Thursday, October 30, 2008

Selling search

A few days ago I asked my students the following question:

It's well-known that internet piracy of music is rampant. How is it, then, that iTunes can make a profit selling songs at 99 cents each? Someone who can use iTunes presumably has access to the rest of the internet. Apple is competing with other producers of an identical product who offer it at a price of zero.

One young lady made a very insightful comment - she pointed out that Apple is not so much selling the music so much as charging a transaction fee for the use of a convenient, reliable and safe search engine. The content may as well be free; it's the search that is being sold.

Finding a song on pirate sites can be difficult, due to spotty labeling, broken torrents, virus-infested files and so on. iTunes users don't have to put up with any of that.

The flat 99 cents that are charged for each song tend to bear out the 'transaction fee' idea. Neither popularity, nor file size, nor the original source of the content affect the charge.

This is the same model that some academic journals use for people seeking PDF files of their articles. The journals also compete with 'free' producers: most academics have free access to these articles at work. There's a big difference in this market, though: buying the reprints from individual journals is a painful process, requiring separate registrations and payment schemes for each publisher. Accessing the articles via a work-place portal is not only 'free' (in the sense that the employer bears the entire cost, usually fixed) but vastly superior in efficiency. Library web sites and databases such as EconLit look through the contents of dozens of publishers for each search.

The biggest search engine of all is Google. Search is free, and content found through the search is usually free. This engine is supported through ad revenue, which I find curious. Though I use it many times a day, I can't remember the last time I clicked on one of the sponsoring ads, even by accident. I don't think I'm alone in this.

It's not unheard-of in the offline world for human tour guides to share their take with those providing the sights of note - iTunes's model. The journal publishers are individual stalls in a bazaar, competing with a supermarket. Google hopes that passengers on the trip will buy from the in-flight boutique, or at least burn into their memory the sponsored posters on the walls.

Tuesday, October 28, 2008

Economists and regulation

Perhaps not surprisingly, the recent financial crises (note the plural) has led more than a few people to think that tighter regulation of money matters may not be a bad idea.

What IS surprising, or has been to a few of my students, is that some of these people are professional economists.

To the general public, the word 'economist' is tied up very closely with 'free trade' and 'free markets'. That they may support regulation seems at first a contradiction.

In point of fact, economists are responsible for much of existing economic regulation. This includes everything from rules for monetary policy, to deciding on the guidelines for the approval of a merger, to controls on firms' pricing policies to encourage competition.

Economics is all about the efficient use of scarce resources. The 'stuff' we have - natural resources, time, knowledge, health and so on - is limited. The stuff we want is unlimited, and the needs of the world's population, while arguably limited, are not being met.

In some cases, leaving markets alone will get the job done, getting stuff where it's most needed or desired without too much lost along the way. That's great.

In other cases, leaving markets alone may result in waste, or inefficiency, or some other loss of the potential available to society, given what we have to work with. It's in these cases that regulation is welcome.

When it comes down to it, economists and environmentalists think rather alike. Our focus just happens to be on different resources, different needs, and different desires. Sometimes. Environmental economics and resource economics are flourishing fields in their own right.

Just as environmentalists, while generally preferring 'free nature', may advocate conservation programs, seed banks and so on, economists, while generally preferring 'free markets', will often advocate helpful regulation.

Thursday, October 23, 2008

Financial markets and change

Lately, I've been re-watching an excellent series of videos on the Industrial Revolution. The show tries to explain, in part, why the Industrial Revolution happened in England, and not in, say, Holland or France, either of which would have seemed more likely candidates to contemporary observers.

Their answer is that many unusual ingredients were required to go from a pre-industrial, static world to an industrial one in which growth was expected. England happened to have them all at the right time.

One of these ingredients, the show argues, was the existence of modern-style financial markets.

In general, before the 15th century-ish we don't see much paper trading in Europe. No stocks, bonds, or other fancy financial instruments. When people bought something, it was usually because they actually wished to own the object or service in question. If someone paid for the construction of a church, it wasn't to 'flip' it. It was because they wanted a church there. There wasn't much lending for the simple reason that most religions frowned on usury, and the law of most lands paid at the very least lip service to religion.

All of this contributed to the static nature of society. Things didn't change because no one was willing to take the risk. People bought what THEY wanted, and not what they hoped other people would like. Producers produced to known tastes, with changes in style or technique being unusual and revolutionary. There were relatively few risky ventures. Society consisted of haves, and have-nots. If you had money, then you usually were in a position to continue to have it. There was no reason for you to risk tossing it all away on something that may not pay off. If you didn't have it, there was (almost) no one willing to lend you the money, because they wouldn't be able to charge a very high interest rate, if any at all.

In general, then, yes, I'd definitely agree that the existence of modern-ish financial markets is absolutely necessary for the kind of prosperous, innovative, dynamic society we've come to know and love.

That doesn't mean that it's without its pitfalls...

According to the video, the Dutch invented modern finance. I'm not sure I agree with this, but let's take it as given for the sake of argument. If nothing else, the Dutch were certainly popularizers of the practice.

Holland started trading paper. A lot of it. Prior to the 17th-ish century, when you bought a share in a ship's voyage, that's exactly what it was. Trading ships were expensive, and so were trips to the Indies, not to mention risky. You bought a share in the ship in order to share your risk with other investors. When it came back to port, you took the corresponding share of the profits from her cargo. If she failed to return to port... well, you had a problem.

The Dutch made popular the practice of trading shares in these ships. Cargo futures, if you will. Instead of holding them to maturity, you'd sell your share to someone else, who could then hold it or share it, and so on.

The same happened with other types of risk and stream of income or future windfall.

What was one of the first uses it was put to?


The video series dwells on this for quite some time. Essentially, what happened was this:

Tulips were new to the Dutch. They imported them from the East. Certain kinds of tulip had ink-blot-like markings. These were considered especially beautiful. ulips grow from bulbs. Bulbs all look pretty much alike and don't tell you what the future flower will look like. Today, we know it was the mosaic virus that caused these markings. Back then, the Dutch thought it was just random chance.

What took place next may look a little familiar...

At first, people bought tulip bulbs because they actually valued the tulips they might grow into.

People noticed that some tulips were selling for extremely high prices, and decided to start selling tulips.

Other people noticed the people who noticed the rise in tulip prices, and joined in.

The rise in people buying tulips raised the price of tulips - even though these people were only buying them in order to sell them at a higher price later on.

The higher the price became, the more people joined in the market, driving the price even higher, which attracted more people.

Eventually, it all fell apart when a few people decided to... NOT pay the price of a house for a tulip bulb.

The Dutch economy went through a crisis, and people left holding tulips lost everything.

This type of bubble happens over and over again.

It's always caused by a large sum of people buying an asset only in order to sell again, without ever intending to act like an owner of the asset.

The bubble gains momentum when the relative price of the asset that is being traded rises for an extended period of time. (The relative price is the price of the good compared to the price of other goods in the economy. Let's say that tulips and onions both start selling for a dollar each. If the price of BOTH goes up to 2000 dollars each, that's not very interesting. If the price of ONLY tulips goes up to 2000 dollars, while that of onions stays at 1 dollar, then there's a problem.)

The tulip bubble is striking because everyone KNEW they were just flowers, and yet jumped in anyway.

The lesson? Buying to sell to others who are buying to sell is a good way to start a disaster. Modern financial markets make this easier than in earlier times, but in the end, the responsibility lies with the investors.

That's easier said than done, of course. It's difficult to stay out of it when someone tells you, 'sell me tulips, even if you think they're over-valued and part of a bubble about to crash, and I'll give you a hefty management fee'.

Tuesday, October 21, 2008

A tale of two Cities

Because they are self-contained economies, online games can lead to interesting natural experiments in economics.

Consider 'City of Heroes/City of Villains'. As the name suggests, this single game is divided into two distinct parts: good guys and bad guys. Subscribers to the game pay a monthly fee for the privilege of pretending to be a hero or a villain. The game world is shared by thousands of players, leading to a vibrant artificial economy.

The economy is set up as neatly as an economics instructor could hope for. The 'City of Heroes' and the 'City of Villains' may be thought of as two closed economies. Each produces the same products. Handily enough, these fall into the textbook favourite of two categories: recipes and salvage. For the present discussion, it does not matter what these goods actually are, only that they exist.

As in textbooks, the only input required for the creation of these outputs is time. Heroes 'arrest' bad guys and villains engage in nefarious acts to produce these goods. For various reasons, the City of Heroes has an absolute advantage in the production of recipes. In particular, heroes have easier access to certain rare recipes than villains do. Heroes and villains produce salvage at roughly the same rate, though arguably heroes have an absolute advantage here, as well. Anecdotal evidence suggests that heroes tend to work in teams more than villains, leading to factory work (heroes) vs cottage industry (villains).

One quirk is that salvage and recipes are complementary in production: if you make one, you generally make the other, as well. For heroes, the recipe/salvage production ratio is on the whole larger than for villains. (For those in the know: due to quick Katies, etc.)

Each City has its own currency. Goods are traded for currency anonymously on a consignment market, under a system that is very close to a Vickrey auction. Sellers post their goods along with a reserve price. This reserve price is not visible to buyers. If a buyer places a bid at or above the lowest reserve price, the good is sold at the bidded price to the seller with the lowest reserve price. That is, this system encourages high bidding by buyers and low bidding by sellers. There is no penalty for changing a buyer's bid, but sellers are subject to a transaction fee for each time they change their price.

While the prices at which items are posted by sellers are not visible to other players, buyers have easy access to the prices at which the last five units of the item have actually sold.

Market prices in the City of Heroes are generally much higher than in the City of Villains. The exception is for certain rare recipes, which due to their scarcity and some differences in tastes are far more valuable for villains than for heroes. (For those in the know: Pool C drops and Pet Damage IOs go for a lot more villainside.)

Scarcity is a constant problem in the City of Villains. There are far less producers (that is, there is a lower population) than in the City of Heroes, and so many goods are not available at any price.

There has been some demand for a merging of the two markets - that is, opening them up to trade. Most opposition has come from dedicated merchants on both sides. These are players who spend a considerable fraction of their time in arbitrage, buying low and selling high - essentially ensuring that the market in each city functions like a market.

Salvage traders in the City of Heroes worry that the price of salvage will drop considerably if there is trade between the Cities.

Most dedicated traders in the City of Villains worry that the entry of more producers (and traders) will lower their profits - right now, the villain market functions much like an oligopoly.

What does basic economics tell us about what may happen if the markets are merged?

First, for the easy part: water seeks a level, and so do prices. If the markets are merged, we can expect hero prices to drop and villain prices to rise, with the exception of the rare recipes mentioned above, in which case the effect will be the opposite.

The more interesting question (for me, at least) has to do with the nature of the money supply, and the speed at which currency changes hands.

The minting of money in the game is very different than in the modern real world. There is no central monetary authority. Instead, players mint their own money. Every time heroes 'arrest' a bad guy or villains mug someone, the game creates new currency and deposits it in the player's account. These are the same activities that also generate salvage and recipes.

In other words, in this virtual world, the money supply rises automatically with the production of goods.

There are some money 'sinks', of course, to ensure that inflation does not get out of control. There are transaction fees, luxury and vanity services that may be paid for and so on. Perhaps most importantly, there are no inheritances. When a player stops susbcribing to the game, the currency in their account is taken out of circulation. There are also restrictions on the transfer of currency between players. It is possible, but intentionally cumbersome and potentially risky.

The Fisher equation, beloved of economists, may provide considerable insight into what's going on.

MV = PY, as the saying goes, where 'M' is the money supply, 'V' is the velocity of money - that is, the speed at which money changes hands, 'P' is the price level, and 'Y' is output.

All this equation says is that, all in all, the value of transactions in an economy (the left-hand side) must add up to the value of output (the right-hand side).

For the purposes of our game world, 'Y' is the aggregate of recipes and salvage.

The same process mints money and produces good, so let's suppose that the money supply is some multiple z of output. That is, suppose that whenever salvage or a recipe is produced, so are z units of currency.

Our equation becomes

(zY)V = PY

Dividing both sides by Y,

zV = P

We now have a formula for the price level.

I mentioned that heroes produce recipes more easily than villains. In a half-hour period (the time for a 'quick Katie' task force, an activity which guarantees the produciton of a recipe by each player), heroes can produce more recipes than villains. The amount of currency (and salvage) produced in this time period is much the same for heroes and villains.

Since z represents M/Y, the money supply over output, z should be smaller for heroes than for villains.

If V is the same for heroes and villains, this suggests that heroes should have lower prices, overall... but they don't.

There are two reasons for this.

One is simply due to my simplifying assumptions. I assumed that all recipes are the same, where in fact heroes only have an advantage in producing a particular subset of all possible recipes - and these are, indeed, lower in price for heroes than for villains. The lesson: be very careful in your assumptions when trying to apply textbook economic models.

The second, more interesting reason, is that the velocity of money is drastically different between heroes and villains. The population of the City of Villains is much lower than that of the City of Heroes. Despite the two cities having similar (but not congruent) tastes, the variety of goods available for sale is much greater for heroes than for villains. All in all, this means that the market is far more active for heroes than for villains, and in turn, money changse hands far more frequently among heroes than among villains. There's more stuff to buy, and it's bought more often.

In terms of our equation, V is higher for heroes than for villains.

Let's look back at the original equation:


Rearranging this,

P = V x (M/Y)

What this tells us is that the higher the speed at which money changes hands, the higher you can expect the price level to be.

If the markets in the City of Heroes and the City of Villains were merged, we should expect the speed at which money changes hands to increase overall, due to the larger effective population of each market. This, everything else being equal, WILL lead to a rise in the price level of BOTH cities.

City of Heroes/City of Villains is quite a popular and active game, and new players join all the time.

There is some worry that if prices keep rising, new players, who start with no currency, will be priced out of the market.

This will not necessarily be the case, of course. Since new players automatically become producers of salvage and recipes as they go about their adventures, a high price level means that they receive large amounts of money for the goods they sell, as well as being charged high prices for those they buy. As any self-respecting economics student will tell you, the absolute price level matters very little: it's relative prices that you need to watch.

Still, there are some valid reasons for being worried about the price level. Suppose that the 'government' - the game's developers - wished to step in and keep the price level below a certain threshhold. What can they do?

They could adjust the rate at which money is minted. By lowering z, they may lower the price level.

They could place additional restrictions on transactions, lowering the speed at which money changes hands. For example, they could code in a law that required a cooldown period of an hour (say) after any transaction involving currency, however minor. This would be annoying for players, but certainly has the potential of lowering the price level. It could also have the perverse effect of raising the price of many items. Since the market works as a blind auction, bidders may choose to bid values very close to their actual valuation of the good in question, since they may not have a chance to do so again before the end of the auction.

They could flood the market with goods, lowering their price. I have a sneaking suspicion that they already do this for certain items. Some salvage is only available for production in October. One would expect that as time went on, the price of this salvage would rise, and then fall as October neared again. Instead, the price of this salvage has stayed remarkably constant. Other prices in the market have been very volatile, but the price of this salvage has stayed at 300,000 units of currency for months, only falling again in October, quite suddenly, to 50,000 units. This suggests that the game's developers have used their control of the game world to create 'helicopter drops' of this product in exactly the quantity required to keep its price constant, and affordable. This is a rather roundabout, but quite effective, way of enforcing price controls. It works here because the goods are entirely identical, may be created by the government at zero cost, and cannot be created by the citizenry except during the month of October. These conditions are unlikely to hold in the real world, where, alas, price controls seldom work.

Another possibility: due to their absolute control of the game world, the developers may have set the price of that salvage to be equal to 300,000, no matter what. This is less likely. Due to the way in which the market works, it could be discovered by players attempting arbitrage. Such a discovery would have led to scandal. Quantity manipulation works better than price-setting because due to the anonymous nature of the market, it is not possible to tell who put a particular item up for sale.

Textbooks, lectures and problem sets are, of course, essential for obtaining a detailed understanding of modern economics.

There's a lot to be said for spending some time in these 'sandbox' economies, though.

Thursday, October 16, 2008

A quickie

Don't Panic.

That's my advice to everyone asking for economic advice.


If something happens to you, personally, then by all means react to it.

If something specific is on the horizon that you need to plan and prepare for, by all means, please do so.

Preparing for vague 'hard times' because the TV says they're coming?

Well, that's half the reason bad times may be coming, right there.

Positive thinking isn't all that powerful in many situations, but in economics, it is.

If people think times are bad, then they'll spend less and invest less. This will ensure that times ARE bad for businesses that make a living by selling stuff to consumers and investors.

Even if everything was just fine and dandy before the gloominess, pessimism WILL see itself justified.

If people think times are going to be fine, the whole thing happens in reverse, and even if something DOES happen to go wrong, things will turn out better than they otherwise would, for the economy as a whole.

In brief: if there's something specific that you need to react to or prepare for, please do. If you wish to buy into the general gloom just because the media says you should, please don't.

If you THINK there's something specific about the current economic climate that you need to prepare for or react to, but can't tell what it is, then this is a perfect opportunity to invest in an education in economics.

(Disclaimer: these views are mine and mine alone, and don't represent those of anyone else. What's more, my personal views tend to change rather quickly, so they may not even represent my own thoughts, a few days from now.)

Tuesday, October 14, 2008

Malthus, price levels and the gold standard

(This will end up being posted on Wednesday, but I started writing it on Tuesday, honest!)

Lately, I've been reading Thomas Malthus's Principles of Political Economy (full text available at the link).

It's a fantastic book on basic economics, written before math was introduced to the subject. In fact, there's a brief section where the author wonders whether formal math should be introduced into 'political economy' at all, since the clarity it brings is at the expense of complexity.

What makes the antique text blogworthy at this particular point in time is what it has to say about price levels.

There are more than a few intelligent people of the opinion that much of the current (and past) financial turmoil was caused by leaving the gold standard.

Before the mid-twentieth century, most currency in the world was backed by silver, gold or a combination of the two. Effectively, this meant that there was a global currency. France may have its francs, and China its taels, but if both were convertible into silver at a fixed rate, then they were just placeholders for the true currency, precious metals.

This is what the 'gold standard' meant: that you could exchange paper money for a known amount of gold at any bank. There was never more money than there was gold. Because gold is a rare metal, many countries found it useful to use silver, as well. The rate of conversion between silver and gold was well-known.

This system collapsed during the Great Depression, in an interesting way that is too complex to summarize in this brief post.

These days, most currencies aren't backed by anything except the government that issues them. In daily practice, this works out pretty well, with some spectacular exceptions.

It used to be that money worked like the market for precious metals, because money WAS precious metals.

Now, money works more like the market for baseball cards, or artistic prints. If a government prints a lot of money, the currency becomes less valuable, just like if a baseball card company printed large numbers of a particular card. This is what's going on in Zimbabwe right now. If a government keeps its printing under control, then the value of the currency can be kept as high as it likes. Witness the British pound.

The argument for returning to a gold standard is that the current system is inherently unstable. Trusting governments to print the 'right' amount of currency has not worked, and instead has led to wild swings in prices, and in currency crises such as that in south-east Asia in 1997.

As far as the argument goes, there's certainly a lot of truth to it. If nothing else, a gold standard would make situations like Zimbabwe's current difficulties impossible... as long as countries stuck to the standard. The reason it collapsed in the first place was that, faced with financial crisis, several governments decided to abandon the standard.

(This is similar policy response to that seen in 1997. Several countries in the crisis zone had tied the value of their currency to the value of the US dollar, and abandoned that standard when under speculative attack.)

Suppose that the world did revert to a gold standard, and stuck to it.


Actually, that's a very complicated theoretical exercise. Instead, let's make things easier. Let's go back to a point in history where the world WAS on a gold (and silver) standard. The economic literature of the time should give a good idea of whether this brought price and financial stability.

This is where Malthus fits in. He was a keen observer of current events, a careful thinker and a compelling writer. The sections of his work that treat with price levels and financial crises of the time are eye-openers: in practice, the gold standard led to surprisingly volatile price levels, as well as the occasional currency crisis.

I've linked to the entire book in PDF form, so it's simple enough to search for 'gold', 'specie', 'silver' and 'currency' and read the relevant sections yourself, but I'll summarize one of his arguments, which struck me for its insight and simplicity.

Malthus noticed that prices in England, a wealthy country, were a lot higher than prices in poorer countries. He wanted to know why. After all, England was the workshop of the world - if it could produce things more efficiently than Sweden, say, then why was everything so much cheaper in Sweden?

The reason given by Malthus? Currency movements. Precisely because of the gold standard, these were very easy to think of and keep track of.

For the sake of argumetn, suppose neither England nor Sweden mined gold. England's goods were in very high demand by the rest of the world. As a result, other countries bought England's goods and paid for them with their gold. On the whole, gold flowed fromt the rest of the world, into England.

What about Sweden? Its economy was based on copper, wood, fish, small amounts of high-quality iron and other natural resources. It was nowhere as wealthy as England. In fact, it had to import many goods - gold tended to flow out of Sweden.

Note that I've only talked about gold movements. Since I assumed neither England nor Sweden produce gold, these movements do not affect production in either country.

Relative to the goods available at home, there is very little gold in Sweden, and a lot of gold in England.

By definition, the gold in each country MUST be enough to buy everything traded in that country. (Remember, the only currency IS gold.) The large amount of gold in England means that gold is relatively 'cheap' in terms of goods: price levels must be high. The small amount of gold in Sweden means that gold is scarce there: a small amount of gold must be able to buy more goods. Prices are cheap.

A really neat, simple argument, and evidence of puzzling price differences under a global gold standard.

I've simplified the argument considerably - Malthus is extremely careful in his thinking, as I mentioned, and he goes over all sorts of possibilities, variations and extenuating circumstances.

Definitely worth a read. Especially if you're currently of the mind that changing back to a gold standard will fix the world's currency-related problems.

Thursday, October 9, 2008

How will the financial crisis affect YOU?

There's a lot of talk in the media about what's in store for banks, governments and financial institutions, but surprisingly little about what will happen to the average consumer. I don't mean in a vague way, such as 'loans may be harder to get', but in how you'll notice that there's something odd going on when you walk into the supermarket or try to get a part-time holiday job.

Let me try to help with that. Before I focus on consumers, though, I'll need to share some background on what's going on with firms.

One of the biggest things that's going on right now, as far as consumers are concerned, is the frozen market for commercial paper. Just like people, companies are occasionally short of cash for the day. If you go grocery shopping and find out at the till that you don't have enough cash to pay for what you put in your basket, then chances are you'll pull out a credit card. It's not that you're bankrupt; you just don't have the cash at that particular moment, and a credit card is a convenient way to borrow small amounts of money for short amounts of time. As long as you've been paying your credit card bills on time, there's very little reason for the card to be declined.

A company's equivalent of a credit card is 'commercial paper'. Let's say that Starbucks finds out on Wednesday that it doesn't have enough money to pay its workers on Friday. There are many non-scary reasons why this might happen. Starbucks may have a lot of its cash tied up in loans to other companies, or in long-term investments. Maybe some unexpected bills have come in. It could be that Starbucks itself is paid on Friday. In this case, it'll issue commercial paper: a very short term, very safe IOU. In the ordinary scheme of things, it isn't difficult to find a buyer for this IOU. If Starbucks says, 'Lend me a million dollars on Thursday morning, and I'll pay you back on Friday evening, with a thousand dollars' interest,' that's pretty much a free thousand dollars.

Or so you'd think.

Not too long ago, a whole bunch of lenders were burned when the company they lent a large amount of money to overnight went bankrupt - also overnight. (I think the company in question was Lehman Brothers, but I may be mistaken.)

This sent the financial world into a panic. There's a lot of money out there that WANTS to be lent (because loans earn interest). The problem is that no one knows who is safe to lend to, anymore.

The situation's very much like that of a person who fell in love, trusted the object of affection, and then was betrayed, only finding out when they woke up one morning to find their wallet emptied and the car keys missing. Lenders are in the 'I'll never love anyone ever again' stage of things.

The markets for commercial paper are pretty much frozen. Very few people are willing to make these short-term loans right now. Not even to really big, well-known companies such as McDonald's. Not even at a higher-than-usual interest rate.

What does this mean for consumers?

For the near future, companies in general are going to have to be a lot more cautious. They can't afford to run out of money, not even for a few hours, because no one is willing to lend it to them.

The first thing that comes to mind is that we're likely to see drastic reductions in what stores keep in stock.

That jalapeno jelly at the supermarket that you love, but no one else ever seems to buy? Gone. Your favourite obscure retro-steampunk-jazz-opera group that HMV always kept a few CDs of? Gone. The lonely copy of 'Care and feeding of elderly komodo dragons, a multivariate regression analysis with thirteen statistical appendices' at the local bookstores? Fuggedaboutit.

Stores will do everything they can to avoid being stuck with unsold goods. Bookstores will stock bestsellers and proven classics in overwhelming preference to anything else. Music stores, already hurting from the online onslaught, will focus on top 40 hits. Supermarkets will try to carry only fast-moving products.

The good news? You'll probably see a lot of clearance sales in the next few weeks as stores try to dump their poor sellers in order to open up inventory space for safer products. Enjoy them while they last.

If you're reading this, you have online access, and are probably able to shop online at places like Amazon. In that case, the loss of variety in stores won't affect you as much as everyone else. If you want your obscure Brazilian soap opera translated into French, you can probably find some place online that sells it, and don't need to rely on bricks-and-mortar establishments.

Less good is the impact this has on new, quirky stores.

I enjoy window-shopping and walking through the commercial parts of town. A lot of the fun comes from stepping into really weird stores that sell things you never suspected existed. (Hush, you. I mean the family-friendly sort of weird.) As fun as such stores are, they have very short life expectancies. With the current freeze on loans, chances are a lot of them will never be 'born' in the first place.

If it's difficult for established businesses to get loans, it's almost impossible for new and unproven businesses to do so.

A lot of stores that WOULD have opened if loans were more easily obtained, will now not open at all. The salaried accountant dreaming of starting his own flower shop will now have to continue dreaming, since a lot of the financing required to start up a business is (temporarily) unavailable.

When you're talking about one flower shop that doesn't get built, it's not so bad.

When you multiply that by all the new businesses that WOULD have started up all over the country, continent and world...

Well, we're going to see less jobs available these holidays. It's probably going to be noticeable if you're out there on the job market. I don't expect the jobs in the economy to actually fall - I don't think a lot of companies will actually fire their workers, at least in Canada... However, there will be much less of an increase in the number of jobs than there would have been without the crisis. People that would have hired, won't hire.

Related to this, you can also expect franchises to stop expanding as quickly as they have in the last few years. If you were hoping for an extra twenty Tim Horton's stores in Yellowknife, you're probably out of luck. Then again, the Tim Horton's nearest me seems to constantly have a lineup, even when other food outlets are doing poorly, so that may be one of the few exceptions...

Due to the inability for companies to get loans, I also expect a fall in the amount of courtesy services, freebies and promotions that are offered. Coupled with this will be a general rise in prices. Both of these will help to cushion companies against possible drops in their now-vital pool of reserve funds.

What does this mean? Coffee shops that used to give a free chocolate square with their drinks might stop doing so. Airlines will continue to cut back on things provided free of charge during flights. The Body Shop has already started charging a small fee for 'gifts' they used to give for free to shoppers who bought many products at once. Two-for-one promotions will become less generous. You may have noticed HMV moving from 2-for-40 to 2-for-60 for similar products in a short amount of time.

I suspect that stores will do what they can to keep posted prices from rising too quickly. They know this can drive away customers, especially if they're one of the first establishments to raise prices. It really looks bad if you're selling a DVD for 30 dollars when the store across the mall has it for 20, even if the store across the mall is THINKING of raising their price to 30 next week. Instead, prices will be raised less directly when possible. Reward or 'points' programs will be made less generous in difficult-to-understand ways. A planned 50% off sale may become a 40% off sale. The cosmetics department may offer half as many free makeup workshops this year than last year. That sort of thing.

That's not to say prices won't go up. They WILL. Not being able to get short-term loans means businesses need to keep around a pile of cash for rainy days. That pile of cash is an extra cost. At least part of the extra cost will be passed on to the business's customers. It's just that price tags won't go up by as much, or as quickly, as you might expect.

I have the nagging feeling that I've forgotten a lot of important consumer-related repercussions that I wanted to mention... Feel free to remind me of them in the comments!

Update: Frosted animal cookies have fallen prey to the commercial lending freeze.

Tuesday, October 7, 2008

Is the CBC inducing a recession?

Disclaimer: More so than the rest of my posts to date, this one is almost entirely opinion. There are many other equally valid views.

I'm an avid CBC Radio 2 listener, and was dismayed to hear their recent news programs focus on Canada's risk of a recession. My disappointment grew as I headed over to the CBC's web site and found several prominent articles on the subject.

Canada's economic fundamentals are sound. Not perfect (no country's are), but sound. Unfortunately, this does not make Canada safe from the antics of panicked investors.

At any given time, in a healthy economy, a lot of money is in motion. Not all of it moves at the same rate. Some money, such as that in chequing accounts, moves quickly. Other money is temporarily frozen in the form of bonds, or tied up in loans that cannot be called in on short notice. These days, foreign money that is invested in Canadian capital tends to be surprisingly mobile. Trading in Canadian assets is brisk; not a big surprise given our strong focus on commodities.

This system can be gummed up by a trusted source crying 'recession', just like the exits to a crowded theatre can be gummed up by someone crying 'fire'. It doesn't matter in the least whether the cry is actually true. All that matters is that it is believed temporarily.

Suppose, for the sake of argument, that Canada's economy is doing just fine, and that investors (domestic and foreign) trust the CBC as a news source about Canada. What happens if the CBC starts saying, loudly and often, in print, on the air and online, that Canada is entering a recession?

Domestic investors may delay their investments. If a bakery was thinking of buying a new bread machine, they may decide to put off that purchase. In a recession, people buy less of everything, including bread. They may also reduce new hires, for the same reason. Result: lower investment and unemployment. The announcement causes the very symptoms of a recession.

Foreign investors may, using similar reasoning, decide to pull out of Canada, or at the very least invest less in Canada than they would have otherwise. That's another induced slowdown in growth.

If (I admit this is a stretch) fears of recession in Canada are tied to fears of US-style bank failures, this may lead people who can afford it to pull their money out of Canadian accounts and into bank accounts in other countries. This may be enough to start a general bank run, causing banks to fail, even if these banks were perfectly healthy beforehand. Generally, banks only keep 10% or less of their deposits on hand as ready cash. The rest is out as loans. Many of these loans take time to call in, so a bunch of depositors asking for their money back at once will break the bank.

There's some evidence that the general public is losing confidence in Canadian banks. The stock value of Canadian retail banks has fallen drastically in the last few days. The timing is consistent with the start of news stories about a possible Canadian recession.

The prediction of a recession or a bank run is too often a self-fulfilling prophecy.

In the CBC's own words, "The mere mention of the word can cause serious jitters for Canadians who have a job, invest in mutual funds or are thinking about making a big purchase."

Exactly. So it'd be really nice if they'd stop mentioning it until it actually happens.

Talking about a recession once output has actually fallen - that is, during the recession itself - is just fine, and may actually prove quite helpful.

Talking about specific, well-defined economic issues that may lead to a recession is also great (e.g. 'Hey, maybe unregulated credit-swap markets aren't the way to go...').

Merely lumping together the punch lines of gloomy forecasts? Not so much.

Thursday, October 2, 2008

Corporations and a free market

I've spent some time recently going over comments made on various blog and news posts regarding the current financial crisis.

Whenever someone complains about grotesquely large CEO salaries, golden parachutes, short-sighted boards or the herd mentality of stock holders, you are almost guaranteed to find a few posts later a reply along the lines of: "Suck it up. That's how the free market works. Capitalism at its finest."

This confuses me.

Few things are less representative of a free market than the modern corporation. It exists only because of very specific laws enforced by governments. Partly by design, partly by historical accident, this framework distorts the notion of 'ownership' into something scarcely resembling the original idea.

A truly free market would see all companies and their owners have unlimited liability (unless they bought insurance). 'Unlimited liability' means that if something goes wrong with the company - say, it goes bankrupt - then its creditors are free to take the money they are owed from the owners of the company.

A basic protection that requires only a touch of regulation is limited liability. In this case, the creditors are only able to take from the owners an amount of money equal to the owners' investment in the company. If you had $100 in a Betamax firm and $1000 in a VHS firm, as well as $10,000 in the bank, if the Betamax firm went bankrupt its creditors would only be able to ask for $100 from you.

This already distorts the notion of ownership from that found in a free market. Because investors are partially protected from risk by the legal framework, there is an incentive, everything else being equal, to spread one's wealth among as many different companies as possible.

('Different' is the key word here. If the companies are all equally profitable but in completely different fields, then the more companies you spread your money about, the less likely you are to lose it completely. Suppose each company has a 50% chance of failure. Put your money in one, and there's a 50% chance you'll lose it all. Put your money in two, and there's a 25% chance you'll lose it all.)

In other words, limited liability already provides an incentive for an investor to split her attention among many different companies. I have a nagging suspicion that this may lead to weakened leadership and less capable entrepreneurs.

A corporation goes even further. Not only is liability limited, but the company itself is considered a legal entity, and if 'the corporation' goes bankrupt, then creditors may only try to get their money back from 'the corporation' - not from anyone who may hapeen to own shares of stock in the company.

These shares of stock are meant to be shares of ownership. This is why they (should) pay dividends, a share of the profits. By and large, they stopped being treated like shares of ownership long ago, and are now closer kin to horse race gambling chits.

'Ownership' has become so distributed in most corporations as to be meaningless. This is recognized in that they are run by a board of directors, ostensibly acting on behalf of shareholders. Unfortunately, most shareholders want nothing more than to play hot potato with their stock, selling it the moment they feel the price is high enough. This leads to an often lamentable focus on the short run, with predictably disastrous long-run consequences.

None of this would be possible without the laws that allow limited liability and incorporation. Modern corporations are antithetic to a free market, not symptomatic of it.