Back to the tax

It’s time to pull our knowledge of economic surplus together and realise the point of our previous articles. We've seen how taxes reduce surpluses and how the loss is shared between consumers and producers. But how this loss is shared depends largely on the type of product being taxed. Some goods are extremely important to us, and even if prices rise we tend to keep purchasing them. What would this demand curve look like?

Figure A shows the relationship between the price consumers must pay for an important good (lets just call the good e for now ;- ) and the quantity of it they buy. The main take away is that even if ‘e’ almost doubles in price from $5.00 to $9.00, consumers still purchase one ‘e’. The mathematically inclined will notice that an 80% increase in price only results in a 67% fall in the quantity purchased, but the intuitive qualitative understanding of what is going on is more important. Lets compare this to a less important good.

What about when we go out shopping for 'Alpaca Woven Foot Loofahs'? Do we act the same way? I'm gonna go out on a limb and say that an Alpaca Woven Foot Loofah is a luxury, and as the price goes up we quickly stop purchasing them in favour of cheaper alternatives. If the touch of treated alpaca fur on your skin is a daily staple you couldn't do without no matter what the price, well humour me and read on. Figure B shows a demand curve where the relatively meagre $1.00 increase results in a drop in the amount of Alpaca Woven Foot Loofahs being bought by 18. A 20% increase in price results in a 90% fall in loofah purchases.

Now what’s the first kind of good we think of when we think carbon tax: electricity! Which is a pretty good example of a product we can't go without. It is said to have low price elasticity of demand, because for a given change in price, demand will change very little, like in Figure A. So what happens when a tax is put in place?

Before we see that, lets first have a look at high elasticity markets and tax. Figure C shows your average Alpaca Woven Foot Loofah market, where ten loofahs are bought for $5.00. Note the elastic (ie flat) demand curve. Remember from How Labor’s new budget is going to reduce our surplus that the area above the price and below the demand curve is consumer surplus, shaded in red here. Because the supply curve represents how much it is costing producers to put together the next loofah, producer surplus is the area above the supply curve and below the price they are receiving, shaded in yellow.

Just as we did with cars, we are now going to throw in a tax. Enter Figure D. For every Loofah that trades the government will take sixty cents, and after buyers and sellers haggle with one another in the marketplace, they finally decide upon a price and quantity that suits both parties (producers and sellers that is). Unfortunately for the tender feet of several participants, the economy enjoys three less loofahs. However if you look closely, you’ll notice that consumers took a relatively small hit (that hit being represented by the purple slice).

Now sure consumers enjoy less loofahs, and those that still purchase loofahs must pay a higher price, but comparing consumers' surplus before the tax to consumers’ surplus after the tax (red shade) there isn't a great deal of difference. Producers’ surplus on the other hand (yellow shade) took a beating. Selling less loofahs at a much lower price has resulted in a relatively large chunk of producer surplus disappearing (the dirty brown colour underneath the purple). Of course the ever present winners take the tax, represented by the blue colour, which while equalling a loss to the private sector, is spent efficiently and equitably by government on public goods, so is not supposedly a loss to society.

Figure E is where it starts to get relevant. Our electricity demand curve slopes downward steeply, representing our inability to switch to substitute products when price rises. As before the red is consumer surplus and the yellow is producer surplus.

Throw down a $6.00 tax per good and you've got Figure F. This time you can see that the loss of consumer surplus (purple area) is much greater than the loss of producer surplus  When producers sell a product that people can’t do without, the burden of the tax is borne predominantly by consumers.

This is the complicated economic way of saying that if we really need a good, companies can raise the price of it without fear of people substituting the good for something else (or just going without). When companies costs rise due to the tax, the tax will be passed onto consumers. I began the previous article noting that politicians have been running their mouths about not letting companies raise prices too high (whatever that exactly means, but that’s an article for another day) due to the carbon tax. The reason I have taken you through the painful process of mapping it out graphically is to really show that companies raising prices and stickin' it to the consumer IS THE ECONOMICALLY EFFICIENT OUTCOME, AS PREDICTED BY MAINSTREAM THEORY TO BE THE NATURAL AND REQUIRED ORDER. There is no politically engineered spin that can turn this into roses. Just as nature intended electrons to gravitate towards one end of a water molecule, the tax is supposed to raise prices and it is supposed to be borne by consumers (us economists love to pretend we’re physicists). This string of articles makes no points for or against a carbon tax, but I hope it cuts through the spin, and shows what all those who are enlightened (including political economic advisers) already know.

Producer surplus

Consumer surplus

Carbon tax

Price increases

Time to take out the trash

I’ve been spending some time thinking and writing about things that no-one else is currently talking about, which is terrible for generating page views on your blog but good for making prudent investment decisions. Today however we won’t be doing any investment analysis; we’ll just be taking out some of the political garbage spoken by politicians of late. By now the carbon tax has kicked in, people have received their first compensation payments, we’ve started paying bureaucrats to take money from polluters so they can give it straight to us to pay the higher prices  being charged by polluters because bureaucrats are taking money from them to give to us to compensate us for the higher prices polluters charge because they are being taxed to… etc (see here), and businesses are starting their first round of defensive excuse making about why prices are rising. Now why would they do this when the whole point of the tax was to raise prices?

The government gave them some incentive when they made threats to companies about how raising prices higher than the tax necessitated would result in harsh reprimands, and also that the government has any hope in hell of proving that such a tactic was in play. Needless to say trying to scoff laugh and swallow my cereal all at once resulted only in quiet choking sounds as I witnessed this most pointless of comments on Sky News Business. Businesses now are covering there backsides in case the government is stupid enough to believe its own threat and tries to prove a price hike was "blamed" on the carbon tax. The truth is, businesses don't need to make up excuses to raise prices; Adam Smith (to whom we pray at night as the father of modern economics) provided one that has been accepted by all schools of economics from day one. Now hold ya breath.

Of course the whole point of the tax is to raise the price of 'polluting products' for consumers and reduce the revenue that producer’s receive for them, giving both the incentive to buy and produce less of the product respectively. In How Labor’s new budget is going to reduce our surplus we looked at this process in detail, and you’ll notice that in that example the “losses” we’re shared out relatively evenly. By this I mean that after the tax was implemented, in the resulting equilibrium, the consumer had to pay an extra forty cents for each car, and the supplier received forty cents less for every car he sold. However this isn’t always so. By changing the shape of the curves (or lines in our example) we can see how the gains and losses from government intervention are shared by producers and consumers. Hold tight…

Political greasing, Quantitative easing, Goose teasing and Society's fleecing

Not only have bankers turned ordinary paper to gold, they bred a golden goose, trained it into a lean, mean, money printing machine, then paddled it silly for ten years. Somebody call the RSPCA. Finally the poor old duck got a decade down the racetrack and simply gave out.

Long live the goose.

For several years alarmists have been screaming about how hyperinflation is going to engulf the world because of the unrestrained money printing being undertaken by Central banks around the world. And let’s face it, most of what I’ve told you says that money printing only begets inflation, at least in the long run. But whenever I talk about money printing and inflation, you’ll notice I always explain it not with an abstract equation involving unannounced assumptions, but in terms of the sequence of events that leads to inflation. In Is Gold a good hedge against inflation I talked about people banging down doors with the copious amounts of extra money in the economy and overwhelming suppliers in the economy. When talking about the other side of the money supply/interest rate coin, I highlight how increased money supply lowers interest rates, enticing borrowers to spend more, overwhelming suppliers from the other side. These are all based on an “all else equal” scenario, designed to isolate the one factor we want to analyse (a change in the money supply) and see what happens if nothing else changes (if you want to dazzle your friends with some fancy Latin, us the phrase “ceretis paribus”: all else being equal). However, something has changed, and it’s this change I want to talk about: banks have stopped lending.

Now that we’ve seen the phenomenal affect that bank lending has on increasing the money supply in Has the printing press lost its value, we can appreciate how hard it is to increase that money supply by a full percentage point when lending breaks down. If banks decide to stop lending as they do in Textbook Land, then the money supply only increases by the amount that the Federal Reserve prints. To increase the money supply by ten percent the Federal Reserve actually has to print ten percent of the value of the money supply.

I could give you some patronising physics style analogy that doesn’t really shed any light or comprehension on the idea; something like, travelling 39,900,000,000,000km to our nearest star would be like travelling 3,652,000,000km to Pluto and then back again 5463 times. Thanks for that. I could work out some ridiculous scenario aimed at making me feel smart and you feel dumb, so will:

If you took the money required to be printed to increase the (M2) money supply three percent (in June 2012) laid it end to end and walked across it to Pluto and back four times (using fresh dollar bills every time for your delicate feet), then walked one thirtieth of the way to Pluto, thought what a stupid idea it was to be doing this, and walked back to Earth (always laying fresh dollar bills as you go), then decided you didn’t like it on the Gold Coast (Australia) and walked across a new dollar bridge to Vegas, you would still have half as much money as Warren Buffet. Our interstellar travel analogy not doin it for ya?

Better yet, if you went straight to Vegas and hit the strip clubs, once Misty Star had enticed all your dollar bills from you, if she went straight to the bank to pay off her student loan, she handed all the dollar bills over with her nimble fingers at the blistering rate of 100 bills per minute (wonder where she honed those skills?) it would take her 186992 years to hand it all over. And she would have the record for most expensive university course ever undertaken in human history.

Now if that has complicated the matter and confused you well good, that is the purpose of physics analogies (to take something complicated and make it more complicated). What’s important to understand is why hyperinflation has not taken flight however.  If banks in Textbook Land refused to lend, although the amount of physical cash in the economy can be increased as it is printed by the central bank, the actual increase in the money supply is meaningless: a statistical discrepancy in a world where big numbers must carry 18 zeros on the end to even begin to impress the female numbers. If the money were not lent out, inflation would be near impossible to engineer. (be aware that this is still an analogy because the fed doesn’t actually print money, but the problem with electronically crediting banks’ accounts with money is the same, they won’t lend it or their will be no demand for loans).  Another way to think about this sprouts from our understanding of why money printing begets inflation from Is gold a good hedge against inflation. When the central bank prints money, the amount that people want to save is assumed to be unchanged (ceretis paribus) so when they have these extra balances, they spend them (banging own shopkeepers doors). However people are currently afraid and the amount they want to save has increased (the amount they want to borrow (the opposite of saving) has certainly decreased) so they are hoarding the extra printed money. All else is not equal! You can see now how quickly a printing press loses its ability to reduce the value of the money you hold in a recession. Sometimes it might be hard to stop your money from GAINING value (god forbid) as prices fall.

It’s hard to believe that it is the same species to put a man on the moon, and who conjured such ingenious inventions such as money, then went and gave someone the right to print as much of it as they want (the only thing that could destroy it!) and this person only gets worried when they lose the ability to devalue money. As discussed in The evil, ever present, value eroding effect of inflation on...Gameshows, what money creators really fear is deflation. I praise our modern society highly for its triumphs, and I certainly don’t have a better one: but I do worry that one day some advanced alien race will stumble upon the ruins of our long dead society. Surveying the landscape for any remnants of our civilisation which are doomed to define us, little remains. They scout the foreign landscape, only to find a World War 2 picture book, a Steven Segal film, that episode of Southpark where a four storey anal probe emerges from Eric Cartman, something that says there are 16 seasons of Southpark, a Midnight Oil music video, and a macroeconomics textbook. I only hope they can’t read our writing.

Has the printing press lost its value?

I’m hoping that right now you’re asking; “How can something that prints money not be valuable!?”  If you’re like me and you find the ridiculous paradoxes erected by us human beings in our all too regular bouts of absolute insanity, you’ll be interested in this one. What follows is a relatively brief explanation of a theory called the money multiplier, which has been explained to death on blogs already. More interesting is the analysis that follows of why it is faltering.

Fractional Reserve Banking

If a country decides to start its own currency, it can print off $1000 (it could choose any amount, but this country thinks $1000 is a nice round number) and give it to the country’s citizens, making the money supply $1000. Some citizens will put the currency in the bank and some will spend it. The money which is spent would then be in the possession of other citizens, some whom will put the money in the bank, and some who will choose to spend it. Eventually it is likely that all the money will end up being deposited in the bank. Never-the-less the money supply is still $1000, all of which is now in the bank. What happens now is that the bank keeps some fraction (lets say one tenth or ten percent) of the deposits and lends the rest out to borrowers. The people who deposited their money at the bank still believe (rightly so) they have their money, which totals $1000, but now the bank has lent $900 out to people who believe (rightly so) that they have this borrowed money. So the money supply now totals $1900. This is the magic of fractional reserve banking. If the borrowers of the bank’s money (and I use that apostrophe lightly) somehow got into financial trouble and couldn't pay back the loans, the depositors would lose their deposits (all but ten percent of them anyways). The process does not stop here though. The newly borrowed $900 is spent by the borrowers with some other citizen, who will now either put this money in the bank or spend it with someone else who might put it in the bank. Eventually all $900 of the borrowed money is likely to find its way into the bank again as deposits.

Once the bank sees these new deposits enter, it will keep ten percent of them ($90) as reserves, and lend out the remaining $810. The money supply now consists of $1900 in deposits people believe they have, plus the $1710 that borrowers believe they have. The $810 of new loans is spent and eventually finds its way back to the bank again, where ten percent of it or $81 is kept as reserves and the remaining $729 is lent out. Each time a smaller amount is lent out, resulting in a smaller amount coming back in as deposits, and a smaller amount being lent out again during the next round. Eventually the whole process peters out and the money supply will have ballooned from the original $1000 printed by the central bank to a whopping $10000. The beautiful part of the maths is, you can still just print a three percent increase in the physical notes and coins, and they will go through our fractional reserve banking process and result in a three percent increase in the money supply. It is called the multiplier model because you can derive a simple formula that spits out a number which you can multiply the monetary base by to give you the total money supply.

A lot of people realised during the GFC that when you put your money in the bank it doesn’t stay there. Banks loan out most of it so that they can charge interest. They give you a little less interest on the money you deposit with them, and the difference is their profit. Banks only keep a tiny fraction of the money deposited with them in their vaults unloaned, and this is so they have some cash on hand for the few people that actually want to withdraw some funds during the day. This is why it is called “fractional reserve banking” and the existence of this process became increasingly clear to people during the GFC as they realised that if these loans couldn’t be paid back, then the money they thought was safely at the bank would disappear. What’s more interesting than this is the recent breakdown of this multiplier mechanism and the relative helplessness this has thrust upon the central bank in its attempts to fan some inflation. That’s the topic of our next article.

Fractional Reserve Banking

Money multiplier

Loans

Deposits

Greek exit: Good or Bad?

Most politicians and fund managers would have you believe that this is a question with an obvious answer (the kind bloggers love) but it is enlightening to envisage some of the different scenarios that might play out and their effects. While it is unlikely that Greece would leave the Euro without defaulting on its debt (one might ask: why did they even leave) it does raise some interesting economic concepts. There is no orderly protocol for a nation leaving the Euro (fine planning by politicians there) so no-one really knows how it might happen.

First of all, why might Greece decide to leave the Euro? We’ve already discussed one reason, so it can go back to the Drachma, and be in control of its own printing press. This way it can lower interest rates by printing money to stimulate the economy. Running the printing press will also depreciate the Drachma on the foreign exchange markets. This occurs because, all else being equal, the lower interest rates will lessen the demand for drachma by savers who would prefer the currency of other countries with higher interest rates (wouldn’t you?). Banks of countries like Australia, who have high interest rates, will only accept Australian dollars as deposits, requiring anyone with Drachma to sell them for Australian dollars so they can deposit them here. The upshot of this is that Greek exports will become cheaper which will stimulate growth. Greece’s tourism industry stands to gain immensely from exiting the Euro (about as much as it suffered from entering the Euro).

Quick recap:

and my quips run low like a deflated bag of Homer Simpson's potato chips.

So why not exit you ask? Might it be easier to pay the debt back with a depreciated currency and a booming export sector. Probably not. If Greece leaves the Euro its debt would still be denominated in Euros, and every percentage point drop in the exchange rate will result in a percentage point increase in the Drachma value of the Greek government’s debt. Instead of reducing the real value of the debt, as we talked about in the Wall Street investor accomplishes what the alchemist could not, printing money actually works against you when the debt is denominated in another currency. If the Greek government promised a fifty Euro coupon (or interest payment) per year when they issued bonds and borrowed money (have a look at The wonderful Central Bank of Oz for a recap on how bonds work) holders of Euro denominated Greek debt will still want fifty Euros. However, once the Drachma has fallen in value, the Greek government will need more Drachma to trade for each Euro, in order to pay the coupon.

How far it falls is anyone’s guess, but Russia’s debt default and peg removal resulted in the Rouble losing sixty percent of its value in a month and in Mexico in 1994, abandoning the US dollar peg resulted in roughly a fifty-five percent plunge in the Peso. Differences between these crises and Greece’s abound, the primary one being that in 1994 Mexico was the only economy that required saving. Default was only avoided when the US provided loan guarantees and this path to a happy ending seems unlikely with most governments already mired in debt. In addition, Russia and Mexico had been running the printing press that Greece doesn’t have for years, which is a positive for the Drachma. However Russia and Mexico were also oil exporters, who benefited from the punished exchange rate in this way (and arguably from oil price recoveries thereafter). Greece is an oil importer, which brings us to more downsides from exiting.

The newly demoralised and devalued exchange rate for the Drachma that Greek people use to purchase goods overseas will be, well… devalued. The price of everyday items will soar. Not everyone realises that oil is used in a lot more than just your car these days (it would be easier to list what doesn’t contain oil). There’s petroleum in everything from frozen food packaging to your toothpaste! Plus of course oil is involved in getting these goods from A to B. Needless to say Greece’s dependence on foreign oil (priced in US dollars) renders it extremely vulnerable to inflation from a depreciating currency.

The ultimate result of an exit will depend on the relative strengths of these basic economic flows as they compete with each other. How they pan out exactly will depend on millions of different variables (most of them running around Greece) which is much too complicated for my humble brain to comprehend. Making money will be about going one step further than these basic economic tools, and seeing the frictions that result in their breaking down. Are the tourist spots that stand to gain so much in remote areas where the government will have trouble enforcing the tax laws (I’d be interested in people’s opinions and knowledge)? Higher incomes for Greeks don't necessarily mean higher income taxes for the Greek government.

Be wary of hidden bias in the opinion of those who focus on the negatives of a Greek exit, and tout that the only happy ending involves Greece remaining in the Euro. Vote hungry politicians and leveraged up hedge funds will take most of the short term pain when Greece exits. Those in cash have the most to gain. People often forget the obvious advantage of defaulting on your debt, and that is that you are now debt free. And investors have short memories: our traumatic economic cycles and repeated mistakes are a testament to that. The episodes in Russia and Mexico are now confined to the history books, rarely bought up but for the nostalgic pleasure of stuffy old blogs. Sure the fallout from the Greek default and Euro exit will be painful in the short run, but I just can’t see us talking about it in five years time, let alone the twenty-five it will conservatively take Greece to get its debt levels under control. Some savvy investors are salivating over the possibility of a debt default, so they can swoop into the resulting carnage and enjoy purchasing good businesses at great prices. In five years time this will just be a rarely quoted episode in history for most and a fond memory of excellent investments for others.

“…the Wall Street investor accomplishes what the alchemist could not – creating gold from dross, real wealth from mere paper…”

A clever and insightful quote from William Greider in his book “Secrets of the Temple” but not entirely true. As we have learnt, in the long run money is worth not the number that is printed on it, but what it can be traded for, which gets smaller over time. A printing press has value not because it can print valuable money, but because it can reduce the value of money.

Paradoxical, scary, and true. One of the primary reasons that the Eurozone is in trouble of breaking apart is that each individual economy doesn’t have its own printing press with which to create its own currency. Is gold a good hedge against inflation and The Wonderful Central Bank of Oz highlight how increasing the money supply can stimulate the economy by reducing interest rates. But with some countries booming (like Germany) and others in recession (like Greece) how much money should you print? The Germans are worried about inflation while Greece is worried about deflation. The reason that Germany can’t have high interest rates while Greece has low ones is actually the same reason that China can’t have high interest rates while America has low ones. When Greece uses the same currency as Germany , it is the same as the both of them using different currencies, but having them pegged to each other at a rate of one for one (see What have China’s money supply and America’s money supply got in common).

Vast economies like America have the same problem of booming states and floundering ones, but taxes are just paid to the government and California doesn’t care if their tax dollars are used to help stimulate Ohio. German taxpayers on the other hand are much more apprehensive about their tax dollars being spent to help the Greek economy, particularly when accusations of tax evasion are so rife in Greece.

The printing press has a less well publicised part to play for indebted governments. Part of the reason why the US has thrown the inflation textbook out the car window and printed copious amounts of money is because even if inflation gets out of hand, it will erode the value of the government’s debt. This was illustrated in Can the Federal Reserve “Really”affect interest rates. If the government borrows $50 billion (in debt) then spends it, it has an incentive to induce inflation. Once money is printed, fast forward to all else being as it was, except prices are now higher (see What’sthe scariest thing out there at the moment for a quick look at what we’ve “yada yada’d” here). Sales taxes are now higher because they are based on the actual prices of goods. You might not think of your wage as a price, but they are most certainly the price of your labour to your employer, and wages rise with money printing too (think lobbying labour unions). This means your income is higher so you pay more income taxes. So the government’s income is higher, but the one thing that has not changed is the value of the government’s debt, $50 billion, and its interest payments. This makes it easier to cover the interest payments and the real value of the debt has fallen.

Without a printing press however, Greece is doomed to be accountable for its actions and honour the full value of its debt. Unless of course it just plain defaults.

Don’t worry, we’ve just begun digging around in this tangled forest of politicians and summits for the real economic deal.

Euro-zone
Government debt
Greece
Inflation
Taxes

How many light bulbs does it take to change sentiment in the Euro-zone?

Meeting after meeting has transpired since the beginning of the Euro-zone crisis (whenever exactly that was) and very few original ideas have emerged. For all the first class airline tickets to Brussels, all that we really have are statements like, “We will not let the Euro-zone fall apart,” and “We will concoct a plan for Spanish banks.” Yet that is all the market seems to need for a rally. It’s about time to write an article on Greece.

When you’re listening to the hyperactive news presenters on sky news business in the morning screaming about non-events that occur in time frames of months, weeks or even days, it’s easy to forget that the real economic events unfold over years, decades, and generations. The outcome of the next taxpayer funded Eurozone gabfest in a few days isn’t that important, but it is important to step back and realise that the best case scenario they are talking about (Greece remaining in the Euro and paying back all its debt) will not occur over a timeframe of months, but we will still be talking about it in TWENTY YEARS! It really puts into perspective the talk you heard this morning, the sell off on Monday, the slight recovery over the rest of this week, and is almost enough to make you turn off the television and wonder why you should care. The fact is you probably shouldn't.

The real point of the title is just another reminder that sentiment will always rule the market, and real game changing ideas and plans will be very far and few between (especially when politicians are involved). Do not get side tracked. Let’s say that tomorrow the Greek economy starts growing at three percent. If spending by the Greek government doesn’t grow at all (except to account for the different amounts of interest it pays as the debt levels change) then at the 3.5 percent interest rate associated with the last bailout package, Greece will have a more acceptable debt to GDP (or income) ratio of sixty percent not on Monday, not by October, or by the end of the year, but in 2035. As the media tries to convince you that day to day affairs are so important that you must switch on every night to hear the latest developments, it is often omitted that the real timescale of the current crises is measured in decades, not minutes. This is exactly what Warren Buffett has alluded to: that if you buy the right stocks, you should be able to switch off for a decade and be reasonably safe, or more precisely: if the stock market closed for ten years you should feel comfortable holding the stocks you’ve bought. The numbers are purposely oversimplified to exaggerate the conservatism and so that the broad message is easy for you and me to understand: the time frames involved are huge.

Of course there is one thing that could abruptly alter this time frame, and that is if the best case scenario doesn’t play out, and Greece defaults on its debt and/or leaves the Euro. With all the government intervention and media attention one might wonder whether economics is playing a part in markets at all, but the mess will still provide us with plenty of intellectual economic stimulation.

Greece
Euro-zone
Bailout package
Mainstream media