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Belmont Club

True lies

February 22nd, 2010 - 3:14 am

Markets work by assimilating and pricing information. But sometimes the information is not available or it’s faked. The Greek debt crisis has focused renewed attention on the accounting procedures used by other European countries to measure their compliance with Eurozone guidelines now that the information shortcomings have been revealed. Investors, having lost confidence in the official numbers provided by Athens are demanding better figures. The Wall Street Journal says new doubts about “sophisticated” reporting practices used in the past are being expressed  not just for Portugal but even for core countries like France and Germany. One particularly controversial practice is the use of currency swaps on the advice of, among others, Goldman Sachs.

In recent weeks, countries’ use of currency swaps has drawn attention. In such transactions, often benign, countries might borrow in a currency not their own, for example, and use a derivative to offset the risk of currency fluctuations. But these instruments can also be used to artificially massage cash flows and liabilities, to meet debt and deficit thresholds. …

Euro-zone governments are under no obligation to disclose the precise nature of the derivative agreements they enter into, making it nearly impossible for investors to discern the potential risks associated with them. Eurostat permitted the use of such transactions to adjust debt figures until 2008. …

Goldman Sachs Group Inc. did 12 swaps for Greece from 1998 to 2001, according to people familiar with the matter. Credit Suisse was also involved with Athens, crafting a currency swap for Greece in the same time frame, according to people familiar with the matter. …

In 2001, Goldman and Greece came up with a now-controversial solution: a new off-market swap. It agreed in the future to convert yen and dollars into euros at an artificially favorable rate. Greece could use that rate when it recorded its debt in the European accounts—pushing down the country’s reported debt load by more than €2 billion, according to people familiar with the matter. … “It was done to dress up the debt figures by some smart idiot in the finance ministry” he said. Greece’s remaining exposure to the complicated arrangement remains unclear.

With Greece’s debt levels stated lower than they were it could borrow at reduced rates of interest. Now that better numbers are available the market will adjust the rates upward. That’s precisely what the Greeks don’t want. What Athens wants is a EU fixed rate because that’s what it can afford. Reuters reports that Greek finance minister George Papaconstantinou wants “to be able to borrow on the same terms as other countries in the euro zone … But investors anxious at the risk that Athens may be overwhelmed by its debts, projected to hit 120 percent of gross domestic product this year, are charging a steep premium to buy Greek bonds rather than benchmark German bunds.”

But the higher rates would make it impossible for Greece to borrow 53 billion Euros. So to avoid “social unrest if the EU forces too harsh austerity on the Greeks” Papaconstantinou is holding out for concessional terms. The market has market reasons for wanting to charge a price and the politicians have political reasons for wanting to set their own price. A lot of the times the politicians win. The temptation to impose price controls by fiat is always greatest when there is either no political will to reduce the demand for a product or no ability to reduce the cost of factors by improving efficiency. And the latest person to be caught in that dilemma and become seduced by siren song of price controls is President Barack Obama who’s announced seeking “sweeping new authority to curb exorbitant rate hikes by the nation’s health insurance companies”.

Obama’s proposal would give the Health and Human Services secretary, Kathleen Sebelius, new powers to review premium hikes by private insurance companies – and in some cases, block those deemed excessive. Anthem’s rate hikes of up to 39 percent in recent weeks have focused attention on the skyrocketing health insurance costs, the very costs Obama vowed to fight when he undertook comprehensive health care reform last year. Obama’s plan would create a new board made up health insurance experts, which would determine annually what are reasonable premium hikes in various markets, and the HHS secretary also would work with state officials, the White House said.

At least part of those rate increases are due to Obama’s proposals themselves. His health care reforms were always going to drive costs up.  According to Noam Levey of the LA Times, who examined the New York experience, average insurance rates were bound to go up simply because coverage was going to be extended to the uninsured — increasing the demand — and mandating that people with pre-existing medical conditions could not be refused. With more and higher-risk consumers entering the market and the supply of medical services inelastic in the short term,  prices were bound to go up. If people can “buy insurance on the way to the hospital” as one economist put it, then the money had to come from somewhere else in the insurance pool. Levey said, “premiums in New York are now the highest in the nation by some measures, with individual health coverage costing about $9,000 a year on average.” But since higher premiums would mean political suicide for the Administration it is going to square the circle by imposing price controls.  So what’s wrong with that? The problem with price controls is that it eventually creates underprovision and shortages in the long run. Everybody will remember his lesson from Economics 101. Here’s how Wikipedia retells it.

The primary criticism leveled against price controls is that by keeping prices artificially low, demand is increased to the point where supply can not keep up, leading to shortages in the price-controlled product. Shortages, in turn, lead to black markets where prices for the same good exceed those of an uncontrolled market. Furthermore, once controls are removed, prices will immediately be subject to rampant inflation, which can temporarily shock the economic system.

A classic example of how price controls cause shortages was during the Arab oil embargo between October 19, 1973 and March 17, 1974. Long lines of cars and trucks quickly appeared at retail gas stations in the U.S. and some stations closed because of a shortage of fuel at the low price set by the U.S. Cost of Living Council. The fixed price was below what the market would otherwise bear and, as a result, the inventory disappeared. It made no difference whether prices were voluntarily or involuntarily posted below the market clearing price. Scarcity resulted in either case. Price controls fail to achieve their proximate aim, which is to reduce prices paid by retail consumers, but such controls do manage to reduce supply.

At the margin the higher cost health care providers are driven out of business. Investment flows to non-price controlled industries unless capital controls are imposed and price controlled health care becomes an unattractive industry to do business in.  Sooner or later good doctors become as hard to find as vacant rent controlled apartments in Manhattan, which is to say, hard to find unless you’re Charlie Rangel.  But if price controls and artificially low rates cause so much damage why do politicians resort to it? Maybe because they live in a psychological world where everything could be ‘fixed’ by writing the right words or talking to the right people. Never mind the underlying economics.  So why not make health care affordable by increasing demand on a fixed supply and then imposing price controls? Simple isn’t it?  Except that it can’t be done, and when the scheme falls apart in the end many politicians will be genuinely surprised because it’s always worked before. Some people will never grasp the principle, strange as it may seem.

Years ago I had an acquaintance who used to borrow money from me every payday. I lent him a few hundred pesos never expecting to be paid back. But one day out of idle curiosity, I gently asked when he might feel able to repay me. He answered, “if I had any money, would I be borrowing?” It made a twisted kind of sense, so why not price controls? They make sense in a world where everything can be fixed. There’s an episode in Mario Puzo’s Godfather when a cancer stricken mobster asks the mafiosi to square things with God.

GENCO Godfather, Godfather, it’s your daughter’s wedding day, you cannot refuse me. Cure me, you have the power.

DON CORLEONE I have no such power…but Genco, don’t fear death.

GENCO (with a sly wink) It’s been arranged, then?

DON CORLEONE You blaspheme. Resign yourself.

GENCO You need your old Consigliere. Who will replace me? (suddenly) Stay with me Godfather. Help me meet death. If he sees you, he will be frightened and leave me in peace. You can say a word, pull a few strings, eh? We’ll outwit that bastard as we outwitted all those others. (clutching his hand) Godfather, don’t betray me.

Betrayal? Why what politician would do that?


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