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    Leverage

    May 25 • Financial Markets, Government, Households • 255 Views

    In many ways, the recent financial crisis was (and is) really about seesaws. A seesaw is a lever that lets you do a lot with a little. Using a seesaw, a person weighing 100 pounds can lift someone at the other end who is much larger.  

    As purchasers of mortgages from financial institutions, Fannie Mae and Freddie Mac had rules about the size of down payments for home loans. Lowered to 3% in 1998, new down payment rules meant that consumers needed a lot less money to get a mortgage. In 2001, the rules again shifted when buyers could use other people’s money and loans for a down payment. Leverage? Yes. It became possible to spend a lot on a home with very little money. According to 2002 Congressional testimony from the CEO of Fannie Mae, financing for low down payment loans (5% or less) grew from $109 million in 1993 to $17 billion in 2002. The number of Fannie and Freddie loans requiring less than a 5% down payment soared to 608,581 in 2007 from 75,694 in 1998. In a paper on the financial crisis, George Mason economist Russell Roberts details the leverage that people enjoyed.

    Investment bankers also had their own seesaw. When businesses can borrow at a low interest rate and then earn a higher return on that money, their profits multiply. Between 2003 and 2007, investment banking firms started to increase their leverage ratio from 21x to 30x.  The leverage ratio compares money borrowed to a firm’s total assets. The change was the result of more lenient borrowing parameters from the SEC during 2004. Interest rates trending downward since 2000 then incentivized further borrowing. Leverage? Yes! Investment banking firms could use a little to borrow and then invest a lot. A paper from University of Maryland associate law professor Robert J. Rhee describes the leverage employed by the major investment banking firms.

    Pondering Greece, I realized that they too had their own seesaw. With debt totaling 113% of G.D.P., they too were spending a lot when they had a little.

    The Economic Lesson

    Hoping to use other people’s money to grow their own assets, in a market economy, individuals, business firms, and governments borrow money. Then, when you have a sufficient return on the investment, you can pay it back. Problems only develop when leverage works in reverse. If the returns do not materialize, then you owe more than you can pay back.

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    No Free Lunch

    May 24 • Thinking Economically • 207 Views

    In NYC, new pedestrian plazas are easing harried city life. Sitting in the middle of a once busy street where traffic congregated, now, you can relax at a table, drink some coffee and enjoy a sandwich.

    The only problem is the opportunity cost. Pedestrian plazas upset former traffic patterns. For certain bus travelers, the new routes add 25% more time for them to get to their destination. Multiply that by hundreds of riders and you get a cost that could be considerable. On the other hand, though, other bus routes actually benefited from their detours and saved riders’ time.

    The conclusion? Whether contemplating health care reform, financial regulation, or pedestrian plazas, I hope that legislators will take economics and remain aware of opportunity cost, thinking at the margin, and cost and benefit.

    The Economic Lesson

    Choosing is refusing. Any decision has an alternative choice being rejected. Optimal decision making involves identifying the best two alternatives, comparing their benefits, and then making a decsiion. In this way, we are minimizing the opportunity cost of all that we decide to do. Whether deciding what to export to other nations or which college to attend, an opportunity cost analysis will maximize efficiency. 

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    Pay What You Want

    May 23 • Businesses, Demand, Supply, and Markets • 249 Views

    The place is the SAME Cafe in Denver, a “pay-what-you-want” restaurant. Recently, one person paid $5 for a large soup and coffee and a second individual left $7.50 for 2 slices of pizza, a large soup, and a salad. Then, a third person decided $7.00 was a fair price for a slice of pizza, a salad, and an iced tea while someone left $1.50 for a large soup, a salad, and a slice of pizza. I checked out the reviews for the Cafe and they are overwhelmingly positive. Good healthy food, great atmosphere.

    I don’t quite get it.

    Yes, as a concept, “pay-what-you-want” has benefits. Those who cannot afford the price of a meal pay less but can volunteer time instead to compensate for their purchase. Those who can afford it pay more, enjoy a meal, and also know they are helping others. Based on SAME Cafe’s reviews, most experiece a communal pleasure. In addition, because the business is a non-profit, it pays no income tax and enjoys all nonprofit perks. With a semi-volunteers workforce, their labor costs must be diminished.

    But I still have many economic questions. Demand/supply graphs tell us that price is determined by the intersection of what buyers are willing and able to spend and the amounts, at different prices, that suppliers can provide. Here, the costs of the supply side seem distant from price determination. If their variable costs such as the food, are not covered, then how can they stay in business? How can they plan for the future? Does it matter that government gets no revenue?

    In a recent NY Times article, a similar venture from Panera Bread was described. Through a non-profit subsidiary, Panera Bread is trying out the “pay-what-you-want” concept. Here though, they provide patrons with a suggested price. I wonder whether a chain can generate the same spirit as a local establishment like SAME.

    Another question: Does anyone leave a tip or is there no wait staff?

    The Economic Lesson

    I suspect we are not talking about a new business model. Instead, these are non-profit charitable ventures, just like Ben & Jerry’s had a charitable foundation that functioned with their for-profit ice cream business. Also, we are looking at the fallacy of composition which states that what is good for one becomes dysfunctional when everyone does it.

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  • Travels of a Dollar

    May 22 • Money and Monetary Policy • 231 Views

    Having just followed the probable travels of a dollar bill at “wheresgeorge,” I’ve been thinking about money. Money is more than coin or paper currency. Because we can easily spend our demand deposits (checking accounts) and savings accounts, they too are money. Anything that people accept as payment, know the value of, and stores value can function as money. 

    At wheresgeorge.com, you can register a dollar bill and then trace its life if its holders record their transactions. Between Marc 5, 2002 and March 5, 2005, a certain dollar bill traveled from Dayton, Ohio to Rudyard, Michigan with stops in Kentucky, Tennessee, Florida, Texas, Louisiana, and Utah. Along the way, the dollar saw a food mart, a race track, and a McDonald’s. Its last recorded user said the bill “was getting pretty old looking.” At that point, we can guess that the bill was retired at a Federal Reserve Bank by someone’s local banker.

    According to the Federal Reserve, in 2007, located primarily abroad, there was approximately $829 billion of coin and paper currency in circulation. In the United States, if banks need more cash (maybe Mondays when ATMs are most popular), they withdraw it from the Federal Reserve bank in their area. On the other hand, when they have too much cash, banks take it to the Fed. At that time, the Fed destroys close to one third of the bills they receive.

    With the life span of a typical dollar 1.8 years, the bill traced by “wheresgeorge” lived to a ripe old age but not as long as most hundred dollar bills which live 7.4 years.  It cost the Bureau of Engraving and Printing four cents to make each bill. 

    The Economic Lesson

    All of this matters because the money supply has an impact on business activity. If there is too much money circulating, then its value can plummet. It fell so much in Zimbabwe recently that people needed wheelbarrows or U.S. money to buy milk. On the other hand, when there is too little money, producers have less incentive to create goods and services because people do not have enough money to spend. During the recent recession when credit froze, less money passed from hand to hand and businesses produced less.

    The Equation of Exchange, MV=PQ, illustrates the connection between the money supply and production (the G.D.P.). Here “M” equals the money supply; “V” is velocity, the number of times the same dollar is used; “P” is the average price of goods and services and “Q” is their quantity. 

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    More Taxing Decisions

    May 21 • Demand, Supply, and Markets, Economic Thinkers, Government • 251 Views

    Would you support a penny an ounce tax on sugar sweetened beverages? According to the NY Times and The New England Journal of Medicine, the idea is becoming increasingly attractive to many municipalities. By putting on our economic glasses, we can better decide whether to support it.

    First, we can ask whether society should be compensated for the cost it experiences from unhealthy behavior. Any cost absorbed by an “innocent” third party because of someone else’s behavior is called an externality. The tax would then be a payback. 

    To make up our minds, we can also assess the cost and benefit of the decision to tax sugary beverages. Diminishing obesity, increased intake of healthier foods, and decreased risk for diabetes, are several of the benefits associated with the impact of a soda tax. As suggested by one study, a 10% tax would decrease consumption by 7.8%. Meanwhile, on the cost side, we have the impact on manufacturers, on jobs, and the expense of implementing the tax. Some people believe the biggest cost, though, is the freedom we lose.

    Finally, we can focus on the tax itself. Opponents point out that the tax is regressive because when everyone pays the same amount, the less affluent feel a larger burden. By contrast, supporters ask us to focus on the revenue’s destination. If the soda tax becomes a “benefits received” levy, then the money would be destined for treatment of sugary drink related maladies.

    The Economic Lesson

    Named after economist Arthur Pigou (1877-1959), Pigovian taxes are levied on undesirable activities called negative externalities. At best, they eliminate the activity. But even when less successful, the revenue that is generated can be used productively.

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