Felix Salmon

Chart of the day: Growth and debt

Felix Salmon
Mar 16, 2012 17:54 UTC

Greg Ip has a fantastic blog post on the subject of America’s GDP growth and the potential thereof. He’s talking about this chart:


The blue line, here, is actual US GDP. The green line is what’s known as “Potential Gross Domestic Product” — the amount of output that the Congressional Budget Office reckons that the US could produce, if it were running at full capacity. (Don’t be confused by the weird formula: potential GDP is released in real 2005 dollars, so I’ve multiplied that data series by the GDP deflator to convert it to nominal dollars. You’ll see why in a minute.)

The main worry in this chart, of course, is the fact that the blue line — actual GDP — is so far below the green line, which is where by rights we should be. Up until the Great Recession, the two series tracked each other very closely. Now, however, they diverge by some $890 billion. That’s $7,800 per household, per year.

Greg’s point is that the green line might well overstated: that the economy can’t in fact grow, sustainably, at the kind of pace that the CBO is assuming it can. As he puts it: “both the level and growth rate of American potential output is much lower than we think”.

I think this theory is entirely plausible. And to demonstrate why, I’m going to take the exact same graph above, but add one more data series to it — this time the amount of credit outstanding in America.


There’s a whole narrative in this chart. From 1970 through the beginning of the crisis in 2008, GDP grew at a pretty steady pace. But the amount of debt required to generate that output just got bigger and bigger — the rate of growth of the credit market was much faster than the rate of growth of GDP. In 1970, GDP was $1 trillion while the credit market was $1.6 trillion: a ratio of 1.6 to 1. By 2000, when GDP reached $10 trillion, the credit market had grown to $28.1 trillion: a ratio of 2.8 to 1. And by mid-2008, when GDP was $14.4 trillion, the credit market was $53.6 trillion. That’s a ratio of 3.7 to 1.

In other words, in order to keep up a steady rate of GDP growth, we had to saddle ourselves with ever more cheap and dangerous debt.

Then, suddenly, the growth of the credit markets screeched to a halt, and we had a major recession. And since then, the size of the credit market has been roughly flat.

It makes sense that if we needed ever-increasing amounts of debt to keep up that long-term GDP growth rate, then when the growth of the debt market stops, our potential growth rate might fall significantly.

I’m glad that we’ve finally put an end to the credit bubble, which had to burst at some point. But it’s naive to think that we can do so without any adverse effects on broad economic activity. So we might indeed have to resign ourselves to lower potential growth going fowards. If only because we’re taking ourselves off the artificial stimulant of ever-accelerating credit.


Your basic intuition is betraying your reasoning. The point you are making in this post is profoundly wrong for two main reasons. And I have seen recently such kind of argument so many times, that I am becoming paranoid about it. So here is my contribution.
Firstly, as one of the earlier comments highlight it is not clear that a reduction in the pace of debt will lead to a lower capital stock, lower productivity, to lower technological knowledge, or to a lower labour supply. What is the connection between the two sides of your reasoning: debt and potential output? I don’t see any: prices, wages, interest rates may change, but those REAL factors remain the same. I suspect that your problem is related to the second point I am going to highlight next.
You may be confusing the impact of debt with the impact of some other aggregate. The central bank and the banking sector can create money out of the blue. But no one can create debt out of the blue.
For the sake of simplicity, imagine a closed economy (the argument is easy to develop this way).There is a certain level of savings which end up having a certain monetary value. If the level of savings increase (and Price level constant), the monetary value of savings goes up as well. The point is that the level of savings may remain constant, but (apparently) de amount of debt may go up. Why “apparently”? Because in this economy (a closed economy), the level of all debt (negative savings), has to be TOTALLY EQUAL to all loans (positive savings).
So for this economy as a whole, it is as if net liabilities (debt) are zero. In the end, the LEVEL of debt is irrelevant, but not the way debt is USED for. So, if I borrow money and just throw it down the tube, I will not be able to pay it back. But this is another problem which has nothing to do with the level of debt itself, but rather with the efficiency of allocating those loans to specific aims.
So unless, we have someone coming from Mars or any other planet, borrow and disappear, or we have a large proportion of debt badly used (which I am not ruling out, for obvious known reasons), we do not have (as a matter of fact) any problem with the fact that the LEVEL of debt may grow faster than GDP. It is one major mark of the very history of modern capitalism. There is plenty of evidence showing that financial intermediation has grown faster than GDP. And in the world of economic theory there are already convincing arguments showing that if the costs of intermediation go down for a while, yes, we should expect intermediation to grow faster than GDP. There is an interesting recent paper by Edward Prescott and associates on this issue.
Do we remember what happened in the 1990′s with a similar story about the “Paper Tigers”? A huge amount of people were sentencing them to oblivion. It was a fashion that proved wrong.

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Kickstarter’s mission creep

Felix Salmon
Mar 12, 2012 16:11 UTC

I had a fascinating conversation last night with a chap from Kickstarter, a site designed to help creative professionals realize projects. And it’s still doing that, pretty well. But there’s clearly a degree of mission creep at Kickstarter, too — especially with regard to some of the most successful and highest-profile projects on the site.

“A project is not open-ended,” says Kickstarter: “Starting a business, for example, does not qualify as a project.” Yet that’s exactly what Matter is doing with Kickstarter.

What’s more, Kickstarter can only be used to fund projects “from the creative fields of Art, Comics, Dance, Design, Fashion, Film, Food, Games, Music, Photography, Publishing, Technology, and Theater”. Which one of those fields is a bar of soap supposed to fall into? Design, I guess. But if the fields of Design and Technology can be so broadly construed as to mean anything, they ultimately mean nothing. And the bar of soap — just like Matter or the famous $1.5 million iPhone dock — is at heart an attempt to start a business, much more than it is an attempt to fund a creative project.

The bar of soap and the iPhone dock are glossy and sophisticated sales pitches: one of the questions yesterday was whether they were closer to SkyMall or to QVC. But there’s a huge difference: SkyMall and QVC sell products which exist. On Kickstarter, you’re buying a hypothetical future product. And I worry that this is going to end in high-profile tears and recriminations at some point, the first time a big funded project fails to produce what it promised.

Getting a product to market is hard. Even companies with business plans and executives and millions of dollars in funding — and a fully-functioning product — can fall down on that front. Look for instance at the Switch lightbulb: in July 2011, Farhad Manjoo of Slate said it would go on sale in October 2011 for $20. In August 2011, Dan Koeppel of Wired magazine ran an article saying that the bulb would go on sale in October for $30. But here we are in March 2012, there’s still no sign of the thing, and the company’s Facebook page is filling up with comments saying things like “I’m going to start my own company making a product that no one can buy. Hmm….what should I not sell? So hard to decide.”

There are two big hidden risks which I think that Kickstarter should emphasize much more than it’s presently doing. The first is on the side of the person with the project. It’s easy, when you’re trying to raise funds, to promise lots of things to lots of people, in that glorious utopian future where you’ve raised the cash that you need and you can actually finish your project. So then you finish the project, and you’re still incredibly busy and stressed, but now you have hundreds or even thousands of things to send out. Which can be a decidedly unpleasant chore. Kickstarter buries its page warning about how shipping “may end up being a bigger part of your budget than you thought”, and doesn’t really talk at all about the massive time commitment involved. For rewards which are individually hand-made, the result can be something much sloppier than the project owner originally intended. Which isn’t really good for anybody.

The bigger risk, however, is on the side of the funder — and that’s the risk that the project will get funded, you will spend your money, and you will end up getting nothing in return. For original-concept Kickstarter projects, that’s probably OK: you supported the arts by funding an artist, and you hoped to get a memento of that funding, but the reward was just a reward, and not necessarily the main reason you funded the project. For things like bars of soap and iPhone docks, however, the great majority of the funders are thinking of themselves as buying a thing. And they’re not properly discounting the very real risk that they will end up with nothing at all.

Even the most well-intentioned projects can run into unanticipated obstacles, some of which could be fatal to the project. And of course there’s the risk too of outright merchant fraud. You put together a glossy Kickstarter video, raise a few hundred thousand dollars, and then just pocket the money while telling everybody that the project is taking longer than expected.

In either situation, your funders have very little recourse. They may or may not, at some point, be able to get a refund from their credit-card company, if they paid with a credit card. But it’s extremely unlikely that they’ll be able to get a refund from the project owner.

Kickstarter doesn’t keep statistics on the number of projects which get funded but not completed, or the number of projects where funders fail to receive what they were promised. It’s hard to know how such statistics could possibly be generated, since projects don’t come with deadlines by which the rewards are deliverable. I, for one, have a number of Kickstarter receivables coming to me; I don’t have them listed anywhere, however, and if they don’t arrive, I’m not going to be particularly upset. There are 12,521 people expecting an iPhone dock, however, and 21 of them have paid upwards of $5,000 to receive 100 docks or more. If I was expecting a shipment of 100 iPhone docks, I’d consider that a real business contract, rather than a much fuzzier form of support for some creative project.

The JOBS act which recently passed in the House would allow Kickstarter to allow project backers to receive equity, rather than specific rewards, in return for their money. The regulatory and compliance costs for Kickstarter would surely be enormous, but might well be worth it, given that SecondMarket is now valued at $200 million. But before Kickstarter moves into the realm of equity stakes, it should probably start thinking much harder about the way in which it’s becoming a shopping site. Because if it doesn’t have a good way of regulating the people on its platform who are fundamentally just selling things, then it’s going to have a really hard time becoming a platform for people selling ownership stakes in companies.


At iPledg (http://ipledg.com/) we do not judge the projects submitted. We feel this is the role of “the crowd”. As long as the project meets the crtieria set out in our project guidelines (largely covering the legal and moral outlines) then we are happy for the crowd to determine the suitability for it to receive exposure and funding. And isn’t that the essence of Crowd Funding??

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GDP bonds are a really bad idea, part 3

Felix Salmon
Feb 22, 2012 22:37 UTC

Can countries issue equity? Greece is making a stab at it, giving its bondholders GDP warrants which start paying out “in the event the Republic’s nominal GDP exceeds a defined threshold”. Chances are, the market won’t give the warrants much value; they’re more symbolic, really, of Greece’s good faith.

But Bob Shiller is much more ambitious when it comes to such things: “Countries should replace much of their existing national debt with shares of the “earnings” of their economies,” he writes in the Harvard Business Review.:

National shares would function much like corporate shares traded on stock exchanges. They would pay dividends regularly. Ideally, they’d be perpetual, although a country could always buy its shares back on the open market. The price of a share would fluctuate from day to day as new information about a country’s economy came out.

This was a bad idea when Jonathan Ford proposed it in August 2009, it was a bad idea when Shiller wrote about it in December of that year, and it’s an even worse idea now, because Shiller’s decided to kick it up another five notches or so:

Greece’s real GDP fell 7.4% in 2010. If its Trills were leveraged substantially—say, five to one—then the dividend paid on them would have fallen by about 40%. This would have done much to mitigate the crisis, making it easier for Greek taxpayers to bear.

This is almost literally incomprehensible. I spent a long time on the phone today with Shiller’s co-author Mark Kamstra, and even he had no real idea what Shiller was talking about here. I can see how an investor might try to leverage an investment in Greek Trills (a Trill being a bond paying one trillionth of GDP every year, in perpetuity) by buying those bonds with borrowed money. But I can’t see how Greece itself could do so. Shiller doesn’t spell it out, but these things would obviously be symmetrical: Greece would have to pay out five times its annual GDP growth in good years in order to get these large savings in bad years. And that seems like a clear recipe for unsustainable debt growth.

Even Kamstra concedes as much. “I think that a country would not issue a levered Trill,” he told me. “I think it gets you in a lot of trouble.”

But even if you put aside the insane concept of leveraged Trills, the idea behind them is still really bad. Kamstra tried to persuade me that the price of Trills would be less volatile than the S&P 500, and he might be right during periods of relatively normal interest rates. But when rates fall, it seems to me that he’s clearly wrong. A perpetual bond like a Trill is valued by adding up the present value of its income stream: how much is this year’s payment worth to me today, how much is next year’s worth, and so on. When you apply a discount rate, future coupon payments are worth less the more distant they are, and the sum of the total converges to the value of the bond.

If the coupons are steadily increasing, however, the math becomes very dangerous. The coupons will rise at the rate of nominal GDP growth, which in the US will probably be somewhere in the 4% to 5% range over the long term. As a result, if you’re a risk-averse person who wants a perpetual US government security and your discount rate is say 3%, then the expected value of a singe Trill is actually infinite. Of course, no security trades at a price of infinity. But the fact that valuations can get so high in a low-interest-rate environment is all you need to know about just how volatile Trill prices could get.

The point here is that Shiller seems to think that the price of Trills would be driven mainly by “new information about a country’s economy”. But he’s wrong about that. new information about a country’s economy tells you quite a lot about what its GDP might do in the next few years. But if you’re holding a perpetual bond, fluctuations of 1% or 2% in the value of short-term coupon payments are not going to make much difference to the value of the bond. What really makes a big difference is the interest rate you use to calculate net present value. In other words, while Trills are designed to respond to news about the economy, in fact they would be an incredibly noisy and volatile instrument reacting mainly to changes in long-term interest rates.

But what if I’m wrong and Kamstra’s right, and economic news is more important than discount rates? At that point, measuring GDP accurately becomes extremely important: the markets would care greatly about differences of just a percentage point or two.

Except, you really can’t measure GDP to within that degree of accuracy. Here’s a recent paper from the Bureau of Economic Analysis:

Measuring the accuracy of national accounts esti­mates is a long-standing challenge for three main rea­sons. One, the early GDP and GDI estimates are based on partial data and are intended to provide an “early read” on the general picture of economic activity for decision-makers. These early estimates are revised as more complete and accurate source data become avail­able. Two, the source data for the national accounts come from a mix of survey, tax, and other business and administrative data; these source data are subject to a mix of sampling and nonsampling errors and biases that cannot be measured in terms of standard errors. Three, the national accounts are regularly revised to re­flect the changes in the economic concepts and meth­ods necessary for these accounts to provide a picture of the evolving U.S. economy that is relevant and accurate for today’s economy. These updates range from ex­panding the definition of investment from investments in plant and equipment to include investments in computer software to updating seasonal adjustment factors to reflect the most recent seasonal patterns.

What does all this mean in practice? Thomas Dall at the BEA helped me out, taking one recent datapoint as an example: nominal GDP at the end of the first quarter of 2009.

When it was first reported, that number was $14.097 trillion. But then three months later, in July 2009, it was revised upwards, to $14.178 trillion. A year after that it was revised back down, to $14.05 trillion, and a year after that, in July 2011, it came down further, to $13.894 trillion. In other words, between July 2009 and July 2011, the GDP figure for the first quarter of 2009 was revised down by $284.3 billion, or 2% of GDP.

And Dall didn’t pick that datapoint because it was particularly noisy: it’s the only one we looked at.

This is bad news for any government thinking of issuing Trills. Governments, after all, go to great lengths to issue easily-understandable series of bonds with fixed coupons, so that the financial markets can price them easily and have a transparent yield curve. The only people welcoming GDP bonds with open arms would be in futures markets, where traders love volatility and try to make lots of money off it.

Which, of course, is the whole reason that Shiller is pushing this idea so aggressively. Shiller is a principal in a company called MacroMarkets, which exists to create “innovative financial instruments to facilitate investment and risk management” — a/k/a volatile new derivatives.

If Trills existed, you can be quite sure that MacroMarkets would immediately create futures and options based on Trills, trying to make money off their volatility. The volatility would depress the price that governments could sell the Trills for, but at the same time it could make a fortune for Bob Shiller. “Bob’s experience in the markets is that if there isn’t enough volatility in the price of the contract, the speculators lose interest in the contracts,” says Kamstra.

So let’s discount Shiller, here, as someone who’s way too conflicted to take at face value about such things. GDP bonds are like most financial innovations: they’re much more likely to do harm than they are to do good. And no country should even dream about issuing such things until some big corporation has blazed the trail first, as a kind of proof of concept. Lots of companies, from Walmart to ExxonMobil, do better in good economies and worse in bad economies: it might make sense for them to issue GDP bonds. Let’s wait until one of them does, so that we can get a feel for how such bonds behave, before we ask our governments to follow suit.

I feel we’ll be waiting a long time. If it’s true that the price of a GDP bond can skyrocket when interest rates fall, that bond would be extremely dangerous for any company issuing it. The market value of the company’s outstanding bonds could easily exceed the company’s enterprise value, with the result that technically shares in the company would be worthless. I can’t imagine any CFO or corporate treasurer risking it. And neither should any finance minister.


““As a result, if you’re a risk-averse person who wants a perpetual US government security and your discount rate is say 3%, then the expected value of a singe Trill is actually infinite.”
This statement doesn’t make sense – discount rates should differ based on the riskiness of the cash flow they are discounting, and 3% is way too low for an equity-like instrument like a GDP bond. ”

It’s worse than that. It’s the same as valuing ecological assets — there is uncertainty in the appropriate “interest” rate, in the one case the relevant discount rate, in the other case the relevant growth rate. This uncertainty is extremely important because of the projection to infinity. If your range of possible valid values for this rate includes 0, then you get strange things happening that depend on exactly how you take your limits.

The bottom line is that, in a context of the real uncertainties of the situation, projecting all the way to t=infinity makes no sense — all that makes sense is to project as far as you are confident in projecting and then make a reasonable assumption about what happens after that. There are various reasonable assumptions one might make, but plenty of them do not value such a financial instrument as having a price of infinity.

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How capitalism kills companies

Felix Salmon
Jan 12, 2012 19:10 UTC

As Mitt Romney cruises to his inevitable coronation as the Republican presidential candidate, increasing amounts of attention are being focused on his history at Bain Capital, where he made his fortune. Did he create 100,000 jobs, as he claims? Or is he a vulture and asset stripper?

Glenn Kessler has the definitive take on the job-creation claim, which he says is “untenable”; as he says, Romney’s method of counting jobs created when he wasn’t at Bain or when Bain wasn’t managing the companies in question doesn’t even pass the laugh test. Meanwhile, as Mark Maremont documents, Bain-run companies — even the successful ones — have an alarming tendency to end up in bankruptcy. And I think it’s fair to say that bankruptcy never creates jobs, except perhaps among bankruptcy lawyers.

The reality is that Romney would have been in violation of his fiduciary duty to his investors had he concentrated on creating jobs, rather than extracting as much money as he possibly could from the companies he bought. For instance, Worldwide Grinding Systems was a win for Bain, where it made $12 million on its initial $8 million investment, plus another $4.5 million in consulting fees. But the firm ended up in bankruptcy, 750 people lost their jobs, and the US government had to bail out the company’s pension plan to the tune of $44 million. There’s no sense in which that is just.

Romney’s company, Bain Capital, was a “private equity” firm — the friendly, focus-grouped phrase which replaced “leveraged buy-outs” after Mike Milken blew up. But at heart it’s the same thing: you buy companies with an enormous amount of borrowed money, and then dividend as much money out of them as you can. If they still manage to grow, you can make a fortune; if they don’t grow, they’ll likely fail, but even then you might well have made a profit anyway.

Private equity companies need growth, because they’re built on the idea of buying, restructuring, and then selling. They’re never in any business for the long haul: instead, they want to make as much money as they can as quickly as possible, sell out, and keep all the profits for themselves and their investors. When you sell, you want to maximize the price you can ask — and the way to do that is to show healthy growth. No one will pay top dollar for a company which isn’t growing.

Private equity is by no means unique in this respect: it happens at pretty much every public company, too. John Gapper, today, has a column about the way it destroys values at struggling technology companies:

Most public companies are run by people who hate folding ’em, and instead keep returning to the shareholders and bondholders for more chips…

Few senior executives, when debating options for a technology company in decline, admit defeat and run it modestly. Instead, they cast around for businesses to buy, or try to hurdle the chasm with what they have got. Sometimes they succeed but often they don’t, wasting a lot of money along the way.

It goes against their instincts to concede that the odds are so stacked against them that it is not worth the gamble. Mr Perez would have faced a hostile audience if he’d admitted it to the citizens of Rochester, Kodak’s company town in New York, but its investors would have benefited.

At many companies, then, both public and private, the optimal course of action is a modest one — run the business so that it makes a reasonable profit, and can continue to operate indefinitely. If you chase after growth, you often end up in bankruptcy: that’s one reason why the oldest companies in the world are all family-run. Families, unlike public companies or private-equity shops, don’t need growth: they’re more interested in looking after their business over the very, very long run.

There’s no limit at all to the amount of growth that the public companies will demand: in 2007, for instance, after a year when Citigroup made an astonishing $21.5 billion in net income, Fortune was complaining about its “less-than-stellar earnings”, and saying — quite accurately — that if they didn’t improve, the CEO would soon be out of a job. We now know, of course, that most if not all of those earnings were illusory, a product of the housing bubble which was shortly to burst and bring the bank to the brink of insolvency. But even bubblicious illusory earnings aren’t good enough for the stock market.

If you want to be fair to Mitt Romney, you could make the point that many of the companies he bought were highly risky, and would probably have gone bust anyway; in that sense he can’t be blamed if they eventually did just that. If a company is going to fail, you might as well squeeze the maximum amount of money out of it before it does. But doing that, at the margin, means more job losses, quicker job losses, and — as we saw at that steel company — a willingness to underfund staff pension plans and stiff the government with the bill. Mitt Romney turns out to have a personality which is highly suited to that kind of ruthlessly callous behavior; that’s how he became so incredibly wealthy. It’s an ugly part of capitalism; it might even be a necessary part of capitalism. But the one thing you can’t do is spin it as a great way of creating jobs.


So much truth in one little essay. I have watched the process Mr. Salmon describes, up close. It was an ugly ending for The Little Company That Could. But FifthDecade has a good point. A functioning ecology does not operate by the ethics of Count Dracula. Why not? Because it would not remain a functioning ecology for long if it did. So why are Germany and Japan better at this, FifthDecade? Maybe because you have to start, fight and lose a major war to learn humility in a world overrun by our species.

Oh well, nothing lasts forever! Eight centuries of global human growth have been a great ride.

After us, the deluge.

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Silly ideas of the day, Dylan Ratigan edition

Felix Salmon
Jan 11, 2012 20:36 UTC

Noam Scheiber is raving about Dylan Ratigan’s new book, giving it his highest praise: he calls it “sensible”. Which is maybe not obvious from the title, Greedy Bastards: How We Can Stop Corporate Communists, Banksters, and Other Vampires from Sucking America Dry.

He’s wrong. It isn’t sensible at all. Scheiber says that “one of the more intriguing ideas” in the book comes from Dick Grasso, of all people, who wants to classify a large part of the CDS market as “online gaming” and therefore “null and void”. Which sounds like one of those ideas which sounds great in the middle of your third bottle of wine.

But giving Scheiber (and Grasso, I guess) the benefit of the doubt, I had a look at the page of the book in question. Here it is, page 54, in full:

We must require not only that banks retain more capital but also that when they place bad bets, they pay the price for their losing bets themselves. Otherwise we are stuck with the worst of two economic systems: like a capitalist country, we have private banks that keep their profits. But like a communist country, we have a system where banking losses are charged to the government. Only when we end this corporate communism will we realign the interests of the banks with the investors they serve. The way to do this is debt reduction or cancelation. If the system is so out of control that we can use a computer to fabricate trillions in new money by simply adding some zeros, then surely we can find a way to delete some zeros as well. By definition, if you can print it, you can cancel it.

As we have already seen, a swap can either be an insurance policy that helps to lower long-term costs for a business or a bet by an outsider on whether a given company or country will succeed or fail. Putting swaps on a public exchange would create the visibility for all to see the difference between commodity insurance that is critical to the economy and speculative bets that are not much different from gambling. In fact, Richard Grasso, former chairman of the New York Stock Exchange, suggested to me in a personal interview that the speculative bets that fueled the financial crisis could be reclassified legally as online gaming — and then cancelled. His technical explanation: “I believe regulators should require the product to be registered with a central clearing agent (like an exchange) and thus able to be monitored globally to prevent contracts being written in excess of the debt obligations they are designed to insure (corporate or sovereign). This is easily accomplished by [regulators] and Treasury issuing a cross-markets rule adopted by non-US counterparts. Any contracts written outside these requirements would be deemed null and void by regulators as simply online gaming.”

This is exactly the kind of thing we need much less of, at least in book form. It’s fine if you’re just shooting the breeze with a bunch of financially-illiterate friends, but it really doesn’t belong in a volume which aspires to present “smart policy” prescriptions.

I mean, we start off OK, with a standard-issue broadside about privatized profits and socialized losses. Got that. But what on earth is this supposed to mean?

The way to do this is debt reduction or cancelation. If the system is so out of control that we can use a computer to fabricate trillions in new money by simply adding some zeros, then surely we can find a way to delete some zeros as well. By definition, if you can print it, you can cancel it.

I’ve spent the best part of a day trying to work out what on earth Ratigan might be driving at here, and I’ve come to the conclusion that he was probably just high. Never mind the fact that he doesn’t bother to identify which debt he wants reduced or canceled; just admire the elegant way that he proves that debt cancellation is somehow the equal and opposite action to printing money. (In reality, of course, printing money is a way of canceling debts, by inflating them away.)

Even more admirable, in a sense, is the way that Ratigan throws in his “let’s just delete some zeros” idea and then jumps straight to something completely unrelated — the idea of putting all derivatives on exchanges. I mean, it’s not as though deleting zeros willy-nilly would destroy the fundamental nature of capitalism as we know it, and might therefore be worthy of, oh, another sentence or two. We’ve got Grasso to get to!

Of course, we’re not going to get into any nitty-gritty here about the difference between exchanges and clearinghouses, despite the fact that Ratigan’s talking about the former, Grasso’s talking about the latter, and the two are not at all the same thing. And we’ll not spend much time either on the silly idea that anything interesting or systemically important happens at the point at which the notional value of derivatives contracts exceeds the amount of the underlying. (It doesn’t.)

Because even putting those points aside, what Grasso is suggesting here doesn’t stand up to the scrutiny of sober thought. (Especially if debt obligations — the underlying bonds being insured — can simply be reduced or canceled by deleting zeros.)

The way that markets and exchanges work, there’s no way that a clearinghouse would ever be able to know whether the counterparties to a derivatives contract had some kind of insurable interest in the underlying. Grasso’s proposal wouldn’t put an end to what Scheiber calls “naked bets”, it would just allow speculators to crowd out genuine hedgers, to the point at which people who did have an insurable interest wouldn’t be able to do any hedging, because the speculators would have got there first and written contracts up to the maximum allowable limit.

Ratigan has a bully pulpit on the television, and his heart is pretty much in the right place. I can see why he’d want to publish a book where he can tease out his policy ideas in detail, while keeping them accessible to his television audience. But it’s irresponsible to boil complex issues down into a simplistic world of good and evil, complete with simplistic solutions (cancel debt! outlaw speculative gambling!). If anything, it plays right into the rhetoric of the Tea Party, which Ratigan hates.

There are big and hugely important issues to be addressed in the global economy; the least we can do is take them seriously. And stop pretending that being harsh on a coterie of banksters would be both necessary and sufficient to solve all our problems.


Foppe, I guess dealing with facts is beneath you right? Especially as they seem to regularly get in the way of your opinions. No wonder you were such a fan of Graeber.

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Golden ticket economics, part 2: Damien Hirst

Felix Salmon
Jan 7, 2012 00:46 UTC

Yes, the Damien Hirst Complete Spot Challenge is a thing:

Visit all eleven Gagosian Gallery locations during the exhibition The Complete Spot Paintings 1986–2011 and receive a signed spot print by Damien Hirst, dedicated personally to you.

Carol Vogel, who says that the price of spot prints is somewhere in the $3,500 to $50,000 range, managed to get Hirst to explain the thinking:

Asked how he came up with the idea, Mr. Hirst responded in an e-mail: “I figured it would be pretty difficult to visit all the galleries, and totally admirable if anyone managed it, so admirable in fact that I thought they would deserve a work of art, so we came up with the idea to do the challenge. I’d love it if people manage it. I remember the golden tickets in Willy Wonka, maybe it’s a bit like that.”

And Greg Allen comments, calling the whole thing “a Black Friday riot for billionaires”:

How awesome that he invokes the utterly deranged Willy Wonka for this thing, which goes beyond difficult; I think it’d be positively hellish. Which is really perfect.

But does it have to be hellish? Even if you don’t have access to a private jet? I decided, with the help of Nick Rizzo, to put together an itinerary for an imaginary plutocrat — let’s call him Pictor Vinchuk — who wanted to curry favor with Hirst and take this bonkers challenge. The rules: he had to fly commercial all the way (I guess his jet’s in the shop), but he would travel first class and stay in the best rooms at the grandest hotels. And, just to make it a bit more interesting, he had to wait until after Davos to start his trip.

Mr Vinchuk’s itinerary starts in Geneva — an easy hop from Davos. We’re trying to make this trip as un-hellish as possible, so we’ve booked him in to the Beau Rivage hotel, arriving on Sunday January 29, where two nights in a lake-facing historical suite will run $10,471. Then on Tuesday January 31, we’ve booked Mr Vinchuk and his companion onto the short flight to Rome. Still, a pair of first-class tickets is $2,682. Another two nights in Rome, at the Hassler Roma Classic Suite, will cost $6,717.

And then comes the low point of the whole journey: there aren’t any flights with first-class seats from Rome to Athens! Poor Mr Vinchuk has to make do with business-class seats, at a minuscule $439.10 apiece. And then slum it at the King George Palace hotel, where his junior suite is a mere $469. All very low-rent. Fortunately we’re only spending one night there, before we hold our nose and get on the final business-class leg of the trip, two tickets at $655 each to Paris.

From here on in, things get much more familiar. There’s the premier suite at the George V hotel, which is $11,450 for two nights. There’s the pleasant train journey to London on Eurostar, $948 for two tickets in first class. And then there’s the lovely Linley Suite at Claridge’s in London, where we spend three nights, which is more than enough time to visit both the Britannia Street and Davies Street Gagosians. That stay will run us $7,288.

Then on February 8 we hop over the pond to New York. Those tickets are a pretty impressive $9,276 each. And we need to spend some time in New York, too, to catch up on friends and make sure to visit the three different Gagosians — on 21st Street, 24th Street, and Madison Avenue. So we’ve booked Mr Vinchuk in to a grand suite at the Pierre, which runs $16,077 for four nights.
On February 12 we leave for Los Angeles: a first-class ticket for that leg is $3,108, and three nights in a deluxe bungalow at the Beverly Hills Hotel is another $8,341. And finally on February 15 we hop a plane to Hong Kong — that’s $15,682 for two first-class tickets — in order to catch the show there before it closes on the 18th. We’ll spend two nights in the presidential suite at the Landmark Mandarin Oriental: that’s $2,524, checking out on the 17th.

Add it all up, and the trip comes to $108,572 for a 19-day itinerary, or about $5,700 per day. And of course there are incidentals, too: meals, cars, helicopters to Geneva, tchotchkes at Harry Winston, that kind of thing. But the main thing, of course, is that you end up spending more money touring the eleven different Gagosians than the value of the print you get for doing so. Otherwise, Damien might think you were taking advantage. And I think we’ve safely managed to do that.

Update: OK, back to the drawing board here: the eagle-eyed Greg Allen notes that the LA show ends on Feb 10, which means that if we get there on Feb 12, we’ll be too late. He also says that “the Spot Challenge is really a challenge to fill the vast emptiness of someone’s life, to provide purpose [sic of the biggest kind] to someone’s leisure time. It’s literally the answer for someone who doesn’t know what to do–not just with their money, but at all.” I feel offended on behalf of Mr Vinchuk!

Meanwhile, Jennifer Bostic reckons she can do the whole trip, for two people, for $13,206, including some pretty grand hotels at some decidedly cheap prices. Of course, the real cost here, as Allen says, is time rather than money. But I would be tickled very pink if a pair of underemployed hipsters did the whole tour for less than the value of the prints, sold them, and made a profit. Listen all y’all, it’s an arbitrage!


for a second, i wished i was an underemployed hipster. i want an itinerary with hostels, lets get this dirt cheap.

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Golden ticket economics, part 1: Next restaurant

Felix Salmon
Jan 6, 2012 23:57 UTC

Economists Justin Wolfers and Betsey Stevenson have a problem with Grant Achatz’s pricing strategy at Next, where tickets are sold at a fixed price and are then free to be resold at an enormous markup on the secondary market. The restaurant is very clear why it won’t auction off tickets instead:

You should auction the tickets. Do a reverse, double blind, dutch auction and give the surplus profit to charity.

An auction would set pricing too high for our sense of value for the meal. One of the reasons that we have so many people trying to buy tickets is because we are trying to do something new, different, and delicious for a great price. We may institute more dynamic pricing in the future, but for now the system is fair precisely because it is blind to everyone – anyone who clicks to buy can buy.

But the Wharton economists aren’t convinced.

“It’s democratic in theory, but not in practice,” said Wolfers…

If a person can sell a ticket for $3,000, the true cost of going to the restaurant — what an economist would call the opportunity cost — is $3000, because that’s how much money the person is giving up for the meal.

Bloomberg’s Mark Whitehouse concludes that Next should “consider selling tickets to the highest bidder and giving the extra money to charity” — precisely the course of action which has been explicitly considered and rejected in the restaurant’s FAQ.

Is Next making a mistake here? Do Wolfers and Stevenson have a point?

My feeling is that the restaurant is the smart one, while the economists are being naive.

For one thing, real people don’t think in terms of opportunity cost — especially not when they’re the lucky winners of a restaurant-reservations lottery. Dan Ariely did research on this at Duke University: he found that once Duke students won the lottery giving them the opportunity to buy sought-after tickets to the university’s basketball game, they valued those tickets at ten times more than the students who lost the lottery.

What’s really going on here, I think, is that the vast majority of people who get tickets hold on to them, go to the restaurant, and eat a wonderful meal for which they paid a reasonable sum. And then there’s a tiny number of people who get tickets, and either discover they can’t use them for some reason, or decide that they’re going to try to flip them for profit.

Because that number is tiny, the supply of Next tickets in the secondary market is tiny — and because the secondary-market supply of Next tickets is tiny, the price of those tickets can become astronomically high. But I suspect that the high secondary-market prices for Next tickets are doing a very bad job of increasing supply — that there are people who can’t use their tickets, and there flippers who are always going to put their tickets up for auction if they win, but there are very few people indeed, and possibly zero, who put their tickets up for sale just because of how much money they might fetch.

As a result, the very few datapoints that we do have, with respect to the secondary-market price of Next tickets, tell us almost nothing about the amount of money that Next tickets would go for if they were auctioned. If Next decided to auction off all its tickets, the total supply of Next tickets in variable-price markets would skyrocket. Demand would probably rise too — but I very much doubt you’d ever see $3,000 tickets in a Dutch auction.

What you would see, on the other hand, would be a lot of semi-disgruntled diners worrying about whether they were suffering from the winner’s curse, and feeling much less chuffed about their meal than the current diners who are generally elated about having won the lottery.

The most important thing in being a restaurateur of a high-end establishment is exceeding expectations; if you auction off tickets, then the price of tickets will naturally gravitate to and possibly past the point at which you can’t do that any longer. That’s why Next is right to worry about “our sense of value for the meal” — because the chances are that their sense is going to be your sense too. If they think a meal isn’t worth more than say $200, and they start selling tickets to that meal at $400 apiece, then they’re setting their customers up for disappointment; I can’t imagine Achatz would ever want that.

Do the handful of people who currently buy tickets for $500 or $3,000 walk away disappointed? Maybe not: there’s a good chance those people aren’t particularly price-sensitive. But when you move away from those people and use the market to set prices for all your customers, big dangers lurk. As Alan Vanneman says, markets are largely foreign to the human imagination. And since restaurant-goers are human, we don’t want to upset them with market mechanisms if doing so is unnecessary.

In the past, I’ve advocated auctioning off restaurant meals in certain contexts, but never as the only way of selling tickets. Restaurant-reservation auctions should be rare things, applying to a minority of your total diners. Most of the time, prices should be fixed, and it’s always nice when demand outstrips supply. That’s how successful restaurants have always worked, and it’s hubristic to imagine that there’s an obviously better way.

Update: Next owner Nick Kokonas responds in the comments, happily demolishing a key part of the auction-happy crowd’s argument: it’s untrue that a $100 ticket ever sold for $3,000. In reality, he says,

a TABLE has sold for $ 3,000. That table was a kitchen table for 6 people that with wine pairings, service, and tax was nearly $ 2,500 face value. This was a case where one blogger got it wrong and EVERY news source since has reported it as if a $ 100 ticket sold for $ 3,000. Big difference.

What’s more, Kokonas confirms my suspicion that the overwhelming majority of tickets are not in fact resold: 99% of them are used by the people who manage to buy them, or their family and friends.

But he does add that there will be a Dutch auction for one two-top per night, with all proceeds going to the University of Chicago Cancer Center. I hope it raises lots of money!


1. Enterprising coders did set up scripts — but those have been effectively blocked by both passive (captcha) and active (ip filtering) means.

2. I don’t believe a ‘ticket’ has ever sold for $ 3,000 — a TABLE has sold for $ 3,000. That table was a kitchen table for 6 people that with wine pairings, service, and tax was nearly $ 2,500 face value. This was a case where one blogger got it wrong and EVERY news source since has reported it as if a $ 100 ticket sold for $ 3,000. Big difference.

3. The number of scalped tickets is very low… we can track transfers and to an extent which are scalped and it is less than 1 %. The majority of transfers that are not between family and friends are processed through our site — a few per day only.

4. Most economists I have spoken with on this (and yes, they do call / email me) fail to consider the fact that we have to tightly control the flow of people into the restaurant and that we are not making widgets… it is not a scalable operation. Those that realize this immediately think — raise prices and find price stability through an auction. I completely understand that from the point of view of maximizing utility (in the economic sense). But it would be a PR / customer service DISASTER. Right now we are offering an experience that is perceived as a great value and that ensures that we have a full house every night. As soon as we take that to ‘parity’ we run the risk of living a bright but short existence. We are planning for the long term — and that includes tangential businesses (our iBook series with Apple for example) that are not factored into their plans.

5. For our El Bulli menu we will be running a Dutch Auction for 1 table of 2 per night… with 100% of the proceeds benefiting the University of Chicago Cancer Center where chef Achatz was treated. We will indeed see where El Bulli pricing settles, albeit for charity and for a very limited supply.

6. I am in the process of building a software suite that will allow restaurants, galleries, barbers, theaters, etc. charge variable pricing in both direction… and indeed use systems to easily sell fixed, variable, and auction pricing in a mix based on both supply and demand — while linking through social media seamlessly… and without having to use third-party deal sites to interact with opt-in customers. Next is in the first iteration of that experiment — there is plenty more (and more interesting) models to come.

– nick

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Uber and the cognitive zone of discomfort

Felix Salmon
Jan 3, 2012 15:30 UTC

If you spend a fair amount of time among privileged dot-com types, you’ll probably be familiar with Uber, a kind of luxury car service for the smartphone era. The idea is that you pull out your iPhone, punch a couple of buttons, and in a few minutes a swanky black car pulls up to drive you to your next destination. You get out, no tipping, and the cost of the fare is automatically charged to the credit card you have on file. Elegant!

You do pay for that convenience. An Uber cab costs significantly more than you’d pay for a taxicab, and I’ve met a lot of people who suffer from Uber sticker shock. I’m one of them, truth be told: after getting charged $43 for my first Uber cab ride, last month, I haven’t used it since. I probably will at some point, when the trip is shorter or when it’s raining or when I’m stuck in the middle of nowhere and there’s no easy way to get a cab. But if you start getting into the habit of using these cars on a regular basis, that habit can get expensive fast.

Uber doesn’t seem to have worked out how it wants to deal with the central question of cost. On the one hand, it’s positioning itself as “everyone’s private driver”: it basically stands in relation to the chauffeur-driven car as NetJets does to the private jet. And compared with the cost of hiring a full-time car and driver, Uber is certainly dirt cheap.

On the other hand, Uber doesn’t like being told that it’s out of reach for people without a lot of disposable income. When Marlooz, a soi-disant “poor freelancer”, said that Uber was “too expensive” for her, the company responded with a 1,750-word data-filled blog post explaining how, even though Uber costs twice as much as a cab, it’s still a good deal. Especially if you’re calling for a cab in San Francisco on a weekend evening, when most of the time the cab you called won’t even turn up.

But the fact is that Uber is too expensive for most people. Hell, taxis are too expensive for most people. Uber is a luxury service, and they charge accordingly. Cab rates aren’t entirely apples-to-apples, but they generally have three components: a fixed base fare, and then a rate for time and a rate for mileage. The meter works out whichever is the higher, and charges you that. And if you compare Uber’s rates to the taxi rates in San Francisco, New York, Boston, Chicago, and Washington, you can see that Uber is a lot more.


San Francisco Base fare Per hour Per mile
Uber $8.00 $75 $4.90
Taxi $3.50 $33 $2.75


New York Base fare Per hour Per mile
Uber $7.00 $57 $3.90
Taxi $3.00* $24 $2


Boston Base fare Per hour Per mile
Uber $7.00 $51 $4.00
Taxi $2.60 $28 $2.80


Chicago Base fare Per hour Per mile
Uber $7.00 $51 $3.50
Taxi $2.25 $19.80 $1.80


Washington Base fare Per hour Per mile
Uber $7.00 $45 $3.25
Taxi $3.25* $15 $1.50

*includes $0.50 in surcharges

The other thing which becomes clear when you look at these prices is that Uber raises its prices pretty much in lockstep with local taxi rates. The cheapest Uber cabs — the ones in Washington — are still significantly more expensive than the most expensive yellow cabs — the ones in San Francisco. But on an absolute basis, it’s easy to see why people in Washington feel happier grabbing an Uber to get home than people in San Francisco do. If you get stuck in traffic and it takes 30 minutes to get home, that’s $29.50 in Washington; in San Francisco, it would be $45.50.

On top of that, Uber has dynamic GPS-based pricing which automatically charges you on a per-mile basis whenever the car is going faster than 11mph, even if it’s only for a brief period of time. And then of course there’s the fancy surge pricing that we saw on New Year’s Eve, when people started getting charged exorbitant rates — Brenden Mulligan, for example, got charged $75 for a ride which took just 136 seconds, and Dan Whaley got charged $135 to go 12 blocks.

Uber loves to explain its surge pricing with fancy supply-and-demand curves, but you could call it a “rip off drunk people” strategy too. Mulligan has ideas about how Uber’s software could be improved: at the very least, it should display the current minimum fare prominently, rather than just the current multiplier.

But this gets back to my disagreement with Jacob Goldstein and Matt Yglesias about the wisdom of deregulating taxi rates. They reckon that deregulated fares are a great idea, while I think they would be chaotically disastrous. And I think that the experience of Uber on New Year’s Eve — which has resulted in a significant number of refunds for unhappy customers — is important here. Uber’s customers are as savvy and sophisticated as cab passengers get, and Uber was genuinely trying hard to be transparent about pricing. After all, if surge pricing doesn’t reduce demand at peak times, it doesn’t really work. And it only reduces demand if people understand what they’re going to pay.

But Uber got a fair amount of bad press from its New Year’s experiment, and of course its fares 99.9% of the time — just like the fares of other deregulated companies like those in Stockholm — are set and fixed. That’s good business: Uber provides a valuable service by allowing people to know, when they’re out and about, that if they want to call an Uber cab, it will take them home for roughly twice the cost of a taxi.

If Uber pricing was continuously dynamic, prices might well come down during periods of light demand, especially in the early mornings. But our brains hate having to do dynamic cost/benefit calculations. Instead, we rely on simple heuristics: “I should always take the subway if I can”, “cabs in New York are cheap enough that I can take them when I want to”, “cabs in London always cost more than you think they will”, “I can afford Uber if it’s just a short ride”, that sort of thing. When we think about the costs and benefits of various different types of transportation, we don’t actually think in dollars, most of the time, just in terms of a vaguer cheap/expensive spectrum. Dynamic pricing like Uber’s New Year’s experiment takes us out of that comfort zone, and people hate being forced to re-think these things.

It’s nearly always a bad idea, then, for companies like Uber to implement variable pricing: it forces customers to think too much, and it invariably happens on nights when demand is high precisely because lots of customers are inebriated and therefore in no position to drive. Or overthink things.

But from the point of view of the passenger, Uber itself adds a whole new level of complexity to what used to be a relatively simple heuristic. Most of us understand pretty intuitively what the differences are, in terms of costs and benefits, between walking; taking public transport; and taking a cab. But then if you move to Stockholm, or if you start using Uber, things become much more complicated, since now you need to work out the tradeoffs between various different cab options. And those tradeoffs, as Bradley Voytek’s Uber blog post explains, get very complex very quickly, and involve things like whether you’re calling a cab or hailing it, your expected wait time, and the probability of a called cab turning up at all.

It takes a long time to turn all of that into an unthinking heuristic, and in the meantime Uber’s customers will always feel as though they’re ticking the “none of the above” box, rather than simply expanding the menu which is currently hard-wired into their decision-making apparatus. And that I think helps explain why many people remain uncomfortable with Uber, even if they’re exactly the kind of people who should love it.

Uber is a great idea in theory, and the mechanics of it tend to work well in practice. But Alex Rolfe has an important point: if Uber’s prices came down to the point at which they were vaguely the same as a taxi, then we could just lump Uber in with cabs as far as our mental heuristics are concerned. Because Uber’s prices are as high as they are, however, and because when they change they go up rather than down, customers react with snarky hostility.

Uber, in other words, is a car service for computers, who always do their sums every time they have to make a calculation. Humans don’t work that way. And the way that Uber is currently priced, it’s always going to find itself in a cognitive zone of discomfort as far as its passengers are concerned.

Update: Rocky Agrawal adds some very smart comments. A taster:

When people feel ripped off, they don’t want to hear about economic theory or the team of Ph.Ds you have developing optimal supply and demand mechanisms.

Most people have a sense of what is “fair”. Study after study has shown that people will make suboptimal economic decisions in the name of fairness. Product and pricing decisions have to take that into account…

I’m disappointed that Uber didn’t turn New Year’s Eve into a positive marketing opportunity. I would have strongly advocated subsidizing rides with some of the company’s $32 million in new funding (from Amazon CEO Jeff Bezos, Menlo Ventures and Goldman Sachs) to create a delightful customer experience. The company is young enough that it could benefit from positive customer feedback.


I think Uber should show the current Minimum Fare BEFORE the user confirms his/her pickup request… Then when the ride starts the user should see a running meter on his/her phone app to make the transaction fully transparent.

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Why Ecuador isn’t drilling in Yasuni

Felix Salmon
Jan 2, 2012 15:27 UTC

Back in June 2007, I looked at an intriguing idea coming out of Ecuador, whose massive Ishpingo-Tiputini-Tambococha oil fields lie underneath the most important area of biodiversity on planet Earth: Yasuni National Park. (Time’s Bryan Walsh has been there. It’s worth reading his report to get a feel for just what’s at stake here; suffice to say that it’s a place which makes even grammar sticklers want to use the term “most unique”.)

Ecuador’s president, Rafael Correa, had a bright idea: instead of drilling for oil in the park, he would ask the global community to pay him billions of dollars not to drill in the park. $3.5 billion, to be precise, to be paid at the rate of $350 million a year for ten years.

On the face of it, the proposal has a certain amount of logic to it. The world has quite a lot of oil; it has only one Yasuni. And while Ecuador would get some desperately-needed cash from drilling for oil, the world would lose an area of paramount importance.

The problem is that we’re talking about Ecuador, here. What was there to stop Ecuador cashing the checks and then drilling for oil anyway? It’s a sovereign country, after all, and one which has reneged on many promises (a/k/a bonds) in the past. As Kevin Koenig puts it:

The proposal has been riddled with problems from the outset, many of them of President Correa’s own making. The proposal’s political and financial guarantees were slow in coming, which is problematic given Ecuador had seven presidents and two constitutions between 1996 and 2006, and defaulted on its Brady Bonds in 2008. Donor confidence was further eroded by several changes in the financial mechanism of the proposal, and frequent turnover of members of the negotiating team and foreign ministers who were the face of the initiative internationally. These factors, coupled with a series of Correa public outbursts and contrarian environmental policies, undermined the proposal’s credibility.

Nevertheless, the Ecuador Yasuni ITT Trust Fund was set up, under the auspices of the United Nations Development Group, and now, more than four and a half years after the original ask, Ecuador has proudly announced that it has managed to raise $116 million, which is enough of a down-payment that it won’t start drilling for the time being.

Obviously, the $116 million which has been raised by the end of 2011 is a far cry from the $1.4 billion that Correa originally hoped to have raised by this point. And if you look at the source of that $116 million, it’s even less impressive. $51 million came from Silvio Berlusconi, who deducted it from the money that Ecuador owes Italy — as though Ecuador was ever going to pay that money in any event. And another $40 million came from Correa himself, who donated the monster libel damages he extracted from opposition newspaper El Universo, in a suit that Amnesty International said “will have a chilling effect on freedom of expression in the country”. Which leaves just dribs and drabs from elsewhere: $100,000 from Turkey, $500,000 from Australia, that sort of thing. There’s no way that those sort of sums can ever hope to come close to replacing potential ITT oil revenues.

At the same time, Correa’s decision to declare victory and hold off on drilling for the time being is entirely rational. For one thing, there’s a lot of domestic popular opposition to the idea of drilling for oil in one of Ecuador’s two great national treasures of biodiversity. (The other, of course, is the Galapagos Islands.) It’s not that the population doesn’t want the money, but more that they’re very proud of the Ecuadorean Amazon, and very skeptical that if drilling does begin, that the proceeds would go to them rather than into the pockets of oil companies and kleptocrats.

On top of that, there’s a very real option value of not drilling for oil. It’s not like the oil is going anywhere, after all: no one else is in a position to drink Ecuador’s milkshake. Ecuador is retaining the option to drill — and that’s a valuable thing, which it loses the minute it actually starts drilling.

And the value of the option is only increased by the precedent set by the existing trust fund. Ecuador has done something important, here: it’s demonstrated that not drilling for oil is something valuable, and something which at least some of the rest of the world is willing to pay for. From here on in, it can continue not drilling for oil every year, getting rents for doing so all the way. Sometimes those rents will go up, and sometimes they will go down. But the more stable and trustworthy Ecuador’s governance, the more seriously its proposals will be taken. And, of course, if drilling starts in Yasuni, then all those future rents get thrown away forever.

Finally, there’s the fact that the reluctance of the international community to trust Ecuador in its oil-related dealings is mirrored by a similar reluctance on the part of international oil companies to enter into long-term contracts with the country. If you were ExxonMobil or Shell or BP, you would have a lot of very good reasons not to sign a contract to drill in Yasuni: you would be paying a lot of money up front, for a share of future oil revenues which could at any point be expropriated by a future government. And of course you would incur even more wrath from all environmentally-minded people around the world. You might not have heard of Yasuni now, but if Chevron started drilling there, I can promise you that you’d know all about it.

As a result, the ITT reserves would have to be drilled for by Petroecuador — certainly Hugo Chavez isn’t going to want Venezuela’s PDVSA to get involved. And Petroecuador is already giving all the money it can to the Ecuadorean government: it couldn’t find any more money just by starting to drill in Yasuni. In order for real money to start flowing, Ecuador would have to wait many years, for the wells to get drilled, the pipelines built (in the face of what would surely be massive opposition), and physical oil actually sold. Much easier to just collect millions right now, hope for much more in the future, and bask in the happy glow of knowing you’re doing the right thing by your national patrimony and for the natural wealth of the planet.

Oilfields, eventually, run out of oil. But untapped oilfields never do. Ecuador’s onto a good thing, here: it would be foolish to throw it away. Which explains why Correa isn’t drilling, despite the fact that he’s only received a tiny fraction of what he asked for.


A few months on, Felix and Nick, and yes, indeed it can be said that Rita was correct, though it’s only possible to state this in retrospect. In pardoning all the convicted journalists, Correa also obliterated the 40 million dollars in damages, which means the funds that *were* scraped together did not include that sum. The part about Berlusconi should still hold true, but it’s always best to verify your opinions beyond all doubt – despite this being a blog, or perhaps precisely because this is a blog under Reuters.

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