The Economics of Prostitution

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Economy perking up? Don’t bet on it.

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

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

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

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

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

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

What is an artificial rate?

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

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

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

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

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

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

Debts and Deficits. Do politicians know the difference?

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

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

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

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

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

Christmas Tree Taxes ... Is Nothing Sacred?

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

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

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

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

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

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

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

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

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

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

Keynesian ... or Kenyan

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

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

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

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