In doing the research for the previous post on China and government held debt and the earlier one on energy usage and wealth creation, one country stood out – the country of Peru.  It stood out not because it topped any particular list but because of the great strides that Peru has taken over the last quarter century to reform it government and economy.  These reforms are reflected in the very low ratio of government held debt to GDP and in the relatively high efficiency with which it uses energy to create wealth.

During the 1980s, the situation in Peru was quite different.  Hyperinflation, which totaled in at an amazing 2,220,200% in the five year period from 1985 to 1990, was a crippling problem, social unrest lead to the rise of the Marxist Shining Path (Sendero Luminoso), and the population had little to no faith in the government, dubbing even their president as Alan ‘Crazy Horse’ Garcia.

During the 1990s, Peru elected Alberto Fujimori and his policies helped put the country on a stable trajectory and get its macroeconomic house in order.  But how exactly did he accomplish this transformation?  Well government is complicated and any success it enjoys has many creators but the Peruvian economist Hernando de Soto played a big role.

de Soto was born in the Peruvian city of Arequipa in 1941 but was moved to Switzerland in 1948 following a military coup and the self-exile of his father a diplomat.  When de Soto returned to Peru he found that the economic situation was appalling.  In reaction to this, he founded the Institute for Liberty and Democracy (ILD) whose influence helped to enact over four hundred laws and regulations enabling the poorer members of Peruvian society to benefit from the having access to capital.

de Soto is perhaps best known for his experiments with the ‘stopwatch’.  The idea behind his experiment is to determine how long it takes for a prospective entrepreneur to open a business.  In other words, de Soto hopes to quantify the transaction cost required to become a legitimate business owner who operates within the law and enjoys the corresponding privileges, including formal recording of the title of ownership and well-defined protection of assets under the rule of law.

What he found was depressing.  He tried to setup a small shirt factor and discovered that it would take 278 full days to get all of the permits needed and that, along the way, the would-be business man had to navigate a level of corruption where the bribe was the accepted currency.  NPR recently aired an engaging piece on de Soto’s efforts which premiered on their Planet Money regular feature.

As a result of his efforts, Peru has gone from the hyperinflationary times of the 1980s to a sustained average growth of approximately 6.6% for the last decade while simultaneously having a very low percentage of government-held debt to GDP around 20%.

Due to these successes, de Soto has been called upon by many foreign governments to help craft economic policies suited to the developing world.  As a self-styled ‘third-worlder’, de Soto maintains a fierce objection to the theses of many of the ‘western economists’ who publically maintain that there is too much capitalism in the world.  He has been powerfully critical of the general notion suggested by Thomas Piketty that capital causes friction between societal groups and that society should move away from such notions. de Soto convincingly asserts that Piketty engaged in rash guesswork when analyzing the situation in the developing world and that Piketty’s book Capital in the 21^st Century represents Eurocentrism at is most extreme.

The basic idea underlying de Soto’s analysis, is that there are really two types of economies in the world: legal and extra-legal.  The world’s elite enjoy the benefits of working within the legal system – benefits that include most especially the right to their property.  The rest of the world, some 5 to 6 billion, sits outside these protections.  This group finds itself in the precarious position where the only protections they enjoy are arbitrary ones conferred locally by some microeconomic or microlegal structure.  Go 2 miles in any direction and the protections vanish.  Step one toe out of line and the protections vanish.

This lack of access to true capital, defined by de Soto as the formal recognition of property rights and all the protections implied by such a recognition, is what holds the poor down.  He traces the self-immolation of Tarek al-Tayeb Mohamed Bouazizi, which led to the Arab Spring, to the expropriation of his property – that is to say by the arbitrary way in which this street vendor was robbed of his wares and his livelihood because he had no formal protection for his property rights.

While he cares most about the poor in the developing world and for ways to lift them out of the extra-legal economy and into the legal one, de Soto also has some criticism for the West.  He has sharp criticism for the lack of transparency in both Europe and the United States evident in the recent financial crisis.

I suppose de Soto see these tangled webs of toxic assets, credit default swaps, and derivatives as steps in the wrong direction; as ways in which the elite erode the property rights of many to enrich a few.  I think he’s absolutely correct.

The year was 1979.  Not a lot was known by the public about China, its people, its politics, or its economics.  Nixon’s historic visit to the mainland had only happened about 7 years earlier and it was still a common occurrence to hear China referred to as Red China.  On March 16^th of that year, the movie entitled The China Syndrome was released in theaters. The idea behind the movie was that negligence and corporate malfeasance at a nuclear plant led to a nuclear meltdown where the core metaphorically sinks through the earth all the way to China.  Eerily, a scant 12 days later, the accident at the Three Mile Island (TMI) plant in Dauphin County, Pennsylvania occurred.  Suddenly, it seemed, all our worst fears about nuclear power were realized and the word ‘China’ had suddenly taken on a sinister meaning independent of the nation in the Far East.

Now with the benefit of hindsight, we can see that the TMI disaster, while serious, was not the catastrophic event that we feared.  Even the far more serious nuclear accidents at Chernobyl and Fukushima-Daiichi have had little in the way of global impact.  Simple analysis of the size of the stored energy in these plants relative to the size of the planet suffices to show that.

However, we are witnessing a meltdown of the Chinese economy, and the impact of this event promises to have a global impact.  Curiously, there weren’t any prescient tales speaking the precarious nature of the Dragon’s economy released to theaters.  Not even a book that made it onto the best-seller list.

Just to set the stage, let’s consider for a moment where we were just a few short years ago, and what the popular wisdom was.  The common idea, spoken by pundit and plebian alike, was that the ‘Middle Kingdom’ was soon to be the dominant player on the world stage.  The reign of the US dollar as the reserve currency was drawing to a close and soon the Yuan Renminbi would be what all the cool countries used.

I was deeply skeptical because I have a long memory and remembered the depressing and relentless drum beat of the 1970s and 80s heralding the United States’ economic doom at the hands of Japan (footage from Johnny Dangerously).

By the early 1990s, it was clear that the strength of the Japanese economy had been exaggerated and its systemic weaknesses ignored.  By the turn of the century, the world started talking about Japan’s Lost Decade, and their economy has yet to recover from that slump, now roughly a quarter of a century later.

I can’t be certain why this cautionary tale was forgotten 10 years later, when economists were all agog with the ‘new economy’ engendered by the internet, and the dot com bubble came and went.  Nor why the message was lost again about 5 years later when almost everybody was considering flipping houses, and the sub-prime bubble grew and burst.

All that is certain is that the message got lost once more – drowned in incessant chatter about the new powerhouse on the world stage.  Never mind that China was following a ‘if you build it they will come’ strategy that piled up debt.  Never mind that China played with its currency and subsidized oil purchases to keep gasoline costs low.  Never mind that the Chinese government built entire cities in which no one lived.  All that mattered to the intelligentsia was that the Dragon of the East had figured out what we in the West couldn’t – how to get around the law that says there is no such thing as a free lunch.

Of course there were voices out there that said something was wrong, but they were in the minority and weren’t heeded then.  Now you can’t hear anything else but words of woe on China.

So how bad is it and for how long should we have known?  It isn’t clear how to answer either of those two questions.  By some measures, China is much better off than other countries.  Consider the following table that shows the ratio of Government Debt to GDP for select countries.  Compared to the US and Japan, China’s central government holds significantly less debt (source:  http://www.tradingeconomics.com/)

But, by other measures, China is in bad shape. According to Forbes Contributor Kenneth Rapoza, its total debt to GDP ratio is approximately 280%.  Is that bad, it’s hard to tell since the US’s total debt ratio is about 332%. What is needed to put debt into perspective is a measure debt to assets, something I am sure is hard to come by for China's economy. That said, it is likely that the ratio of China's total debt to its assets is much higher than that of the US. Further on, the same article has this to say about China’s growth in debt:

Perhaps the most telling point is that China itself feels that it is in trouble.  It took the unheard-of step of adjusting its currency three times in a short period of time this summer.  It also has been buying stock on its own exchange.

Will China fall?  It is hardly likely.  What is more likely is that its spend-now-and-pay-later expansion is coming to an end.  China will still be an economic giant, and that’s probably good; after all, it has an incredible comparative advantage just due to population size.  But it is very unlikely that it will ever dislodge the West from its pre-eminent position until it corrects its internal problems with liberty and human rights.  Unfortunately, that isn’t a movie plot that can sell.

In a recent article in the Washington Post, blogger Ana Swanson reported on a new study in the field of economics that found some revealing and, perhaps, surprising results.  The article, entitled, Why some billionaires are bad for growth, and others aren’t, summarizes the findings of two economists, Sutirtha Bagchi of Villanova University and Jan Svejnar of Columbia University. (Note: Bagchi and Svejnar published their findings in the Journal of Comparative Economics and a summary of their findings is available at the link.)

In their analysis, Bagchi and Svejnar, took Forbes magazine annual list ranking the world’s billionaires, normalized the raw data to account for country size (either by GDP or by population or somehow – Swanson wasn’t particularly clear on this point), and then correlated the result with economic conditions in the country as a whole.  According to Swanson, what the pair concluded was that as wealth inequality grew so did economic conditions for the general citizen worsen in the form of slower economic growth.

Also, the Bagchi and Svejnar correlated a percentage of the billionaires’ wealth to their political connections to the government.  This measure of cronyism is supposed to help shed light on the positive and negative mechanisms that cause concentrations of capitol to exist in a country and that lead to wealth inequality.  To illustrate this point, Swanson notes that the United Kingdom and Indonesia have similar Gini coefficients (I found them to be 38.1 and 38.0, respectively, in the World Bank Gini coefficient table) but that the business climate in these two countries are quite different.

The implication of this further analysis helps justify the title of the article – namely that not all concentrations of capitol come about for the same reasons and some billionaires are better than others.

In a nutshell, what Bagchi and Svejnar concluded were:

• Gini coefficient doesn’t tell the whole story determining national growth
• Cronyism is a drag on the economy
• Innovation isn’t a drag on the economy

Wow!  What a big surprise.  I would never have seen that coming.  Some billionaires actually deserve their fortunes because they enable rather than impede growth.  To be fair, Bagchi and Svejnar didn’t actually state that billionaires who earned their money without political connections helped economic growth, simply that they didn’t impede it.

There are really two points that are worth addressing.  The first one is on methodology.  The second is on economic and philosophical outlook.

The methodology employed in the study requires one take the data with a grain of salt.  For example, a few, simple queries of the Forbes list, Google, and the World Bank find the following data for Columbia and the United States.

The data in this table do support the idea that the larger percentage of billionaires in the population the slower the growth as the percentage of billionaire-held wealth in the US is almost 3 times higher than that in Columbia.  But that’s where the data stop making sense.  Bagchi and Svejnar determined that 84% of the billionaire-held wealth in Colombia is due to political ties with the government.  In other words, it is due to cronyism.  In contrast, they found that only 1% of the billionaire-held wealth in the US is due to cronyism.  Making the required adjustments, I found that ratio of Crony Wealth to GDP was 4.1% for Colombia versus 1.4% for the US and yet the Colombian GDP growth rate is double that of the US.  Paradoxically, the Gini coefficient, which measures income inequality and is supposed to not be a reliable indicator of the harm that concentrations of capitol have on an economy, seems to be much more correlated with the Bagchi-Svejnar conclusion than their measure of ‘politically-connected wealth inequality’.

Perhaps the way that they chose to classify billionaire-held wealth is the problem.  Well, I don’t have access to the original article so I can only quote what Swanson said

Now I’m not asserting that the Bagchi-Svejnar conclusions aren’t correct.  They may be for all I know.  I am asserting that there seem to be correlations that support some of their conclusions and others that don’t.  Causation is another thing entirely.

Now on to the second point on the economic philosophy behind this whole revelatory study.  Basically, these two economists claim to have discovered a data-driven conclusion that it matters how people get that wealth and how the government spends its money.  In other words, that the basic neo-Keynesian idea about money and spending is wrong.  That it is not enough for an economy to get money moving.  That is does matter if the work is productive.   That those who say “Go ahead and dig ditches even if you have to fill those ditches back up again.  All that matters is that we’ve kept busy.” are wrong.

Of course, Bagchi and Svejnar may not say it quite that way but the conclusion is inescapable.  For that matter, Ana Swanson may not say it that either but how else can one interpret the subtitle of her article ‘Not all inequality is created equal’!

Its common ‘wisdom’ bandied about at water coolers, dinner tables, and political gatherings, that while the United States has 5 percent of the world’s population is uses 24 percent of the world’s energy.  Sagely nods and enlightened shakes of the head always come in the wake of such an utterance.  But what does this statistic really mean – that we are wasteful, that we take from others, what?

To the common man, this statistic indicates just how wasteful the United States is, just how predatory its consumption is, and so on.  But it turns out that really isn’t the case.  The real situation is much more nuanced and subtle and the results show a few ‘surprising’ things – surprising relative to the common wisdom and preconceived notions of just how bad the situation is in the United States.

First, the United States is comparable to its North American counterparts of Canada and Mexico in both energy consumption and wealth creation but actually ranks above both of them in how efficiently it use its energy.  Second, the United States is much more efficient a wealth creation machine per unit energy than any other country its size in either Asia or Europe.  Third, the United States produces a tremendous amount of energy, much of which is used by the rest of the world.

So the answer to the question posed above is that the fact that the United States has 5 percent of the world’s population and uses 24 percent of its energy doesn’t really mean much at all. Let’s see why.

The Methodology

Good conclusions rest firmly on good data so let’s start by collecting individual statistics on the various countries around the world.  The following table shows the population, gross domestic product (GDP) per capita, total GDP, energy use per capita, area, and efficiency (to be defined below) of 21 nations from various continents.

The data referenced to calendar year 2011 since that is the latest year where data were available for all 5 categories.  GDP values have units of United States Dollars (USD).  The unit of energy use per capita is kilogram oil equivalent (KOE), which is a normalized unit of energy that allows for world-wide comparisons.

To promote transparent discussions, each of the data points was obtained in the following way:

• Population and GDP values – Google search using ‘population <country name> 2011’
• Energy Use – Google search using ‘energy consumption <country name> 2011’
• Area – Google search using ‘area <country name> square kilometers’

where <country name> stands for one of the 21 names listed above.

The efficiency metric value is calculated as the ratio GDP per capita to energy use per capita and, as a result, has units of USD/KOE and state how much, in terms of goods and services, were produced per unit of energy.

The Interpretation

Okay, with great data comes great responsibility.  So how do we interpret the data responsibly?  The first, and most obvious response, is to compare apples-to-apples.  The easiest way to do this is to compare energy use per capita in a bar chart.

Perhaps surprisingly, Canada is the largest per capita consumer of energy in the sample studied. In 2011, Canada consumed approximately 7333 KOE versus the United States 7032 KOE. Saudi Arabia and Norway are close, consuming 6738 KOE and 5681 KOE, respectively.  China, one of the world’s largest consumers of energy and one of the greatest polluters has a modest energy consumption of about 2000 KOE,  two thirds less that the United Kingdom and about half of Japan.

But does this apples-to-apples comparison really tell us the full story?  The answer is clearly no.  What matters isn’t just how much of a commodity is consumed but also what is accomplished as a result of that consumption.

The situation has its analogy in basic family economics.  It is one thing to spend (i.e., consume) $10,000 on a new roof and an entirely different matter to spend $1,000 on Pet Rocks.  The first one is a larger expenditure, by a factor of 10 compared to the latter, but is clearly a better investment.

The most honest measure for what was produced by a country is the GDP per capita, taken as the value of all the goods and services made by the average citizen.  There is no way to further evaluate the production beyond that since matters of cultural, societal, or philosophical valuation vary from person to person.  The GPD measures, in some sense, what others in the market are willing to pay and nothing else.  Nonetheless, it’s all there is.

This approach leads directly to the efficiency metric defined in the table above.  When efficiency is displayed in a bar chart a much different story emerges.

The United States and Canada each fall squarely in the middle of the pack, with their values of efficiency falling almost exactly on top of the median value for this sample.

At this point, the reader may be thinking that this is still not a true apples-to-apples comparison.  After all, shouldn’t some adjustments be made for size and complexity of a country?  The most obvious factors that I thought of that influence efficiency would be

• Climate (how hot or cold)
• Area (how big or small)
• Economic system (capitalist, social democracy, communist, etc.)
• Work force participation and training

Certainly a greater percentage of energy is consumed in colder countries compared to more temperate ones just to ensure the survival of the population, and this expenditure is not reflected in the GDP values.  In addition, the amount of energy consumed for transportation is another expenditure that is not directly reflected in GDP.  Finally, political forces shape the overall productivity of the work force either through the system of economic organization and/or through the percentage of able-bodied and trained citizens in the work force.  The Soviet Union was notorious for having a very poor return on its energy expenditure even though it had immense resources.

Of these four factors, the only one that is relatively easy to work with is the size of the country in area, which is taken as a proxy for the size of the transportation expenditures.  The following graph shows a scatter plot of efficiency versus country area.

There are clear correlations between the size of the country and the efficiency, with the European (Norway, France, Germany, Spain, Italy, and the UK) countries and Japan topping the list.  The Latin American countries (Peru and Mexico) also do pretty well although Mexico (with a 6.28 efficiency) definitely underperforms relative to its two neighbors to the north.  For the most part the Middle East (Israel, Saudi Arabia, and Turkey) and Africa (Egypt, Nigeria, and South Africa) have terrible efficiencies well below the median, except for Israel, whose performance is indicative of the European countries.

For countries larger than 2 million square kilometers, only Brazil outperforms the United States and Canada.  How much of this is due to climate is unknown but it is worth noting that Brazil has focused on energy efficiency and renewable energy sources in the past couple decades and some of that effort must be reflected in these numbers.  Of course, it hasn’t been without a price as the cost of food in Brazil has risen over the years.

Parting Thoughts

None of the analysis presented above is meant to defend the United States from the observation that energy is wasted.  Most citizens in the United States pay only a little attention to how they consume energy since the cost to them is relatively small.  It is clear that we can do better.  However, it is also not the case that US citizens consume energy like a drunken sailor on leave spends money.  Given the size of the nation, in both area and population, and the innovations and discoveries that originate here, the US makes a good return on the energy it consumes.  In addition, the US produces the largest amount of oil and natural gas in the world, and is second in production of coal and the generation of electricity (http://www.eia.gov/beta/international/).  It is patently unfair for intellectuals to continue to promulgate the myth that the US consumes energy at the world’s expense, a myth all the more dangerous since it is wrapped up in that innocent-looking little statistic that they like to throw

I suppose the origin of this particular column came from a rather comical conversation held over dinner.  My wife mentioned that her father used to tease a cook he knew about her efforts in the kitchen. Her father contended that cook’s efforts were proof that Marxism was wrong about the value of a thing made in the economy.  According to Marxism, the value of any object is determined by the total amount of labor required to make it.

The cook would select a great recipe for the main course, would purchase the finest ingredients, and would labor long and diligently over the preparation.  Of course, the meal would often be a great disappointment and, sometimes nearly inedible.  Any restaurant serving such a dish would soon go out of business.

The inverse situation also occurs.  There seems to be many instances were by accident, an entrepreneur just happens to ‘catch lightning in a bottle’.  A simple idea brought to market with minimal effort makes a fortune for its owner.  If you are thinking about the pet rock then you are reading my mind.

A very comic example of this latter situation occurs in the original movie version of the Producers, where Max Bialystock moans:

So what to make of this Marxist idea?  How much truth is there in the idea that if it took twice the amount of effort to grow one type of crop, say a bushel of wheat, as it did to grow another, say a bushel of corn, then the bushel of wheat holds twice the value as the bushel of corn.

Oddly enough the idea originated well before Marx, with roots being traced back to the philosophical works of the Middle Ages.  Thomas Aquinas is credited for noting in his Summa Theologica that:

This concept also shows up in the classical school of economics.  It was touched on by Adam Smith in his Wealth of Nations but it doesn’t seem that Smith actually embraced the idea as being applicable for anything more than the most primitive of societies (or rude societies as he put it).

Other classical economists, for example Ricardo, held more broadly to this concept making it part of their structure for economics.  Although even then, there were doubts about the universality of this idea. The labor theory of value was embraced by Marx as an important and operative principle but it seems clear that the notion, with no additional provisos, is untenable.  The notion that the buyer in the transaction has no place in determining the value of the thing being purchased is short-sighted and laughable.

Perhaps the best illustration of how much of value lies in the eyes of the customer is the following passage from Chesterton’s The Queer Feet:

If the labor theory of value is not a viable approach for determining value, what is?  That is a question that occupies a great deal of economic discussion even until today and there is no universally held belief.  Mainstream economists do lean toward the idea that free trade best uncovers the value of a good or service because in the free market the value of the thing will be determined best by the currency that will be offered to purchase it.

As a result, trade is actually seen as the mechanism by which value is created or imparted to a good or service.  Free trading allows for the assessment of value by letting lots of people ‘vote’ on the value.  To paraphrase Churchill, this economic democracy is the worst form of finding value except all the others that have been tried.

Please pass me the pet rock.

There has been a lot of recent buzz centering on the fear that certain segments of the population have about genetically modified organisms or GMOs.  These apprehensions are a part of an ever-growing concern that people around the world have in the way that their food is produced and how healthful said food might be.  Concerns over GMOs rank up there with the movement to have free range livestock and organically grown foods.  So what does all this biological science have to do with a blog on economics you might ask.  Well, simply put, everything.

At its core, economics is the study what goods and services society produces where, when, and how; who produces it; and who consumes it.  Sometimes, it even ventures a guess as to why but that question is broached far less often than at first it may appear.  Since the production of goods and services happen in the faces of finite resources and perpetual scarcity there is always a downside to every decision.  If resources are being spent one way they are not being spent on something else.

So of course, the decision to embrace GMOs fully, partially, or not at all is, at its core, a decision about how resources will be spent to satisfy on of the most basic human needs – the need to eat.

Identifying the particular risks of using GMOs is the province of a host of people, including the biologist, the botanist, the farmer, the food distributor, the politician, and so on.  Once the risks have been listed, the weighing of these risks is purely economics and is the province of us all.

However, it is hard to properly weigh the risks when a twofold set of errors is in play as it seems to be now.  The first error is one of emotional rather than rational thinking.  The second is the lack of vision is seeing the lost opportunity or unseen costs of choosing one over the other.

I mention these errors because there is mounting evidence that the developed countries are so mired in a dread of the GMO-monster that they are consigning millions of people in the developing world to avoidable chronic hunger, malnutrition, or death.

Emotional Thinking

The first of these errors, the indulgence in emotional thinking, seems to be gaining ground in many of the modern debates.  Within the past decade, there has been a rise in trendy, boutique causes where the passion is profound but the logic is scarce.  A familiar example is the movement in certain circles to avoid vaccinating a child due to the fear that the vaccinations cause autism.  There isn’t strong evidence to support this conclusion but that doesn’t stop certain people from engaging in emotional attacks against those who honestly disagree with this conclusion.

Advertisers and marketers are eager to fan the flames of emotionalism if it helps sell a product and one such case is the recent switch by Chipotle to ‘non-GMO ingredients’.  Chipotle’s website presents a slick picture

with catchy little lead-in phrase (G-M-Over It) and a short paragraph extoling the companies conscientious “Farewell” to GMOs.  Following the ‘Learn More’ link leads to an equally emotion-filled excerpt:

But if the reader were to persist in reviewing the reasons why Chipotle is saying “Farewell” to GMOs that reader would find a lot of far less emotionally-laden and circumspect words.  Buried in the ‘fine print’, are phrases like “we don’t believe the scientific community has reached a consensus” and “we believe it is prudent to take a cautious approach to GMOs”.  Even further in, Chipotle admits that while it is now shunning GMO plants, it has not eliminated GMOs from its supply chain.

So how much of a “Farewell” can they have made?  It seem more likely that this new campaign to eliminate GMOs (or appear to be doing so) is not designed to protect customers from their dangers as much as it is to boost the flagging stock price of company, which has been on a downward trend since February of this year.

Lost Opportunities to Eat

If this emotionalism were simply fueling an advertising campaign to separate consumers from their money, then one might argue that this it is a victimless crime with no real repercussions.  But in world with limited resources, there are significant lost opportunity costs.

One unseen cost is that the use of land, livestock, and crop resources at less than peak efficiency means that less food is being produced than otherwise would be.  That would be okay if there were plenty of food – that is to say the supply of food matched the demand.  In that case, there would be no incentive to raise production and no pressure for prices to rise.  Such is the long term trend in the US (although food prices have been rising recently and it may be that the bottom has been reached) but is not the case in the developing world.

The Genetic Literacy Project recently published an article by Michael Dzakovich that points out fears over GMOs have prevented their use in Africa.

Mr Dzakovich provides a vivid picture of the unseen costs of slow adoption of GMOs when he writes

Other articles on the Genetic Literacy site suggest that GMOs may help reduce carbon emissions and lower toxic pesticide use.

Clearly there are pros and cons in adopting wide-spread use of GMOs and the risks and the benefits need to be carefully considered.  But emotional arguments and slick advertising campaigns only serve to further hide and obscure the lost opportunity costs and people may be unnecessarily dying as a result.

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.