Saturday, November 19, 2011

Subsidizing stupidity

First a look at what happens with subsidies on the effects side, not the 'lets put them in place' side of things.  First off is China and gasoline from Chua Baizhen at Bloomberg News 09 JAN 2011:

The government introduced a new fuel-pricing mechanism in December 2008 that tracks global crude costs. A month later, it raised a gasoline consumption tax fivefold, pushing domestic pump prices above those in the U.S. and ending an era of cheap, subsidized fuel. The government has made 13 price adjustments since introducing the system, most recently on Dec. 22.

China has subsidized gasoline use for quite some time and the government has been feeling the effects of trying to provide a 'stable' price point for gasoline to the Chinese public.  I had looked at in part in a larger article on the Directivity of China that I put out in FEB 2007 as the subsidies were whipsawing the central government of China. 

Consider that when external prices are higher than the internally subsidized prices, then the Chinese government must pay the difference between world market prices and local prices if it wants to keep supply constant.  To do that requires incurring debt.  This also creates an unsustainable demand for product which, when not having to adjust for market prices, is used as if there was no change in the economic cost of the gasoline.  Thus the product loses its 'value' that is its perceived benefit per cost, because prices are artificially low.

If it lets supply float, however, and China is unwilling to pay market prices, then supply drops (long term supply contracts would still keep amounts flowing into China, but only to contract levels) because there is a delta between demand and the amounts supplied on the non-spot market.  This creates scarcity of product, although at a given price point.  The product is seen as having a set price but has a higher 'value' due to its scarcity and is used less.

Now in the 'salad days' when external prices are below the 'subsidized' prices, the government reaps a net gain either via companies selling gasoline paying more in taxes or, in the case of State purchasers, the government reaping a windfall between low purchase cost and high sales cost.  What happens in this scenario, as I outlined, was smuggling, as lower cost gasoline is smuggled in through the Chinese borders and sold at a cost lower than the subsidized, or set, fuel cost.  In this case the set price as compared to the market price changes the 'value' perception as well, and the higher 'value' gasoline is that which is smuggled in as it has a lower cost.

It is all the same gallon of gasoline, mind you.

Government interference in pricing structure changes not just the price but the perceived value of the good in question.

This I went over in a 2008 post on Bipartisanship the opposite of good government, which looked at the housing bubble and its bipartisan support, and then the US Senate ignoring testimony on how the world oil market could be gamed as pointed out by the US Senate Committee on Energy and Natural resources by Steve Layton, President and CEO of Equinox Oil Company, part of the Independent Petroleum Association of America.  I'll excerpt this part to show how the concept of 'subsidies' works here, as well:

First, world oil prices are essentially set by the last barrel sold. A year ago, Iraq exported about 700,000 barrels/day. In December 1998, it exported about 2.3 million barrels/day. By March it will have another 500,000 barrels/day of capacity on line. Iraq was the only OPEC country to boost its oil revenue in 1998. As other OPEC countries have reduced production to stabilize oil prices, Iraq has become the swing producer of world oil. The swing producer sets the price.

Second, Saddam’s objectives differ from other oil producers. He wanted higher oil prices when he invaded Kuwaitmoney he needed to build his military forces. Now, he can’t spend money to buy arms. But, he can – by keeping oil prices low – punish his enemies, first by reducing the income to Saudi Arabia, Kuwait, Iran, and others; second, by driving critical U.S. production to be shutdown and plugged forever.

Third, looking purely at demand and productive capacity, today’s surpluses should not drive prices to their historic depths. We estimate that worldwide production capacity currently exceeds demand by about 4 percent.

This had been exacerbated by problems in some Asian economies but put China in the seat of having the ability to draw in funds under bonds to boost industrial development via changing its investment climate.  In a very serious way Saddam Hussein was hurting the US domestic oil production system (that is the independent small producers) and due to consumption drops in places like S. Korea and Japan, allowed the Chinese central bank to reap a windfall between set pricing internally and external pricing that was aided by changes in investing law.  The Chinese economy picked up steam and increased its productive capacity and was able to roll over its 5 year bonds in 2002-3 by demonstrating continued production.  The problem was that those 5 year vehicles started coming due, again, after 2007-8  and some investors wanted their actual full face value of the bonds paid out.

As I wrote in 2007 China was undergoing the whipsaw from low oil costs to high ones and had to start inching prices up for gasoline then.

Now over to Iran which subsidizes its gasoline and natural gas industries.

Iran faced a major problem at the end of 2007, in that its major natural gas supplier (who supplies 5% of the domestically used natural gas in Iran) was Turkmenistan, which I examined in The shockwaves of 5%, where jihad meets economics.  Turkmenistan is a major conduit and supplier of natural gas which has not only normal economic ties, but ones to a Red Mafia outfit that wheels and deals in natural gas (as well as tv stations, hotels, and all sorts of other things).  Europe was seeing the need to meet natural gas consumption and was raising the price of natural gas on the global market.  Although Turkmenistan doesn't have a direct pipeline to get natural gas to Europe, it has intermediaries that could move it through Russia to Ukraine and then into places like Poland, Romania and Hungary, to sell it at a higher cost.

I have examined Iran's oil system in two previous posts:  Iran's Oil Problem and Iran's Oil Outlook.

Facing the multi-million if not multi-billion dollar price differential between fixed contract prices to Iran or fluid and higher prices in Europe, Turkmenistan was seeing potential dollars fly out the window.  It conveniently had 'supply problems' with Iran and trillions of cubic feet of natural gas wound up in holding facilities in Ukraine (although anonymously, no one 'claimed' it) and Iran faced a sudden and immediate supply problem for natural gas.  Its refineries have not been kept up since the revolution and can supply such a small portion of natural gas and gasoline, that Iran is forced to import both.  When sections of Tehran must go cold and dark to make sure bakeries can keep running, the government in Iran suddenly faced a major problem.  It caved and paid higher fees and the natural gas flowed again.  Presumably the amount siphoned off went to Europe so it was a 'win' for the anonymous holders of the gas in Ukraine, a 'win' for Turkmenistan, a 'win' for Europe and a 'loss' for Iran.

Iran got to this predicament through a multi-fold governmental problem that, primarily, refused to keep up the oil infrastructure in the country.  The refineries are the most complex part of the system and they are on their last legs and no one will invest in them as Iran keeps an insane contract policy of charging what it feels like charging for crude oil, without regard to market price.  If it needs more billions to run terrorists, it charges more.  Gazprom warned Putin about this and China found that their 'investment' wasn't going to get them better treatment or stable prices, so they yanked $10 billion out when they found this out.  After that, Iran subsidizes oil and natural gas use.

It is, therefore, priced below market cost and the delta is made up in crude oil sales.

With that said there has been no marginal expansion of the oil fields in Iran (to keep nominal production constant) and the infrastructure is losing oil in the pipelines through poor maintenance (not stolen as in the case in some African countries, just leaking out of the system).  Higher world costs helps a bit on getting income, but when gasoline prices go up faster than the rate of crude oil increases (it is a refined or value added product, after all, and has a production cost delta added in), then Iran must pay that cost.  Most oil producing nations with refineries are also natural gas exporters as natural gas is a byproduct of refining crude oil.  Iran must import BOTH gasoline and natural gas, which tells you what is about to happen to their oil system.  They can keep patching it up a bit, but without a major re-investment in new facilities, plus a major production expansion, Iran is facing a huge economic crunch.

What the subsidies do is to put a set, below market price on gasoline and natural gas, which means that it is not gaining a true 'value' perception by the population.  They then use it to the maximum of the low price, which is above what can be sustained and more is imported to meet demand.  Iran has slowly had to move away from subsidizing both products, because its faltering oil production is not meeting the cost of increased use of both products.

Now lets shift from China and Iran to the good old US of A!

Lord knows we love our subsidies!

We subsidize: home sales, retirement, medical benefits, student loans, 'clean fuels', agricultural products (both raw and refined)... and we get bubbles, lots of economic bubbles... You name it and our lovely Congress probably has a subsidy that comes in many forms: price supports, direct subsidies, rebates on taxes, and the ever lovable 'regulations' to support 'social causes'.  This goes far beyond Fannie/Freddie/Ginnie/Sallie, SSA, the M&Ms, ethanol, solar power, mortgage debt, student loan debt, unsustainable retiree benefits plans, IRAs, HSAs, and on and on and on.

Since we have all seen the housing bubble (and, btw, the laws and regulations that caused those have NOT been repealed, which means we can get ANOTHER one any time Congress feels like putting another few trillion on the debt) and, instead, go to everyone's choice for 'why the hell are we doing this?' which is the shifting away of cropland for producing food to producing ethanol.  This is done via regulations (mandating a certain amount of gasohol to be sold or ethanol added to fuel), direct subsidies to farmers and some payoffs on the tax side for use via equipment purchases.  All of these have created a problem because the US Big Agribusiness (which benefits immensely from this) has done damage to the global market for corn.  In particular it has hurt our NAFTA partner Mexico as I go over in Where is the international law with NAFTA? which looked at this phenomena.

Ahhhh... Free Trade!  The great panacea!  Unless you add subsidies, of course, and then you get unintended consequences as unsustainable and bolstered trade tends to hurt Free Trade.  In this case the victims are multi-fold but the main one is Mexico.  First off our subsidies to farmers makes our already low cost of production of crops even lower than any other Nation on the planet.  No one can compete with crop outputs like those in the US.  Don't worry, our government has a solution to that.  Mexico, with its relatively backwards agribusiness, soon saw the small and local farming communities having to compete with subsidized corn from the US produced from huge systems and farms that could utilize modern technology to the utmost to cut per acre cost of overhead beyond what any small farm could ever hope to do.  Well that was OK in the early days as, hey, those stupid Gringos were opening factories just over the border in Mexico!

Mexican workers flocked to them and the agricultural sector suffered as all those good, high paying jobs in the factories meant people could buy cheap corn from the US.

Those were the days, huh?

Remember Saddam Hussein and last barrel sold setting price from above?  Yeah, subsidized crude oil prices to keep prices low, globally.  Remember him?  Remember what happened in China?

Yeah, Chinese labor was cheaper than Mexican labor so the factories promptly went transnational and moved production to China.  All in the name of subsidies: in the US, in China, in Iraq.

And the Mexicans?  Well they still had cheap corn and many people went to work north of the border in farms which paid a bit better than the failing system in Mexico.

I'm not painting Mexico out as a 'victim' here: they have their own regulation and subsidy problems with crude oil which add no end to their internal problems.  Especially when you get all 'environmentalist' on those topics.  Mexico is in no way, shape or form a 'victim' save of its own corrupt system.

What we did in the grand old US of A was up the subsidy for ethanol via various means.

Farmers saw that you could make more, per acre of marginal income, by producing the corn that would be made into ethanol, which isn't a food crop nor a feed crop for animals.

There is a set amount of arable land in the US and when production of a subsidized crop increases it does two things: it reduces the yield of its similar counter-parts (feed corn) and it starts to look to expand its output by putting fallow land to use which raises the price of fallow farmland as it sees a demand increase.

What happens is that feed corn (both for cattle and human consumption) undergoes a price increase as less is produced, farmland property undergoes an increase in valuation due to increased demand, and we produce more of a product that is subsidized to protect it from lower cost producers overseas (mostly Brazilian ethanol but others also produce it cheaper).

In Mexico the price of corn for tortillas skyrocketed in 2006-09.

Elsewhere in the world food shortages started to appear in Egypt, India, and since China has done wonderfully Progressive things with its farming sector it has gotten a Progressive Dustbowl and a decrease in farm labor due to its subsidizing industrial output.

Everyone, and I do mean over 3 billion people, depend on the US of A for FOOD.

The US of A sets food prices like nobody's business because our subsidized Big Agriculture generally outcompetes everyone due to vast acreage put into production and modern farming techniques.

Our educational system, meanwhile, has been concentrating on the humanities and subsidizing those, so we don't produce many new farmers, agronomists, and even folks in the hard sciences and engineering have suffered in output because of subsidized student loans.  In the hard fields of maintenance blue collar jobs the US is no lacking a half million welders, alone.  This isn't talking about the other jobs necessary to maintain our infrastructure: pipe-fitters, bricklayers, sanitation personnel, road crews, ditch diggers... there are good jobs going begging because of the feeling of 'entitlement' to a good life without having to maintain it via our educational system.

And that elite education costs too much.

Well, it is subsidized, after all, and so you get a bubble economy in it.

If we were still training the maintenance people at a clip to maintain the infrastructure, this wouldn't be a problem for our civilization.  Maintenance and marginal expansion would help us get through tough times.  Iran doesn't do that to their oil infrastructure and is now paying a price in unrest and having to demonize external enemies for internal problems.

OWS isn't a disease, it is a symptom of rot to the very core of our society manifesting on its skin.

To that we can thank: subsidies put in by government regulation which now strangles every aspect of our economy.

Let go on with a bit from Vladimir Dvornikov's article On "Iron Laws" of Economics and this is not an endorsement of his full line of thought it is an illustration of where we are and he is coming in after talking about minimum wage laws:


It is important to notice, that the last time the absolute fatalism in the economic area is replaced by a liberal one. "Ironness" of the economic laws is accepted here, but, most probably, not as inexorabliness, but as heartlessness, hardness, and cruelty. "The laws of the market are cruel, but the society, by means of the state, can interfere with its actions, in order to bridle the passions and mitigate the consequences of the spontaneous market". Thus, in the given case, though the objective force of the economic laws is admitted, at the same time, it shows their moral defectiveness, which makes them rather alien and hostile for the majority of the people. Here, the government is offered a little comic role, as a "lubricator" of the iron laws (to keep them from clanking) without, indeed, any hope for improvement. The supporters of the "regulated market ", if I am to understand, are trying to remain seated on two chairs at once, and, as a rule, are falling from both.

The unsteadiness and ambiguity of the moderate fatalism induces the most active minds to pass to the following step - to reject completely the abstract economic laws and to declare government as a sovereign ruler and legislator of the economic life. Namely, the government, here creates and legally fixes "uniform rules of the economic game", which all of it's participants, managing in the given territory, are obliged to observe strictly. Thus, the once almighty economic laws receive the modest role of national customs or peculiarities, which should be taken into account while drawing up of rules of game. But who, tell me, presently may vouch for viability of any cabinet? As a result, the instability of a situation, connected with the changing of political tendencies and tastes of the government on the one hand, and the absence of the firm and objective goals in economic activity on the other, stimulates the most hazardous and vigorous players in "economics", either to bypass, or directly deny the governmental decrees. From here originates, and by it is fed, the powerful and well-organized sector of the "shadow" economy: not paying (in opposition to the "light" one) taxes, or even establishing it's own "rates", with which the state conducts eternal, ruthless, and, in the final account, a fruitless war for incomes.


The more government regulates the less it can adequately control and no one trusts that control as it sways only to its own wants for power via the forms of politics.  The very regulations that are meant to 'uplift' and 'protect' people become the instrument to use against them as the political winds blow.  All of those wishing for government to 'moderate' any economic ill then proceed to lobby politically to get that done so yet more falls under sway of government and out of kilter with economics.

Yes there are Iron Laws of economics.

Our entire world has been trying to deny this for decades due to the siren's song of subsidies, promising everlasting good and inculcating everlasting agony.  It isn't the only siren sitting amongst the rocks, but it is the easiest to succumb to and once the ship heads towards the rocks then others of its kind are then the focus of attention.

More subsidies!

More regulations!

The loss of freedom and liberty amongst those rocks?  Ah, those who listen never tell us about those, now, do they?

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