Monthly Archive: June 2015

Yes, dear reader, the title of this article is not a misprint.  I am advocating that we take one US city and level it.  Think of all the economic activity that will result as the country bends its time and resources to rebuilding the city.

Now, to be sure, I don’t mean that we do this unannounced and without warning.  There could be a national lottery wherein one city, chosen at random, would be slated for total demolition.  The citizens would be given ample time to pack up their belongings, family pets, and the like.  Spaces for them in nearby cities and suburbs would be secured where these lucky ones wait until their new homes are ready.  Once the city was cleared, a bomber could fly overhead and drop a small nuclear weapon onto the heart of the downtown district.

Once the heat and radioactivity have faded, tens or hundreds of thousands of workers, who had spent the intervening time studying under government sponsored job-retraining programs, can swoop in, clear out the remains, and rebuild the city.  In relatively short order, the residents could return to a brand new, shiny community ready for action.

Note the abundance of economic activity this city-revitalization would spur; how numerous industries would see an influx of revenue.  Local transportation and rental housing (homes, hotels, motels, campgrounds, or whatever) would see a spike in demand during the outflow of the population prior to the extreme makeover.  The military-industrial complex would also get a piece of the action since they would be responsible for the bombing run, which would keep munitions manufacturers and aerospace corporations profitable.  Of course, the greatest win-fall goes to the construction and materials companies whose job it is to rebuild the new and gleaming metropolis.

Hmmm…..

Sounds ridiculous doesn’t it.  Who in their right mind would ever advocate wanton destruction just for the flurry of activity that would result?

Take a peek at some of the places where this idea rears its ugly head.

In our first example in the circus of the economic bizarre, consider, if you will, the possibility of space aliens attacking the planet as a rallying cry for economic production

In this space alien piece, from 17 to 30 seconds, the ‘host’ of the show literally says:

Wouldn’t John Maynard Keynes say that if you employ people to dig a ditch and then fill it up again, ah, that’s fine, they’ve been productively employed…

How strange of a definition he presents for ‘productively employed’.  How is digging a ditch only to fill it up again productive?  Makes the ‘nuke a city plan’ sound positively brilliant.

Our second offering in our gallery is more whimsical.

Taken from the movie ‘The Fifth Element’, this scene mocks the idea that destruction ultimately leads to progress.  But an idea has to exist in the first place to actually be mocked and this particular idea seems to have been around for quite some time.

Perhaps the best argument against this kind of thinking comes in ‘The Broken Window’ parable written by Frederic Bastiat in 1850.  In this short essay, Bastiat examines the unseen costs (lost opportunity costs) of having a perfectly fine window broken and the vapid thinking that says that that destruction is beneficial to society.

Of course, a little destruction may be beneficial when it removes a valueless or costly thing out of the way of a new thing that actually brings value to society, but that we need to be very sure that the thing being replaced is valueless.  As Henry Hazlitt says in his book ‘Economics in one lesson’

It seems to me that the key phrase ‘unless those items [sic] have already become valueless or acquired a negative value by depreciation and obsolescence’ is conveniently omitted from the regular dialog.

Trained economists, no doubt, know and understand this subtlety, but if they do they like to keep it to themselves.  The average level of discourse in the media is well typified by the two clips above.  It seems to me that we should be very cautious in concluding that an object is truly valueless and that destruction is the correct course of action.  I’m not saying that such a conclusion should be rare but rather that it should always be highly scrutinized.  When we get to the point of saying that it would be better to have people dig ditches just to fill them back up then we’ve run out of good ideas.  And when we’ve run out of good ideas, nuking an entire city starts to look a lot more attractive.

One of the hot-button items in the current news cycle is the ‘stinging defeat’ that the Obama administration suffered at the hands of Congress last week.  This defeat took the form of an overwhelming rejection of certain trade provisions that were proposed by the administration be made law.

I am not interested in taking up space in this column to discuss the merits and demerits of the laws themselves.  Even though trade certainly falls under within scope of a blog of ‘musings about time and money’, I haven’t invested the time to really form an intelligent opinion about the proposed powers that the president was seeking.

No, what I want to comment on is the lack of clarity in the terminology associated with these laws.  This lack of clarity was abundantly clear to me as I struggled to keep TPP straight from TPA from TAA.  There were simply too many T’s to keep straight without careful thought and confusion was sure to abound.

Sadly, it seems that even trained journalists (I often wonder if that term is an oxymoron – but I digress) seem incapable of discerning the difference.  A point that was driven home as I listened to NPR’s Steve Inskeep

as he clumsily interviewed Paul Ryan about these matters.

NPR’s bio has the following to say about Mr. Inskeep

Despite his probing intellect and passion and compassion for his fellow man, Steve is apparently unable to keep his alphabet soup straight, so as a public service in the opposite direction of the usual, I present some basic information about the three T’s back to NPR.

The TPP

The Trans-Pacific Partnership (TPP) is a proposed trading framework between the United States of America and eight other Trans-Pacific countries – Australia, Brunei, Chile, Malaysia, New Zealand, Peru, Singapore, Vietnam.

The TPP is essentially a larger, and perhaps more ambitious, version of such free trade arrangements as NAFTA or the Israel Free Trade Agreement.  The United States has entered into many such agreements (14 by my count).  Its advocates tout its promise of open markets in Asia, level playing fields when it comes to such things as intellectual property rights and import/exports, and to the influence the US will have in improving working conditions.  Its opponents point to infringement on US sovereignty, the jobless and rather dismal recovery, and the threat of displaced workers, which brings us to item two – the TAA.

The TAA

The Trade Adjustment Assistance (TAA), is a federal program (or maybe more appropriately a set of programs) designed to help certain segments of the economy that are damaged by the opening of new markets, either domestic or abroad, to new competition.

The largest function of the TAA is to provide assistance to displaced workers who find themselves either out of a job or threatened with weakening wages and bargaining power due to an increase in the labor pool.

A familiar situation in which TAA-like service may have been applied was during the transition from typewriters to word processing programs for the desktop computing (although the TAA doesn’t cover workers displaced by technology or changing tastes).  This relatively sudden change in technology and office process forced almost all employees in the typewriter manufacturing sector out of work. These workers could have received help from the TAA to train new jobs in different sectors (if the TAA had actually been able to help).

Proponents of the TAA point to the continuity it brings to the lives of workers as they transition into new careers: minimizing impact to them and their families and keeping them in the work force.  Most sides agree that the objectives of the TAA are sound, but some point to the particular implementation as being flawed.

The TPA

The final T in the trinity (yet another T-word) is the Trade Promotion Authority (TPA). Also known as Fast Track,  the TPA is a power granted by Congress to the President to act as a single negotiator for the United States.  With this power comes great responsibility, so when a deal had been tentatively struck, the President must then bring the completed deal back to Congress where it is subjected to a single up-or-down vote, with no opportunity for amendments.

The TPA is very controversial, primarily due to the concentration of power to negotiate potentially disruptive trade deals in the hands of a small number of bureaucrats.  Those in favor of granting the president TPA argue that no foreign country wants to negotiate with 536 people (all of Congress and the president) and the fact that Congress has the last word.  TPA opponents insist that closed-room negotiations that impact thousands or millions of workers is un-American and that it places too much power in the hands of people who might be corrupted by it (see Lord Acton’s famous maxim).

Summary

Despite the similarity in their acronyms, the three Ts taking center stage in this current trade debate are really distinct things of varying controversy.  The least objectionable is the Trade Adjustment Assistance (TAA), which seems to have universal support for what it tries to do even if opinions disagree on how to do it or how efficacious the current implementation is. The next two Ts are close in their controversy level, but I think that the Trans-Pacific Partnership (TPP) runs in second.  Sides are divided on whether they like what this deal brings to the table but not as much as they seem to be in disagreement on how it will happen.  Granting the president Trade Promotion Authority (TPA) seems to be a real sticking point and if he doesn’t get this authority the next logical question is how will the US negotiate free trade agreements (maybe there is even debate as to whether it should, but that is a topic for another blog).

So it’s easy to see that the 3 Ts are quite different and that with a little work, even a journalist should be able to keep them straight.

In honor of American Pharoah winning the first Triple Crown in 37 years, this week’s column will concern itself with that fine art of subtle economics – making book.  For those you aren’t familiar with the terminology, to make book is the phrasing used to describe how a bookie balances the risks associated with backing a gambling opportunity. The idea behind making book is to guarantee a positive expected income for the bookie no matter what happens in the event.

The treatment here is patterned after ‘The Parable of the Bookmaker’ found in the book ‘Financial Calculus: an introduction to derivative pricing’, by Baxter and Rennie and the very readable discussion of ‘The Art of Bookmaking’ Matt Elliott.

Both treatments consider, for simplicity, the case with a sporting event with two possible outcomes.  I’ll stick with the horse racing theme used by Baxter and Rennie.

Suppose that we are having a runoff between the great Triple Crown winners of yesteryear and American Pharoah.  I think that, without a doubt, Secretariat is the greatest of the past winners; an opinion that is shared in sporting circles.  Now let’s imagine that we are pitting Secretariat against American Pharoah as our sporting event of the millennium.

As bookies, we want to accept wagers from bettors who are both favor Secretariat and those who favor American Pharoah, but we want to do so in such a way that regardless which horse actually wins, we can meet our payouts and still take home a tidy profit.  How do we do this?

First, let’s start by examining the probability that each horse will win the race.  Since this is a fantasy race, we can run the race as often as we like, and suppose that in doing so we find that Secretariat is 3 times more likely to win than American Pharoah.

Now we have to set the odds.  The actual language and notation associated with quoting the odds seems to differ from country to country and culture to culture so I am going to give a set of definitions that maximize the overlap with all cases.  First define the stake as the amount of money that the bettor (or punter as it is sometimes known as) places on the outcome.  A winning bet pays the bettor back his original stake plus an additional amount of money called the return, since it represents the return on his investment.  Thus the successful bettor walks away from the track with the sum of these two, which is called the payout.  In symbols, if st is the stake and r is the return then p = s + r is the payout.  The unsuccessful bettor simply walks away.

Now if we set our odds consistent with the probabilities found in our fantasy running, we would set the odds as follows:

In other words, the probability each outcome is implied as the stake/payout giving P(Secretariat) = 0.75 and P(American Pharoah) = 0.25, where P(x) is the probability that x will win the race.  Note that as expected, Secretariat is three times as likely to win as is American Pharoah.

Well this is certainly the scientific way to set the odds.  Unfortunately, it is also stupid.  To see this, we calculate the expected payout.  To keep things concise, let’s use add to our symbol vocabulary by letting AP and S stand for American Pharoah and Secretariat, respectively.   In the event that Secretariat wins, the profit the bookie makes as follows:  he gets to keep the stake offered for American Pharoah and has to give up the return on Secretariat.  In symbols, profit(S) = st(AP) – r(S).  In the event that American Pharoah pulls off the upset, the bookie’s profit is the stake on Secretariat minus the return on American Pharoah, which in symbols is profit(AP) = st(S) – r(AP).  To get the expected profit, the bookie multiplies the profits associated with these two events by their probability of occurrence and finds that his expected profit is zero (left as an exercise to the reader).  This result holds no matter how much money is staked on either horse, since there are only two options – they balance out.

So a bookie offering such odds works for free in the long run and finds himself at the end of his career having, on average, earned no money.  More likely, before he gets to the point of having a quiet retirement he finds that he is bankrupt due to the fact that on any given occasion he is liable to lose a huge amount of money.

The amount he is liable for does depend on the stakes offered and the easiest way to understand this is to look at a table of outcomes given different stakes.

Notice that there are four different scenarios with different amounts places as bets on the two horses.  In all cases, the bookies expected profit is zero so that were the race to be run every day, the bookie would, as predicted above, break even.  However, during that time the bookie’s profits would wildly fluctuate between a reasonably handsome profit of $10,000 when American Pharoah pulls of the upset and nobody bet on him to a disastrous loss of $25k when many people back the longshot and he wins.

Obviously, the bookie needs to keep his financial health (and as a result his physical health as well).  In order to do that, he needs to ‘slant’ the odds in his favor.  He does this by actually playing with the percentages sold of the racing contracts so that he has a positive profit no matter which horse wins.

Several examples of how to set the odds to make a profit are shown in this next table.

Before beginning to discuss the results shown in this table, note that the amount bet on the two horses is fixed at $5K for American Pharoah and $10K for Secretariat.  I’ll briefly discuss the added complexity associated with attracting the appropriate amounts for both horses below.

The first case is the fair-odds, break-even case that caused our bookie’s concern.  In that case, the implied percentage of the race came out exactly to 100 percent.  This percentage, denoted by o, is given by o = st/p.  For the first case, o(AP) = 0.25 and o(S) = 0.75; adding up to 1.0, as expected.  In the other cases, the bookie sets the odds in such a fashion that the corresponding percentages add up to be more than 1.0.  In the second case o(AP) = 5/18 = 0.28 and o(S) = 15/19 = 0.79 for a sum total of 1.07. This extra 7-percent margin give the bookie a positive expected profit but still exposes him to substantial loss if the longshot come in.

A better setting of odds is in the third case, where o(AP) = 5/14 = 0.36 and o(S) = 5/7 = 0.71.  Again the margin is set at 7 percent (0.36+0.71 = 1.07), but in this case the bookie is sure to make a profit of $1,000 every time.

In the final case, the bookie can make even more profit by having a margin of 15 percent, but he does so at the expense of the bettor (how else?).  In particular, the bookie realizes this profit by cutting into the return on investment of the bettor who backs the longshot.  The return on investment (ROI) is defined as the return divided by the stake, or r/st.  Notice how the ROI drops progressively as the bookie’s exposure to risk drops.

In realistic situations, the bookie never gets a fixed amount plopped on each horse with the subsequent opportunity to set the odds in such a way that favors him.  Rather, he needs to sell contracts with the bettors and then adjust the odds as bets come in so that he makes book.  More details of how this is done can be found in Matt Elliott’s discussion but I’ll note, in passing, that a margin of 7-percent seems to be a customary target but that it seems that the bookie is happy when he can achieve 5 percent.

I’ll close with one last point.  Throughout this discussion, I’ve intermixed gambling terms like bookie, odds, payout, and longshot, with terms usually reserved for business situations, like return on investment, contract, and sell.  This wasn't by accident.  Gambling and business meet squarely in derivatives trading and hedge funds all across the financial markets.  But that is a topic for another day.

I suppose that the subject matter for this particular column started with the arrival of a magazine in my mail box a few days ago.  The magazine in question is entitled ‘Arthritis Today’ and its presence alongside the more normal mail was a real puzzle.  My first reaction was that this was the typical mix up where my neighbor’s mail makes it into my box and vice versa.    A glance at the mailing label dashed that notion; the name and address clearly indicated that it was intended for a member of my family.

At bit more of reflection soon led to the answer.  One of my clan had been having problems with his hand and had gone to see a doctor.  The diagnosis was mild osteoarthritis and a generic treatment program – indicative of the whole ‘we don’t quite know how to treat this so we’ll say something you could have figured out for yourself’ attitude that sometimes is seen in the medical profession – was prescribed.

I’m sure our insurance company was promptly billed and less than two scant weeks later, this magazine arrives unbidden.  So the questions of who sent it, when was that particular decision made, how did the publisher know where to send it, and why was it thought relevant seemed plausibly answered.  There was only one lingering line of questions.

Who pays for this magazine?  Is it a marketing technique, where one issue is sent in hopes that a permanent subscription will result?  While possible, this idea seems highly doubtful.  There were no indications that the publisher was tempting our dollars from our wallet.  No gaudy disclaimers like “fabulous first free issue” or “trial offer” adorned the front of the mailer.  This issue of Arthritis Today was sent in the standard clear, thin, plastic bag used for existing subscriptions, which is designed to let you see the content while keeping the pages relatively safe from the elements.

The most plausible explanation is that somewhere between money leaving my paycheck to pay for the family’s health coverage and revenue flowing into the publisher’s offices to pay for staff salaries, print costs, marketing, distribution, and the like, there is a complicated shell game that goes on that makes acceptable the risk of sending out the magazine unsolicited to a perhaps disinterested household.

Several possible explanations exist for how that risk can be perceived as low even if the reality is quite different.  Perhaps the doctor’s office pays for the subscription as part of the service they provide.  Perhaps the drug companies with a vested interest in pushing the next big arthritis drug underwrite the cost.  This later explanation seems to be the most likely as there was a 20-page pamphlet entitled ‘Arthritis Today: Drug Guide, 2015’ that piggybacked along with the main publication.

Most likely this last inference is the correct one. But even if the drug companies are directly underwriting the cost of this publication, all that has done is to move the risk associated from one entity (the publisher) to another (the pharmaceutical companies), it doesn’t eliminate it.

We could keep on this way, peeling layer after layer from the onion, but in the end, after all the dust settles and the smoke clears, we still have the undeniable facts that someone is bearing the cost to produce this magazine and the risk that he may not make a return on the investment.

Of course, taking risk and passing on costs is par for the course for businesses.  Almost every business must shoulder risk in order to grow and must bear a cost associated with that risk.  The cost usually has two components; the first is associated with mitigating the risk and the second is associated with how large will the payout be if the risk realizes.  Ultimately some or all of these costs gets passed on to its customers.  The amount of risk taking is held in check by the fact that the customer based may finally have enough and move on to a competitor.  People are willing to bear a cost when it is a mild irritant or when it looks like it will be limited in time.  But push the customer base too far with large or open-ended price hikes and there is an excellent chance that they will leave to find greener pastures, leaving the firm to bear the costs themselves.  Competition acts as the natural balance to risk taking.

What is different in the ‘Arthritis Today’ situation, is that there is no danger that the risk and associated costs will be born directly by the company – no matter which one in the chain from publisher, to doctor, to pharmaceutical company.  Each of them are in a position to take more risk and pass on more cost than a normal business because of the government mandates and regulations regarding health care. All of the businesses in this chain know that the customer base is a captive audience; that there is no real way for them to move onto a competitor.

This situation is then a textbook example of what is known as a moral hazard.  When a moral hazard is present, a firm can and will take a greater risk when they know that some other party will be stuck with the cost.  In this case, the particular cost is born by my health care coverage provider who will then pass the pain directly onto me in the form of higher premiums, larger deductibles, or both.

Overall, the cost of receiving this magazine is small but it is worrisome for two reasons.  The first is the basic principle that I shouldn’t have to bear a cost as a captive customer base.  The second is that this case is a symptom of an endemic problem throughout the economy.  Many of the government-backed, ‘too big to fail’ or ‘special interest’ programs show the same type of moral hazards on a much grander scale.  I’ll be exploring some of the more egregious ones in future columns.