. The credit crisis, the reduction in gambling revenue and subsequent layoffs dramatically reduced the demand for housing and therefore the price of housing. As more and more homeowners found themselves under water, the foreclosure rate increased. Median home prices in Las Vegas peaked at $344,900 in April 2006 and currently sit at $129,950.

Las Vegas will recover. People will return. The question is not 'if', but 'when'. In the meantime, if you have never been to Vegas, now is the time. Room rates are cheap, the food is good and there are plenty of shows to see if you don't like to gamble.

Sources:
Employment Development Department, State of California
United States Department of Labor, Bureau of Labor Statistics
Housingtracker.net

Ireland’s Economic Crisis

For those in Canada who may not be fully aware of Ireland’s economic crisis, we thought it would be a good idea to blog about what is really going on. The country has been in recession since the second quarter of 2008.

Last Thursday the government shockingly disclosed that the final cost of bailing out the Irish banks could rise to 50 billion Euros ($60 billion) – much more than previously announced. So what could this mean  for the 5 million people who live there? It will cost roughly 10,000 Euros for every man, woman and child, huge amounts of public money will be required. The country will have to undergo major cuts in expenditure along with tax increases. For the time being, the government has promised not to borrow any more money nor will it seek any more emergency funding from international lenders at least until next year.

This all stems from reckless lending by its banks during a boom that ended in 2007, and as property prices fall, is now becoming one of the biggest busts in history. The deficit for this year will be 32% of GDP – 10 times the limit set for member countries of the EU, mainly due to the extra cost of capital for major banks. But unlike some other European economies (Greece), Ireland has acted early to tackle its debt. Greece was on a threshold before it cut public wages and raised taxes. It acted slowly to address its troubles, and only then as a condition of a 110 billion euro ($145 billion) bail-out by the European Union and the IMF.

Ireland did this early on. Markets have not yet rewarded these steps, largely due to its bank struggles. Apart from the money poured into its banking system this year, Irish government bond yields are increasing. The yield on ten-year government bonds neared 7% on September 29th, a record spread of 4.7 percentage points above those of Germany.

These increased bank losses required bail-outs which raised deficits and lead to even more budget cuts. Another shock came when Allied Irish Banks, one of the two largest financial institutions, was practically nationalized with an injection of 3 billion Euros (not to mention the sudden removal of its chairman and managing director last Thursday).

It is also speculated that if bond yields rise further, Ireland and Portugal might have to borrow from the European Financial Stability Facility (EFSF). This probably is not the case.

Reports show that Ireland has raised enough money to finance this year’s borrowing requirement (it will spread the cost of bank bail outs over several years). Portugal is also not as desperate for cash as Greece was in the spring. In the unlikely event that Ireland was forced to borrow from the EFSF, the fund might find it hard to impose conditions harsher than the ones it has volunteered for already. Click here, for an article in the Economist, and for news on further actions Ireland may be taking click here, for an article in the daily mail.

European Financial Stability Facility: €440 billion fund established in June for struggling euro-zone countries.
More information can be found here.

Greed and the Pharmaceutical Industry

A relative of mine, whom I greatly respect, has a chronic disease and shared his frustrations on facebook. His posting and subsequent comments inspired this blog, and to him it is dedicated.

"...every individual...endeavours as much as he can .. to employ his capital in support of the domestick industry, and so to direct that industry that its produce may be of the greatest value.......and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, ... led by an invisible hand to promote an end which was no part of his intention."

An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith 1776

Smith's basic premise regarding the workings of a market economy is that decisions are based on personal welfare (greed) and that people respond to incentives. Be clear though, the greed applies to both sides of the transaction.

The pharmaceutical industry is an easy target for those that do not like the results of free markets. A drug company develops a drug that can cure millions of people and then charges enormous sums of money to those people that want the drug. The argument goes something like: "The drug companies are just in business to make a profit off the backs of the sick".

A quick search of the web brought up numerous articles attesting to this. For example:

• A November 2009 article from BBC regarding a drug for liver cancer. (Click here)
• A March 2010 article from the Telegraph regading a drug for bone marrow cancer. (Click here)
• An August 2002 article from New Zealand TV regarding a leukaemia drug (Click here)

Cue the economist, devoid of ethics and a general "caring" for the world at large ... we are a dismal bunch.

Pharmaceutical companies are in business to earn a profit. To that end, they undertake medical research develop new drugs, patent them and submit them to clinical trials. If the clinical trials show sufficient efficacy with tolerable side effects the drug is licensed for sale in a particular jurisdiction. Each different jurisdiction requires its own licencing procedures. A 2003 article in the Journal of Health Economics estimates that the capitalized cost of bringing a drug to market is around $800 million. (Click here)

Why would a firm invest $800 million on a product? To earn a profit. They are greedy. They make no apologies for their greed, nor should they.

So what of those people who think those drugs should be available to them for free? Or at least at a price where the developer doesn't earn profits? Why is it that people want pharmaceuticals? To make their quality of life improve, or to extend the length of their lives, or the lives of loved ones, or a combination thereof. All of these reasons create benefits for the drug user and their families ... they are greedy, they want to increase their well being.

Adam Smith tells us that it is this mutual greed that drives a market economy. People want drugs to make them better and firms will develop those drugs to earn profits. If no one wanted the drug, the firm wouldn't bother to create it.

There is a lot of hypocrisy on the anti-profit side. I have never heard of an accountant, sales rep, biochemist, secretary or fork lift driver offering to work for a pharmaceutical company for free. So why do these same people expect that a pharmaceutical company will do all that work producing drugs for free? These very people, that object to the profit motive, are also among those that sue drug companies when the drugs don't perform exactly as intended. Is that not greed?

Our patent system gives the developer of a drug the exclusive right to produce and sell a drug for a period of 20 years. After that time, other firms may produce and sell the drug. This system encourages the research and development needed to produce new drugs and also ensures that the price of drugs will eventually fall.

Greed is not a bad thing. It is the motivation for decision making. We tend to do what is best for ourselves. Everyone doing this is how a market works. Market economies have their shortcomings, but they are better, by far, than anything else we have tried to date.

Now, I have to go take my medications that are way too expensive!!!

UK Budget Deficit Figures

According to the Office for National Statistics (ONS), new public sector borrowing hit a record £15.9bn for August. This comes after inflation led to a rise in interest payments on index-linked government bonds. Officials claim this is further evidence that the coalition is right to press ahead with cuts. Net debt, relative to GDP, rose to 56.3%. That borrowing figure was about £3bn more than economists expected.

An article in BBC news quotes the latest figures for borrowing in the first 5 months of the financial year reaching £58.1bn. Interest paid out on government debt was close to £4bn in August. This disappointment on the spending side is caused by the retail price index (RPI), being negative a year ago and interest spending being low.

What the article does not mention is that debt interest costs will not deviate much from £70bn under the coalition’s plans, increasing to £66.5bn in 2015-16. In comparison, under labour’s plans, the Office for Budget Responsibility (OBR) claims it would have reached this level earlier, in 2014-15. That is a lot of money.

Tax revenue is rising, but so is the cost of dealing with the nation’s borrowing. The article notes that the forecast for 2010-11 borrowing as a whole is around £149bn, down from last year's total of £155bn.

The ONS figures leave out the impact of financial intervention by the government, which reduce overall borrowing because of profit contributions from the part-nationalized banks. The rise in the RPI (used to set payments on index-linked bonds), meant interest payments were at £3.8bn, almost three times what they were in August last year and the country’s finances could be out of whack for some time.

But it may be too early in the fiscal year to draw major doom and gloom conclusions. Before this month, borrowing figures had come in lower than expected in 9 of the previous 12 months, with revenues coming in unexpectedly strong.

The bottom line still stands that revenues are usually always weak in August, and so far they are still 9% up on last year, compared to a Treasury forecast of 6.6% growth in 2010-11. If nothing changes, total borrowing this year would still come in several billion below forecast.
And for those suggesting the government’s borrowing will lead the country to bankruptcy, well it is simply not the case and an old saying of ours comes to mind. When pigs fly?

Governments can default on their debt but they can’t go bankrupt. Before the election, the UK still had triple-AAA credit rating, and the market was demanding and interest rate of only 3.9% to lend the government money. For a reference, U.S bonds were 3.7%. Whatever the coalition is facing, it is certainly not bankruptcy or default.

Investors are worried about the huge debt in the financial sector, and of those debts, how many the government will be forced to honour. This ties in to the latest headlines in Ireland, where the government has lost control of it’s balance sheet.

Another article in today’s BBC news gives the latest report on Irelands banking and property crisis. We should be reminded here, that reducing public borrowing is only part of the problem as governments also need to be concerned with what is happening in the private sector. This ties in to the latest headlines in Ireland, where the government has lost control of it’s balance sheet.


Index linked: An investment, where the return rises in line with inflation.

UK National Statistics website found here.

Burgernomics

We often talk about the difference between "normal" and "inferior" goods in the classroom, a distinction that depends not on product quality, but the effect of changes in income on demand. When income falls, the demand for normal goods decreases, but the demand for inferior goods increases. Typical examples include Kraft dinner (a student staple), used cars and public transit.

A couple of articles lately caught our attention. The first, from the Sep 3rd edition of the Globe and Mail, reports on the increase in sales at McDonald's and Burger King. Things are so good, in a recession, that McDonald's is increasing their dividend and Burger King is being bought out. (Click here for article)

Today an article from Reuters indicates that Jack-in-the-Box is closing 40 stores in Texas and the south-east. The reason given is that high unemployment in those regions has decreased sales. (Click here for article)

We can only conclude that Jack-in-the-Box is normal while McDonald's and Burger King are inferior.

For our money, Five Guys Burgers and Fries is still best.

Green Job Creation

An article in Reuters, finds that California voters are divided on a ballot measure that would suspend a global warming law until the state's jobless rate falls to 5.5 percent for a year.
Those in favour of the suspension claim that the Global warming Act to reduce emissions will cost jobs in California. Opponents argue that the act will boost the economy and help create green jobs.

In a recent blog, passing wind, we explained that switching to green technologies can and did induce job creation in the UK. Economics 101 tells us that government investment, subsidy and regulation along with technological change can produce green jobs, resulting in a rise in the employment level. Where there is a market in going green, there is a demand for labour employed.
Germany’s renewable energy sector for example now employs more than a quarter million people. Similarly, Spain has also benefited by job creation as a result of their green sector.

It is important to know whether these new green jobs represent a net benefit to society or whether they are being created at the expense of other jobs elsewhere in the economy. Green jobs created by government intervention have opportunity costs; subsidy money or advertising money could have been spent elsewhere in other sectors. Do these green investments allow specific jobs to be created in a way that has social value?
For us, the answer is of course yes. We think policy can be a driver of innovation rather than an impediment, and it is helping to push the private sector into green job creation. Solar panels don't put themselves up. Wind turbines don't manufacture themselves.

Perhaps the Californian critics are unaware that all forms of energy are heavily regulated and often subsidized. Energy sources being developed and set up within a country is hardly the result of pure market forces, but rather a result of both private and public choices. It reflects a mix of innovation and investment on the one side, and of regulation, taxation and subsidy on the other.

Update: Minimum Wage and Fiscal Policy

It has been a busy month for us. We have now passed 1000 page views and this is the 17th post this month, albeit a short one.

Earlier this month we commented on the effects of a minimum wage. (Click here for blog) In that blog, we suggested that the minimum wage actually caused unemployment among the very people it was supposed to help, and that minimum wages are favoured by trade unions as a method of increasing their own pay. We'd like to think that the NY Times reads our blog, but we doubt it. They published an article about the effects of minimum wages in South Africa that provides evidence of what we were saying. (Click here for article)

In the Quebec arena story, we attacked the efficacy of discretionary fiscal policy and it's ability to create jobs. (Click here for blog). Expansionary policy is used during a recession to fight unemployment. We took the opposite view of Paul Krugman and suggest that fiscal policy doesn't work and offered an article about Los Angeles as evidence. Yesterday, McClatchy's Washington Bureau posted an article offering more examples. (Click here for article)

They Hire Economists

The Huffington Post recently reported on a pending piece of legislation working its way through congress. If it passes, small-business owners can zero in on banks most likely to make small-business loans. The anticipated bill could create between 500,000 and 700,000 new jobs.

The article highlights that most large regional, national and international banks favour multimillion-dollar loans to large corporations, not small-business loans. The reason being that the fee incomes on the large loans are much greater and it allows them to hire expert in industries they want to target. They employ economists and market researchers to help them avoid lending to businesses within riskier industries. This last statement reeks of asymmetric information and economies of scale in monitoring... so for those a little rusty of your “lemons” here is a quick refresher:

Often, borrowers are more aware of the hazards of financial contracts as they know more about the risks involved in a project for which they need finance. These informational asymmetries are the underlying cause of adverse selection first introduced by Akerlof in 1970, better known as the lemons problem. A lemons problem arises in debt markets as lenders have trouble figuring out whether borrower’s investment opportunities are attractive enough compared to the level of risk involved (“good risk” or “bad risk”)

These large banks can actually choose the growth industries that are more likely to be successful. The average cost of information decreases as the amount of intermediated resources is augmented, which normally occurs when the size of the entity grows. This is one of the mechanisms to reach scale economies on information, and can be achieved by the endogenous growth of the bank or by merge.

Large banks are still required to meet the goals of the Community Reinvestment Act, which states they must lend in the communities where they accept deposits. Providing small-business loans within their community is one way to do that. But, they prefer businesses with at least two years of profitability, excellent credit scores and owners with many years of related experience. The lenders also require solid collateral to be pledged.

Small community banks however, are able to make small business loans profitably. Taking advantage of the U.S. Small Business Administration's loan guarantee programs, they then sell the guaranteed portion into the secondary market. The upfront fees paid by borrowers, points received from buyers of the guaranteed paper, and servicing fees are sources of profit for them.

The bottom line here - small banks make small loans because they find them profitable. Large banks prefer larger loans and don't usually compete with small banks. That is why the pending small-business legislation is creating a fund to lend $30 billion to community banks with favourable terms. Whether or not the banks decide to participate, and to what extent they will make loans that they would not have otherwise made, remains to be seen.

Although the small-business bill can help you get financing, good credit scores and sound underwriting will still prevail.

Perhaps we really need more personal relationships in finance and banking. The lack of the latter and the current “one-size-fits-all” approach, might well have contributed to the huge credit losses of the recent past. Mortgages have not been given according to individual judgment in a case by case decision, but based on corporate guidelines. Perhaps it is time to bring a little more personal judgment into the banking system; doing so would help to alleviate the lemons problem.

Large banks like the ones we talk about in this article don’t do this for exactly the reasons stated above. This does however leave us with the potential for moral hazard problems… a landscaping contractor gets a loan ... and the branch manager suddenly gets a new landscaped yard? Or perhaps a bank makes a series of bad loans to people with poor credit histories because they were good kindergarten buddies, or were college roommates.

All of these problems can be overcome with government regulation. Is it any wonder that Canada, with its extensive regulation of the financial markets, was the only major country to survive the 2007-2009 credit crises? Is it any wonder that top UK bankers are leaving in droves?

See also this article in the Financial Times, Departing bank CEOs. *May need a subscription, but worth the read.

Terms:

Moral hazard: The tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behaviour.

Asymmetric information: The failure of two parties to a transaction to have the same relevant information. Examples are buyers who know less about product quality than sellers, and lenders who know less about likely default than borrowers.

Source: Economics by N.Gregory Mankiw and Mark P. Taylor