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.