Thursday, June 29, 2006

An Opportunity Lost…for Social Security

One of the unfortunate aspects of the Bush second term has been the lack of any progress on the Social Security front. What a lesson on how an agenda can get killed by other fires. The second big opportunity lost is on tax reform. That will be the topic of a future post.

I still think a great way to think about privatizing social security is as follows. Why not let anyone with the right to future social security benefits securitize those benefits and invest the proceeds in a limited set of investment funds? Take the situation of someone who is 50 years old and has earned the right to maximum social security benefits under current law. I believe that is, in current dollars, around $3,000 per month. If that person, let’s say it is me, were to start taking benefits in 20 years, and collect them for 15 years, the present value of the benefits at a real interest rate of 4% would be over $175,000. Not bad when you think about it. So let me sell my right to these future benefits to a bank, who will in turn pay me the $175,000 present value, less of course some transactions costs. A couple points right away: One, you might not want me to give up my entire social security benefits, but only 50% of them. Fine, I still have $87,500 to invest. Two, you might want to restrict me to certain investment vehicles. Fine, just give me Fidelity, Vanguard, and TIAA-CREF. Third, if you let me do this, I would be willing to even forego some percentage of my future benefits. I personally would consider an offer to get in cash today only 75% of the present value of my future benefits. The rest I would let the government pocket, which in turn would help solve the solvency problem of the Social Security system. Or you could tell me that in order to opt into this new regime, I will only be able to start benefits at age 72, instead of 70.5. I would still opt in. This is very important; by giving people choice, there is always a gain, and that gain can be shared.

Now where do the banks get all the cash from to give to the people selling their future benefits? They raise cash by selling bonds that are backed by the future benefits. For anyone interested in the prosperity of the banking sector, this is interesting. Think of the fees that this would create. Lots of bonds being sold, and in turn lots of cash coming into the equity markets. In a sense, the de facto liability that the government has in regard to future social security benefits just got transformed into real debt – but not on the US Treasury’s (accounting) balance sheet.

There are lots of details that I could discuss, for instance on how to deal with people who have not yet earned the right to the maximum benefit, or on new people coming into the system.

The question might be: what do we gain by this? I think one contribution is indeed what President Bush has said, about the value in having people own their retirement fund and in being responsible for their future security. Another contribution is in reduction of uncertainty. How many people have even thought casually about the present value of their social security benefits? How many people even believe that they will get anything? There is nothing like being able to look at the current value of your retirement investments to focus your attention on what you have and what you need to do in order to secure a future. Reducing economic uncertainty is always an improvement.

I think there are also some interesting political economy aspects to this change. What would happen to the political pressures to increase benefits to retirees? As a retiree would never see their benefit check, just the annuity or whatever they would be getting from their investment fund, I think the link between the government and the retiree’s well-being would be cut. For instance, when I retire, if I don’t have enough income to live off, am I going to blame my employer, who provided me with a defined contribution retirement plan?

More on the Alleged BP Corner

I've been taking numerous calls from the press on the alleged BP cornering scheme (see my blog from last night). I have had a chance now to read a bit more about it, and in particular I read the Wall Street Journal's page one, 1500 word story on the events.

What I found most surprising is that the WSJ missed, or left out, some key points. First, and as I said in my post last night, the complaint itself admits that BP did not make any profit from the scheme. Now I agree that this does not mean there wasn't an attempt to corner the market, but shouldn't any story mention the key fact that the strategy appeared unsuccessful? Even better, the reporters should dig into why profits weren't made. Perhaps, the traders who were short found other ways to cover their positions? Or, maybe there were just not that many shorts who needed to cover their positions with February propane. Going along with this, there is ample evidence in the complaint that other traders had suspicions of BP's attempts to corner the market -- one trader referred to a BP trader as "Cody Hunt," a joking reference to one of the Hunts of the silver market corner.

The second fact that the WSJ left out, which is in the complaint, is that on February 15, the pipeline supplying this market ruptured, "reducing the amount of propane that could be delivered from the pipeline." With all the discussion in the WSJ piece about higher prices, would it not be appropriate to mention the possibility that other factors, like a ruptured pipeline, might have caused the price increases?

Third, what exactly is the link between one month's contract for TET propane and any wholesale or retail prices for propane? That is, how would even a successful corner on something so fleeting as a one month episode have a meaningful impact on real prices? I do not dispute that cornering activity is destructive of the real purpose of commodity markets, which is to discover what the price should be at any point in time on the basis of the fundamentals of supply and demand. And resources devoted to cornering are wasteful in that they are devoted to purely redistributive goals. But let's keep a rational perspective and not think that such temporary price disruptions necessarily flow through to consumers in any kind of direct fashion.

One last thing in the complaint that is intriguing is that BP, on February 24, redesignated 3 million barrels of February propane as now being available for March. Reading between the lines a bit in the complaint, I think the CFTC viewed this as a further attempt to reduce March supply. An alternative explanation is that BP saw that they would not be able to unload all their huge February supply, so they started taking action to make it available in the future.

Wednesday, June 28, 2006

When is a Corner really a DeadEnd?

I talked to a reporter this evening about the breaking story on how some traders at BP (British Petroleum) attempted to corner a segment of the US propane market. One fellow already pleaded, and it looks like he will bring down some of his colleagues. And given the situation with fuel prices, this will not look good for BP -- even though the events happened in '03 and '04.

But the curious thing -- a twist on the dog that didn't bark -- is that by BP's own admission, they lost money on the strategy!

So take the following scenario. Someone borrows 100 gallons of gas from me, promising to pay me back in a week. Heh, heh, I think....and begin to buy up all the available supply of gas. Come next week, I think, that poor lapdog is going to have to come begging to me to buy the 100 gallons that he needs to pay me back. What fun that will be.

But what if my counterpart is at least as shrewd as the nearest tree, and he anticipates what I might be up to. So he lines up an alternative supplier for the 100 gallons, and when I try to extract my profit from him, he turns to the supplier next door and buys the 100 gallons he needs. I get my 100 gallons, plus I have an extra 100 gallons that I probably had to pay higher prices for.

This sounds like the BP case. They lost money with their strategy because of the high prices they paid for the supply they "cornered" and they also had to hang on to a lot of the supply they bought (they wanted to sell it to the short traders for February delivery, but had to hold onto it into March).

(This is also similar to the classic story of predatory pricing, where one firm holds the price of a product very low, waiting for the competitors to go out of business. The problem is that holding price down costs the predator a lot, and the competitors often have a simple response of letting the predator have all the market at below-cost prices.)

I don't doubt that some of the BP traders might have had in their minds the dreams of a classic corner. They likely even discussed their strategy, which they thought of as a corner. At UCLA, I remember Harold Demsetz saying how businessmen often collude to charge the competitive price. Collusion and corners are hard to implement. Should we punish people for trying? I can certainly understand why the commodities exchange, the CFTC, might want to penalize the traders and the firm -- BP in this case. But should we send them to jail? Seems a little harsh to me. I don't dispute that the effort to corner a market is socially wasteful, but do we really know that these guys were not just doing their price discovery job, but using colorful language to make what might be a dreary day trading job a little more interesting?

The last twist here is that when I started explaining this to the reporter who had called, he clearly lost interest. He was asking me about how often such things must happen, and how damaging they would be (now really, how much do you think consumer prices were affected by propane prices on one set of February 04 contracts for propane in one part of the country?). Just another case of the media looking for a story that will sell, instead of one that will inform?

Saturday, June 24, 2006

Marginal Revenue

If there is one concept in economics that does not get recognized as being critical, it is that of marginal revenue. I just got done teaching a bunch of smart undergrads in Tuck's Business Bridge Program, and to a great extent much of my seven sessions is built around the idea of marginal revenue.

The key idea is this: if you want to sell more units, you have to lower the price. What happens to your total revenue as you lower your price? Well, there are two offsetting effects: one, you get more revenue by selling more units (at the new price). This is money from home. But the second effect is that you lower the price on units you would have sold anyway. This second effect reduces revenue, and overall, your marginal revenue is the sum of the two.

Think of Apple and Itunes. If the price per song is reduced, Apple will no doubt sell more songs than it otherwise would have. But it will also reduce price on all the songs it would have sold anyway. 0

Playing around with examples is really instructive. The net effect depends on things like the slope of the demand curve, and what the level of current sales is. And of course, all this is summarized by the elasticity of demand, but just jumping to elasticity tends to make one lose sight of what is really going on.

The application of marginal revenue that is on my mind now involves the decision to increase in production capacity in an oligopoly. Suppose there is an industry with only a few firms. If one firm adds more capacity, it will pick up some additional units of sales...but no doubt it will also cause a decline in price for the units that the firm could have sold anyway. To think of an equilibrium in investment for such an industry, we need to invoke the idea of a Nash equilibrium...and the thing that will drive that equilibrium will be the two effects discussed above: the revenue from addtional capacity versus the effect on "inframarginal" sales.

Why micro textbooks don't emphasize this more is beyond me. The applications to pricing alone are worth several chapters.

My first post

This will be a blog on a variety of topics, with a focus on economics and world political affairs. I tend to the libertarian side of the political spectrum but am open-minded.

More later...I am just having my technology consultant (my son) set this up for me.