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Tuesday, August 31, 2010
Risk, Return and Moral Hazard
Reuters reported on Tuesday that the Bank of Montreal (BMO) missed their profit target in the third quarter due to reduced trading revenue. (Click here for article). Banks earn revenue from the interest spread between deposits and loans, fees, advisory services, trading revenue and investment banking.
Today in the Globe and Mail, Murray Leith, vice president and director of research at Odlum Brown Ltd. tries to convince investors that they should get out of their bond holdings and return to equity investments. (Click here for article). Mr. Leith's argument is:
“With Canadian 10-year government bonds and high-quality corporate bonds currently yielding less than 3 per cent and 4 per cent respectively, it’s a mathematical certainty that the average Canadian bond fund will not achieve a compound annual return of 5 per cent over the next 10 years.”
It's hard to argue this point. A drop in interest rates below the current 0.75 percent overnight rate would be required. Not impossible, but highly unlikely. Mr. Leith's next point is also not debatable:
"The returns for stocks, on the other hand, should be much higher in the next decade than they were over the previous 10 years."
Notice the choice of words in the two quotes. When talking about bonds, Mr. Leitch uses "will not" but when discussing equities, he says "should be". The first implies certainty, the second implies risk. A 4% Government bond held to maturity is guaranteed to pay 4% annually. A share in any company over the same time period has an uncertain return. Most investors are not stupid, they are risk averse, prefering a guaranteed rate of return to a risky one.
Bonds trade in the OTC market where prices are not transparent. Most individual investors do not "trade" bonds, they buy and hold. Firms like BMO and Odlum Brown earn income by trading securities on behalf of their clients. The commissions on bonds are very small and are only earned once if held to maturity. Commissions on stocks can be up to 2% to buy and 2% to sell.
We do not mean to imply that investors should not hold equities, but they should do so as part of a well balanced portfolio designed by a qualified advisor, preferably a fee-based one, and fully understand the risk and return associated with the portfolio. There is a moral hazard problem with commission based advisors. They must sell you something to get paid.
Today in the Globe and Mail, Murray Leith, vice president and director of research at Odlum Brown Ltd. tries to convince investors that they should get out of their bond holdings and return to equity investments. (Click here for article). Mr. Leith's argument is:
“With Canadian 10-year government bonds and high-quality corporate bonds currently yielding less than 3 per cent and 4 per cent respectively, it’s a mathematical certainty that the average Canadian bond fund will not achieve a compound annual return of 5 per cent over the next 10 years.”
It's hard to argue this point. A drop in interest rates below the current 0.75 percent overnight rate would be required. Not impossible, but highly unlikely. Mr. Leith's next point is also not debatable:
"The returns for stocks, on the other hand, should be much higher in the next decade than they were over the previous 10 years."
Notice the choice of words in the two quotes. When talking about bonds, Mr. Leitch uses "will not" but when discussing equities, he says "should be". The first implies certainty, the second implies risk. A 4% Government bond held to maturity is guaranteed to pay 4% annually. A share in any company over the same time period has an uncertain return. Most investors are not stupid, they are risk averse, prefering a guaranteed rate of return to a risky one.
Bonds trade in the OTC market where prices are not transparent. Most individual investors do not "trade" bonds, they buy and hold. Firms like BMO and Odlum Brown earn income by trading securities on behalf of their clients. The commissions on bonds are very small and are only earned once if held to maturity. Commissions on stocks can be up to 2% to buy and 2% to sell.
We do not mean to imply that investors should not hold equities, but they should do so as part of a well balanced portfolio designed by a qualified advisor, preferably a fee-based one, and fully understand the risk and return associated with the portfolio. There is a moral hazard problem with commission based advisors. They must sell you something to get paid.
"Current Account Deficit Widens" ... So ??
If you read the headline in the Globe and Mail on Monday, you may have been inclined to believe that the world was coming to an end ... or perhaps the country was headed for dire economic times. (Click here for article)
Fortunately, such is not the case. We should, however, be prepared to see the current account in deficit for some time. The current account is a record on international payments for the purchases of goods, services and resources. When the current account is in deficit, it means that the value of our imports exceeds the value of our exports. If this is largely due to a trade deficit, one component of the current account, then measured GDP will be lower.
Our exports have fallen because the economies of the two largest countries in the world, the US and China have experience slower growth. If we built washing machines, this would be a problem because we would have to sell them for less. But Canada is a resourced based economy. By not selling a tree, or rock or barrel of oil, it doesn't depreciate. Our wealth does not fall, only our income and only temporarily.
Our imports have increased because Canada escaped the financial meltdown experience in the US, Europe and Japan. Our banks are stable. Our recession was not as deep and did not last as long. Our housing market didn't collapse and we didn't panic. Americans had it much worse and because of the decline in wealth and income, they didn't travel. Airfares and hotels rates in the US fell and we took advantage of them. Our imports are higher because we travelled.
The recent decline in the Canadian dollar is a result of the current account balance. Fewer people needing Canadian dollars to buy our trees and Canadians selling dollars to travel. The Bank of Canada allows the dollar to fall. This will reduce the price of our exports and increase the price of our imports providing an automatic stabilizer.
Our currency is falling because of market forces, as it should. The yuan, and now they yen are undervalued as a specific policy to encourage exports.
Don't fear the current account.
It will self correct.
Fortunately, such is not the case. We should, however, be prepared to see the current account in deficit for some time. The current account is a record on international payments for the purchases of goods, services and resources. When the current account is in deficit, it means that the value of our imports exceeds the value of our exports. If this is largely due to a trade deficit, one component of the current account, then measured GDP will be lower.
Our exports have fallen because the economies of the two largest countries in the world, the US and China have experience slower growth. If we built washing machines, this would be a problem because we would have to sell them for less. But Canada is a resourced based economy. By not selling a tree, or rock or barrel of oil, it doesn't depreciate. Our wealth does not fall, only our income and only temporarily.
Our imports have increased because Canada escaped the financial meltdown experience in the US, Europe and Japan. Our banks are stable. Our recession was not as deep and did not last as long. Our housing market didn't collapse and we didn't panic. Americans had it much worse and because of the decline in wealth and income, they didn't travel. Airfares and hotels rates in the US fell and we took advantage of them. Our imports are higher because we travelled.
The recent decline in the Canadian dollar is a result of the current account balance. Fewer people needing Canadian dollars to buy our trees and Canadians selling dollars to travel. The Bank of Canada allows the dollar to fall. This will reduce the price of our exports and increase the price of our imports providing an automatic stabilizer.
Our currency is falling because of market forces, as it should. The yuan, and now they yen are undervalued as a specific policy to encourage exports.
It will self correct.
Saturday, August 28, 2010
The Market for Organs
Not the musical kind, the human body part kind.
We found an article on the BBC website, written by an ethics expert, that states that selling organs such as kidneys should not be a criminal offense. (Click here for article). The author tries to explain the market for organs using supply and demand, then goes on to talk about the ethical and legal implications.
We are not philosophers and can't seem to get "ethics" into our utility functions. As such, we tend not to discuss matters pertaining to ethics. We could only wish that ethicist didn't play with economics because they don't seem to be very good at it.
In our first year courses, we spend the better part of 4 weeks convincing our students that price affects quantity supplied, not supply, and that other variables such as technology, input prices and number of sellers affect supply. Not apparently true according to our ethicist. And to top that, he suggests that if donors received financial compensation, fewer people would donate. Price goes up, quantity supplied goes down ... a downward sloping supply. An interesting phenomenon.
Whether or not a free market should exist for kidneys, livers, lungs etc., is a normative question and one that has no economic answer. Whether a free market would reduce the shortage is a positive question and one that economics can answer; yes it will.
The market for blood is a little less controversial, since the human body continuously produces blood. When we donate, the body replentishes itself. Kidneys and lungs don't grow back. The Labour Day weekend is approaching and the radio is flooded with appeals for blood donors due to a perpetual shortage of blood. Offering to pay people for their blood would ease the shortage.
For some, giving blood is the 'right' thing to do. Economists argue that these people get some kind of pleasure from knowing that their blood will help a complete stranger. Others would donate blood if needed by a close friend or relative because they get positive utility from that, but otherwise would not. For the first group, the marginal benefit from donating is always greater than the marginal cost. For the second group, the marginal benefit is only greater if they know the intended recipient. Compensating people for the time it takes to donate blood would increase the marginal benefit whether they knew the intended recipient or not. This would reduce the shortage of blood.
No ethics involved, just straight forward economics. Welcome to the dark side.
We found an article on the BBC website, written by an ethics expert, that states that selling organs such as kidneys should not be a criminal offense. (Click here for article). The author tries to explain the market for organs using supply and demand, then goes on to talk about the ethical and legal implications.
We are not philosophers and can't seem to get "ethics" into our utility functions. As such, we tend not to discuss matters pertaining to ethics. We could only wish that ethicist didn't play with economics because they don't seem to be very good at it.
In our first year courses, we spend the better part of 4 weeks convincing our students that price affects quantity supplied, not supply, and that other variables such as technology, input prices and number of sellers affect supply. Not apparently true according to our ethicist. And to top that, he suggests that if donors received financial compensation, fewer people would donate. Price goes up, quantity supplied goes down ... a downward sloping supply. An interesting phenomenon.
Whether or not a free market should exist for kidneys, livers, lungs etc., is a normative question and one that has no economic answer. Whether a free market would reduce the shortage is a positive question and one that economics can answer; yes it will.
The market for blood is a little less controversial, since the human body continuously produces blood. When we donate, the body replentishes itself. Kidneys and lungs don't grow back. The Labour Day weekend is approaching and the radio is flooded with appeals for blood donors due to a perpetual shortage of blood. Offering to pay people for their blood would ease the shortage.
For some, giving blood is the 'right' thing to do. Economists argue that these people get some kind of pleasure from knowing that their blood will help a complete stranger. Others would donate blood if needed by a close friend or relative because they get positive utility from that, but otherwise would not. For the first group, the marginal benefit from donating is always greater than the marginal cost. For the second group, the marginal benefit is only greater if they know the intended recipient. Compensating people for the time it takes to donate blood would increase the marginal benefit whether they knew the intended recipient or not. This would reduce the shortage of blood.
No ethics involved, just straight forward economics. Welcome to the dark side.
Wednesday, August 25, 2010
Hire Workers or Buy a Firm?
An interesting article in the Atlantic got me out of summer vacation mode and inspired me to blog. (Click here for article).
There has been an increase in merger and acquisition activity recently and the author questions why firms would do this when there is so much unemployment. The implication seems to be that firms can grow by buying up another company with its existing employees and capital, or go into the labour market and hire more workers for their own company. Either way the company grows.
The article indicates that the reason lies in uncertainty and the difference between short run and long run decisions. An interesting argument to be sure, but one that does not fit well with either corporate finance theory or with labour market theory.
The answer lies in the speed at which prices adjust, particularly stock prices and wage rates. A decline in economic activity decreases the demand for labour. It also reduces the expected profits of firms and thus the demand for stocks. With no change in supply, a decrease in demand causes prices to fall.
Stocks are homogeneous and the markets for them are very efficient. Labour markets are relatively slow to react. Stock markets reach new equilibriums very quickly based on new information. Labour markets, for a variety of reasons, do not. Unemployment is caused by a decline in labour demand without a fall in price.
Since stock prices adjust faster that labour prices, it is more profitable to acquire an existing firm whose stock price reflects the high wage, than to hire new workers at a wage above equilibrium. This argument is the same with or without uncertainty. Risk only changes the discount rate, not the decision making process.
There has been an increase in merger and acquisition activity recently and the author questions why firms would do this when there is so much unemployment. The implication seems to be that firms can grow by buying up another company with its existing employees and capital, or go into the labour market and hire more workers for their own company. Either way the company grows.
The article indicates that the reason lies in uncertainty and the difference between short run and long run decisions. An interesting argument to be sure, but one that does not fit well with either corporate finance theory or with labour market theory.
The answer lies in the speed at which prices adjust, particularly stock prices and wage rates. A decline in economic activity decreases the demand for labour. It also reduces the expected profits of firms and thus the demand for stocks. With no change in supply, a decrease in demand causes prices to fall.
Stocks are homogeneous and the markets for them are very efficient. Labour markets are relatively slow to react. Stock markets reach new equilibriums very quickly based on new information. Labour markets, for a variety of reasons, do not. Unemployment is caused by a decline in labour demand without a fall in price.
Since stock prices adjust faster that labour prices, it is more profitable to acquire an existing firm whose stock price reflects the high wage, than to hire new workers at a wage above equilibrium. This argument is the same with or without uncertainty. Risk only changes the discount rate, not the decision making process.
Monday, August 16, 2010
Unemployment Creates Better Employees
We have recently been working on a paper that deals with the amount of effort that university faculty put into their jobs. This includes the effort that students see; class preparation, marking, office hours etc., and the effort that students don't see; committee work, research, professional development, conferences etc. One of the early papers on the topic of shirking is entitled "Equilibrium Unemployment as a Worker Discipline Device" by Carl Shapiro and Joseph E. Stiglitz published in the American Economic Review in June 1984.
"Shirking" refers to a situation whereby employees do not put in the effort required or expected from the employer. Employers can reduce the amount of shirking by employing managers to monitor employees and discipline or terminate the underperforming employee. This, however, can be expensive since managers expect to be paid and are not, themselves, productive.
Paying a wage rate that is above the equilibrium wage can reduce management costs. When a worker is terminated, they can get a new job at the equilibrium wage. This would be a reduction in pay. Because the cost of shirking is now borne in part by the shirker, less monitoring is required. The wage premium, or efficiency wage, depends on the equilibrium condition in the labour market. The closer the economy is to full employment, the higher the equilibrium wage and thus the higher is the efficiency wage.
Unemployment can reduce the efficiency wage. If employees can not immediately find alternate employment, then they will incur a cost if they are caught shirking. The deeper the recession and the longer the average length of unemployment, the lower the efficiency wage goes. This is the Shapiro/Stiglitz argument. Employees must increase their productivity if they want to keep their high wage jobs in times of recession.
This is the essence of an article we found in the Miami Herald. (Click here for article)
"Shirking" refers to a situation whereby employees do not put in the effort required or expected from the employer. Employers can reduce the amount of shirking by employing managers to monitor employees and discipline or terminate the underperforming employee. This, however, can be expensive since managers expect to be paid and are not, themselves, productive.
Paying a wage rate that is above the equilibrium wage can reduce management costs. When a worker is terminated, they can get a new job at the equilibrium wage. This would be a reduction in pay. Because the cost of shirking is now borne in part by the shirker, less monitoring is required. The wage premium, or efficiency wage, depends on the equilibrium condition in the labour market. The closer the economy is to full employment, the higher the equilibrium wage and thus the higher is the efficiency wage.
Unemployment can reduce the efficiency wage. If employees can not immediately find alternate employment, then they will incur a cost if they are caught shirking. The deeper the recession and the longer the average length of unemployment, the lower the efficiency wage goes. This is the Shapiro/Stiglitz argument. Employees must increase their productivity if they want to keep their high wage jobs in times of recession.
This is the essence of an article we found in the Miami Herald. (Click here for article)
Sunday, August 1, 2010
A Further Comment on the Cost of Education
We have previously blogged on the cost of education, in particular on the cost of textbooks. There was an article in the New York Times online edition yesterdaythat caught our attention and deserves a comment. The article, entitled "$200 Textbook vs. Free. You Do the Math", discusses the cost of textbooks. Click here for the article.
Reputable publishers help overcome the asymmetric information problem associated with textbooks. When you purchase a book, you have no idea whether the author is qualified to write on that subject or not. Publishers require that their authors be qualified if they wish to maximize profits. Therefore, they are willing to spend money to determine qualifications. After manuscripts are written, publishers hire other experts in the field to read them and comment. Being involved in this process has shown me that first drafts are not always correct or current. I have found outdated policies, and poor references such as VCRs and Atari game systems, not to mention the usually spelling and grammatical errors. I do not proofread manuscripts for free.
The problem with open source (free) textbooks is that the buyer must incur the cost of determining the qualifications of the author(s). It may cost you more than $200 to determine whether an open source calculus text is accurate. You do the math!
Reputable publishers help overcome the asymmetric information problem associated with textbooks. When you purchase a book, you have no idea whether the author is qualified to write on that subject or not. Publishers require that their authors be qualified if they wish to maximize profits. Therefore, they are willing to spend money to determine qualifications. After manuscripts are written, publishers hire other experts in the field to read them and comment. Being involved in this process has shown me that first drafts are not always correct or current. I have found outdated policies, and poor references such as VCRs and Atari game systems, not to mention the usually spelling and grammatical errors. I do not proofread manuscripts for free.
The problem with open source (free) textbooks is that the buyer must incur the cost of determining the qualifications of the author(s). It may cost you more than $200 to determine whether an open source calculus text is accurate. You do the math!
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