Doctors should stick to medicine.

A recent article in the Vancouver Sun makes us believe that Dr. Rajendra Kale went to the Hugo Chavez School of Economics (see our previous blog). Dr. Kale has proposed the abolition of parking fees at B.C. hospitals and care facilities. Like President Chavez’s implementation of rent controls, the reduction of parking fees will only result in a shortage of spaces. Where patients are now worried about having to feed the meter, at a zero price they will have to worry about finding a parking spot in the first place.

Any time that prices are set below the market equilibrium, a shortage will exist. When a shortage exists, potential buyers incur “search costs” – which is the value of the time they have to spend searching for something. Significant search costs only exist when there is a shortage. For example, we use Vancouver General’s parking rate of $7.50 per hour and a person that earns a wage of $15 per hour. If parking is “free” and it takes a half hour to find a parking space because there is a shortage, that person has spent $7.50 worth of their time looking for a “free” spot. Economists have a saying: “There’s no such thing as a free lunch”. It means that in every decision, something has to be given up.

For people with wage rates higher than $15 per hour, the opportunity cost of searching for a parking spot will exceed the $7.50 per hour that the hospital is currently charging. It is a nice idea to have volunteers do valet parking, but how much will it cost to do the criminal record checks? I doubt that I would just hand over my keys to someone that offers to park my car for me. We could always pay people to work as valets at hospitals, but the minimum wage is $10 (or soon will be) and no doubt the union will require a wage much higher than that. Perhaps that wage, and the $14 million lost parking revenue will come out of the doctors’ pay, though we doubt it.

There is no indication whether doctors are willing to give up their reserved parking stalls to provide patients with more access to free stalls. We doubt they will, and will argue that their time is too valuable to be looking for parking. Yet this is exactly the argument we are making above. Paying $7.50 to park is less than the time cost that would be incurred in searching.

We could argue this point forever, but since the Doctors are busy playing economist, we have to go prep to do some open heart surgery …. the instructions are on the web somewhere … aren’t they?

Chavezian Economics

It’s always nice when Hugo Chavez, President of Venezuela, or his allies introduce new economic policies. Not so nice for the citizens of Venezuela, but nice for us because they are easy to critique. This time around, it is the imposition of rent controls as reported by the Washington Post.

The new law would expand previous rent freezes to include direct pricing regulations by the government. In addition, any tenant that has been living in a home for 20 years would have the right to buy that home. According to President Chavez, this new program is for “the benefit of the majority”. (The whole issue of social welfare is a topic for an entirely different blog.)

Pick up any introductory microeconomics textbook, however, and you will get a different analysis of the effect of rent controls – a form of price ceilings. Ceilings are designed by politicians to prevent prices from rising and, for them to be effective, they must be below the market clearing price. At prices above the clearing price there will be a surplus and when there is a surplus, prices fall.

When prices are set below market clearing, the number of buyers exceeds the number of sellers. Adam Smith (1776) recognized that prices rise in his circumstance to clear the market. The number of units that people are willing and able to buy is equal to the number of units that others are willing and able to sell when price is allowed to adjust.

The problem with rent controls is that they do exactly the opposite of what they are intended to do. If landlords cannot earn a reasonable rate of return on their investments due to price controls, they will stop building new rental units. Landlords that are currently renting accommodations will find that their revenues are falling and will not be willing or able to properly maintain their rental units. The quantity and quality of rental units will fall.

At the same time, the cost of renting falls below the cost of ownership and more people choose to rent. Others, who were sharing accommodation, now seek units for themselves. This increase in people seeking units, coupled with landlords reducing the availability of units creates a shortage of affordable housing. This is exactly the opposite result that the government was trying to achieve.

The story gets a little worse however. Because there is a shortage of affordable housing it takes longer to actually find a suitable place. The time spent searching for living accommodation imposes an opportunity cost on renters and is a non-productive use of resources. Search costs reduce the total output of the economy.

President Chavez, and other politicians must realize that in the battle between the Invisible Hand and government policy, the Invisible Hand usually wins.

The Economics of Organ Donation

One of Greg Mankiw’s Ten Principles is that people respond to incentives. It always amazes us that policy makers overlook this simply concept. 

Getting people to sign organ donation card or even to donate blood has always been problematic and it may be a result of a lack of incentive. A recent study published by Knowledge@Wharton – the business school at the University of Pennsylvania – offers a solution to the dearth of organ donors. 

According to the study, there are currently 110,000 Americans on the wait list for organs yet only 40% of eligible Americans sign organ donor cards. In two of the three most populous states, New York and Texas, opt-in rates are just 7% and 10%. 

We understand that there is a thriving black market in organs. In that market, money serves as the incentive. Most people are born with two functioning kidneys though the body can function with only one. Thus, unlike most organs, donating a kidney won’t kill you. For some people, the cost of donating a kidney is less than the benefit (price) being offered in the black market. We don’t advocate an open market for organs, but not for ethical reasons. Our objection is based on economic reasons. The market is plagued by asymmetric information leading to both adverse selection and moral hazard problems. We are, however, in favour of compensation for blood donors. (No, two cookies and a glass of orange juice doesn’t cut it) 

The Wharton article explains an experiment done by Judd Kesler from Wharton and Alvin Rosh from Harvard. The experiment looked at the decision to donate organs. Instead of describing the choice in terms of organs however, the researchers used generic commodities. This removes any ethical bias from the experiment. A full description can be found in the Wharton article. 

The result of the experiment shouldn’t be a surprise to anyone. When given an incentive to voluntarily donate a commodity, the number of participants willing to agree to be donors increased significantly. The incentive was fairly simple. When it came time to decide who was to receive an organ, patients that were registered organ donors went to the top of the list. Patients who were willing to give up their organs upon death had a greater probability of receiving organs should they require them. 

Public policy makers need to recognize the powerful effects that incentives play in the allocation of scarce resources.

Babies are Normal Goods

When income rises, the demand for most goods increases, and when income falls, consumers buy less. Economists call these ‘normal’ goods. There are some goods, however, where purchases change in the opposite direction of income. Classic examples of ‘inferior’ goods are macaroni and cheese, used cars and public transit.

A recent study by the Pew Research Centre and reported in the Globe and Mail looked at the effect of income, GDP, unemployment rates and claims for jobless benefits on fertility rates in women aged 15-44. Using births per 1000 women as their dependent variable, the researchers found a significant positive correlation with income and GDP. After GDP fell during the recession of 2007-2008, fertility rates fell from 2008-2009. The suggestion is that the decline in income made women decide not to conceive and that reduced the number of births 9 months later.

The study was conducted in the U.S. and the results were more pronounced for Hispanics and blacks who suffered greater unemployment than did whites. The researchers also found that the effect was more prevalent in states that were hit hardest by the recession, and occurred later in states that went into recession later.

Evidence from previous recessions tends to indicate the fertility rates recover after the recession is over. What we are witnessing is an intertemporal substitution effect. Women are still having children, but they are postponing pregnancy when incomes fall. Not surprisingly, the effect of income changes decreased with age. There was no appreciable effect on women age 40-44 where the intertemporal choice is constrained by menopause.

The evidence suggests that births rise and fall with income and we must therefore conclude that babies are normal goods.

Kudos to Hewlett-Packard

On September 22, computer equipment maker Hewlett-Packard Co fired their president and CEO and replaced him with former EBay CEO Meg Whitman. (See the Reuters article) While we pass no judgement on the hiring of Ms Whitman, we applaud the decision to fire Leo Apotheker. It’s not that we have anything against Mr. Apotheker, but he was responsible for the bad decisions made at HP over the last few years – whether he made the decisions or not. The result of those decisions has been a steady erosion of shareholder wealth. The chart below shows the adjusted closing prices of HP stock on the NYSE since late 2009.

One aspect in the theory of the firm is that there must be an ultimate monitor. Given the choice of working or ‘shirking’ (not being productive on the job), employees will always opt to shirk since it maximizes utility. To ensure that employees don’t shirk, a firm must employ monitors to ensure productivity. An employee that is caught shirking faces a punishment so that there is a cost to shirking and a benefit to working. Workers then become more productive. 

The argument can also be made for the monitors of the workers. What ensures that they do not shirk in their monitoring duties? The solution to this is another level of monitors whose job it is to monitor the monitors. The same kind of penalty must apply to monitors that shirk. Each successively higher level of monitors receives a higher level of compensation which increases the penalty of shirking.

Ultimately, there must be one person that monitors everything. That person is the President/CEO. The President acquires information about the firms operations and opportunities and makes the decision as to what is to be done and how it is to be done. If something goes wrong, it is the fault of the ultimate monitor. If bad information was received by the President, then someone below him did not do their job, and the ultimate monitor must take responsibility.

HP made two decisions lately that suggest the President made choices based on inaccurate information. One was the acquisition of Palm, the second the foray into the tablet market. Both decisions cost shareholders dearly. It was the President’s fault, he had to take the fall.

Anyone interested in the role of monitoring are encouraged to read the paper by Alchian and Demsetz listed below.

One final thought:

While writing this blog, a newsarticle popped up on the computer screen saying that the President of the Swiss banking firm UBS has resigned as a result of the $2.3 billion loss associated with a rogue trader at their London England branch. (See the Globe and Mail article) 

Alchian, Armen A. and Harold Demsetz  Production, Information Costs, and Economic Organization   The American Economic Review, Vol. 62, No. 5 (Dec 1972)  pp 777-795

A Canadian Institution Succumbs to Technological Change … Finally

The Canadian government has recently announced that it has halted the Canadian Wheat Board’s role as the monopoly seller of Canada’s wheat and barley production. See the Globe and Mail article for all the details. 

Farming conditions in the 1930’s were very different than they are today. Small family owned farms were the norm and farming was a labour-intensive industry. Communications technology made transactions costs relatively high and limited access to financial markets made risk management techniques expensive. Transportation technology also made long distance movement of grains expensive and access to the railway was required in every community. 

As a monopsonistic buyer, the CWB was able to act as an insurer of farm incomes. By managing grain inventories from year to year, the CWB was able to control prices, paying below market prices in some years and above market prices in others. As a monopolistic seller of Canadian wheat and barley they could capture the economies of scale in communication that were not available to individual farmers. As the owner of rail cars, they could reduce transportation costs and insure that all farmers could get their product to market. 

Technology has changed however. Farmers in Leader Sask. can check prices on the ICE Futures Exchange (formerly the Winnipeg Commodities Exchange), the Kansas City Board of Trade, the Chicago Mercantile Exchange and the New York Mercantile Exchange (a division of the CME Group). These exchanges also offer futures and options that can be used to hedge the risk of fluctuating prices. Farmers can even purchase financial derivatives based on the weather. 

Changes in materials and engine technologies have caused the price of capital to decrease relative to labour and farming has become more capital intensive. This has lead to the demise of the family farm and the rise of commercial farming. Larger operations are able to capture the economies of scale provided by bigger and faster harvesters. Transportation technologies have also decreased the price of transporting grains by truck to main railway lines. 

All of the CWB’s reasons for existence have been overcome by technological changes. That doesn’t mean that everyone is happy. Small farmers will no longer be able to compete with the agricultural conglomerates. This leaves them with two choices: continue as they are and bear the costs of their operations, or sell their land to a larger producer. 

Technological change is generally a good thing though it does not affect everyone in the same way. The farms around Leader Sask. will continue to produce food, thought the town of Leader may eventually fade away.

Budget deal gets done and everything fal

The US Congress and Senate finally came to a compromise and passed a bill that increased the debt limit and allowed the US government to continue paying its bills. Why then are equity prices and the Canadian dollar all falling?

The increase in the debt came at a cost. The budget must be cut by $ 2 trillion over the next 10 years. (See a CNN article for details of the deal) That restriction will prevent the government from using discretionary fiscal policy as a tool to stimulate the US economy. With interest rates as low as they can go, the US has no room for expansionary monetary policy either. Since the US dollar is the world’s numeraire currency (the currency against which all others are measured), they have no exchange policy. None of this would be a problem except that it appears the US economy is headed for a recession. (See the Globe and Mail article). It would be a recession that the government cannot fight.

The deal also means that transfer payments from the federal government to the states will be reduced, thereby further straining their budgets. Forty-nine of the fifty states are required to have balanced budgets, so the reduction in transfers must be met by an equivalent reduction in state government spending. Those cuts reduce aggregate demand and further weaken the economy.

Any reduction in the US economy will result in a decrease in their imports. Since the US is Canada’s largest trading partner, our exports will fall. Aggregate spending in Canada is curtailed and that will slow the rate of economic growth here. The reduction in our exports also causes a reduction in the demand for the Canadian dollar which is why the loonie has fallen from its recent highs. (See the Bloomberg article)

The problems in the US have caused investors to reduce their holdings of US dollars, preferring instead the relative safety of gold and the Swiss Franc. We have recently seen record highs for both. The rise in the Swiss Franc has been dramatic enough to cause a decline in that country’s economic growth. To combat this, the central bank in Switzerland has recently reduced their interest rate to 0.25% and has initiated their own version of quantitative easing. The foreign exchange markets are now awash in Francs as the central bank forces down the exchange rate. (See Bloomberg article)

We will be watching the continued fallout from the political situation in Washington and try and keep you informed as the impacts are felt around the globe.

A new twist on our conspiracy theory

We had previously written the plot for a financial thriller based on the bizarre drama being played out in Washington. The debt deal is done and we will post a blog on the repercussions shortly.

We did find a news article in CNN that we really weren’t expecting. A rating agency in China has downgraded US debt. We had predicted a downgrade, but we were expecting it from one of the US rating services. In our previous blog we noted that such a downgrade would be detrimental to China’s holdings of US debt.

So another twist for Mr. Frey’s novel … the US Treasury Department has a mole planted deep within the Dagong Global Credit Rating Company. At the appropriate time, the mole initiates the downgrade setting in motion the selloff of US debt.

Some Insane Thoughts on the US Debt

On August 2, 2011 the United States will reach its maximum allowable debt level. When that happens, the US Treasury will no longer be able to fund the budget deficit and the United States government will technically be in default. The rating agencies will have to downgrade US Treasuries from their current AAA rating. Their bond prices will fall and the yields will rise. 

Congress, Senate and the White House are trying to put together a budget that will allow for the debt ceiling to be raised above its current $14.3 trillion limit. The Democrats don’t want any cuts to social programs. The Republicans don’t want any new taxes. The White House wants a deal that stretches to 2013 – after the next Presidential election in 2012. No one seems to be willing to compromise and the rhetoric is flying in all directions. 

A lesson in fiscal policy: to reduce a budget deficit, a government must raise taxes, reduce spending or both. The military is a non-starter as are subsidies to the energy and agricultural sector. The bailouts of Detroit and Wall Street are not to be questioned. Medicare, Medicaid, Social Security and pensions are vote killers. The astute reader will start to see the magnitude of the problem. 

Markets have been reacting by selling the US dollar, not by selling off Treasuries. As the US dollar falls, gold, the Canadian dollar, yen and Sterling all increase in comparison. (The euro has its own problems) 

Any rational person would think that this problem needs to be fixed and fixed fast. Politicians in Washington, however, don’t appear to be behaving rationally. But what if it is all a carefully orchestrated symphony of economic warfare? 

What will happen if politicians don’t reach an agreement? The rating agencies downgrade the debt and bond prices fall. The balance sheets of financial institutions take a hit due to the loss on Treasuries. To prevent the credit markets from drying up due to insufficient bank capital, the Fed institutes QE3, providing financial institutions with liquidity. The liquidity is used to purchase more government debt at reduced prices. The sellers of US debt receive US dollars which are then sold into the foreign exchange market depressing the value of the US dollar and causing an increase in the price of gold. Who is selling the gold in exchange for US dollars? Perhaps the US government and the profit on gold sales pays off some of the bonds.

After a period of adjustment, bond prices recover, gold falls and the US dollar rebounds. The US government buys gold off the market to replenish their reserves. (Buy low, sell high – not necessarily in that order) The financial institutions repay the Fed with the treasuries they have accumulated ending up with stronger balance sheets than they started with. 

So who loses in this scenario? Ask who is the largest external holder of US Treasuries and you will have your answer. The major flaw in all this is that the politicians have to be involved and agree to the plan and the secrecy, which we find highly unlikely. If we throw in a murder and a love interest for the economist that uncovers the plot, we have a pretty good Stephen Frey novel though.

The US Debt Debaucle

I would love to interupt my vacation in Florida to do an entire series of articles on the US Debt situation, but the sun is shining and I am feeling "disinclined" as Capt. Barbossa would say. There are enough news articles floating around.

To summarize the issue, the US Congress has imposed an upper limit on the amount of debt that can be issued by the US treasury. The ceiling will be reached early in August. To reduce the amount of borrowing, the government must reduce the size of the deficit. This requires an increase in taxes, a decrease in spending, or both. The Tea Party wing of the Republicans has vowed not to raise any taxes. The Democrats don't want to cut spending on social programs. Hence the stalemate.

The 14th Ammendment to the US Constitution tends to imply that the US Government cannot default on its debts which brings into question whether or not the debt ceiling limit is constitutional or not. President Obama sounds like he believes the 14th supercedes the ceiling. The US Supreme Court will have to decide at some point.

Moody's has threatened to downgrade US debt if they default in August. That would cause an increase in US interest rates and a drop in treasury prices. Banks holding treasuries would have to write down their holdings which, once again, would cause them to fall below the capital adequacy requirements. Enter QE3.

One issue that I have not seen, and am not entirely sure about (since palm trees are more interesting) is what happens to corporate debt ratings in the event of a downgrade of US government debt. In the mid 1990's when Canada's debt rating was downgraded due to the debt-to-GDP ratio, the bond ratings of all major banks was also downgraded. I recall the reason being that no private corporation in a country can have a higher credit rating than the sovereign debt rating. I reiterate that I don't know if that is still true, but if it is, the backers of certain Republican lawmakers may see an increase in their borrowing costs and a coincidental drop in their bond and stock prices if the Congress can't overcome this impasse.

An update on the European poker game

Last month we wrote a blog entry about the ‘game’ that is playing out in Europe with respect to the Greek debt situation, the proposed EU/IMF bailout, and Germany’s reluctance to go along with the plan. A thorough discussion of the issue surrounding a potential default can be found in a Financial Post article. 

The Flop

A Reuters article confirms that Fitch has cut Greece’s credit rating, as expected. The rating is now B+ which puts it well into the “junk” category. Most investment policy statements of mutual funds and pension funds prohibit the holding of bonds rated less than BBB (or equivalent). The rapid selloff has lifted the yields on Greek bonds to 16.18% (Bloomberg June 25/11). With debt of 150% of GDP, this means that the interest payments alone take up 24% of GDP. An article in the online version of TIME magazine indicates that Germany has capitulated on their demand that Greece roll over maturity dates, and will join France is supporting the bailout. The bailout is contingent on Greece significantly reducing their deficit.

The Turn

The Greek coalition government has fallen apart over the austerity budget that is required to meet German/French conditions for the EU/IMF bailout. A reshuffling of the cabinet has been met with protests from other parties according to a CNN article. The general populace does not want to bear the brunt of an inefficient and corrupt government and has taken to the streets in protest. A Reuters article explains the alleged corruption and shows photos of the scale of the Greek protests. The bailout is contingent on the austerity measures that must be passed and implemented by a coalition government that can’t agree and imposed upon a population that refuses to accept those measures.

The River

So, as time runs out in Europe, we wait for the last card to be turned and find out who is bluffing. The betting is taking place in the market for credit default swaps where the rate on the 5 year CDS is 2025 basis points (20.25%) according to fxstreet.com, and on the foreign exchange market where the euro has fallen to a 3-week low, according to a Reuters article. We’re still betting on a bailout, followed by an orderly restructuring of Greek debt supported by the private institutions that hold the debt. 

Bombardier Bombs This One

The British government has recently announced that a consortium led by Siemens, a German firm, was its preferred bidder for the Thameslink route. This route is a £6bn North-South cross-London venture demanding Siemens to provide 1,200 new carriages. This is bad news for Derby firm Bombardier, who lost out to the competition. In the BBC report here, we economists can’t help but comment on this quote by Mark Young, regional co-ordinating officer for Unite:

"The government's decision to award this contract to a consortium which does not have British manufacturing and British job creation as its prime focus is absolutely disgraceful".

Most important transport proposals in the UK are promoted by local authorities and the Highways Agency, and are usually financed by central government. These are then decided on a case by case basis by the Secretary of State for Transport as to whether or not to approve funding. Part of the decision-making process involves a detailed appraisal of the proposed scheme using an approach specified by the Department for Transport (DfT). The commonly applied appraisal method in transport is cost-benefit analysis (CBA). CBA effectively compares the projected future stream of benefits from a project with its initial and future costs. This allows numerous competing projects to be ranked. The project is deemed worthwhile if and only if it is predicted that the monetary values of the revenues will exceed the monetary values of the cost. In order to determine VfM, policy makers turn to cost benefit analysis. For those who are not familiar with Value for Money, the HM Treasury defines value for money in the following manner:

"VfM is defined as the optimum combination of whole-of-life costs and quality (or fitness for purpose) of the good or service to meet the user’s requirement."

What we should explain, is that VfM is not the choice of goods and services based on the lowest cost bid. At the core of any procurement policy is a guarantee that an infrastructure project will allow taxpayers to get value for money. Bombardier was not able to demonstrate that the NPV cost to society of the carriages they would provide, were less than what it would cost for the same service provided by Siemens

Siemens represented the best Value for Money (VfM) for tax payers. This measure used in transport and investment appraisals allows policy makers to analyse and sift through efficient firms and not so efficient ones. Clearly Siemens falls in the latter category.

References
HM Treasury (2006) Value for Money Guidance

Environmental Policy by Demand

There are several methods of implementing environmental policy. Governments can use taxation, tradable permits or command and control mechanisms. Another method, and the subject of a recent Washington Post article, is to change consumer tastes.

Policies designed to effect the supply side of the market typically result in lower quantities but higher prices, often leading to the formation of black markets. Higher prices tend to induce more production, not less. Supply side policies also require government resources to enforce them; for the collection of taxes or the monitoring of market participants.

A concerted effort thirty years ago brought to the world’s attention the plight of dolphins that were drowning in tuna nets. We now see tuna labels adorned with the dolphin free logo.

The same exercise is now being focused on the effects of shark fin soup. It is estimated that 73 million sharks are killed each year for the production of this soup. As the Post article reports, a group at the University of Hong Kong has initiated a program of public awareness in an attempt to reduce the demand for this Chinese delicacy.

The benefit of demand side initiatives is that a reduction in demand causes the market price to fall, reducing the incentive to catch sharks. Demand side solutions also require less government involvement and a more efficient allocation of resources.

Reducing demand reduces the economic incentive to produce. Reducing production lessens the harmful effect on the environment. Saving sharks may not be as easy as saving dolphins however. After all, who is cuter; Flipper, or Jaws?

Mother Nature does equilibrium analysis

Rumour has it that we are facing a long period of anthropogenic global warming. If the predictions prove correct, then Richmond BC and Halifax NS may be gone in 150 years due to rising sea levels.

We have always found the economic analysis of global warming to be suspect. The Stern Report spawned several rebuttals regarding assumptions and methodology. These models usually end up looking like Malthusian models. The world changes and no one reacts. Technology is exogenous. People don’t move away from coastal locations until tragedy strikes.

Judging from a Reuters article found in the Vancouver Province, however, there is another factor missing in the economic models. Apparently, Mother Nature took my Principles class. Demand curves are downward sloping and as supply increases, price falls and equilibrium quantity rises. The supply of CO₂ in the atmosphere has increased as a result of the burning of fossil fuels. As supply rises, it becomes easier for trees to capture and sequester the carbon. Quantity demanded is rising. Trees are using the CO₂ more intensively and becoming denser. It appears that Mother Nature’s demand for CO₂ is not perfectly inelastic.

What this all means is that we need to focus on the extensive margin, planting more trees (demand shifts right) as well as the intensive margin, denser trees (change in quantity demanded). There must be a research grant in there somewhere.

And yes, Mother Nature passed my course.

Big Banks and Credible Threats

Game theory suggests that, in repeated games, one player may attempt to influence the outcome of the game by making threats. We see that in the case of labour-management negotiations: ‘if you don’t give us a pay raise, we will go on strike’, or ‘if you don’t accept our final offer, we will lock you out’. For these tactics to work, the threat must be credible. That is, the player receiving the threat must believe that the player making the threat will actually carry through with it. This is the theory behind an article in the Telegraph regarding the regulation of big banks in the U.S. and Britain.

After the financial collapse of 2007-2008, governments have looked at increasing the oversight and regulation of the financial sector. This is particularly true in the U.S. and Britain where government bailouts were the largest. For obvious reasons, banks have no desire to be regulated. In response to the prospect of greater regulation, big banks have threatened to move their operations to other countries. Banking is a service industry, and as such, can be operated in any country in the world. The potential for job losses and the reduction in tax revenues is supposed to make politicians reconsider their positions.

The problem for the banks is that the threat isn’t credible. Suppose that Barclay’s Bank wanted to move their operations out of the UK. The question is where would they go? Certainly not to the U.S. where politicians are also making regulations stricter. Definitely not Canada where banking regulation is much stricter than the U.K. Perhaps Iceland or Ireland will take them, given that they are both on the verge of bankruptcy from bailing out their own banks. Greece, Portugal and Spain don’t have the resources or the willingness to backstop big banks in the event of another financial crisis.

If rating agencies such as Moody’s and Fitch downgrade sovereign debt rating as a result of a big bank moving into their country, the increased debt costs may outweigh any benefit from job creation and tax revenue.

The banks’ threat is simply not credible. Governments will increase banking regulation and oversight. Shareholders will lose, taxpayers will gain. Game theory in action.

The Price of Coffee and Gasoline

Gasoline prices are rising and coffee is rising even faster. Gasoline prices will stabilize, but the same cannot be said for coffee. The full story can be found in an Associated Press article that we found in the Seattle Post Intelligence.

The price of gasoline rose due to a feared supply disruption caused by the political turmoil in Egypt, Libya, Syria and Yemen. President Mubarak of Egypt has stepped aside and NATO is attempting to influence Colonel Kaddafi to cede power in Libya. As the region begins to stabilize, the risk of a supply disruption decreases and the price of oil and therefore gasoline will fall.

Coffee prices are more complex. An increase in demand from the rising incomes in China, plus inclement growing conditions in some major production areas has caused demand to rise and supply to fall simultaneously. While the supply disruption appears temporary, demand is predicted to continue its rise. Coffee, it seems, is a normal good.

Over the long run however, the supply response to higher prices will be greater for coffee than it is for oil. It is easier to plant coffee bushes than it is to find extractable oil reserves. So for the short term, bet on coffee. In the long run bet on oil.

A Game of Texas Hold ‘Em in Greek

Good poker players study probabilities. Great poker players study their opponents. Economists study game theory. We look at the potential outcomes from the decisions of players and then, based on assumptions of their objectives we predict outcomes. We thought we’d apply a little game theory to the unfolding Greek debt fiasco and make a prediction of the outcome. The details of the mess can be found in a recent article from Reuters.

The players are Greece, the IMF (International Monetary Fund) and the other members of the EMU (European Monetary Union). Greece has a mountain of debt that will require large cuts in government programs or excessive tax hikes, neither of which are politically appealing. Greece would like to restructure their debt by unilaterally lengthening the maturities. Rating agencies have indicated that they will treat this as a default.

The IMF has stated that they will not extend further aid to Greece unless the other EMU members guarantee the Greek debt. This is a political problem for Germany, Netherlands and Finland. Voters in these countries don’t want to risk assuming Greek debt when they, themselves remain committed to conservative fiscal policy.

The IMF includes countries like Canada, the U.S., Russia, Brazil, India, China and Australia that have no desire to get caught up in the European mess. These countries will insist that the EMU countries guarantee the debt. At the moment, IMF leadership is in a state of turmoil, though that is a different story.

If EMU members don’t guarantee the debt, the IMF won’t lend and Greece defaults. This may lead to contagion where Ireland and Portugal also default to reduce their debt burden. Spain and Italy may follow. Widespread sovereign debt defaults will cause the euro to fall against the US dollar, Sterling, Swiss Francs and the Yen. A depreciation of the euro causes the price of oil in Europe to rise, which may lead to recession and inflation. An increase in European interest rates will tame inflation but further reduce growth.

The prediction: The IMF will call the EMU’s bluff and not extend further credit to Greece without a guarantee. Germany, Finland and Netherlands will not budge. Greece will put in motion a restructuring of their debt. Rating agencies will restate their position that Greece is defaulting. The euro will come under selling pressure. Germany will capitulate and guarantee the debt. The IMF will extend credit. Rating agencies will downgrade German sovereign debt.

Of course, all this depends on the river card.

The Varied Effects of Gasoline Prices

A recent article in the NY Times concerning the price of gasoline caught our attention because it touched on so many concepts related to the demand for gasoline. (Click here for article)

An increase in gasoline prices will cause different people to react in different ways. Some will be forced to pay the higher prices and cut down on their consumption of other goods. Others will be able to change their lifestyles and reduce their consumption of gasoline. One thing is certain; as the price of gasoline rises, people purchase less gasoline. The only question is, by how much?

Economists use the concept of elasticity to measure the responsiveness of consumer purchases to changes in price. Over relatively short periods of time, consumers can generally not react and we say that demand is inelastic, meaning unresponsive. The NY Times article quotes a MasterCard source that says consumption of gasoline has fallen by 1% over the last year. The US Energy Information Administration reports an increase in gasoline prices of 38% over the same period. The elasticity measure is (-)0.026, indicating an inelastic demand – consumers, in general, are not reducing their consumption of gasoline significantly.

When prices rise, and consumers continue to purchase gasoline, the consumption of other goods must fall. Consumers are worse off since the price increase reduces the purchasing power of their income. We should expect the demand for normal goods to fall and the demand for inferior goods to rise. There is evidence of this at the True Value hardware store, where sales of replacement parts (an inferior good) have increased.

Over longer periods of time, more consumers can change their consumption, and elasticity increases. People become more responsive to the price change. This is usually a result of people simply not being able to respond in the short run. A person with a 50-mile (80 km) round trip commute can change jobs, relocate, or purchase a small vehicle. None of these options may be possible in the short run. If gasoline prices remain high, we would expect to see the sales of smaller vehicles increase first and then perhaps see people moving closer to their place of employment. These are long run responses.

Consumers’ response to changing prices depends on whether or not they can easily change their spending patterns. In the short run they may not be able to change and thus the demand appears to be relatively inelastic. Over a longer period of time, if prices stay high, consumers will respond and demand becomes more elastic. Evidence of this behaviour can be found in this article.

© 2011 Pearson Canada Inc., All rights reserved, Used by permission

The Ace of Mortgages

I am upset that the federal government in Canada will not compensate me for losses when I go to the casino, and I hope that that seems like an unreasonable request. Residents and potential home buyers in upscale Monterey California are upset that the U.S. federal government will no long assume the downside risk on residential real estate in their area. This should also seem like an unreasonable request.

The issue was brought to light in a recent article in the NY Times. The federal government has reduced the maximum mortgage insurance amount in Monterey County to $483,000, well below the average selling price. This transfers the risk of housing prices onto home owners.

Mortgages can, and have been modelled as put options on real estate. Put options are more commonly understood in the context of equities, or stocks. A put option on Exxon shares gives the buyer (holder) the right to sell the Exxon shares at a predetermined price (the exercise price) prior to some preset date (the expiry date) and imposes an obligation on the seller (writer) of the option to purchase those Exxon shares. The writer is assuming some of the downside risk on the Exxon shares and the holder pays the writer a premium for assuming this risk. A put option is not unlike an insurance policy on a stock. The amount of the premium is related to the amount of time until expiry, the risk free interest rate and the probability that the price of the stock will fall to the exercise price – which depends on the difference between the current price of the stock and the exercise price, and the volatility of the stock price.

A home owner with a mortgage always has the option of defaulting on the mortgage, essentially selling the home back to the lender for the amount of the mortgage. The probability of a homeowner defaulting depends on the loan to value ratio and the interest rate. As housing prices fall, homeowners are more likely to default. Who bears the risk of a default depends on whether the mortgage is insured. If it is, the insurer bears the risk, if it is not insured, the mortgage holder bears the risk. This could be the initiating lender, the holder of a mortgage-backed security, or a government sponsored enterprise such as Fannie Mae or Freddie Mac.

Without government participation in the housing market, mortgage interest rates and down payments would be determined by a potential buyers income and credit score. Lower income and/or low credit scores would require higher down payments and higher interest rates to compensate the lender for the higher risk of default. This is not unlike the pricing of stock options. It is for this reason that Monterey County homeowners are upset. If the government will not assume their risk, they will be required to pay the higher option premium when there is higher risk.

For more information on options see the Chicago Board Options Exchange education center.

For more information on mortgages as put options, see the article by Ronel Elul in the FRSB of Philadelphia Business Review Q3 2006.

A River Runs Through It

Water is an interesting commodity. It is essential for human life, but less expensive than diamonds. Two thirds of the planet is covered with it and it is short supply. And almost everywhere, the ownership of water is not well defined. The first issue was dealt with by Adam Smith. The second has something to do with the difference between fresh water and salt water. The third has caused a lawsuit between Wyoming and Montana (and more strange comments from Sarah Palin). Stories can be found at Billings Gazette and CBS-Sacramento.

At issue is water that flows from the Big Horn Mountains of Wyoming, into the Tongue and Powder Rivers, through Montana where they join the Yellowstone River then the Missouri and Mississippi, before finally emptying into the Gulf of Mexico. The water is a common property, meaning there is no well-defined property right. If the people of Wyoming use the water, they impose a negative externality on their downstream neighbours. The Coase Theorem suggests that there is a market solution to such a problem.

In the case of Wyoming and Montana, Wyoming benefits from taking water out of the rivers before it gets to Montana and Montana benefits from Wyoming not taking water from the rivers. This suggests that Wyoming would be willing to compensate Montana for water it takes, and also suggests that Montana would be willing to compensate Wyoming for not taking water out of the rivers. Alternatively, the two states could negotiate a contract that stipulates how much water Wyoming can take from the rivers before it reaches Montana. This is exactly what happened in 1950 when the two states, along with North Dakota, signed the Yellowstone Compact allocating water rights.

Like so many agreements, however, the potential for technological change was not considered. In the 1950’s irrigation involved flooding fields. A large portion of the water used drained back into the river systems and was available for downstream use. The development of new technologies have reduced the amount of water required per acre of farmland and thus increased the net amount of water taken from the rivers, though not the gross amount. This was the issue of the lawsuit. The court found that the original agreement referred to gross, not net amounts and found in favour of Wyoming.

Having lost the case, Montana must now renegotiate with Wyoming for water and again, there is a market solution to the problem. Expect to see more of this type of litigation in the future where water rights are not well defined in a world of changing technology.

Sarah Palin's comments are the same issue, but between competing users in the same state.

On Low Voter Turnouts

Today is Election Day in Canada … again. With four main parties, and a host of fringe parties, we are going to the polls for the fourth time in 8 years. As in the last 4 elections, we can expect that, today, one out of every three eligible voters will choose not to exercise their right to vote. This begs the question of what, if anything can be done to increase voter turnout.

Journalists, political scientists, ethicists, psychologist, and other “experts” have tackled this question with no dominant strategy. The fail, we believe, because they don’t ask ‘why’ the electorate chooses not to vote. Once again, economists come to the rescue.

People are maximizers – one of the essential assumptions of economics. The implication of this is that an individual will undertake an action if they believe that the marginal benefit to them exceeds the marginal cost to them. When applied to elections, this means that an individual must believe that the benefit to them of casting a vote exceeds the opportunity cost of casting the vote. There are several other things that an individual can do with their time other than making their way to a polling station to cast an uninformed vote. An informed vote takes even longer and costs more.

In the riding where I reside, the incumbent won the last election by almost 7,000 votes, beating his closest opponent by 16.15 percentage points. I ask myself, ‘will my one vote change the outcome of this election?’ The answer is clearly ‘no’. Thus the marginal benefit to me of casting a vote is zero and the marginal cost is positive. The rational thing for me to do is not vote.

Some may argue that if enough people cast their votes, they could make a difference. This argument, however, requires that those that didn’t vote in the last election would have all voted for the same candidate. If the non-voters are randomly dispersed amongst all parties, then an increase in voter turnout does not change the outcome of the election.

If the economic argument is true, then there is nothing that can increase voter turnout in a meaningful way. Australia has made it mandatory to vote which increases the benefit of voting (avoiding the penalty for not voting). This method however is economically inefficient. You can force me to cast a ballot, by imposing a penalty, but since the ballots are secret, you cannot stop me from spoiling it. I will minimize my cost of voting by not becoming informed and spoiling the ballot. The law increases voter turnout, but not the legitimacy of the election.

So, Canadians, get out there today and vote … or don’t vote … but make your choice rationally.

Why Canucks fans should bet on the Blackhawks

Gambling presents an interesting challenge for economic theory. If, as we assume, most people are risk averse then gambling for the sake of gambling contradicts our theory of utility maximization. If, however, gambling provides some form of entertainment then it may not contradict our theory.

When visiting a casino, purely for research purposes, we witness people engaged in social activity while playing blackjack, roulette and the slots. This may lead us to believe that the money spent at a casino is really no different than money spent at a movie theater. It is a form of entertainment.

It has been argued that rational, risk-averse individuals purchase lottery tickets, knowing full well that the chances of winning are less than one in 14 million, because it provides them the opportunity to dream of what they could do with a multimillion dollar prize.(For us that would be a house near Mile 0 in the Conch Republic)

There is yet another form of gambling which we typically call insurance. There is a positive probability that I will become sick or injured when I visit the United States and I place a bet that that will happen. The amount of the wager is the premium on my travel insurance policy. If I am wrong then I lose my wager and stay healthy. If I am correct I win the bet and the insurance company has to cover my costs.

Which is why Canucks fans should bet on Chicago in game seven. If the Canucks win they move on to the next round and fans will be ecstatic and won't care that they lost the bet. If Chicago wins Canuck fans will be devastated, but the pain will be partially offset by the winnings they receive from betting on Chicago. In this case a sports wager is an insurance policy.

Go Canucks go!!!

The Inefficiency of Monopolies

With the recent $39 billion offer by AT&T to purchase T-Mobile we thought we might say a little about the inefficiencies of monopolies. An article on 24/7 Wall St. explains what a monopolist is and lists ten companies in the U.S. that are effectively monopolists.

When economists investigate inefficiencies, we use the non-existent perfectly competitive market at the benchmark. In this market structure there are many buyers and sellers of a homogenous good and no barriers to entry. Individual firms are small and have no influence on the market price. When this is true, the marginal (incremental) cost of the last good produced is equal to the marginal benefit to the consumer and the sum of consumer and producer surpluses is maximized. (Consumer surplus is the total benefit received minus the total amount paid. Producer surplus is total revenue minus the variable cost of production) Price is equal to both marginal cost and marginal benefit.

In a monopoly, firms have the ability to set their price to maximize profits. Reducing the amount of output causes the product price to rise and the marginal cost of production to fall. A monopolist will produce until the marginal revenue is equal to the marginal cost. They will then set the price for that level of output to the maximum amount that consumers are willing to pay as determined by the marginal benefit.

At the profit maximizing level of output, the price equals the marginal benefit, but is higher than the marginal cost. The monopolist’s chosen output is less than the socially optimal level of output. There is a transfer of consumer surplus to the firm, and also a deadweight loss to society due to the monopolist’s output being below the socially optimal output level.

In the case of patent-protected monopolists, we are willing to accept the inefficiency, at least temporarily, since research and development tends to benefit society as a whole. Without the monopoly profits, firms would have no incentive to develop new products.

Unions are monopoly sellers of labour.

The Vern and Monica Parable

Vern worked hard and saved his money so that he could buy his own truck and start a delivery service. His continued hard work allowed him to keep buying more trucks and expanding his business. Each time he bought a new truck, he advertised that he was hiring and was willing to pay $15/hr. Kevin applied and Vern hired him.

One of Vern’s clients, Monica, worked hard and saved her money and opened a bakery. Every morning Kevin delivers Monica’s flour in one of Vern’s trucks. Monica’s specialty is sourdough cobs which she offers for sale at a price of $4.95.

On one particular Monday morning, Monica’s flour delivery doesn’t arrive and Monica has to close her bakery. When she phones Vern to find out what the problem was, he tells her that his drivers went on strike demanding an increase to $18/hr. Vern assures her that the problem has been solved and the her deliveries will continue tomorrow morning as usual.

Sure enough, early the next morning her delivery arrives and all is well in the bakery again. Later that day, Kevin drops by Monica’s on his way home and asks her for a sourdough cob. Monica takes one off the shelf, puts it in a bag and places it on the counter. She looks at Kevin and say “That will be $6.95 please.” Kevin looks at the price board and says to Monica “But you offered to sell it for $4.95”. Monica responds “I changed my mind”. Kevin doesn’t buy the loaf and turns to leave. The next person in line says “I’ll take that loaf” and Monica responds “That will be $4.95 please”.

Kevin looks back at Monica and mutters “That’s not fair”.

Asymmetric Information in Labour Markets

Asymmetric information is a situation wherein one party in a transaction has a different information set from the other. In labour markets, the job seeker knows their true abilities and work ethic while the prospective employer does not. Firms must spend resources during the hiring process to overcome this problem. Anything that a job seeker can do to reduce these transaction costs improves their chances of obtaining employment.
When unemployment rates are low, an education credential can serve as a signal. For example, a university degree in almost any subject, indicates that the graduate has the ability to learn and has the commitment required to complete a four year program. These traits are valuable to an employer. While the same traits may be found in someone without a degree, that information is expensive for an employer to discover.

When unemployment rates are high, different signals are required. Being unemployed for a very long time sends a bad signal regardless of the job seekers abilities. A prospective employer must ask themselves why no one has hired this person. The answer to that question is expensive to determine. An article in Huffington Post citing a FRB Cleveland study shows the difference between unemployment rates by education, and length of unemployment by education. It also points out that “must be currently employed” is a common requirement in job ads.

The message is clear. Employed persons have a better chance of getting a job than unemployed persons. How then does someone with a BA in Economics find a job? Since it is almost impossible to convince a prospective employer that you have the traits they are looking for, get someone else to prove it to them. Get a job. Sounds counterintuitive, how does one get a job if no one will interview them? A job seeker should accept a job well below their qualifications. For example, they could apply at Starbucks. Any job sends a signal that is different from unemployment.

Immiserizing Growth

Seems to be a week for International Trade Theory, so today’s topic is “immiserizing growth”, something that can happen when the ‘small country’ argument in the standard Ricardian model doesn’t hold. Two articles appeared in the same edition of the Globe and Mail that illustrate this phenomenon. Both deal with the acquisition of iron ore mining interests in Canada by foreign interests. One is a story about China, and one is a story about India.

A small country is one that is small enough, economically, that they can’t affect the world price of traded goods. When that is true, the world supply of the country’s imports appears to be perfectly elastic, as does the world demand for the country’s exports. For most countries in the world this is an accurate assumption. For large countries, however, an increase in imports and/or exports can alter world prices. Canada, for example, is too small to affect world prices. The United States is not. China has become a large country and India soon will be a large country.

The economic boom in China has caused a global increase in the demand for raw resources such as coal, iron ore, copper and oil. As a result, the global equilibrium price is rising. That is good news for countries like Canada, Brazil and Australia that export these commodities, but bad news for China and India that import them. As input prices rise, the cost of production rises and the price of their exports most rise. This reduces terms of trade in the growing countries and slows the export driven growth. Under extreme circumstances, the increase in input prices can cause economic growth to stop, and ultimately lead to an economic contraction – immiserizing growth.

In an effort to secure supplies of iron ore and thus prevent input prices from rising, both China and India have purchased interests in Canadian producers of iron ore. Watch for more investments in Canada, Australia and Brazil.

Dutch Disease

A recent BusinessWeek article quoted an Australian bank economist as saying that “there is risk of Dutch disease effect”, in response to the growing exports of coal and iron ore from that country to China, and the incumbent rise in the value of the Australian dollar. We thought it would be a good time to explain the “Dutch disease”.

The phenomenon is based on an analysis of the Netherlands after the discovery of natural gas in the 1960’s. When the output and export of natural resources increases due either to an increase in demand or a new discovery, resources such as capital and labour are required to extract the natural resources. The increase in demand for capital and labour from the new export sector drives up wages, and diverts capital from existing exports and from non-traded goods. The cost of capital may or may not rise depending on the extent of international capital flows, but the return to capital will fall as other input prices rise.

The increased costs in the non-traded sector leads to price increases, while in the existing export sector, output falls. Prices of traded goods are determined in international markets and small countries have little or no effect on those prices. As exports increase, the domestic currency starts to rise in value. The domestic cost of imports falls and puts more pressure on domestic producers. So long as the new exports continue, real income rises.

The ‘disease’ occurs when demand for the new export falls or new supplies in other countries cause a global price decrease. Returns to capital, and the demand for labour, fall in the new export sector. Declining incomes reduce consumer spending in the non-traded sector. While the other export sector still exists, it takes time to shift capital from one industry to another and during this period of adjustment, output and incomes fall and unemployment rises.

The success of the new export sector can ultimately lead to recession. This is what Australia is worried about; though the problem is less severe for a geographically large diversified country such as Australia, than it was for a geographically small specialized country like the Netherlands.

Sexual Discrimination or Risk-based Pricing

Just when you thought you’d seen the height of political stupidity, another politician opens their mouth and out comes absolute drivel. We’re not referring to Mike Huckabee’s recent “misspeak” when he said the President Obama grew up in Kenya. Nor do mean the Texas immigration bill introduced by Representative Debbie Riddle that would make it a crime to employ an illegal alien with punishments up to two years in jail and a $10,000 fine – unless, of course, that illegal alien is cooking, cleaning, minding the children or cutting the lawn of those wealthy Texans that can afford domestic help. (click here for article) And, no, we are not even including the proposed law in the State of Georgia that would make a miscarriage punishable by death. (click here if you don’t believe us)*

As silly as these are, the Europeans have decided that insurance companies that charge men more for life and automobile insurance than they do for women are practicing sexual discrimination. The price differential has nothing to do with women having statistically lower accident rates, or that women have statistically longer life expectancies. Women pay lower insurance rates because they are women, and that cannot be permitted in an enlightened society. (Click here for article)

Fairly priced insurance is based on the probabilities of a certain event happening within a certain time period. Individuals that are risk averse (those with diminishing marginal utility of consumption) will always choose to buy fairly priced insurance, and will often purchase insurance that is not fairly priced. An insurance company can estimate risk based on historical data and observable traits. For example, smokers pay higher premiums than non-smokers because, statistically, they die sooner. An insurer with many clients can rely on the law of large numbers to predict probabilities for the “average” client in a certain demographic subset. In Europe, apparently, women are not to be treated as an identifiable demographic subset.

What the European law makers are hoping for, no doubt, is that men and women will pay the same premiums based on the average of what they pay now. Sorry, not going to happen. One insurance company may try this, but a second would come along and realize that women are being over charged. They could create a policy that would be cheaper and attractive only to women. Women would then ‘self-select’ into that policy. When they do, the single priced policy would only be sold to men, and since the price is less than the risk for men, that company would go bankrupt. The men would then flock to the only other policy available, and the price of that policy is below the pooled risk, and that company also goes bankrupt. The result; no insurance market.

This is not a new idea. It comes from a paper written in 1976 by Michael Rothschild and Joseph Stiglitz: Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information, The Quarterly Journal of Economics Vol. 90 No. 4 pp. 629-649

Clearly, insurance executives have read this paper, and politicians have not. The insurance industry has been notably silent on the issue because, in the short term, the only solution to non-discrimination is to increase the price women pay for insurance so it is the same as the premium that men pay. Women will be subsidizing the profits of the insurance company, but that is not discriminatory.

As we have previously tried to explain, markets are terribly efficient. We believe that insurance companies will create a mechanism that is not deemed discriminatory and that allows individuals to self-select into policies at the price they are currently paying. For example, insurance contracts are filled with exclusions – events under which the policy will not pay. (Terrorism, war etc.) We can propose a specific set of exclusions that will allow people to self-select into life insurance policies. Policy “A” has a low premium but does not pay out in the event of death from prostrate cancer. Policy “B” has a high premium and will not pay out in the event of breast cancer. Since there is no mention of the insured’s sex, these policies are not discriminatory. We will leave it up to the reader to figure out who buys which policy.

*Thanks to Graeme for drawing this one to our attention.

A Note on Sovereign Debt

A recent article, posted on Yahoo! News that discussed the possibility of the United States defaulting on their debt caught our attention, but only because of the misinformation that was implied. The United States Treasury currently owes approximately $14 trillion. (Click here for debt clock) The article suggests that if and when the US government defaults, debt holders will be able to take control of US assets.

The debt that is issued by sovereign nations is in the form of debentures, not bonds. The difference is that a bond is secured by a lien on a certain asset. In the event of default, the bond holder has the right to take possession of that asset. In this respect, a bond is similar to a mortgage. Stop paying your mortgage and the lender gets to take your house through foreclosure. A debenture, however, is not secured by any specific asset, but rather, is a claim on all assets. In the event of a default, assets are sold to meet the demands of debenture holders. In the event of a US default, debt holders are not entitled to seize ownership of Chicago.

Looking at the top 10 list, no regular reader of this blog should be surprised to see China in the number one spot. To keep the value of the yuan low, the Chinese government must continually buy up the excess supply of US dollars that result from the trade imbalance. These are held in the form of US government debt. The same is true of the Brazilian holdings. That country’s government is trying to prevent their currency from rising as well. Oil exporting countries also have a trade deficit with the US and thus hold US debt.

The Caribbean Banking Centres seems to surprise the author, but not us. Banks exist in the Caribbean to avoid taxes in the United States. Their deposits (liabilities) are predominantly in US dollars and therefore to avoid currency risk, most of their assets (debt instruments for example) should be held in US dollars. An educated guess would be that banks in Jersey and Guernsey would hold large amount of UK debt, and banks in the Seychelles would hold large quantities of euro denominated debt.

One last thing that the article does not mention is that the US government owes 14 trillion US dollars and the US Federal Reserve has the unlimited authority to print US dollars. If the world’s creditors demanded instant repayment of the entire outstanding debt, the US could simply turn on the printing presses and print $14 trillion. Note that this is not an option for the European PIIGS since they don’t have the authority to print euros.

We are currently negotiating with the US government to take control of Fort Zachary Taylor State Park as payment for our debt holdings. Not having much luck.

Another “Bricks and Mortar” reduced to rubble.

First we reported on the demise of Blockbuster, then the bankruptcy of Borders. Prior to those, Sam the Record Man and A&B Sound closed their doors. Yesterday, the Financial Post published an article claiming that HMV would be closing their Canadian stores.

All of these stores had one thing in common; they sold products from physical locations (bricks and mortar) that were easily digitized and delivered electronically over the web. Perhaps because of long term leasing agreements, they did not react fast enough to competition from such vendors as Amazon and the Apple Store. Revenues fell, but costs did not. Losses led to more debt, revenues did not recover. Business plans were changed many years too late and the inevitable happened.

There are other companies that will face similar challenges in the next few years. Any company that relies on selling entertainment products that are, or can be delivered in electronic format will disappear. It is far less expensive for consumers to shop online than it is to go to a store in person. With the pending releases of new and improved tablet computers, expect to see more books being delivered online.

We’ll go out on a limb here and make some bold predictions. Chapters/Indigo will scale back or abandon their Coles brand which occupies expensive locations in shopping malls. Rogers will begin closing their movie rental outlets. The remaining Virgin Megastores will close. Even large retailers are likely to scale back their offerings. We noticed that the Fred Meyer outlet we visited last week had removed their music/movie department. Walmart and Target can’t be far behind.

Thomas Robert Malthus (1766-1834)

The world’s population is growing exponentially, and the world’s agricultural production is increasing arithmetically. At some point the amount of food required to feed the population will exceed our ability to produce it. When that happens there will be social unrest and an increase in deaths caused by wars, famines and disease. The way to prevent such a calamitous end is to reduce the birth rate through the postponement of marriage and restraint from the temptations of premarital sexual relations.

At least that’s what Malthus said in 1803. Fast forward a couple of hundred years and the same story is told. This time it’s the World Wildlife Fund, as reported in Newser.com.

The Malthusian predictions never came to fruition for several reasons, some social, some economic. When the demand for food increases, the price of food will increase. That makes land that was once unprofitable to farm more cost effective. The supply of food increases. In addition, existing farms can be used more intensively growing more food per acre. The increase in food prices makes the use of fertilizers more efficient. The increase in food prices also encourages research and development in agriculture. New technologies are developed and land becomes more productive.

A colleague of mine tells me that we need to study history so we don’t make the same mistakes again. At some point, researchers will heed this advice and we will stop seeing the same stories we saw 200 years ago. Until then, stock up on food and water because the world is coming to an end.

Tuition Fees Debate

In recent years, there has been a huge change in the economic climate. We learn from first year principles that when our opportunity cost of time spent in the workforce is greater than that of pursuing higher education, rational people choose school. Thus, universities have been struggling to meet surging market demand for places during this economic downturn. An article in BBC news reported that Cambridge will be raising tuition fees to £9,000. This isn't all that surprising if you consider that the efficient way to reduce quantity demanded (number of students wanting to attend university rather than work for lower wages) is to raise the price. Interestingly, Oxford will be raising their fees to a mere £6,000. Those without the willingness to pay £9,000 will move from Cambridge to Oxford where it is relatively cheaper to get a degree. The bottom line is that raising prices makes sense from an economic perspective. A new efficient equilibrium will be reached.

So what about those who are against raising fees, and even believe that education should be free? The benefit-pay-principle means that as education is an investment and students gain from it financially, it is rational to borrow at this stage of their life to finance their education, forgoing current earnings in return for higher future earnings.

If we did not charge fees, placements would be allocated by the next best way, say by GPA. That means that those who slacked off in high school and got low grades (but who potentially could be brilliant) wouldn't get the chance to study. Society would loose out as a whole. Higher education is what we label a positive externality, or in this case a merit good. The idea is that the benefits to the individual can spill over to the rest of society, giving rise to macroeconomic advantages. A well-educated labour force will increase efficiency and productivity leading to lower unemployment rates and increased returns with benefits to the supply-side of the economy. Further, benefits of growth can stimulate capital investment in the physical sense and adoption of technological development.

Finally, in case some of you get confused, economists have a very precise definition of demand. Confusing quantity demanded with demand (and supply and quantity supplied) will inevitably lead to serious mistakes in the most simple of economic analysis.

The specific quantity desired for a good at a given price is known as the quantity demanded. For example, if Starbucks lowers their price of a tall coffee from £1.50 to £1.00, the quantity demanded will rise from 30 coffees an hour to 40 coffees an hour. (a movement along the demand curve)
A change in demand refers to an increase or decrease in demand brought about by a change in the conditions of non-price determinants. (a shift in the demand curve)

Usage Based Billing

This is a first for us. We actually had a request for a comment on this topic.

Canadian internet service providers (ISPs) have requested permission of the regulatory authorities to begin billing customers on the basis of how much data they download. Their argument, it seems, is that the increased usage is beginning to slow down their networks and they need the increased revenue to be able to finance an upgrade to their infrastructure.

The economics of the internet are similar to the economics of any transportation system. The marginal cost of providing the service is low and constant up until demand reaches capacity. At that point congestion increases costs. A recent Financial Post article estimates that the cost of transmitting 1 gigabyte (GB) is currently less than one cent. Capital intensive industries, such as the internet, have high capital costs and low marginal costs, and marginal cost is almost always less than average cost. While marginal cost pricing would be efficient, it would not be sustainable. This said, Bell’s proposal to charge $1.12 per GB for usage above 60 GB and $1.87 per GB above 300 GB, as reported in a CBC article, seems to be a bit high.

Finance theory helps us evaluate the claim that the ISPs need the additional revenue to fund upgrades. Investment decisions are based primarily on net present values, a number that discounts future costs and revenues to determine the profitability of an investment. If the NPV is positive, the investment will add to profits. The key is that NPV looks at future cash flows, not historical cash flows. The interest rate used in the discounting is the risk adjusted weighted average cost of capital. A quick review of BCE’s annual report shows a mix of common and preferred equity, long term debt and retained earnings in descending order of magnitude. They do not rely heavily on past profits to fund infrastructure.

We suspect that the real motive behind the push for usage based billing is to make services such as Netflix more expensive. BCE has purchased CTV, Rogers owns Sportsnet, Shaw and Telus sell television delivery through cable or internet TV. Unlimited internet usage with lowcost Netflix makes their broadcast businesses less profitable.

Fighting Chinese Inflation

We have previously discussed the cause of the inflationary threat in China (click here for blog). This week, we have pulled together some news article showing some of the policy options that are available to countries that are trying to fight inflation. All of the articles apply to China.

The first line of defense is usually to increase interest rates. As rates rise, borrowing gets more expensive so construction costs rise, the demand for durable goods falls and the net present value of investment options decreases. All of these serve to reduce domestic demand and reduce inflationary pressure. A Reuters article dated Feb 8, 2011 explains that China has exercised this option raising their lending rate for the second time in the last seven weeks. Unfortunately the savings rate, at 3% is below the inflation rate of 5.3%. The real interest rate on savings is negative which creates a disincentive to save and an incentive to spend which is counterproductive to the policy goal. This effect is discussed in a Feb 9th Bloomberg article.

A second method that is available to some countries is to increase the reserve requirement. Reserves are funds that are held by banks against deposits and in some countries this rate is dictated by the regulatory authorities. Canada has no required reserves. China does, and a CNNMoney.com article indicates that that ratio has been increased to 19% for major banks. The effect of this is to reduce the supply of loanable funds in the market place, reducing liquidity and slowing the growth of credit.

China has adopted yet a third measure to try and control its inflation. A BusinessWeek article dated Jan 9, 2011 indicates that Chinese banks are being required to increase their capital ratios. (Capital divided by assets) An increase in capital ratios reduces the amount of funds that are available for lending, which gives the same results as increasing the interest rate or the reserve requirement.

China’s monetary authority is trying every tool available to it, except for one. The inflation in China is being caused largely by their policy of having the yuan pegged to the US dollar at a rate below its equilibrium value. The resulting capital inflows increase the domestic money supply and that is the root cause of the inflation. Let the yuan float and the inflationary pressure will dissipate.

Substitutes and Complements

It is an exercise in mental gymnastics when we try and explain the relationships between substitute goods and complements in the class room. Typically it’s butter-margarine or blue ray players and disks. Students often don’t see why we bother.

The ongoing saga of the collapse of Borders illustrates the issue and also reinforces the need for an understanding of economics in the world of finance. An article from Bloomberg indicates that Borders in on the verge of a Chapter 11 filing, perhaps as early as next week. Borders still wants to undertake a merger with Barnes & Noble, but we can’t understand why B&N would want to take on the obligation of the additional real estate. (Click here for article)

A second article, from Venturebeat discusses Amazon.com’s latest earnings report. (Click here for article) While earnings were less than expected, the article does indicate that e-books outsold paperbacks by 15%. As we’ve been pointing out for the last little while, this is Border’s problem. Electronic delivery of books is a substitute for the printed version. In addition, the cost of shopping at Amazon is lower than at Borders making Amazon is a good substitute for Borders.

Our third article comes from Huffington Post and has to do with 4th quarter earnings at UPS. (Click here for article) As internet shopping continues to increase, the demand for shipping services also increases. They are complements. The following graph compares the relative stock price movement of the three companies over the past five years. Amazon and Borders have been moving in opposite direction, as our theory predicts. UPS has not been moving in the same direction as Amazon as we might expect. Reasons for this may include the general decline in the economy over the last 2 years and the increase in fuel costs over the time period in question. Another reason can be found by studying Amazon’s shipping policy which indicates that UPS is not the sole distributor of Amazon products.

Data was obtained from Yahoo! Finance. Stock prices are adjusted for dividends and normalized to February 2, 2006

Correlation or Causation (lies, damn lies, and statistics)

Economics is a social science and, as such, follows the scientific method. We isolate a problem and try to solve it, or observe a particular behaviour and we attempt to explain it. That entails a series of definitions and assumptions, the construction of a model and the formulation of a postulate or hypothesis. Once this is complete, we then undertake a statistical analysis and see if the model supports or rejects our hypothesis.

Not all disciplines follow such a methodology. For example, Reuters published an article citing a University of Victoria study that suggests that the privatization of BC liquor stores is responsible for an increase in alcohol related deaths in that province. (Click here for article) According to the article, a statistician from George Mason University takes issue with the way the study was done and the interpretation of the data. If, as the UVIC study suggests, the decline in government liquor stores causes more alcohol related deaths, then opening more government run liquor stores should result in fewer deaths.

What the study apparently omitted was a hypothesis of causation. That is, did the privatization of liquor stores cause the increase in deaths or was there another factor that happened to be related to the timing of the privatization and also to the deaths? We did a quick and dirty survey of some literature to find out what may affect the demand for alcohol and the increase in alcohol abuse.

Most studies suggest that alcohol is a normal good. When income rises, alcohol consumption rises. (See the BBC article). Another study tests this hypothesis for causation and finds that increased alcohol consumption can lead to higher incomes due to social networking. (See report on San Jose State U study) However, during a recession, when many people lose their jobs, depression can lead to an increase in alcohol abuse. (See University of Maryland study) This would appear to be conflicting. However, the first case deals with alcohol consumption and the second with substance abuse which are entirely different. (See article in the Irish Medical Times) In addition to income and depression being factors, genetics may also play a role. An article from the Scotsman suggests that Scottish residents born in Scotland or Ireland are more likely to suffer from alcohol abuse than those born outside Scotland. Celts are more susceptible than Anglos, Saxons or Normans? (Click here for article)

We would suggest that the authors of this particular study redo their analysis correcting for the recession. Our suspicion is that the opening of the private liquor stores coincides with the recession and that the “cause” of the alcohol related deaths has more to do with depression, induces by job losses and falling income, than it does with privatization. This would show a correlation, not causation.

A note on food prices

An interesting article found on the Huffington Post website, originally published by Reuters, suggests that this year’s higher food prices are here to stay. (Click here for article). We don’t necessarily disagree with the article, but we do question some of their analysis.

First, there is a quote from a Chicago based commodities trader that says “Everything is set to the point where supply equals demand right now.” This seems to imply that at some point in the past, or there will be a time in the future when supply does not equal demand. Markets tend to adjust quickly to shortages and surpluses. This is especially true of actively traded markets such as the commodity markets. A surplus occurs when the amount supplied in the market exceeds the amount demanded. Markets react by reducing prices. When demand in the market exceeds supply, a shortage occurs and prices rise. Thus, the adjustment of prices always creates a situation where supply equals demand.

Extreme weather, droughts, and floods certainly have an effect on the supply of food and any of these events causes food prices to rise. Likewise an increase in fuel costs also reduces food supplies and raises prices. Also, as of January 1, 2011 all new tractors must meet Tier 4 emission standards which increases the price of these capital items. (Reported on Farms.com)

On the demand side, there are a couple of things to note. The demand for ethanol is high because the US government uses policy to support corn farmers. As anyone that has consumed liquor knows, ethanol can be produced from almost any crop: corn, rye, barley, sugar cane, rice, grapes, blueberries, elderberries, cactus, potatoes … the list goes on. Also on the demand side, governments keep stores of foodstuffs to protect against supply shocks. When crops are good, governments buy food and store it. When crop yields are low, governments can mitigate price rises by depleting inventories. In the year(s) after a poor harvest, governments replenish their reserves, temporarily increasing demand. This is not permanent.

China has a different problem. Their official policy of undervaluing the yuan makes their exports cheaper, but it also increases the price of their imports. India, and the remaining BRIC countries (Russia and Brazil) have been attempting to slow the appreciation of their currencies as money moves away from Europe and the US. This also causes import prices to rise.

Most food crops are seasonal in nature and producers can change output in a year or less. If food prices are expected to stay high, watch for an increase in the number of farmers producing the more expensive crops and reducing the production of the lesser expensive crops.

This is the ‘invisible hand’ that Adam Smith referred to and it is the way that markets work.