EclectEcon

Richard Posner deserves the next Nobel Prize in Economics

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Supply Management, Risk, and Exploiting Consumers

A few weeks ago, I posted a link on Facebook to an article criticizing supply management schemes in the agriculture industry in Canada. Supply management raises prices to consumers by restricting the supply of farm products such as milk, eggs, and chickens. It does this by limiting the amount of quota (licenses to produce given amounts). And when supply is restricted, prices are driven up by the forces of supply and demand. The article focused on the role of marketing boards (who enforce supply management) in restricting the choices of consumers, limiting our ability to buy farm-fresh, less-"manufactured" produce. But it also nicely summarized the criticisms from most economists concerning supply management:

The Canadian food cartel goes by its own special name: “supply management.” Critics have charged that supply management makes food disproportionately expensive (especially for the poor), cripples our agricultural sector and is holding us back from entering lucrative trade deals with Asia.

In response to this article, a former student wrote,

Yes, quota is expensive - but what it does do is allow organizations (like farm credit canada) to lend out money to farmers because of a 'guaranteed' price. 

and in a later comment he wrote,

[B]esides farm credit canada - I am not sure that any financial institution uses quota as collateral. In fact - sure about that.

These two comments about supply management require some careful consideration. 

His first comment suggests that there is some over-riding social justification for providing a non-market mechanism to reduce price variability and risk for farmers. I don't see it. Farmers (especially now, but perhaps less so 50 years ago) are in touch with markets all over the world and can readily deal in commodity futures to hedge their risks. Providing high, stable prices is not the only way to reduce the risks that farmers face.

Essentially, the student is arguing that consumers should be forced by marketing boards to pay higher prices as a way of buying insurance for farmers to protect the farmers from price variability. This argument never held much sway for me even before farmers could trade futures on the internet. If farmers (or any businesses, for that matter) are concerned about price variability, they can save more during the good years to see them through the lean years. If doing so is costly to the farmers then, to be blunt, perhaps some farmers (likely the least capable ones) would exit the industry, and prices will rise (or stop falling as much) enough to cover all the costs and risks of all those remaining in the industry. 

Both the market solution and the marketing board solution for dealing with risk lead to higher prices. However, the market solution lets the market determine what risks should be compensated and by how much. Furthermore, it is abundantly clear that marketing boards set supply restrictions that are too tight and force prices higher than they would otherwise be. The evidence: farmers are willing to pay millions of dollars for quota. The only reason they do so is that they expect returns that are sufficiently high to cover the opportunity costs of buying the quota. And they only reason they can expect such high returns is that they receive higher revenues from higher prices.

The student raises an interesting question in his second comment. If quota reduce risk, why won't financial institutions allow farmers to declare that quota are assets that can be pledged as collateral for loans? One possibility is that there is high political risk attached to the quota --- at any time a more libertarian gubmnt could be elected that would abolish supply management schemes. I doubt this argument should carry much weight. More likely, the quota cannot be pledged as collateral because of some legal fiction that they still belong to the gubmnt (as is the case with taxi licenses in some jurisdictions) even though they can effectively be bought and sold.

As a result, we have double gubmnt intervention in the markets for commodities: (1) marketing boards restrict supply and force up prices. But then farmers are unable to use the quota as collateral, and hence (2) we have the farm credit intervention as well. 

What a mess! And because the quota have value, untangling the mess to move toward more nearly market-oriented solutions will be politically difficult, if even possible.

---

Before readers get the wrong idea, I am quite sure there are many marketing boards like the various vegetable marketing boards in Ontario that do far less harm because they do not have the authority/ability to practice supply management. These boards do pretty much the same things that are done by trade association-type groups in many jurisdictions in the US. My only question about these groups in Ontario is why the gubmnt provides them if private trade co-operatives can accomplish the same things.

does ROC mean "return ON capital" or "return OF capital"? or is this just a hidden Madoff-type Ponzi scheme?

Can you imagine buying into an income fund that pays over 9 percent? In today's market? That's what the BMO (formerly Bank of Montreal) paid last fall. From the Globe and Mail (h/t BenS):

 The BMO Monthly Income Fund pays a fixed monthly distribution of 6 cents a unit, or 72 cents annually. Based on the fund’s Oct. 17 price of $7.57, that implies a yield of about 9.5 per cent.

How on earth did they manage that? And if it's legitimate, how do I buy into that fund?

Well, they didn't do it by beating market indices, and they didn't do it with judicious management. Here is what they did do:

...[C]onsider that the fund posted an average return of just 3.1 per cent for the five years ended Sept. 30. A skeptical investor might well ask how the fund can afford to pay such a hefty distribution. Answer: By giving investors their own money back. [EE: huh??]

Accountants call it return of capital (ROC), and here’s how it works: When the fund’s fixed distribution exceeds the amount of interest, dividends and realized capital gains generated by its investments (after all fees are paid), it makes up the difference with ROC.

Where does the fund get this capital that it is returning to investors? From the money paid into the fund by investors! The numbers seem based on unrealistic expectations:

Taking into account its management expense ratio (MER) of 1.57 per cent, the fund would have to make more than 11 per cent, before the MER, to generate a net return of 9.5 per cent to cover its distribution. But given the fund’s conservative asset mix of roughly half equities and half fixed-income and cash, that seems unlikely.

... [I]f we assume (generously) that the bond component will earn 5 per cent, before fees, the equity component would need to appreciate by more than 16 per cent annually.

Funds like this seem like group annuity funds more than anything else.... You pay a bunch of money up front to receive a monthly payout that will eventually exhaust your principle. That's what happens when you buy an annuity.

But in this case, it is an entire group of investors who are buying something like a group annuity. The longer the fund can attract new suckers  investors, the longer the fund will last, and the longer an initial investor can receive a monthly cheque before the fund folds. 

What am I missing? This sounds more like a Ponzi scheme than an income fund. 

Afternoon Tea at The Fairmont Pacific Rim, Vancouver

While I was in Vancouver at the end of November, enjoying all the Grey Cup festivities with the Roughrider Pep Band, I took time out to go to afternoon tea with my friends Jason and Kaori. They recommended that instead of the usual, traditional afternoon tea experience, we try afternoon with an Asian twist at the Fairmont Pacific Rim. I'm glad to have had the experience (and especially to have had the time with Jason and Kaori), but afternoon tea at The Pacific Rim doesn't measure up to the exacting standards set by many places.

Afternoon tea at the Pacific Rim is served in the lobby, as is appropriate, and is served on low tables in a pleasant setting. Unfortunately, the remainder of the lobby has tiled floors, and the overall ambient noise level is far too high for a relaxing afternoon tea. Also, as I entered the section set aside for afternoon tea, it was clear that we were going to be seated at a large square table and that others would be joining us and sharing the table, something I have never experienced before. My guess is that many people would prefer that setting because it was near a huge fireplace; but I prefer the intimacy and quiet of a smaller, non-shared table, and asked that we have a private table to ourselves. The server immediately complied with the request.

After Jason and Kaori arrived and were seated, the server presented us with a box of about sixteen different teas to choose from. Jason and Kaori had little difficulty finding teas that they wanted, but I was at a loss because there was no lapsang souchong tea in the box. The server knew little about tea, and in fact had to ask for help when we couldn't read some of the fancy labels because the calligraphy was too ornate.

After much discussion and investigation, we were able to determine that the BC Forest Tea was a smoky tea that might be similar to my favoured lapsang souchong tea, and I ordered that. I was delighted with it. It was smoky but not overly so.

The server was quite content to pour the hot water into the heavy iron tea pots and walk away from us, but I asked that the tea not be left to steep too long. She said it should steep for 15 minutes, but then checked the label and saw that the BC Forest Tea should steep for only a few minutes, lest it become too bitter (just like lapsang souchong tea). In fact, I find that far too many tea servers don't realize that tea shouldn't steep so long and don't understand how bitter tea can become if it does. Maybe they expect us to mask the bitterness with milk and sugar, but those things just adulterate the flavours of teas in my opinion. Another negative: we had to request additional hot water several times because the server was quite unattentive; and heaven forbid we be offered fresh tea leaves.

The food portion of the service began with a small plate containing one small scone apiece for Kaori and me (Jason ordered sashimi since he was on a zero-carb diet). The scones were not very good, which is too bad, since they should be a major part of a proper afternoon tea. They were small and dry, and there was only one per person (with no replacements offered). However, the clotted cream was superb. Kudos to the Pacific Rim for getting that right.

When we had finished the scones, a serving tray with sandwiches and desserts was presented. It was a two-tiered arrangement with sandwiches on the bottom and desserts on the top. 

As you can see, the "sandwiches" were quite different from the usual afternoon tea sandwiches. There was the standard egg salad on white bread, and there was chicken but it was on focaccia. The remaining sandwiches seemed more like sushi than sandwiches to me: crab on rice, wrapped with cucumber; shrimp on rice; tofu on rice, wrapped with seaweed; and raw tuna on rice. They were all interesting and, for the most part enjoyable. But I felt slightly awkward eating some of them:

The desserts seemed rather standard. As I expected, I quite enjoyed the tart, but the others were good, too, and seemed relatively fresh.

Overall, as I said at the outset, I am glad to have had the experience of this variety of afternoon tea. This, despite the fact that I'm not a big fan of sushi or sashimi. The B.C. Forest Tea was superb, the sandwiches were .... well ....  interesting; and the desserts were good.

For me that major disappointments were that the server didn't seem to know as much about tea as she should and even seemed a bit resentful of my requests for more intimate seating and for more information about the tea. Also, the scones were downright pathetic. And, finally, I have given up expecting that places in Canada will offer additional scones or sandwiches with their afternoon tea.

If you are looking for something quite different from the standard afternoon tea, you might want to consider the Pacific Rim. But I doubt if I will go back before trying other places in Vancouver.

- - - - - - - -

My previous reviews, ranked in order of preference:

      These three were superb. Highly recommended:

• The Four Seasons, London, England
• The St. Regis Hotel, Houston, Texas
• The Lanesborough, London, England
  

Those in this large middle group ranged from very good to just okay. I would consider returning to them, but those in the upper portion of the list were significantly better than those in the lower portion of this section:

• Claridge's, London, England
• The Dorchester, London, England
• The Ritz, London, England
• Brown's, London, England

           ----------

• Scolfe's Tea Room, Boreham Street, England (superb, but not really afternoon tea)
• The Pump Room, Bath, England (also superb, but not really afternoon tea)
•  The Windsor Arms, Toronto, Canada
• The Fairmont Pacific Rim, Vancouver, British Columbia (this review)
• The Saskatchewan Hotel, Regina, Saskatchewan
• The Boathouse, Guelph, Canada
• The Grand Hotel, Eastbourne, England 
• Langdon Hall, Cambridge, Canada

These next two were unacceptable:

• The Royal Crescent Hotel, Bath, England
• The Queen's Hotel, Portsmouth, England

 

Is Multi-Culturalism a "Delectable Lie"?

Salim Mansur has recently published a book on multiculturalism, The Delectable Lie, published by Mantua Books. He was in Regina, Saskatchewan, last week, speaking about  and debating the topic with Khurram Awan. Salim Mansur is a professor of political science at The University of Western Ontario and, as regular readers of Eclectecon know, a good friend. Khurram Awan is an attorney who worked for a group of Muslims in their human rights cases against Rogers Communications, Maclean's magazine, and writer Mark Steyn. 

The deck was clearly stacked against Mansur, who has been described as a modern, moderate Muslim. There was virtually no advertising of the event at the university, despite my pleas that the event be advertised widely. And it appeared that about 80% or so of the audience was made up of friends of Awan.

Mansur's presentation focused on the contrast between 19th-century liberalism and many different cultures. He relied heavily on political philosophy, John Stuart Mill, and catch-phrases from the U.S. Declaration of Independence (probably a strategic error in presenting to a left-leaning, anti-US audience). He also cited incidents of honour killings in Canada and Pierre Trudeau's reported regrets about having supported multi-culturalism.

Awan focused on legal aspects, essentially saying that all cultures must abide by the laws of the land. 

I found the entire event extremely disturbing.

• Questioners were clearly hostile to Mansur and were allowed to make inappropriately long speeches themselves attacking him. One, in particular misquoted Mansur, misrepresented Mill, and attacked his reference to the US Declaration of Independence, all to audience nods and wild applause. 
• In response to all these questions, Mansur continued to emphasize that they would not be able to have these discussions in a country that doesn't value freedom as much as we do in Canada, and that is his concern. This point seemed to fall on deaf ears.
• When I asked Awan how to reconciled the freedoms of expression and religion when they come into conflict, he launched into a discussion of "hate speech", which was appropriate, and then mentioned "competition in the marketplace for ideas", a view to which most classical liberals subscribe. His only criticism of this view was that he thought Rogers had an obligation to provide a venue for opposing views so that this competition could take place. Afterwards, I took him to task for that position (not being allowed follow-up questions and not being allowed to make a speech myself). He admitted that he, himself, would feel no obligation to provide equal time for Mansur's views in his own speeches, but argued that Rogers had/has an obligation to provide equal space for people who oppose views like those of Mark Steyn.

Of course this is incorrect. When I called him on it, he alleged that Rogers has a monopoly in the media. Nonsense. The CBC and many other media outlets certainly provide support for views counter to those of Mansur or Steyn (or Ezra Levant, for that matter). Also, if the issue is one of monopolization of the media, that should be a Competition Policy issue, not a human rights issue.

• A Muslim woman complained that Corner Gas doesn't hire female comedy writers but that she is a writer for CBC's "Little Mosque on the Prairie." She somehow attributed her freedom to be a comedy writer in Canada to her Muslim faith, but the logic of that escaped me. Nevertheless, the audience applauded wildly. Once again Mansur's response essentially said that she is lucky to be in Canada, for surely Muslim women in other countries, where Muslim and Arab cultures dominate, would not have the freedom to pursue such interests. Again, the pithiness of this type of response seemed to slip right past the audience.

In Mansur's book, I am especially enamoured of his work on the clashes of freedoms. For example, on p119, he approvingly cites Dworkin's piece, "The Right to Ridicule."

The theme throughout his book is well-stated on p134:

Multiculturalism was promoted as a policy that would make for a tolerant, accommodating and peaceful society tending towards increased diversity as a result of open-door immigration policy. But tolerance of the intolerant, the accommodation of those who push extremism of one sort or another as the Islamists or the Khalistani Sikhs have done, under the cover of multiculturalism [EE: and, I would add, under the cover of "freedom of religion and charter guarantees] has amounted to the undermining of liberal democracy from the inside. This is the paradox of liberal democracy, its vulnerability resulting from its concerns to improve the conditions of living for its citizens and its commitment to remain true to its principles of freedom and individual rights even as some might want to subvert them.

As I blogged many years ago, when the freedoms conflict, freedom of expression must take dominance over freedom of religion. Otherwise intolerant religions will dominate.

Update: Here is yet another example of the clashes that can result as we try to work our way through the conflicts between various freedoms [h/t Jack].

Central Bank Lending and Favouritism?

Generally central banks are thought to be lenders of last resort in liquidity crises. But the U.S. Fed's actions during the liquidity crisis of 2007-08 seems to have been something different. Steve Williamson analyzes the Bloomberg data [h/t Gabriel]:

The three largest borrowers from the Fed during the crisis were Citigroup, the Bank of America, and the Royal Bank of Scotland. It seems widely recognized that the first two were essentially insolvent during the financial crisis, if not now, and the last one essentially failed during the crisis. Lending to these banks certainly does not appear to have been simple liquidity-easing.

This type of lending is NOT lending to help banks through liquidity crises. Rather, this type of lending (at 0.01% when the federal funds rate never dipped below 0.5%) is just a handout, an attempt to shore up otherwise insolvent institutions. I have a gut feeling that the Fed has over-stepped its mandate in these situations.

 

High School "Economics"? A tragedy in so many cases

A Facebook friend who is in high school wrote, 

Was just exposed to the most patronising, liberally biased video in class, which is being taught as fact. How is this allowed?

It was a 45 minute video about how we should feel bad for having more than third world countries and should therefore stop buying and producing things for ourselves until others have the same stuff as we do. I wasn't allowed to suggest alternatives. I was also told I was out of line for suggesting that perhaps this wasn't the best source we could have used.

To every student who faces this situation, and to every teacher who wants to consider alternatives, I have two recommendations.

First, read the famous Krugman piece about third-world labour, In Praise of Cheap Labour. It is a classic, very readable piece that points out how much better off workers are in the third world because we buy stuff that they manufacture.

Second, look for some Free to Choose videos by Milton Friedman. These are some of the best analyses, again at an accessible level, of policy formation that does and does not help poor people. 

 

A Drop in the Price of a Substitute...

It's straight-forward in introductory economics: a drop in the price of a substitute for good X shifts the demand curve for X to the left and leads to a reduction in the equilibrium price of X. Also if sellers of X anticipate that the prices of substitutes are about to fall, they will likely reduce their prices in anticipation of the drop in the prices of substitutes.

Here is an excellent example: Black Friday. In this case, X represents Canadian retail goods, and the substitute for which prices are dropping is US retail goods.

Today is not a holiday in Canada. We had our Thanksgiving back in early October. But because most of us live within a short drive of the US, many Canadians love to join the frenzy in the US and go shopping for bargains down there. 

According to a new poll by Angus Reid for UPS Canada, Canadian retailers can expect to lose one of every five shoppers to U.S. Black Friday-Cyber Monday discounts. Thirty per cent will be shopping for the holidays.

Merchants in Canada are responding by lowering their prices here; they are holding their own "Black Friday" sales, even though today is a regular work day for most of us.

Canadian retailers have good reason to be nervous today as the Black Friday phenomenon in the United States spreads further and runs longer.

Retailers north of the border are offering more of their own Black Friday deals, and more are getting in on the action.

... “If we can provide what [shoppers] are looking for on Thursday, then we may prevent a U.S. shopping trip on Friday, or at least get some of those sales at Sears Canada,” spokesman Vincent Power said.

Okay, you pedants, I realize that retailing isn't perfectly competitive; nevertheless, the supply and demand model works well to explain what is happening in this example.

 

 

Market Failure and Gubmnt Failure

As a result of the OWS and the walk-out of Greg Mankiw's introductory economics class at Harvard, many people have written many things. Paul Krugman has deferred to this article by Robin Wells. I find much to disagree with in her piece:

• She writes,

 Compared to past years, instructors need to acknowledge the limits of free markets earlier in their courses. Students should understand the difference between the conceptual importance of free markets and their real world limitations. Explain that much of the current economic distress arises from markets that don’t behave competitively -- the labor and financial markets.

But many of the problems over the past five years have arisen in part because of gubmnt regulations. Basel 1 and Basel 2 were regulations, designed by financial politicians. Also, Barney Frank et al encouraged the subprime market and the growth of mortgage-backed securities. And don't forget that the gubmnt bailed out Goldman, et al. indirectly by bailing out AIG.  If markets don't behave competitively, one important reason is gubmnt intervention in them.

• She writes,

 The dramatic rise in U.S. income inequality compels us as instructors to address it. 

This issue has been well-addressed by Ironman at Political Calculations, where he shows that personal income has, if anything, become more nearly equally distributed over the past 20 years. The growth in income inequality among households and families likely has more to do with demographics such as family formations, divorces, and assortative mating.

Further, to point to the gap in income between the developed and the developing world as something might be bad ignores the phenomenal growth in personal income brought about by trade in developing countries. Here, as usual, I refer to Krugman's wonderful piece on sweatshops, "In Praise of Cheap Labour".

• She writes,

 [I]nstructors who lecture on the superiority of free markets without acknowledging the dysfunction in the wider economy are at risk of appearing out of touch and exacerbating antipathy towards economics.

My reaction, in writing to MA about this was 

 "Instructors who lecture  on the failures of free markets without acknowledging the dysfunction of gubmnt and politicians are at risk of being out of touch with reality and exacerbating the seriousness of future crises."

If universities are failing, it is because there are too many professors in too many fields claiming to know what gubmnt should do to solve the problems of the world. If economists have a little humility and claim that while markets fail, so do "experts" and politicians, we should be lauded, not scorned, for providing balance to the typical elitism that passes for erudition at major universities.

Bunting, Baseball, and Probabilities

I  recently posted on Facebook that I was frustrated because Jim Leyland, manager of the Detroit Tigers, always (well, frequently) seems to call for a bunt when the lead-off batter reaches first base. There were two comments.

• a former student, knowledgeable about Moneyball, said, "it's called 'manufacturing runs'". I think he was jerking my chain.
• a friend from many years ago posted that he thinks Leyland doesn't bunt enough. I clearly disagree.

The source of my frustration with Leyland's tactic (which is well-known) is the overwhelming evidence that the average number of runs scored in an inning is higher when there is a runner on first with no outs than when there is a runner on second with one out. Put differently, teams are more likely, on average, to score more runs if they don't bunt!

Yes, there will be times when the batter at the plate grounds or lines into a double play or strikes out, and yes, there are some batters who are so bad that you'd rather have them bunt than strike out or ground into a double-play (which is why it often makes sense to have pitchers bunt in the National League). But overall, roughly speaking, in general, you're more likely to score more runs by NOT bunting than by bunting.

I can readily imagine that the probability of scoring at least one run goes up when a team follows the bunt strategy, but the main times that is important occur late in a game when the team needs one run to tie or go ahead. It doesn't make sense to reduce the probability of having bigger innings earlier in a game. 

Leyland is clearly a bright and good manager. But this is one aspect of his game where it might be nice if he read more MoneyBall or Bill James or Baseball Prospectus material. 

Sims and Sargent?

I am, quite frankly, mystified that the Nobel prize in economics was awarded to these two model builders. Their models have done virtually nothing to help us understand macroeconomics in any useful way. And in the Nobel Prize committee's write-up, the economists on the committee demonstrate some serious ignorance. What I have in mind is this statement:

This change was primarily a reaction to economic events during the 1970s, when the inflation rate increased due to higher oil prices and lower productivity growth.

What? Maybe those things precipitated the inflation, but the inflation of the 1970s and 1980s would not have been nearly so serious or persistent had it not be ratified by the actions of central banks everywhere who dramatically pumped up the money supply. Supply shocks by themselves do not cause persistent inflation; only monetary authorities can do that.

One important aspect of their work is that policy makers have reaction functions. But that was part of the growing literature of the era. I didn't particularly think they made a major contribution in that aspect of macroeconomics.

Sims and Sargent are both way smarter than I can ever hope to be, but I don't think their contributions to economics were all that great. 

Prices and Sustainability

I recently received a call for papers from The International Journal of Sustainability Economics. I am, to say the least, skeptical about the economics that appears in such a journal. 

At the beginning of 21^st century the sustainability concept was mainly a basis for developing policies consistent with a continued use of resources into the future without causing environmental crisis. But the situation has evolved, and the global economic crisis in 2009 was the ultimate consequence of short-term economic thinking. We need a new form of economic development, addressing the needs of the present without undermining the needs of the future. The International Journal of Sustainable Economy (IJSE)addresses sustainability issues within economic theory and analysis.

Every time I read things on sustainability, I am struck by how rarely people mention using prices to promote sustainability. 

If people are so convinced that we are going to run out of x, y, or z, I encourage them to buy up access rights and options to mine/harvest/whatever x, y, or z. If they are right, they'll serve two functions:

• They'll drive up current prices and induce others to use less x, y, or z, and
• They'll make a fortune for their progeny.

But nope. Most people who write about sustainability have all sorts of plans for how to interfere with the price system, plans for telling others what to do, and plans for imposing their own forecasts on others who don't share them.

I wish people who are concerned about sustainability would do more speculating and less preaching. I wish they would do more to encourage the use of prices and less to interfere with those very speculators who are doing so much to make sure we have resources for the future.

More on Gun Control

My gut instinct is to oppose guns and to favour gun control legislation. But gut instincts can be wrong.

Ever since John Lott and others started examining the relationship between gun control legislation and crime, I've had to put my instincts in check. The evidence seems pretty strong that jurisdictions that allow people to carry guns have less crime. As one street person once said, "Are you really gonna mug someone if you think they might pull out a gun instead of their wallet?"

Here is just the latest tidbit of evidence used by John Lott to support his position. Excerpts:

Murder and violent crime rates were supposed to soar after the Supreme Court struck down gun control laws in Chicago and Washington, D.C.
 ...

But Armageddon never happened. Newly released data for Chicago shows that, as in Washington, murder and gun crime rates didn't rise after the bans were eliminated -- they plummeted. They have fallen much more than the national crime rate.
...

In the first six months of this year, there were 14% fewer murders in Chicago compared to the first six months of last year – back when owning handguns was illegal. It was the largest drop in Chicago’s murder rate since the handgun ban went into effect in 1982. 

Meanwhile, the other four most populous cities saw a total drop at the same time of only 6 percent. 

Similarly, in the year after the 2008 "Heller" decision, the murder rate fell two-and-a-half times faster in Washington than in the rest of the country. 

It also fell more than three as fast as in other cities that are close to Washington's size. And murders in Washington have continued to fall. 

I would rather not believe the evidence that keeps piling up, but it is too overwhelming to ignore.

Some years ago, when I was president of the Canadian Law and Economics Associaton, I tried to persuade people to invite John Lott to be a keynote speaker. People objected that he was too controversial. 

 

The Flight to Safety?

According Bloomberg, US 90-day T-bills are pay zero interest right now. That's right, zero:

BONDS

U.S. 3-month	0.000%
U.S. 2-year	0.198%
U.S. 10-year	1.713%

Why on earth would people pay a dealer's commission to buy something with a zero interest rate for the next 90 days? Here are some possible explanations:

• The US economy may be in serious trouble, but for the next 90 days (even 2 years or 10 years, judging from these interest rates) people think the US is far less likely to default on its debt (or experience rampant inflation) than any other country. This is a flight to safety.
• Further, people expect that even though the US economy is in trouble, other economies (especially those using the Euro) are likely to inflate much more rapidly over the next 2 - 10 years. If their own currency suffers from inflation, then holding assets in US bonds will net them major gains in terms of, say, the Euro. If the Euro inflates more rapidly than the US$, then the US price of Euros will continue to drop over time. Shifting 100 Euros to the US might (according some people's expectations) lead to a return of 110 Euros two years from now if this happens, even if the funds in US$ earn nothing!
• Another possibility: some people think there has been a gold bubble. If so, they would rather earn zero (or very low returns) rather than suffer a capital loss from holding gold or other commodities. [think of the folks who lost small fortunes in the late 1970s when the price of gold dropped from $900/oz to $300/oz]
• Maybe I misread the Bloomberg charts. I admit to this possibility.

Nevertheless, my best guess is that people really are at their wits' ends and have no idea what might happen over the next 90 days, 2 years, or even 10 years. If the Euro crashes or if the Middle East erupts, in either case, US t-bills look comparatively safe. Note my emphasis on the word "comparatively".

So why don't more people put their money in Cdn T-bills, Aussie T-bills, etc.? 

My friend, King Banaian (presently a representative in the Minnesota house, and a fine economist) says it's because there aren't enough of these other T-bills for any of them to form a strong alternative to US T-bills. 

But I certainly would expect more positive action for Canadian currency and Canadian T-bills. As I wrote to my friend, Romero, this morning, I expect the price of the Canuck buck to rise to $1.10US eventually. But when and how long it will take to get there is way up for grabs. And meanwhile other things can change to affect this exchange rate.

Addendum: For more on the problems (and flight from) the Euro, see this. Excerpt:

Another current of gloom, slower-moving than the debt crisis but just as ominous, is also in full flow. The outlook for the euro-area economy is deteriorating fast, which augurs ill for attempts to wrest the finances of indebted countries under control. At best there will be a wrenching slowdown; at worst, a relapse into recession.

Put differently, if you are CFO for a major international firm, would you rather place some short-term funds in banks that might be in big trouble any day now because of their holdings of risky sovereign debt? Or would you rather just park the funds in US gubmnt t-bills. I can understand why lots of CFOs would take the latter option.

Sell Stock in These Firms? Why?

Jack recently sent me this link listing eight firms where employee morale is low. The title of the article is "Companies Where Employees are Losing Hope."  His email message had the subject line, "Sell if you have any of these." The eight firms are:

1. Best Buy
2. Research in Motion
3. Talbots
4. Hewlett-Packard
5. US Postal Service (can people sell stock in this?)
6. Nintendo
7. Cisco
8. Eastman-Kodak

But read the article to see why they are listed.

My response, relying on the Efficient Markets Hypothesis was: 

Oops. Too late. All the smart money and all the quick traders who had access to this information long before I saw it have already sold the stock. Many have probably even sold it short. As a result the share prices have probably, on average, fallen already to where they belong (in some fundamental sense), and there are no gains left for me to earn and no more losses for me to avoid. All this information (and more) is already captured in the current prices of these stocks. Furthermore, if I had owned any stock in these firms, I would already have suffered a capital loss. Selling now is likely to be no more profitable (or loss avoiding) than selling any other stock.

Which is why I advocate holding index funds for nearly all of us who want to have some equity in their portfolios.

Street Freak: Should Make for an Exciting Movie!

Several weeks ago I received a review copy of the book Street Freak by Jared Dillian. [note: I have no connection with and have never met Dillian, his publisher, his publicist, etc.]. My review will be slightly different from many of the reviews I have seen, in part because of my interest in finance and the recent financial crisis, and in part because of my background and training.

I was particularly intrigued by Dillian's perceptions and reactions to The Efficient Markets Hypothesis, [EMH]. I think the EMH is correct in the sense that markets tend toward its implications even if not instantaneously. For perhaps a better explanation of the EMH, see this. My own take on the EMH is this:

The general idea (for me) of EMH is that schmucks like me are unlikely to be able to beat the market consistently because by the time I receive new information and by the time I figure out what to do about that information, others who are much smarter and much more actively involved in the markets (e.g. people like Dillian) will have already taken advantage of that information.

And we see this theme emerging time and again in Street Freak. Early on, Dillian questions the validity of the hypothesis,

Theories on market efficiency had killed people's work ethic. If you can't beat the market, then why try? But you can win, I thought. The market can be beaten. ... This was the most passive, spoiled, unmotivated group of [people] I had ever come into contact with. [p 16. In all quoted passages, emphasis in the original, expletives altered in brackets].

Dillian was in a major investment bank (Lehman Brothers), where traders had up-to-date nano-second information on multiple terminals about the markets. That's a little different from the folks with a single terminal and a two-second delay in receiving information from the financial centres.

And Dillian would probably subscribe to some form of the weak EMH, as is clear from this:

... I was relieved that index arbitrage involved actual skill. This meant that the markets were, for the most part, efficient. ... Other index arbs around the street were bidding and offering futures, conspiring to limit the arbitrage profits of the other players. [p62]

Smart guys with up-to-date information bidding and playing against each other, driving prices to efficient points. But it is a process, not a fixed equilibrium. New information and new analyses move the equilibrium all the time.

I mentioned nano seconds above. Here is a good example of how Dillian exploited those time differences (thus forcing markets in the direction of the EMH all the more quickly):

Efficient market theory says that the arrival of news in the marketplace is immediately and perfectly disseminated, and no one person acting independently can get ahead of it. But I'd spent days watching this. The number would come out --- boink --- and for a split second, nothing would happen. This tiny period of time, a half second, maybe, was enough of a window for me to send out an arb basket and move the market before anyone else did. It was a delay that could be exploited (let alone discovered) only by someone with exceptionally fast reflexes and exceptionally acute concentration. [pp 89-90]

Of course once the arbitrage possibility became known, it was programmable. Computers could make the trades even faster, thus driving the market toward new equilibria that incorporate the information even faster. As Dillian says,

I realized that I was becoming a victim of technology. If both futures and stocks are traded electronically, you can replace labor with capital. You can instruct a computer to do a human's job. It would be a very basic program, one that an intern could write.

... The pit was becoming increasingly irrlevant. I was becoming increasingly irrlevant. I'd just gotten a job making buggy whips as the first automobile was rolling off the assembly line. [p140]

... It was clear that the arb had been turned into a robot trade, and we were the last holdouts trying to do it by hand [p145].

As long as there are people looking for opportunities, then deviations from the EMH tend to be narrowed. As an example,

I'd arrive at the floor in complete darkness, the streets deserted, and I'd check trades for breaks, buy/sell errors, and [goof]-ups.

It's hard to believe markets do not tend toward efficiency with traders like Dillian around.

Further support of the EMH comes from Dillian's work in the small cap [small firms] segment of the market:

...[There were] basically penny stocks that would issue a press release about some new government contract, and the stock would be up 1,000 percent in a single day.

[We] noticed that before these stocks would spike, there would be a small but noticeable increase in volume. We figured that this  was dirty insider buying. [Stuff] like this happened all the time; it was not uncommon for there to be a small increase in volume before a major news event.

Economists and others have long been aware of this phenomenon. And he is absolutely right. What is more, as he and others exploit this knowledge, markets move toward even the semi-strong variant of the EMH. 

My point with all this is that with traders throughout the market looking for angles to exploit, and with computers operating at the speed of light to execute the trades, it isn't surprising that many traders with access to quick information and gi-normous computing power can beat the rest of us in the market. Further, those same traders may sneer at concepts of the Efficient Markets Hypothesis, but they are the very ones, competing with each other, who drive us relentlessly toward it.

Of course that doesn't mean the EMH explains everything. I love contemplating how such a massive financial crisis like the last one could be consistent with the EMH. It just doesn't make sense. And I conclude that the EMH indicates tendencies, but it certainly is not the end all and be all of finance.

- - - - -

What about the rest of the book, though? I loved a couple of lines. For example,

Most people know thre NYSE as the friendly trading floor that they see on television, but what they do not know is that it is also a mean-spirited regulatory bureaucracy. [p207]

and

Human beings are not well-equipped to deal with randomness. [p263]

But overall the book was off-putting. It is an amazing story of a driven man who was non-Ivy-League but who became increasingly successful on Wall Street as a trader. His insights rival those of Michael Lewis in Liar's Poker. But Liar's Poker is much better written.

To be blunt, Dillian comes off as a bully, not as a careful chronicler. Even if he was a Street Freak during his days with Lehman, he shouldn't have written in that style for this book. Maybe it's just the academic in me, and the language and style of the writing evoked a kind of revulsion I didn't expect to find within myself. I know people talk like the quotes in the book. But Dillian isn't content just to quote all the expletives. He uses them at a high rate in his writing between the quotes, too. This style may capture Dillian's personality, but it is also distracting or worse [this all said despite the fact that I sometimes talk like that, even in my lectures, and I have been known to break a phone or two in anger, as Dillian seems to have done with some regularity]. If anything, I think this style is what put me off the book the most. 

At the same time, there is a straight-forward tale of his growing difficulties due to his bipolar condition and his obsessive-compulsive behaviour. Dillian's challenges as he worked his way through these conditions are insightful and touching. His wife must be an angel to have put up with his behaviour. But to start the book with a completely confusing rendition of his obsessive-compulsive behaviour is another turn-off. 

Despite these criticisms of the book, the story is good. And it is especially intriguing in light of the recent UBS $2.3billion losses resulting from actions of an index trader. 

The energy, the crises, the challenges all make good drama. I expect this would make a tremendous film. The language would be appropriate there, as would the transitions. I fully expect the film rights to this book to be worth quite a bit. I just hope they get good writers and a good director.

.

[note: both of these books are available in e-book format, my preferred method of reading these days.]

Some Important Facts about US Taxes

From John Lott, who points out what ought to be obvious about (1) double taxation and (2) which income groups pay what share of taxes:

[L]et's take a simple example. Suppose Warren Buffet invests his money in a company and that company earns $1. The company pays 40 cents in income taxes. If the remaining 60 cents is paid as a dividend, the 15 percent dividend tax rate leaves the stockholder with 51 cents, for a combined effective tax rate of 49 percent. The analysis is the same if the company keeps the money, raising the value of the company stock, and creating a capital gain. The rate would be higher if there is a state income tax.

 Mr. Buffett's secretary in Nebraska simply doesn't pay a 49 percent marginal income tax rate. When President Obama addressed Congress on September 8, he claimed that his proposals didn't amount to "class warfare." Of course, the president then went on to claim that the wealthy aren't paying their "fair share" of the taxes. 

But the wealthy are already bearing a much larger share of taxes than their share of income. For example, the top 1% of Americans in terms of earning might account for 20% of total income, but they already pay 38% of income taxes. By contrast, the bottom 75 percent of workers make 33 percent of total income and pay only 13.7 percent of income taxes. 

Is It Possible to be a Quasi-Libertarian?

I tend to think of myself as a libertarian or at least as having strong libertarian tendencies. What this means, I think, is that I recognize the gubmnt has important roles such as law enforcement, provision for contract enforcement and the common law, and (dare I say this) the provision of some sort of social safety net. But the problem with this last gubmnt activity is that it creates distorted incentives and opens the door for lobbying for increased gubmnt actions to raise the height of the social safety net. This is a problem, potentially, because the higher the social safety net, the lower are the incentives for people to prepare for and plan for different contingencies in their own lives.

Unlike many libertarians, I am willing to tolerate this problem to some extent. I am willing to use the force and power of gubmnt to require that we all become "our brothers' keepers" to some extent. But not much, especially when individuals choose to take risks of serious personal loss that they ought to know about and ought to prepare for (yes, this is a normative statement).

I was prompted to write this by a recent Bryan Caplan posting at EconLog, where he writes,

[C]ritics of libertarianism will never run out of empirically plausible "hard cases."  When faced with these hard cases, the best response we'll ever have is, "Charity can probably provide for the deserving poor.  Everyone else should live with the consequences of their actions - and stop blaming total strangers for failing to help them."

This conclusion of his posting captures my views pretty well. At the same time, I have little objection when the gubmnt provides some basic family welfare (e.g., beans have high protein content and will keep people from starving). 

Having said this, though, I'm not at all in favour of using gubmnt to force us all to help out all people who suffer calamatous losses. For example, consider those who lose their homes to hurricanes, floods, etc. These are clearly insurable risks, and it is beyond me that people choose to live in high risk areas without having adequate insurance. If the answer is that the insurance premia are "too high" (whatever that means), then I still see their choice to live there as a voluntary decision; they could have lived elsewhere.

In these instances, I support the role of (and indeed have contributed to) private charity to help people through the transition after natural disasters, and I have offered assistance to people who have maxed out their deductibles and co-pays for various unexpected calamities. And that is an important part of my quasi-libertarianism: private charity must step up, especially to the extent that gubmnt doesn't always do a very good job.

People Respond to Incentives: Divorce, Part II

Earlier I wrote how some couples in China were getting divorced so they could engage in more real estate speculation (here).

Here is another example of how people respond to incentives and seek a divorce:

I know a young couple with several children. They have been separated for a few years, but hadn't bothered to get a divorce (essentially the transaction/legal costs, even in an amicable divorce, outweighed the expected benefits, so they hadn't bothered). 

Some years after their separation, they looked into providing orthodontic care for one of their children. It turns out that the conditions of their respective health/dental insurance policies will not let them use the benefits from both parents' policies to help defray the costs if they are married, so they are finally getting divorced so they can apply the partial benefits from both policies toward covering the costs. 

This is an odd situation. Most health insurance policies require that the insured submit a claim first to one company and, if that policy doesn't cover everything, then to the second company. Apparently that is not the case for the companies insuring these parents.

I haven't read about or heard about other types of responses to these health insurance policy conditions, but I have to wonder whether some parents might get divorced just to cover orthodontic and other health and dental care costs from their policies in this fashion. 

More Evidence that Demand Curves are Downward-Sloping

Netflix increased its prices. And whaddya know.... subscriptions declined. We teach it all the time: an increase in the price leads to a reduction in the quantity demanded.

The customer backlash against the higher rates, kicking in this month, has been much harsher than Netflix Inc. anticipated. That prompted management to predict Thursday that the company _the largest U.S. video subscription service_ will end September with 600,000 fewer U.S. customers than it had in June.

So what really happened was that Netflix executives know that demand curves are downward-sloping --- they expected some drop-off in subscriptions. But they underestimated the price elasticity of demand (econ-speak for how responsive the quantity demanded would be to a given increase in the price). 

One reason for the drop-off in quantity demanded is that people will rent or watch fewer movies. But another reason, one which will affect Netflix even more in the longer run, is that their higher prices open the doors for even more competition than already exists. From the same article,

This could be an opportune time for would-be rivals to attack Netflix's streaming service too, BTIG Research analyst Richard Greenfield wrote in a Thursday blog post. Internet retailer Amazon.com Inc. launched a free streaming service for subscribers to its two-day shipping service earlier this year. Greenfield and other analysts believe Google Inc., already the owner of YouTube, is eager to expand its Internet video offerings to include more movies. One way Google could achieve that would be to buy Hulu.com, which has been put up by for sale by the television network owners that supply its video content.

This provides another good example in which the price elasticity of demand (responsiveness to price changes) will be greater in the long run than in the short run.

Broken Windows and Auto Accidents

I spent 45 minutes teaching the economics concept of opportunity costs to my intro students recently, including going through an example of trade-offs and environmental quality, explaining that (given scarcity) the optimal amount of pollution is greater than zero. Then to see if they grasped the concept, I asked "What do you think is the optimal rate of automobile accidents?"

One of the students said "zero". 

I pretended to push a button, said, "buzzzzz. Thank you for playing. We have nice parting gifts for you after the show."

I asked the rest of the class, why the optimal accident rate is NOT zero.

First answer (which shows how poorly I teach this stuff, I guess): because auto accidents create jobs for people in auto repair shops. 

I wasn't expecting to teach Bastiat's famous Broken Window Fallacy at this point in the course, but what the heck, why not? so I did:

• Yes, the auto repair guy received more business, but if the people in the accident didn't have to spend the money on auto repairs, they'd have it available to spend on something else. Having to spend it on auto repairs actually reduces the demand for lots of other people's services.
• If you really think having auto accidents is good for the economy, let's go out and smash up a bunch of cars! If one is good, surely more is better!
• The main point: it ignores opportunity costs. The scarce resources that go into auto repair could have been used to produce something else. Using those scarce resources to increase the demand for the services of some identifiable workers slides us along an opportunity cost curve and means those resources are not available for use elsewhere in the economy.

hmmm. I wonder how many of the students actually believe the stuff I try to teach....