Canadian Dollar as an International Unit of Account

In Macroeconomic Principles and Money and Banking courses we teach that money has three uses: a medium of exchange, a store of value, and a unit of account. The first two are reasonable easy to explain. The third is a little more difficult. What is truly confusing is when other countries start using your currency as a unit of account, but not as either a medium of exchange, or a store of value.

Such is the case when a foreign nation or institution issues debt in Canadian dollars as the World Bank did in 2007. (click here for the press release). The government of Israel also has outstanding debt issued in Canadian dollars (click here for quotes). The most common reason for doing this is risk reduction. Buyers of bonds prefer less volatility in the currency of issue. For a country that has volatile currency, they can assume the risk by issuing a more stable currency. The benefit is a lower interest rate to the issuer. An illustration may help.

Suppose that Percy wishes to pursue his lifelong ambition of purchasing a pineapple ranch in his native Ghana. The offered price is 1.5 million Ghanaian cedi. To finance the purchase of his ranch, Percy calls on his Swiss friend, Heinz, and asks for a loan of 1.5 million cedi. Heinz is willing to lend Percy 1.02 million francs. Over coffee, they agree on a loan of 1 million Canadian dollars and the documents are prepared. Heinz converts his 1.02 million francs to 1 million Canadian dollars and then delivers them electronically to Percy who then converts them into 1.5 million cedi. Both parties are happy.

But what about Canadians? Since Heinz is buying the same number of Canadian dollars that Percy is selling, there should be no effect on the Canadian dollar exchange rate. Likewise, since the Bank of Canada isn’t issuing any new dollars, there is no effect on the Canadian money supply. Canada is not affected. Heinz is lending 1.02 million francs, Percy is borrowing 1.5 million cedi and they have agreed to use the Canadian dollar as the unit of account. The same argument holds true when Percy makes interest and principal payments to Heinz. Again, Canadians are not affected.

Money, as a unit of account, has no effect on the real economy. Assets can be denominated in any currency on earth, or for Star Trek fans, even gold pressed latinum, so long as both parties can agree.

The Economic Cost of an Education

This is an exercise that I do with my first year students to see if they really want to complete a Bachelor Degree. How much will your degree cost?

The Accounting students are always the first to respond. Forty courses at $350 per course is $14,000 plus another $4,000 for textbooks. Maybe add $1,600 for transit passes and a couple of hundred for paper, binders, pens etc. Answers typically come in around $20,000 for a 4-year business degree. (Canadian universities are heavily subsidized). Of course accountants don’t really understand costs the way economists do, so I wait patiently for the one glimmer of hope – that one student that has enough potential to warrant turning to the dark side.

Finally, a hand goes up. “What about the time that is spent going to school?” The bait has been taken! Reel them in and turn them into economists!

I suggest to my students that is takes about one hour outside of class for every hour in class to maintain a 3.0 GPA (B average). That’s eight hours per week for 14 weeks or 112 hours per course. Forty courses require 4,480 hours. In the Greater Vancouver area, unskilled jobs typically pay about $12 per hour. The value of the time spent is $53,760 at a minimum. Total cost $73,760. Textbook costs amount to about 5.4% of the total. Note that as tuition and/or the value of time increases, the textbook percentage drops.

It is because of this calculation that I cannot understand the logic behind a federal rule concerning textbooks that was discussed in the July 22nd edition of the Fort Worth Star-Telegram. (Click here for article).

We have previously blogged on the cause of undergraduate waiting lists. Shortages occur when governments set prices below the market equilibrium. So now the US government is going to regulate textbook prices. The next time you go to your doctor, won’t it be comforting to know that he or she didn’t read the textbook because it wasn’t available? Shortages will occur. Authors require compensation and publishers are profit maximizers.

For what it’s worth, I choose the textbook that I believe is most suitable to my teaching style and the learning objectives of the course. I have never made a decision based on the price of a textbook and hope that I never do. Anyone that doesn’t like my decision is free to take a course from another instructor or at another institution. Or, perhaps, they can purchase a copy of Economics For Dummies ($21.99) and watch a YouTube video.

Give these yachts some thought

Yachts for profit maximization, not utility maximization? This is exactly what is being reported in an article last week in ChinaDaily news, click here for the article.

To most people in China, yachts are luxury goods that are associated with an extravagant life of high status and leisure. Some believe there may be other reasons in owning a yacht, reasons that enter one’s production functions and not utility functions.

The bosses of successful companies are purchasing these yachts to make more money. Many multi-million dollar business deals are being done out on these boats when they set sail. The yachts being bought by the rich are a way of signaling. Signaling, in economics terms, occurs when it is hard to distinguish "good" types from "bad" types (in this case business deals), and there is a costly method available to signal you are good type such that the cost of signaling is too high for bad types that they won't do it. Yachts are status symbols that offer privacy and entertainment and impressive views during small trips for business partners. This is where the profit maximization comes in. The results of these meetings are the business deals that are negotiated in these pleasing environments.
Here is some math that may help…

The yachts cost roughly 2,000 Yuan ($300) a day, even if they stay docked and don’t sail. This is 400 Yuan more than the city’s monthly per capita income in 2009. For one year the cost of keeping a yacht then would be about 730,000 Yuan ($109,500), not to mention the 6 to 7 million Yuan just to buy it. If the business deals were in the multimillion profit range, to pay off the whole cost of the boat (fixed and variable), you would only have to do one of these business deals successfully once a year.

The article also reports that China is now the world’s second-biggest consumer of luxury goods, and their total consumption accounts for 27.5 percent of global consumption in 2009. The yachts are not luxury goods in the way Canadians would perceive them to be here. The increase in luxury good consumption in China is the result of an increasing population and personal incomes. This is a Utility maximizing purchase, such as Chanel, Hermes, Dior etc.

Monopolist vs Monopsonist

In a previous blog, we discussed the difference between rent seeking and the monopoly power derived from a patent. The harmful aspect of a monopolist comes from the profit maximizing production level. A monopolist will produce where marginal revenue is equal to marginal cost and then charge whatever the market will bear. Since price is higher than marginal cost, we get an allocative inefficiency that we call a dead weight loss. This loss is offset by the benefit to the economy caused by technological change when the monopolist is protected by patent.

A monopolist is a single seller of a product, a monopsonist is a single buyer. When this occurs, the buyer will purchase a quantity where the marginal revenue product equals the marginal resource cost. The buyer will then use its market power to pay what the market will sell at. Since the price will be below the marginal revenue product, we have a dead weight loss similar to what we get in a monopoly.

The Canadian Medical Association and the American Medical Association are monopoly sellers of medical services in Canada and the United States respectively. Insurance companies are rapidly becoming monopsonistic buyers of medical services. When the power of a monopolist meets the power of a monopsonist, the outcome is closer to what we would expect in a competitive market. A July 17th article in the New York Times discusses exactly this situation. (Click here for article)

What happens when a monopolistic seller meets a firm that behaves as if it was a monopsonistic buyer, but doesn’t really have the market power? This is the situation discussed in a Globe and Mail article dated July 22. (Click here for article) Sears has been pressuring its suppliers to reduce their prices due to the weaker US dollar (stronger Canadian dollar). Unfortunately for Sears, they are not a monopsonistic buyer of cosmetics while Chanel is a monopoly in their lines. In this case, the market power lies with the monopolist. Chanel has refused to reduce the price at which they sell to Sears and is pulling all of their products from Sears stores across Canada.

When is a Market Not a Market?

An article published by Bloomberg news on July 21st presents a good case study of why we, as economists, are always careful in how we define markets and market prices. Click here for article.

A competitive market is one that has many buyers and many sellers for a particular homogeneous product, all of whom have the same set of information. In most places, the housing market approximates a competitive market. The interaction of the buyers and sellers in this market determines the equilibrium price, the price that we would normally see, and the quantity sold. Changes in the determinants of either supply or demand will cause the equilibrium price to change.

One thing that can lead to a change in both demand and supply is the expectations of future prices. If prices are expected to fall, supply will increase as owners try to sell before the price does fall, and demand will decrease as potential buyers wait for prices to actually fall. An increase in supply and a simultaneous decrease in demand will cause prices to fall. The widely held belief that prices will fall is sufficient to make prices actually fall.

When supply and demand move slowly, transactions will occur and new prices will be determined. However, when there is a dramatic change in either supply or demand, market participants may not be able to agree on an exchange price. This appears to be what is happening in Dubai. The pre-credit crisis boom saw a large increase in the number of homes being built and a large number of new buyers. As credit collapsed and the global economy faltered, housing prices began to fall. Foreign owners of Dubai real estate found that the value of their holdings had fallen below the amount of the outstanding mortgages and they defaulted. Banks naturally foreclosed and became property owners.

There are now so many sellers and so few buyers, that a competitive market no longer exists. No one is sure what the equilibrium value of real estate is. Later this year, the banks will be in position to auction off the foreclosed properties, and at that time, a new equilibrium price may be determined. Credit Suisse estimates that the price of real estate my fall by 20% as a result of the auction process. (On top of the 50% drop that has already occurred)

A forthcoming article from Boston based economists John Y. Campbell, Stefano Giglio, and Parag Pathak suggests that the average drop in real estate values due to foreclosure in Massachusetts is 27%. Click here for article

When the auction process begins and if they can do it without minimum required bids market participants may begin to get a sense of the fair value of their holdings and the Dubai housing market may once again be a market.

Sprint Needs a Microeconomist

An article in the Wall Street Journal caught my attention while I was supposed to be vacationing on the Oregon Coast and I couldn't resist. It seems that Sprint is having a problem signing new customers to their superfast 4G network because they don't have enough phones. Click here for the article.

Cellular phone companies typically offer deeply discounted phones when customers sign long term expensive contracts. The higher contract rates create a negative substitution effect - customers are inclined to purchase something else. The higher rates also create an income effect - a reduction in general purchasing power. When the substitution effect is small and the income effect is large, firms can increase profits by offsetting the income effect. In the case of Sprint, this means offering the 4G phone at a deep discount.

Economists use a technique known as "decomposition" to determine the sizes of the two effects. The details can be found in an intermediate micro text. If done correctly, the profit maximizing contract rate and length, and the profit maximizing price of the phone can be set. In Sprint's case, it appears that the elasticity of demand was overestimated. Consumers were not as responsive to the price increase as Sprint believed. This causes the income effect to be overestimated and the phones priced too cheaply (or the service priced too cheaply).

The effect - when you underprice something, there is bound to be a shortage.

Corporate Finance and Macroeconomics

“I’m going into Business Admin. Why do I have to take macroeconomics? I’ll never use this stuff!” A comment we hear all too often from our first year students that are forced by their cruel advisors to take our courses. We hope this June 5th article from Reuters and the following explanation illustrates the direct relationship between the two subjects. Click here for article.

A recent report from the Royal Bank of Canada suggests that senior executives from companies around the world are avoiding going to the markets to raise cash even though interest rates are still at extremely low levels. Corporate finance theory tells us that firms will undertake new capital projects when the net present value is positive. The discount rate used to perform the NPV calculation depends, in part, on the risk free interest rate. In Canada, one-year treasuries are yielding 1% in nominal terms. Why, then, aren’t firms taking advantage of the low interest rates and investing in new plants and equipment.

The answer may lay in the macroeconomic forecast for the next two years. With most industrialized countries in the world reducing government spending and raising taxes to deal with their rising debt levels, the growth in global aggregate demand is expected to slow. Slower economic growth means that there will be fewer capital investments that have lower NPVs today than they will in a year or two. It is therefore prudent for firms to put off investment spending for 1-2 years.

This reduction in investment spending, as one of the components of aggregate demand, further reduces the growth rate of GDP. Measures of business confidence show firms’ expectations of short term economic conditions. When confidence is low, so is investment. This idea reinforces the Keynesian argument for deficit spending – an argument we have discussed in a previous blog.
Firms are currently avoiding raising funds by issuing capital because it is currently too expensive. With market indexes some 20% below their recent highs, equity has become 25% more expensive. Watch for signs of recovery in China to stimulate export spending in the rest of the world. This will cause global GDP to rise and the subsequent increase in business confidence will lead to increased investment.

This may seem to be a circular argument: a decrease in investment reduces GDP which reduces confidence, which reduces investment. It is more like a self-fulfilling prophecy. Investment is, after all, the most volatile component of aggregate demand and the cause of most recessions and recoveries.

(“Investment” is used in the economic sense; the production of real capital.)

To Pay or Not to Pay - That is the Question

With apologies to the Bard.

When it comes to allocating after-tax profits, the directors of firms have two choices. They can pay the money to the firm’s shareholders in the form of dividends or they can keep the money to be reinvested to foster future growth. In theory, if the rate of return that a firm can generate with the funds exceeds the rate of return that a shareholder can obtain on an alternate investment, the shareholder would desire the funds to be reinvested. Again, in theory, a firm’s board of directors will structure dividend policy in the best interests of the shareholders. A few recent news articles offer illustrations.

British Petroleum, faced with billions of dollars in damages from its ongoing Gulf of Mexico problems has cancelled their dividends to conserve cash, thus reducing the need to borrow. An increase in debt makes the shares a more risky investment. Thus, cancelling the dividend was in the best interest of current shareholders, even though it reduced their current income. Click here for the Financial Times article.

The Ford Motor Company, who along with the other two big US automakers cancelled dividends on both common and preferred stock to conserve cash during the credit crisis. Ford was the only one of the three that did not require emergency loans from the government. Now that Ford’s sales and profits have increased, they are in a position to reinstate the dividend. Again, the board did what was best for the shareholders. Click here for the Reuters article.

In a different application of dividend policy, Yahoo! has recently announced a $3 billion buyback of outstanding shares. Suppose that a company’s shares are trading at $100 and they pay a $5 dividend. The investor receives a 5% return. Unfortunately, this dividend is taxable in the hands of the investor. Suppose instead that the firm uses the cash to purchase its own shares on the market. A reduction of outstanding shares by 5% increases the value of the remaining shares by 5%. This 5% increase in share price is not immediately taxable in the hands of the shareholder. Click here for the Bloomberg article.

Unfortunately, there are occasions when a board does not act in the best interest of shareholders. When a company has a large amount of cash on hand and invests those funds in treasury bills yielding less than 2% interest, shareholders are worse off. If the company paid that money out shareholders would then be able to reinvest those funds in shares that yielded more than 2%. Such is the case with Sears Canada. Click here for the Globe and Mail article.

For more on dividend policy see, for example:
Fundamentals of Corporate Finance, Richard A. Brealey, Stewart C. Myers et al., McGraw-Hill Ryerson