Monthly Archives: November 2008

At what price?

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When we speak of profitability we are talking about a cost benefit analysis. Am I better off sitting on the couch or going to get a slice of pizza from the fridge? That will no doubt depend upon the degree to which I’m either hungry or tired. If I’m more tired than I am hungry then I can best maximise the use of my time by lounging around on the couch. On the other hand, if I’m more hungry than tired then I’m perhaps happy to pay the cost (getting up and walking to the fridge) of obtaining pizza since I consider the benefit of eating pizza to be greater than that cost. When the benefits of doing something outweigh the costs (including opportunity costs) that action is said to be profitable.

Let’s say I’m hungry though and there’s no pizza in the fridge – there’s just an apple in the fridge. Outside in the yard there’s a plum tree and at the top of the plum tree I can see a nice juicy plum and, as it happens, I prefer plums to apples. However, the cost involved in obtaining the plum is significantly higher than the cost involved in obtaining the apple. The apple is right there in front of me for the taking but eating the plum would require I spend 5 minutes clambering around in the yard… If I really like plums way more than apples then maybe I’m willing to go out and clamber around in the yard, but I’d have to really like plums a lot more. Now what if, at the time when hunger strikes, I’m currently dressed in a suit ready to go to work? In that case the cost benefit analysis would change yet again – not only would I have to spend 5 minutes clambering around in the yard but I’d have to change my clothes first (so as not to ruin my suit) and then get dressed again for work afterwards… perhaps under these circumstances I’d no longer be willing to do what was required to have the plum and I’d just take the apple. In any event, through the construction of more and more elaborate (but hardly unrealistic) scenarios you can easily envisage that we will eventually arrive at a point where the additional cost of having that plum (as opposed to the apple) is greater than the perceived additional benefits that this would bring me. Above a certain price, the plum simply isn’t worth having – and the price paid is ultimately my time and effort. Above a certain price I’d rather spend my time eating apples (or doing something else like going to work) than I would jump through the necessary hoops required in order to be able to eat plums.

Now most of the time people think of petrol as coming from Saudi Arabia out of massive pumps which can, like taps, simply be opened or closed to produce more or less petrol as needed. And indeed for the better part of the last 2 decades it appears that tap has been running rather freely with oil and petrol prices during that period being what most people would now, in hindsight, see as a relatively cheap. More recently, from 2000 until around 2004 the price of light crude oil was hovering somewhere around $30 per barrel. However from 2004 until mid 2008 the price exploded from around $35 to approximately $160 per barrel and, at the time of this writing, has now settled down to around $50 a barrel again.

At a certain price, and from a producers point of view, people aren’t willing to do much for oil… they’re willing to “turn on the tap”, so to speak, but they’re certainly not going to be clambering around in the yard for it. However if you pay someone enough then they will go to great lengths in order to obtain oil for you. Indeed, when the price of oil is higher than about US$70 per barrel they’ll be willing to move to some of the most inhospitable places on earth, invest in 400 tonne dump trucks and expend vast amounts of heat, water and (ultimately) effort to process tonnes of tar sand in order to bring you a barrel of oil.

However, as we noted above, those people investing not inconsiderable sums of capital in 400 tonne dump trucks and those people spending their time living in a camper vans next to Canada’s tar sands in order to operate such dump trucks are making an economic choice… they are investing that capital in dump trucks to the exclusion of all other possible uses of that capital and their decision to spend their time mining tar sands necessarily precludes the possibility that they might do something else with that time instead. Quite simply, the mining of the tar sands of Canada (and the additional oil that is produced as a result of this) comes at a cost – a cost we will never know since the alternative possible uses of that capital and labour will never be known but you can be certain that as a result of mining the tar sands of Canada there is something else that was not produced instead.

Had the price of petrol never surpassed $70 a barrel and, in a hypothetical situation, had the price of croissants in Canada skyrocketed to $15 each then perhaps the capital that was invested in dump trucks would instead have been invested in bakeries and, rather than spending their time training to be machine operators perhaps the pool of Canadian labourers would have spent their time instead as apprentice bakers. Would that have been so bad? I don’t know – it’s like asking if it’s better for someone to get pizza or lay on the couch… what is the best (and most profitable) course of action really depends on their personal preferences. However, in the case of the choice between croissants and petrol what we are asking is not the preferences of an individual but the aggregate sum of all the preferences of all the individuals in the economy, which are reflected in the prices that they are willing to pay for both croissants and petrol. If the relative prices of croissants and petrol remained reasonably consistent with the ratios that we’ve seen over the last few years then we probably wouldn’t expect dump trucks to be melted down and turned into pastry ovens any time soon. On the other hand, if the price of croissants shifted significantly against that of petrol then we might well expect to see basic goods such as metal and machine tools reoriented to support the baking industry instead of the petroleum industry. In a free market, if such a shift occurred then it would simply be indicative of a change in consumer’s preferences and the new investments in baking equipment could be applauded by the (soon to be) satisfied consumers in the market place.

The problem is that presently our prices appear to be sending some pretty mixed signals. One day the price of oil is through the roof and the next it’s through the floor… and nor is the price of oil in isolation here. Stocks, housing, commodities, durable goods – pretty much across the board we have yoyo prices. Economists wondering what is causing the volatility in prices are no doubt tempted to try to interpret these in terms of supply and demand (since, as we’ve all been told, that’s where prices come from right). And on a case by case basis, with a bit of imagination, such economists might find semi-plausible explanations for many of the price shifts that we’ve seen lately (in the case of wheat, for example, the issue of government subsidied for biofuels is often raised). However it is not the price of any one good in the market or even any one category of or group of goods that has seen volatility. Practically everything is on the move and the economy looks like it’s walking on sailors legs. The economy looks drunk… the kind of legless drunk that usually comes just before someone throws up all over your trousers and collapses unconscious on the floor.

It is absurd to try explaining the volatility in these prices in terms of fickle and changing consumer preferences. Consumer preferences simply have not changed (both in the upward and downward directions) sufficiently to justify the price swings we’ve seen of late. Nor am I inclined to believe that these price changes are the result of supply shocks. This would be peculiar indeed on such a global scale. The bigger the market the smaller you would expect the shocks to be. The effect on prices, of regional problems with the supply of products, would typically be dampened by the sourcing of alternative products from other countries. But that’s not what we’re seeing – we’re seeing global and massive price shifts. So if we’re not willing to accept changes changes in demand as the cause of our changing prices and we’re not willing to accept changes in supply as sufficient to have caused recent price volatility either then we’re only really left with one other choice… and that’s that the prices are not functioning correctly – which is to say that they do NOT reprepresent a relationship between supply and demand.

More and more, I’m starting to doubt the accuracy with which the prices in our market places reflect supply and demand. Of course the US government handing over hundreds of billions of dollars to subsidise various non profitable industries in the US (notably in the banking sector) certainly doesn’t help. The fact that banks can bid up the prices of goods in certain sectors of the economy without having to make sure their activities are profitable raises serious questions about the relevance of the prices of those goods. If government coercion is used to force money to be spent “recapitalizing” Citibank then is any of the capital that Citibank controls or are any of the goods that Citibank purchases currently priced at levels that reflect the preferences of consumers? The answer, quite obviously, is no. And the more the government interferes with the economy (whether that be by way of propping up ailing banks or by fiddling with interest rates to try to boost share prices and “keep home owners in their homes”) the more we have to admit that prices in the market are not being set by the market but are, in fact, being set by government. As in the socialist commonwealth, we have prices in name only – but those prices are not what you think they are. They don’t express the relative importance of goods to individuals in the economy and they don’t reflect the scarcity or abundance of those goods either. These are not prices that will ensure demand is met by supply and nor will they protect us against shortages (of things like savings) and wasteful gluts (of things like cars and houses). 

Our prices find themselves forced into a rather unnatural ménage les trois – no longer solely the marriage of supply and demand (as is natural). More and more they are the perverted prices that central planners have either explicitly sought to place on these goods or have inadvertently brought about by way of their hubris, incompetence and stupidity. What will be the price we pay for all this government fiddling? Ask the Russians – they know from experience. When you take away prices you take away the freedom of consumers to choose and the rational basis for production. The result is poor people without choices and without economy.

The real cost of poor accounting

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I recently wrote about the tangible consequences of the profits and losses that entrepreneurs in the economy make:

“When companies make a loss then, what goes missing from the economy is not money either… indeed, if under our present banking system this happens from time to time this is entirely incidental. More importantly, for human concerns, is the fact that loss making companies consume many more resources than they give back to the economy… The loss is not fictive or imaginary – it is not some wild hysteria or a lack of faith in the system – it is the loss of those real resources that the company consumes (steel, iron, health insurance and mathematical modelling services).”

However it must be remembered that the profits and losses that companies announce are estimated on the basis of the company’s accounts. These accounts will be maintained, and thus the profits and losses expressed, in monetary terms, and the ledger entries in theses accounts will contain monetary valuations of the various assets, liabilities, revenues and expenses relating to the company’s operations. 

In the absence of any significant inflation or deflation of the currency, these valuations will ordinarily be fairly accurate estimates of the relative values of the capital used to operate the company. For, the goods and services that make up the capital, income and expenses of companies will be purchased in markets and the monetary value of these things will be the result of a all of the market participants trying to outbid one another for available resources (such as land, labour, wood and steel). Different companies may pay different things for the same goods and some companies will abstain from purchasing goods that they consider too expensive at a price that is entirely acceptable to other companies that happily purchase at that same price (thus reflecting the fact that these goods have different values for different companies). However if the average price paid for a kilo of oak is higher than the average price paid for a kilo of steel then we can say that oak has a higher relative value, per kilo, than steel to the economic system as a whole. This is perhaps because it is preferred by consumers or perhaps because it is more scarce than steel. Regardless, it will indicate that oak can only economically be put to more important uses whereas steel might be used for purposes that were more mundane.

What if, however, we were to hack into the accounts of all of the companies in the nation and replace the prices that they actually purchased or sold steel for with some other random price? Surely their profit and loss statements at the end of the year would be much less accurate than they were before, would they not? If the price that we substituted into their accounts was lower than the price that they had actually paid then the companies that purchased steel would appear to be more profitable and the companies that sold steel would appear to be less profitable than they actually were. Such an accounting error might force some of the steel producers into liquidation, despite the fact that these companies were in reality entirely beneficial to the economy and producing much needed steel. Similarly, such an accounting error might prevent various companies that buy steel from realising that they were not profitable – with the result that these loss making entities would continue to consume real resources from the economy where it simply was not rational for them to do so, from the point of view of the economic system as a whole.

Even if the switcheroony that we performed with the steel prices didn’t cause any companies to liquidate entirely, it would certainly confuse the price signals in the market place such that steel producers were tricked into believing there was less demand for their product than was the case (thus cutting production) and such that steel consumers were tricked into believing there was more steel available than was the case (causing them to wastefully put steel to uneconomic uses).

The negative consequences of our meddling would therefore be twofold. On the one hand our actions would imbalance supply and demand and, if we were to continue to meddle with the company’s books over a long period of time, would eventually lead to a steel shortage. Secondly however, our actions would undermine the ability of companies (and thus the economy as a whole) to accurately gauge their profitability. Of the two side effects, this later could well be the more serious since it will cause ongoing long term real losses to society and the economy as a whole.

One of the primary costs of most companies, of course, is the cost of borrowing. However interest rates do not currently emerge naturally from a free and competitive market. Indeed, in as much as they concern our present discussion the price paid for savings by borrowers is set by central banks entirely arbitrarily. This is not to say the interest rates are set randomly without any consideration to current market conditions. However the relative preferences of consumers (borrowers) and producers (savers) are entirely ignored by central banks when setting interest rates and even the relative scarcity or abundance of real savings in the market place, it seems, is paid very little heed. Primarily what motivates central banks in setting interest rates today is a peculiar Keynesian notion of full employment and, as though the two were somehow diametrically opposed, a “watchful eye” on inflation to balance this.

The fundamental meaning of the accounting concept of profitability, it seems, does not even enter into the equation. Certainly attention is paid to broad statistics such as the CPI, PPI and the GDP. However the fact that interest rates – one of the primary costs incurred by every entrepreneur in the economy – are not an accurate reflection of the real costs of borrowing both to companies and to the economy as a whole means that the ability of every entrepreneur and every borrower in the economy to gauge their profitability has been severely undermined, in real terms. Hence the ability of central banks to calculate the profitability of the economy as a whole and the relevance of statistics such as the GDP is also undermined (even if these statistics were accurate – which is rather doubtful considering the methods currently used to calculate both inflation and the GDP).

What this means is that the normal mechanisms for ensuring that only profitable activities take place (i.e. liquidation and bankruptcy) and that production remains positive with respect to consumption are not working properly. There are millions (perhaps billions) of entrepreneurs all over the planet making what they believe to be profits when in fact these entrepreneurs are a burden to the societies that they live in – consuming scarce savings of real resources which are, as a consequence, no longer available to be put to truly profitable uses. In wasting those resources, the societies that employ central banks have prevented the existence of countless profitable companies that most certainly otherwise would have existed and which, far from being a burden on our societies, would have enriched them and employed just as many people (if not more) than the unprofitable companies resulting from a misguided Keynesian “full employment” policy.

Fundamentally the fault of central banks is that they do not focus on that which should be the focus of all economics – the satisfaction of human needs. Instead they focus on the much narrower goals of the “need for employment”. And in their pursuit of that narrower goal they disregard entirely whether or not the “employment” that they seek to encourage is profitable or not, and thus whether or not their actions (even should they succeed in realising the desired objective) will be good or bad for the economy.