Argentine President Cristina Fernández de Kirchner had a large color photograph on the cover of today’s Financial Times — not, like the last time, when she had just won a landslide reelection victory, but because she is initiating a process of nationalizing (or, rather, re-nationalizing) the largest oil company in Argentina, YPF. The Financial Times reported this as follows:

A visibly angry Ms Fernández made the announcement on live television to a cheering audience at the government palace. Rejecting recent criticism from Spain, Ms Fernández said she would not bow to foreign pressure. “I am a head of state and not a hoodlum,”’ she told business, union and political leaders in the audience.

The visible anger may have been due, according to another story in the FT (Fernández takes her revenge), to the Malvinas/Falkland Islands dispute not having been taken up by the Sixth Summit of the Americas which just concluded in Cartegena. President Fernández left the summit early, and, reportedly, disappointed. While it seems like stretch to me to attribute the re-nationalization of YPF to a desire for revenge over the Malvinas (since it is Spain that is being punished by this, rather than the UK), this FT piece is nevertheless well worth reading for its account of the economic and political vicissitudes experienced by YPF, which apparently had better arrangements with the president’s deceased spouse than with her.

Not surprisingly, the re-nationalization move has great popular appeal in Argentina, as evidenced by the cheering audience mentioned above. Since the global financial crisis, and indeed since before the crisis, it has become fashionable (especially in Latin America) to fix the blame for all problems on “neo-liberalism,” and it is understood that one of the key features of neo-liberalism is privatization. Thus re-nationalization is seen not only as an intrinsically good thing for the people of Argentina to have control over their resources (what President Cristina Fernández de Kirchner has called, “recovery of sovereignty and control”), but also as a blow for “economic justice” that will reverse the perceived errors and injustices of privatization and neo-liberalism.

Even while the president was being reelected by a landslide there were many articles in the media about the financial difficulties that the president was inheriting from her previous term, and not a little speculation on how exactly she would go about handling it. Well, now we know. After squeezing the country’s once-legendary agricultural industry and nationalizing pension funds in order to get state hands on more resources, the president will now turn to further nationalizations, and with oil prices rising YPF is a very tempting target. Because Argentina has been frozen out of international credit markets since its debt default ten years ago, the Argentinian economy has been forced to operate on a cash basis vis-à-vis the rest of the world. This absence of the irresponsible use of credit has resulted in the economy growing for the past decade, which has in turn resulted in some superficial economists learning the wrong lesson from Argentina’s default (cf. Incommensurable Defaults).

Nationalizing YPF has strong parallels with the policies pursued by Cristina Fernández de Kirchner and, before her, by her husband (since deceased) Néstor Kirchner in regard to agriculture. The FT’s front page article claimed:

Ms Fernández accused Repsol of “emptying” YPF. But analysts and industry executives said the real culprit for Argentina’s loss of energy self-sufficiency and ballooning imports bill was the government’s failed energy policy, which set domestic prices at well below international levels.

Simon Romero and Raphael Minder wrote in Argentina to Seize Control of Oil Company in the New York Times:

Seizing YPF appears to be a popular move in Argentina, where caps on residential energy prices and a growing economy have helped push energy demand to new highs. Argentina’s oil production has declined in the last decade as regulatory uncertainty persisted over price caps and the policies over profit remittances. Many Argentines still resent the privatization of state-owned companies in the 1990s, so taking on YPF gives Mrs. Kirchner the opportunity to go after a symbol of that time.

With Argentina’s formerly profitable agricultural industry, the Kirchner’s kept prices below market rates internally and created high export tariffs. Not surprisingly, agriculture become unprofitable in Argentina, and many Argentinian producers moved their operations to neighboring Uruguay. Now little Uruguay exports more beef than spacious Argentina. Like most populist economic measures, the short-term feel-good benefits come at a very high long-term cost.

President Cristina Fernández de Kirchner has continued populist policies with the oil industry, and with petrochemicals priced below market rates they are being used unsustainably. Now that Spain’s Repsol management has been ousted, and even banned from the YPF building, not merely the prices but the actual operations of YPF will be politicized. The model for this is the politicization of the administration of PDVSA after the failed coup against Hugo Chavez, which latter oil company has declined in efficiency continuously since the ouster of its experienced management.

Given how disastrous this move will likely be for Argentina and its economy in the longer term, and the negative diplomatic fallout that will result, one must ask why the president is doing this. The short answer is Peronist populism, which has been entrenched in the Argentine political system since the middle of the twentieth century. The longer answer would include many factors, including the fact that, while popularly elected (and by a wide margin), Cristina Fernández de Kirchner can appeal to David and Goliath themes. One need not be an unelected tyrant in order to make a show of one’s defiance and claim to represent the underdog.

Argentina’s century-long decline will not be arrested by populism or re-nationalizations. People may cheer in the short term, but the Argentine economy will stagnate in comparison to other economies in the region — especially in comparison to Brazil, Chile, and Peru, which are experiencing robust growth on sustainable foundations. And in this context I do not necessarily mean “stagnation” as a complete absence of growth, as it is more likely that Argentina will experience unsustainable growth followed by repeated crashes when reality catches up with the market. This has the effect not only of immiserating the people, but also of creating an unstable and unpredictable business climate.

Argentina’s decline will not be dramatically visible over a year or two, just as steady but small economic growth is not obvious over a year or two, but over a decade or two these things add up. And in addition to not being immediately evident, one must compare the reality with the counter-factual conditional of what the Argentinian economy might have been if more sustainable economic management had been practiced. Since human beings have short and imperfect memories, and cannot usually grasp what is counter-intuitive, there is very little penalty paid by a political regime for its foolishness, especially when a given regime is out of office by the time the consequences of its actions must be paid for. While all systems of popular sovereignty suffer from this weakness, the effect is exacerbated by irresponsibility.

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Grand Strategy Annex

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Cash Flow is King

17 January 2011


How to Make a Killing

in the Insurance Industry

Insurance company fat cats can expect to grow fatter.

Without Really Trying

Suppose you ran a business and you could get the government to force people to buy your product or service under threat of penalty. That would be really sweet, wouldn’t it? Well, health insurance companies in the US are now in this enviable position. One could say that anyone who doesn’t go right out and set up shop in the insurance industry is a fool, except that there are significant barriers to entry to the industry. It takes a lot of money to be in the insurance industry. You have to sit on a mountain of cash, and you have to have a lot of cash flow to make it work.

Sometimes people in the business world say, “cash flow is king.” Even a business that isn’t doing so well can leverage its cash flow for its benefit, if it has a cash flow to leverage. Small businesses routinely do this in minor ways by, for example, charging their business purchases on credit cards that give them benefits. So if you have a lot of cash flow but not much profit, you can still get something out of the cash flow. It’s sort of like juggling money.

Big businesses leverage their cash flow in big ways. Indeed, some industries make their money not from sales of goods and services, but from the management of their cash flow. The insurance industry is one of these industries. It is not usual for an insurance company to pay out $1.06 in claims for every dollar it takes in from premiums. How do they stay in business? They sit on so much cash, that they invest the cash they sit on and they make some money from capital gains. An ADP representative once told me that this is how they make their money too.

The pending individual mandate to force the uninsured to purchase health insurance is a promise of even greater cash flow to the insurance industry. During the run up to the passage of health care legislation in the US, the insurance industry lobbied hard for the mandate and for penalties that would really bite: “AHIP objected to the version of the penalties in the original Senate leadership proposal as insufficiently strict to induce many people to become insured.” The insurance industry was never fooled about this, though the popular press persisted and still persists in characterizing this legislation as “reigning in” the healthcare insurance industry and calling them to account. This behavior has been encouraged by the Kafkaesque title of the legislation: Patient Protection and Affordable Care Act (ACA).

I encourage the reader to look over a document from the Urban Institute titled Why the Individual Mandate Matters dated December 2010. Here’s a quote from the Urban Institute‘s report:

“Three important goals of reform are to increase health insurance coverage, to eliminate discrimination by health status in the sale and maintenance of health insurance, and to increase the affordability of coverage. Without an individual mandate, these would all be affected by the natural tendency for people to want to pay for health insurance only when they believe they will need health care services. Since those currently without insurance have significantly lower costs on average than those paying for insurance, the mandate will bring lower-cost people into the insurance risk pools. This would lower the average cost per person covered and thus lower premiums.”

When you read the insurance industry treatments of the problem you find formulations like “a diverse risk pool of enrollees.” This sounds very nice, but what does it mean? In the context of health insurance, it means health diversity. In other words, some people are weak and sickly, and some people are strong and healthy, and the insurance industry, as well as a lot of politicians, want the strong and the healthy to subsidize the weak and the sick. Failure to do so they call “adverse selection.” You know what adverse selection is in evolutionary theory? It is extinction. This is a debate about extinction. Go figure. I can say things like this bluntly and honestly because I don’t have to care what other people think of me, but politicians and politically visible persons (like CEOs of major companies) can’t be honest. They cannot afford to be honest.

How much cash flow are we talking about as a result of the individual mandate? I did some very rough calculations — literally on the back of an old envelope — and if we take the frequently cited figure of 47 million Americans without health insurance, and divide this by average household size of 2.59, we get more than 18 million uninsured households. I found figures cited between $46,000 and $50,000 as the median US household income in 2010. I took the lower number of $46,000, and found estimates between 7.5 and 12.8 percent of household income to be spent on healthcare (the Urban Institute’s report cited above gives a rate of 2.5 percent, but this is not to be taken seriously). If we pick a number between the two percentages cited, between the high and the low figure, we get about $4,650.00 annually for health insurance per household. This is an unrealistically low number, but I’m doing a conservative calculation. With these conservative numbers, we find that the individual mandate would funnel another 83.7 billion dollars into the coffers of the insurance industry annually. This is cash flow that they can leverage even if they have to pay out a little more than 83 billion in claims.

Now, if I were an insurance executive, even if I had to operate under government regulations (what industry does not have to deal with regulators?), I would be very pleased indeed to hear that the government was going to force people to spend another 83 billion dollars in my industry. Even if I didn’t get all of it, I could count on getting a portion of it. And we all know that an expanding industry is an industry in which the established players don’t have to fight over scraps. A bigger pie means a bigger slice for everyone invited to the table.

But the business model of profiting off investments has weaknesses. Sometimes no profits are to be had from investments. Sometimes investments lose value. This can create a crisis. During the last stock market plunge prior to the 2008-2009 debacle, insurance companies were hit quite hard. Policy prices spiked as the industry sought to make up their losses. My business policy increased significantly. Nothing could be done about it. You pay the bill, you accept the fact that you may have lost your profit for the year, and you hope that next year will be better. C’est la vie.

What happens when everyone is forced to buy insurance, the insurance companies have their money invested, and the stock market tanks, threatening the industry as a whole? After all, we do live in a capitalist economy (more or less, granting exceptions like the nationalization of the airport security industry following 11 September 2001), and no one has figured out how to have a free market without a business cycle. The business cycle is a fact of life in a market economy. It will happen again, like it or not. We can do our best to smooth out the business cycle, but we won’t eliminate it.

When this eventuality comes to pass, and premiums must spike sharply across the board, for everyone, the politicians and the insurance company executives will say that there is nothing they can do about it. And they will be right. Honestly, under these circumstances, there is nothing that can be done except to raise everyone’s premiums, or to let a few companies go bankrupt, or a combination of the two. But it is one thing to understand this, and another thing entirely to explain it to more than 300 million people with an attention span shortened by the cleverest spin doctors in the business. Maybe there will be congressional hearings. Maybe heads will roll. But the one thing that is sure is that the money has to come from somewhere. The politicians could turn to the expedient of printing money, thus creating inflation, but that has been made more difficult by the same measures that have been introduced in the attempt to minimize the business cycle.

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Grand Strategy Annex

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