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

How Labor’s new budget is going to reduce our surplus

Today I will once again digress from our macroeconomic analysis for some opportunistic politician bashing. As July 1^st fast approaches, it’s becoming less and less likely that even our acrobatic Julia Gillard won’t be able to pull off the super backflip required to repeal the carbon tax. I was hoping I wouldn’t have to do this, but through some crafty economic graphing we can show you EXACTLY how the government is wasting your money. It’s not often that you can promise that. Once businesses have to pay a tax on their carbon emissions, they will inevitably raise their price to cover some of the cost. That’s not what this article is about. The government plans to use the money raised by the tax to reimburse households for the increase in prices that will occur, so it is often touted that overall, no one will suffer. This is of course rubbish and here’s why.

If you don’t like graphs and numbers don’t worry about the colourful pictures underneath. All that you really need to understand is that: the demand curve slopes downward (because as the price goes up, we as consumers tend to buy less of a good) and the supply curve slopes upward (because as the price goes up, those greedy producers tend to want to sell more). You can see from graph A that at $8.00, people will want to buy two cars ie two cars will be demanded, and further down the demand curve, if the price were only $6.00, four cars will be demanded. The supply curve in graph B works the same way but in reverse. At $5.60 suppliers will only want to sell 3.6 cars, but at $6.00 they will supply 4 cars. (note however that the three demand curves in the graphs A, B and C are all the same ie based on the same equation, and all three supply curves are based on the same equation). Of course only one price and quantity can arise in a market, and buyers and sellers get together and decide on the price that results on the same amount being supplied that is demanded. That price on our graph as you can see is $6.00, where four cars will be sold in our market.

What’s important to notice for the purpose of implementing a tax, is that some people would have bought a car even if the price of the car was $8.00, and those people have only had to pay $6.00. In fact, based on the demand equation used, if the price of a car were nine dollars, one car would still be bought, implying that one person values a car at nine dollars. If the price were eight dollars, two cars would have been bought. Yet all these people only had to pay $6.00. This excess of “value received’ over “amount paid” is called, oh yes; consumer surplus, and you can bet by the end of this article, I plan to convince you that labor’s carbon tax is gonna reduce it. One way to calculate consumer surplus is to work out at each price how many cars would be sold, and calculate how much extra value was received above the six dollar price that was paid. For example if the price were nine dollars, one car is sold (implying it was valued at nine dollars) and six dollars was paid for it, meaning an extra three dollars in consumer surplus was enjoyed. At eight dollars, one more car would be sold, meaning this car (valued at eight dollars) provided a consumer surplus of two dollars. Doing this for every price will allow you to calculate total surplus, however a better way is to calculate the area underneath the demand curve, but above the price. This is the green shaded area in Graph A, and is equal to $8.00 (the fact that this equals the $8.00 highlighted on the vertical axis is purely coincidental).

In graph B you’ll notice that even if cars were sold for only $5.60, producers of cars would still wish to sell 3.6 of them, yet at the market price they are able to receive $6.00 for each car. As you can see, these producers are receiving a producer surplus of forty cents. Producer surplus is worked out by calculating the area above the supply curve but underneath the price: the yellow area in Graph B, equal to $8.00.

One of the cool things about having studied economics is that you know the true “value” being traded in a market is not just the price of a good multiplied by how many are sold. It’s not gonna get you laid or anything, but it does gives you a useful tool for analysing the costs and benefits of a lot of government intervention. The effect of a tax is to put a wedge between the price that buyers pay and the price that sellers receive. The government pockets the difference.

Assume the government decides to put an eighty cent tax on every car sold. With a bit of algebra you can work out that, based on the demand and supply curves we used, the price that buyers pay will be $6.40, and the price that sellers receive after the tax is $5.60. 3.6 cars will be sold, and what you end up with is a pretty little picture that looks like a triangle house with elevator doors (in Graph C). At the higher price, less cars are demanded by consumers, and the lower price received by sellers (after paying the tax) means they wish to supply less cars. The resulting equilibrium in Graph C shows how consumer and producer surplus have both shrunk to $6.48. The grey area is represented by the tax collected by the government (eighty cents multiplied by 3.6 cars). The reduction in surplus results because at the higher price for consumers, some people won’t buy a car (and hence won’t have one), and at the lower price received by suppliers some won’t sell a car (and hence receive money for it). This area is highlighted in Graph C, in that most relevant of all colours, red. The total loss in surplus is equal to sixteen cents, or one percent.

Now we usually put up with some loss of surplus due to taxes because the money raised can be used to provide useful goods and services that the market generally won’t produce (roads, schools etc). However when all the government is planning to do is give the money back, the reduction in surplus is for nothing! This just goes to show that while in economics you can never get something for nothing, in politics you can have something taken away, and receive nothing in return. Such is the magic of government intervention.

So don’t let some polarised one minded labor lacky (and I know liberal has them too) tell you that just because the government is giving the money raised by the carbon tax back that no-one’s paying. We’re all paying. And that’s before you take into account the hundreds of thousands of dollars of administration costs wasted on operating a pointless tax. The next time they tell you how important it is to return to surplus, ask them: what about my surplus? And this is before you even begin to debate on whether or not this tax is necessary, but that’s an article for another day.

2012-13 Budget

Labor government

Consumer surplus

Producer surplus

Budget surplus

Can the Federal Reserve "Really" affect interest rates?

At the end of When is an Investment not an Investment I talked about the inevitable rise of real interest rates once the RBA has finished lowering them by printing money. It’s now time for a discussion on real and nominal variables. While this isn’t totally necessary to understand the next article, it does highlight an interesting anomaly: a lower interest rate at the bank shouldn’t necessarily induce anyone to borrow more.

In So what’s the best way to hedge against inflation? I talked about how nominal interest rates (the full interest rate quoted by banks) are made up of two components (check out paragraph three for a recap). The “expected inflation” component is simple enough to undertand, but businesses generally don’t care about this. Once you borrow money, inflation in a funny way is your friend (making Ben Bernanke your hero). Just as the dollars that Rob Mariano won in 2010 weren’t worth as much as the dollars his wife won six years earlier on Survivor, the dollars that businesses use to pay back their loans years later are not worth as much. To understand this abstract use of the term value think which dollars you rather have, the ones that Rob was given, or the ones that Amber was given six years earlier, that could buy more goods. Businesses that borrowed in 2004 got Amber’s dollars, and the banks that lent the money were getting Rob’s dollars back in 2011. So if the nominal interest rate rises (and hence your nominal borrowing costs rise) but expected inflation rises as well, they tend to cancel each other out, and the real cost of borrowing hasn’t changed. What’s left is the real interest rate that businesses need to be concerned about. This relationship holds virtually one to one. If the expected inflation rate falls by one percent, the nominal interest rate tends to falls by one percent, but businesses have no incentive to invest further, even though the nominal interest rate has fallen. In the long run lenders face the same trade off. If their inflation expectations rise they will be happy as long as nominal interest rates rise to compensate them (one percent higher inflation, one percent higher nominal interest rates). you can see that even though the nominal interest rate has changed, no one has borrowed more or saved more. The nominal interest rate is (approiximately) equal to the real interest rate plus inflation expectations.

Its only when that residual, the real interest rate, changes that there is an incentive to move money. This residual is simply determined by borrowers and sellers getting together and deciding on an interest rate in the market: it is determined by the demand for and supply of savings. It should be becoming clear now that it is not controlled by the central bank, at least in the long run. So what’s the best way to hedge against inflation explains how investors vote with their feet and determine interest rates. In the short run the RBA can print money and lower nominal rates as in The Wonderful Central Bank of Oz (which, holding all else equal lowers real rates) but rates will eventually rise back to their original level to maintain the real interest rate, and then a little bit more to compensate savers for the extra inflation from the additional money printing. The primary point to take away is that the real interest rate hasn’t changed.

This illustrates, and this is common, accepted, mainstream economics, that the reserve bank can only affect the real interest rate and borrowing in the short term. Any investment made at the lower interest rate thanks to the Central Bank will be unprofitable when things normalise.

Something's gotta give

China has chosen to widen the band on its Yuan exchange rate, starting today, allowing its currency to fluctuate a further one half of a percent either side of the peg. However most people can only see the Yuan appreciating. This makes our recent articles on the ballooning money supply of China, caused by its undervalued exchange rate, quite timely (that’s my version of a brag). Following China’s gradual easing of its capital controls, it was either going to have high inflation or a higher exchange rate. It also shows that china is not going to be bullied by anybody about its exchange rate. When the US was screaming the loudest about the Yuan being undervalued (which as we said causes large exports) China’s trade surplus was massive (when exports are larger than imports it’s called a trade surplus) boosting the economy along!  But the data of late on Chinese trade has shown a drop in exports! If China was going to bow to US pressure to raise its exchange rate, you’d think they would bow in the face of bullish economic data, not soft. What’s more, the soft trade surplus data has resulted in diminished outcries from the US. I think this is evidence that Yuan appreciation will never have anything to do with US tantrums (which will never be as scary to Hu Jintao as having the wrath of all China bearing down on him, but that’s an article for another day).

But we can think of some other reasons that China might want to raise its currency!

More on the business cycle soon. I haven’t forgetten.

When is an investment not an investment?

On Tuesday we talked about the loose monetary policy of theFederal Reserve and how it was propping up stock prices. This process falls under the term mal-investment in its simplest form. Mal- investment is a term developed in the Austrian school of economic thought. It simply refers to poor economic decisions being made by firms, and resources being allocated inefficiently to areas of the economy where prices would otherwise not send them. The Austrian business cycle predicts that the artificially low interests rates (the price of money) and government intervention give misleading price signals and result in money pouring into the wrong places, ultimately causing asset bubbles. It is a competing economic theory with the more mainstream neoclassic economics, which tends to believe that you can smoothly adjust monetary (central bank) and fiscal (government spending) policy to adjust the level of investment in the economy. With the booms and busts in the business cycle, you can’t help but wonder if they’re wrong.

The Austrian Business Cycle Theory predicts that when interest rates are lowered by a monetary authority for an extended period, businesses will borrow and overspend on capital goods in order to ramp up production (the credit expansion phase). The eventual end is that businesses have large loans which were used to purchase equipment which is not needed. The resulting default on these loans causes the contraction in credit and the ensuing chaos. The big problem with the Austrian Business Cycle Theory is that it doesn’t provide a very convincing reason why people would make these bad economic decisions. The sophistication of forecasting techniques and relative transparency of central banks lead me to believe that a recurring and erroneous overspend on capital goods by the whole business sector is unlikely. I believe booms and busts are more to do with the short term outlook of business, moral hazard, and an inability to comprehend a system as complex as a national, let alone global economy (although we do our best to make some sense of it here). However, whatever the reason for it, you can’t deny that “mal” or “bad” investment occurs. Did the economy really need 2 million houses in 2005? Did it really need a company called webvan.com so bad that it was worth 1.2 billion dollars? History suggests it didn’t. And yet these investments continue to go ahead, cycle after cycle.

The green shoots of the next cycle of mal-investment in its simplest form are occurring as investors are pushed out of bonds and into riskier investments like stocks as described in Economy doing too well. Stocks Slump. This is how bubbles begin. Initially, long term capital investments are too illiquid for businesses to be convinced to invest; a fund manager will invest in shares knowing that he can sell them at the push of a button, whereas a factory cannot be quickly sold before it drops in value when Bernanke announces a withdrawal of stimulus. However hold interest rates down long enough, and mal-investment eventually sprouts into more complex forms of investment as the boom cycle gains momentum, but with one thing in common: being inefficiently allocated, they are unlikely to make a sufficient return. The reserve bank can lower interest rates to make borrowing less expensive, but it can’t engineer profitable investment opportunities.

Mal-investment doesn’t just come from the private sector. Governments around the world have been “allocating” (blowing) cheap money to “inefficient projects” (cash for clunkers) like it’s going out of fashion. It is private sector mal-investment that is the primary concern though, as it has the ability to grow to epic proportions. Eventually enough printed money runs out of profitable avenues  for investment, and so it starts chasing bad ones. These bad investments are profitable when it costs 3% per year to borrow, but when rates inevitably rise the investments tank. Next article I plan to show exactly why reserve bank stimulus won’t help the economy.

Economy doing too well. Stocks slump.

On Monday night while everyone was peacefully sleeping (possibly on a mattress stuffed with money because they don’t trust the Bernanke fuelled financial system) the US markets did a peculiar thing. Good (or should I say improving) economic data from the United States has started to trickle out over the last eight months in the form of a slightly lower unemployment rate. The market marched steadily higher but then hit a roadblock. Then, on said Monday night, the inflation fairy Ben Bernanke commented on the frailty of this recovery in jobs, and the unchanged weak outlook for the US economy. Markets rallied. This is a prime example of the short term mindset of Wall Street traders driving prices.

The obvious question is why should stocks rally when the economic outlook is dire? The obvious answer is that there is no good, long term sustainable reason. However there is a short term, get rich quick, Ponzi scheme reason. And here it is. In The Wonderful Central Bank of Oz I outlined how Central banks like the RBA and the Federal Reserve manipulate interest rates by buying and selling bonds. In practise central banks only deal in government bonds when manipulating interest rates. However as interest rates on these bonds fall, holders find themselves less willing to hold them. They sell their government bonds and use the money to buy slightly riskier bonds. This higher demand for riskier bonds increases their price and lowers their interest rate. The price changes tend to ripple through all assets, until money flows into stocks, pushing up their price.

In theory this is how monetary policy spreads through the economy and affects interest rates, including the implied rate of return on stocks. As Ben Graham originally highlighted, this return is inversely related to price like all assets, but I digress. Traders and fund managers know this so as soon as they get a wiff of words like Quantitative easing they dive into the share market. A more realistic description of the same (monetary policy) process is that with interest rates at rock bottom levels traders can borrow money cheap and plow it into the stock market. Ben Bernanke wants this because it makes everyone feel richer. People who feel richer spend more, which will supposably kick start the economy. Ben Bernanke has promised the continuation of this cheap money until 2014. But what traders have been worried about up until Monday night is that if the economy improved too much, the proverbial punchbowl would be removed in the form of higher interest rates and less cheap money being printed. Traders are aware that without these low interest rates the market will fall and the economy wont be able to stand on its own two feet. However they will buy as long as the “hot” money is coming thick and fast and cheap from the "fed". They all think they’re smart enough to jump out before the drop. They can’t all be right. Bernanke’s less than stellar report on the economy has allayed their fears of stimulus withdrawal, and the market surges. Anyone who can’t get to sleep tonight click here for the same old scripted political drawl. This is classic short termism at its greediest, and the first sign of the “mal-investment” that begins every boom cycle. In the next article we’ll talk more about this term and see how we’re already stoking the next asset bubble before we’re even finished popping the last one.

What have China’s money supply and America’s money supply got in common?

At the end of What do Chinese economists and Rhianna’s feet have in common? we saw how China mops up extra money flowing into its country as the United States buys its goods. While this will reduce the money supply, we have learnt that it will also increase interest rates. Americans are currently getting around two percent on their saving deposits, but if they were to put it in a Chinese bank account they would get closer to seven or eight percent. Better yet, why not borrow money in America at rock bottom interest rates, exchange it to renminbi at a fixed unchanging rate, and put that money in a Chinese bank account. The continuation of this process will increase the money supply in China, and negate attempts by the Chinese government to reduce it. Up until recent years the Chinese have of course been wise to this “carry trade” (after all, this concept was foreseen by mundell and flemming in the 1970s) and have had tight “capital controls” over money flowing out of and into the country. However loosening of those controls means that as the Chinese central bank raises interest rates to "make way" for the American demand, "hot" investment money will flow in and interest rates will fall again, rendering null and void the attempt to curb inflation.

China’s economy is less than half the size of the United States as measured by income or GDP. However China’s money supply was measured in October to be a third larger than that of the United States in this article. As the US continues to depress its interest rates by printing money, the carry trade will flow into China and balloon their money supply, and the Chinese will have limited ability to contain the torrent.  This is the so called “impossible trinity” proposed as part of the Mundell –Flemming model. Of a fixed exchange rate, free capital flows, and control over the money supply, you can have any two, but you can’t have all three. And that’s why. An inflationary monetary policy in the US will translate to an inflationary monetary policy in China. So what have China’s money supply and America’s money supply got in common? Unfortunately for China’s money supply: Ben Bernanke.

What do Chinese economists and Rhianna’s feet have in common?

Trick question. Nothing.

Armed now with your newfound knowledge on interest rates and the money supply from The wonderful Central Bank of Oz it’s time to take it to the next level.

China has had its currency fixed to the US dollar more or less since 2004. The low value at which the renminbi is set makes renminbi cheap to buy for Americans, and hence Chinese goods are cheap to buy. A currency is said to be relatively cheap if you dont haveto part with much of your currency in order to get one unit of another. If the renminbi price of a Chinese good stays the same, then the less of your currency that you haveto give to get one unit of renminbi, the cheaper a good becomes. This process is described in slightly more in detail in Is the Australian economy “diseased?” This creates a large demand for Chinese goods from America. If this demand becomes great enough, it outstrips the Chinese manufacturing sector’s ability to produce (or supply) the goods, and prices begin to rise. This is the same effect described in Is gold a good hedge against inflation? except that the demand pull comes not from the domestic government printing money and spending it, but from Americans taking advantage of relatively cheap goods. As described in Is the Australian economy diseased? if the currency were floating and not fixed, the value of the renminbi would tend to rise as Americans scrambled to get their hands on it to buy cheap Chinese goods. The more expensive renminbi would make Chinese goods more expensive and the American demand would subside.

With the fixed exchange rate however, Americans can keep enjoying cheap goods indefinitely. But to stop the increased demand for renminbi from raising its price (and maintain the fixed "peg") the government must raise its supply. They print renminbi to give to Americans, which as we know results in inflation. But we also know the government can mop up this extra liquidity (cash) by selling bonds as we saw in The wonderful Central Bank of Oz , which is equivalent to raising interest rates. The other side of the "interest rate money supply coin" is that the Chinese are raising interest rates, to curb demand by the Chinese, to "make way" for the extra demand from Americans (who are not directly affected by the interest rate increase). But this works fine only while China has capital controls in place to stop money flowing into the country. The reduction in capital controls announced greatly dilutes China’s ability to reduce its money supply as we’ll see in the next article.

The wonderful Central Bank of Oz

Back in October 2011 I wrote about China’s rising inflation. Further news about China easing its capital controls here provides a prime opportunity to illustrate one of the most elegant and forward thinking economic ideas of all time.

But first a little information on the link between interest rates and the money supply is in order. In The evil, ever present, value eroding effect of inflation on… Gameshows I talked about the Reserve Bank of Australia, Australia’s central bank, manipulating interest rates. Here is a brief a brief example of how they do it.

The best way to understand the connection between interest rates and the money supply is just to apply it to yourself. If the central bank were to print lots of money, all else being equal, people would find themselves with more money than they required. And what do we do with extra money that we don’t need. We put it in the bank. Even if you decided to spend the extra money, in that case the business owner who you bought goods from would now find himself with the extra money, and it would eventually find its way into a bank. Those banks that we love to hate then find that people are more willing to deposit money and realise that they can lower interest rates they pay on your deposit. If the banks are paying lower interest rates to get money from depositors, in theory they can charge lower interest rates on their loans. This is the basic link between interest rates and the money supply, and basically all you need to know for the next article. However, for those who want a more in depth explanation of the mechanics of how the central bank does this, read on.

A lot of money is borrowed today with the issuance of bonds. A bond is just an IOU. If Woolworths wants to borrow some money it simply stipulates how much it wants to borrow, when it will pay this amount back, and how much money (interest) it will pay you each period. A bond is even simpler than an ordinary loan in the sense that the amount that is borrowed at the start is not slowly paid back over the life of the loan like your home loan, it is paid back as a lump sum at the end. The dollar value of the interest paid each month is fixed and doesn’t change.

If Woolworths wanted to borrow $5000, and said it would pay you $50 interest every year, you would be receiving $50/$5000=1% interest every year. Now imagine for a moment that someone wanted to buy the bond for $10000. What interest rate are they receiving? The actual dollar value of the interest doesn’t change, it’s still $50. But now the interest rate is $50/$10000=0.5%. this is the critical inverse relationship between interest rates and bond prices. As former rises the latter falls and vice versa. So all that the RBA has to do is change the price of bonds and interest rates will change. They do this using the universal law of supply and demand. They can increase the demand for bonds by buying massive amounts, increasing the price. Of course they buy these massive amounts of bonds with massive amounts of money (the RBA is of course the only entity legally allowed to print money) and this is what brings about the increase in the money supply we talked about earlier.

This is a short run outcome. The RBA cannot in the long run affect the real price of anything. Money printing in the long run can only cause inflation, which has the opposite effect on interest rates. For a run down on the effects of inflation on interest rates, check out  So what’s the best way to hedge against inflation?

This is the RBA's primary inflation fighting tool, alluded to in So what’s the best way to hedge against inflation? In ­­Is gold a good hedge against inflation? excess demand caused by money printing (which in Australia can be done only by the RBA) was described as causing inflation (and we now know this would cause an increase in interest rates). Of course the RBA could reduce the money supply and alleviate the excess demand, causing interest rates to rise again.

This can be thought of in another way. If the RBA lowers interest rates (by increasing the money supply) it makes it cheaper for businesses to borrow and increase investment demand, and consumers with mortgages have lower repayments and hence more money to spend in the economy. If this were to get out of hand and inflation took hold, the RBA can raise interest rates, which will reduce business spending, and create that familiar tightening feeling in all home owners throats, alleviating inflation pressures. This demonstrates again how the money supply and interst rates are two sides of the same coin, even as a tool of the RBA.

How hedge funds use debt 2

Following on from how hedge funds use debt

A lot of people think that because a hedge fund is large they’re safer, but this is not so.  If two hedge funds have the same leverage ratio, obviously the bigger one is more leveraged. Hedge funds have become so large that when managing a big one, it becomes hard to find a place for all the money. There are only so many overvalued and undervalued stocks in the world, depending on your strategy. In addition to this, for large hedge funds, position size becomes an issue. Simple demand and supply says that when demand for a share goes up, the price will rise. When an individual investor buys a share, this isn’t an issue, but when a large hedge fund tries to buy a share, their demand ALONE can shift the price up. When you’re trying to purchase a share cheaply this becomes a bit of an issue. It becomes even more of an issue when you’re trying to sell out of a position. Most hedge funds that go broke do so because they got caught with shares that were being punished in a crisis, and couldn’t sell out without causing the price to crash further. Even the most liquid markets can dry up for the largest of hedge funds. On top of this, once other hedge funds find out about your position, they tend to trade against you.

“Long Term Capital Management” (and a host of other failed hedge funds) found this out the hard way. Their strategy involved taking advantage of tiny arbitrage opportunities. For example investors will tend to accept a lower interest rate on newly issued government bonds, because they tend to be more liquid than bonds near maturity. However, as the new bonds near maturity, the premium disappears and the bond price falls. By (short) selling the new bonds and using that money to buy the older ones, when the prices converge Long Term Capital Management make an almost riskless profit. Unfortunately the profit might only be three percent of the value of capital used. For this strategy to bring in reasonable profits massive amounts of leverage were required. Taking into account leverage can really deflate the “spectacular” returns posted by hedge fund managers. A thirty percent return might sound pretty good, but with five times leverage this amounts to a six percent return on assets held, slightly more than you can get on a savings account right now! And considering the average return on the ASX 200 is around twelve percent, nothing to crow about.

The next lesson Long Term teaches us is the danger of such leverage. Leverage of 17.5 times turned a 2.45% profit into 42.8% in 1995, but Long Term thought that this wasn’t an issue due to the “riskless” nature of arbitrage. But when Russia defaulted on its debt this set off a wave panic which set all investors’ minds on running to safe havens. Logic and valuation took a back seat (as it often does in a panic) and so arbitrage strategies like Long Term’s, which rely on investors bringing price anomalies (like mispriced treasuries) into line, started to go wrong. Worse still everybody knew it. Hedge funds began to trade against Long Term, sending the spreads wider between securities that Long Term was betting would get smaller (and vice versa). They hoped that eventually Long Term would lose enough money that they would have to unload their positions, pushing themselves (Long Term) further into the red as they sold, and increasing the profits for the other hedge funds.

Leverage reduces the necessary loss that will put a hedge fund out of business. If your leverage ratio is one (ie no borrowing) you need a loss of one hundred percent to finish you (not counting that investors will start pulling their money out before this). If your leverage ratio is five, you can only lose 20% (a fifth), and if your leverage ratio is 17.5, a 1/17.5 or 5.7% fall in the value of your assets will ruin you. What’s more, your creditors will be watching your leverage ratio skyrocket. If you start with a leverage ratio of five, and then you have a five percent drop in your assets, without any further trading, your leverage ratio creeps up to 6.33. A seven percent loss brings it up to 7.15 times. And a ten percent loss drives your leverage ratio up to 9 times (giving a debt equity ratio of 800%). And the higher it gets, the more nervous lenders get, and the more of your capital they demand in order to continue extending your loans. Eventually lenders decide enough is enough and force the hedge fund manager to liquidate his holdings and pay the loans back. Game over.