Free Lunches

This note was originally published at 8am on November 29, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“The state is the great fictitious entity by which everyone seeks to live at the expense of everyone else.”

-Frédéric Bastiat

 

In Frédéric Bastiat’s 1950 essay, “That Which Is Seen and That Which Is Unseen”, he describes the impact of opportunity costs on economic activity.   In his essay, a small boy breaks a window in a store.  The glazier comes to repair the window and is paid six francs for the job.  Some observers would suggest this is a positive economic event as it increases the money circulating in the community.

 

There is, of course, no free lunch.  In the case of Bastiat’s essay, the unintended consequence is that the store owner with the broken window must pay for the repair of the window.  In using six francs to pay for the repair of the window, the shopkeeper no longer has six francs to expand his inventory, advertise for the shop, or purchase personal goods.  In effect, the transaction has two sides and it is not even certain to be a zero sum transaction, especially if the glazier does not spend his incremental six francs within the local community.

 

In modern economic theory, the key current debate relates to the role of the government in transactions.  The Allowance Rebate System (more commonly known as Cash for Clunkers) program is a prime example of this dilemma.   Under this program, car buyers were incentivized to purchase new cars by being given a $4,500 rebate for their old cars, which then had to be scrapped.  Practically, this was a transfer of money from tax payers to car buyers.  In the short term, new car sales skyrocketed. Meanwhile, older vehicles, which admittedly produced more pollution, were taken out of the national car population.

 

Akin to Bastiat’s essay, the question in the case of Cash for Clunkers Car is whether destroying an otherwise productive asset, such as a working car, actually benefits the economy.   In looking at some key results of Cash for Clunkers, the implication is at best inconclusive.  Specifically,

  • The program led to market share gains for Japanese and Korean car manufacturers at the expense of U.S. manufacturers. (Incidentally, the equivalent Japanese program did not include U.S. produced cars.);
  • A study by the University of Delaware concluded that for each vehicle trade, the net cost was $2,000, with total costs exceeding benefits by $1.4 billion; and
  • A study by economists Atif Mian and Amir Sufi indicated that the 360,000 additional purchases in July and August 2009 were pull forwards that were completely reversed by March 2010.

So, once again, no free lunch.

 

On the back of rumors of an IMF bailout of Italy, global equity markets rallied in a big way yesterday.  Not surprisingly, the Italian equity market was one of the global leaders yesterday up an impressive +4.6%.  While we would suggest this was more of a short squeeze than anything, there is perhaps a fundamental case to be made if the IMF rumors finally come to fruition . . . or is there?

 

Our trusty research intern Josefine Allain pulled together some detail around the rumored IMF plan.  According to the rumors, the IMF would provide €400-€600B to Italy at a rate of 4-5%, which would allow Italy up to 18-months to implement reforms without having to refinance. 

 

Setting aside the fact that the IMF denied it is in discussions with Italy, the plan has two main issues.  First, the IMF only has $285 billion currently available.  Second, an expansion of the IMF, or an explicit Italian bailout fund, would require a substantial contribution from the United States (likely more than $100 billion).  Clearly, given the current political environment in D.C. and on the back of another tacit U.S. debt downgrade this morning from Fitch, the likelihood of the United States stepping up to bailout out Italy is slim to none, absent a global financial crisis.

 

Indeed, European credit markets continue to signal that no free lunch from either the ECB or IMF is imminent.  Specifically, the Italians “successfully” sold €7.5 billion of bonds this morning versus a maximum target of €8.0 billion.  The 3-year yield was 7.89% versus 4.93% on October 28thand the 10-year average yield was 7.56% versus 6.06% on October 28th.  Success is a relative term.

 

In the Chart of the Day today, we’ve highlighted the Euribor-OIS 3-month spread, which measures the spread between what banks charge each other for an overnight loan of their excess reserves versus what they could earn by lending it risk free to the central bank.  The key take away is simply that risk, not surprisingly, has accelerated dramatically in the last three months in the European banking system.   In early July this spread was less than 0.20 and it is now at 0.94.  No free lunch there, to be sure.

 

This afternoon Keith and I are going to take a much needed break from the grind and go across the street to play a quick game of hockey at Yale’s Ingalls Rink.   Ironically, it will cost us $10 each, so there isn’t even free lunch time hockey.

Keep your head up and stick on the ice,

 

Daryl G. Jones

Director of Research

 

Free Lunches - Chart of the Day

 

Free Lunches - Virtual Portfolio


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