EclectEcon

More Toothless Treaties from the EU

Once again European leaders have announced a treaty to deal with the sovereign debt crisis in Europe, most notably resulting from fiscal profligacy in Greece, Portugal, and Italy. These agreements are toothless. They have no enforcement mechanism, and they do nothing different from what the initial EU and Euro treaties did: they extract promises from all parties that they will act to reduce their annual deficits and, if they do, then other countries might help them through the difficult periods. From WaPo:

European leaders adopted a groundbreaking new treaty Monday that binds them to imposing caps on deficits and government debts to combat the painful financial crisis that has sabotaged prosperity across the continent and left it slipping toward recession.

The treaty, endorsed by 25 of the 27 European Union governments, was intended as a gesture to show skeptical financial markets that European governments are at last committed to gaining control over lax borrowing habits that over the last four decades have helped create dangerously high debts.

I nearly lost my coffee onto the computer screen when I read that. As the article further notes,

... [A] chorus of European officials and economists have questioned the wisdom of the treaty in the first place. The pact was unnecessary, they contend, because European rules — merrily ignored over the years — already forbid excessive government deficits ...

These promises might sound nice politically. But unless they can be enforced (how?), they merely prolong the agony and open the door for protracted gamesmanship. 

What will Germany (and France? others?) do if Greece (along with Italy and Portugal?) does not get its fiscal house in order? 

• Invasion and conquest are not likely options.
• Tell them they must try harder.
• And we really mean it this time.
• Kick them out of the EU and the Euro pact? 

The last option is the only realistic one. The only question is, how long before it happens, before Greece de facto defaults even more on its debt by abandoning the Euro, and consequently many financial institutions, counting on bailouts from the IMF and their own gubmnts, lose buckets of money? Or will the taxpayers of these countries hosting these banks once again be required to bail out the stockholders and creditors of those financial institutions? 

This is moral hazard, writ large on an international scale.

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Addendum: Stratfor points out that a variant of the first option listed above is not beyond the realm of possibility:

The German government proposed last week that a European commissioner be appointed to supplant the Greek government. While phrasing the German proposal this way might seem extreme, it is not unreasonable. Under the German proposal, this commissioner would hold power over the Greek national budget and taxation. Since the European Central Bank already controls the Greek currency, the euro, this would effectively transfer control of the Greek government to the European Union, since whoever controls a country's government expenditures, tax rates and monetary policy effectively controls that country. The German proposal therefore would suspend Greek sovereignty and the democratic process as the price of financial aid to Greece.

Though the European Commission rejected the proposal, the concept is far from dead, as it flows directly from the logic of the situation.

 The EU rejected this proposal. Understandably. How might the EU enforce it if Greece, at the last minute, refuses to hand over the controls to their gubmnt?

 

A New Promotion from Delta Airlines??

The juxtaposition of these two items in the seat-back pocket made me laugh:

I don't recall ever having to pay for those bags in the past.

[reminds of the 1950s Shelley Berman skit about flying]

Google Auto-Completion: Here's some info I never expected to see

I use Google Search a LOT. 

This morning, I was trying to remember which tennis match at the Australian Open had involved a rally in which the combatants had a 42-shot rally.

So I opened Google and started typing "42 shots Australian Open".

After having typed the first part "42 shots", I was rewarded with this fact:

42 shots = 1.86313236 liters

I did some further calculations. It turns out that Google assumes a shot is 1.5 fluid ounces. 

I'm sure I shall make great use of these facts many times.

Supply Management, Risk, and Exploiting Consumers

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

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

In response to this article, a former student wrote,

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

and in a later comment he wrote,

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

These two comments about supply management require some careful consideration. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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