RateWatch #400 – Cartels

March 27, 2004 by Dick Lepre

What's Happening

The Treasury market has been "slapped around" this week making the upcross at month-end look somewhat doubtful. We are getting into a pattern of expectation of healthy jobs reports and disappointing data. In all likelihood the bullish upcross is going to dissolve at month's end
and next Friday's Employment Report will determine what happens next.


A few weeks ago, I was extorting the value of the free market economy while writing about
offshoring. In trying to further understand the free market economy it might be interesting
to look at the opposite. The opposite is the controlled economics of cartels.

There are several things which I can think of that have been cartelized :
1) oil
2) diamonds
3) coffee 
4) cocaine.

Cartelization seeks to countermand the law of supply and demand by regulating the supply. 
The law of supply and demand may be likened to a 3-legged stool.  The legs are supply,
demand, and price.  In a “normal” economy there is an elasticity of supply, demand and price which serves to get people stuff at the lowest possible price while still providing opportunities for profits for the providers.

Each of the cartels has been formalized. Oil is OPEC.  Diamonds are controlled by De Beers. Coffee was controlled by Association of Coffee Producing Countries.  Cocaine was controlled by the Cali and Medellin drug cartels of Columbia.

Each of these cartelized items is interesting. Coffee and cocaine are easiest to understand. The supply of those two commodities is limited by the relative difficulty in producing them. Most of the world's cocaine comes from the Andes - Peru, Colombia and Bolivia. Coca leaves - the precursor of cocaine hydrochloride (the stuff people snort) or cocaine hydrofluoride(crack) the stuff that everyone on COPS seems to have in their cars – grow in only certain climates.  These are tropical climates with high rainfall. 

The Colombian drug cartel is a fact of geographic convenience combined with an all-too-familiar set of political exigencies. Columbia is north of the cocaine growing regions but perfectly situated to trans-ship product to the U.S.  Colombia has a history, from marijuana production and distribution, of being able to supply Americans with drugs. Part of the irony of this is that interdiction of marijuana importation into South Florida in the late 1970's led to the same people
who smuggled and distributed the drug into the U.S. turning to cocaine smuggling and distribution.  Marijuana is bulky and easy to interdict whereas cocaine is not.  Marijuana smuggling was done, generally speaking, by loading “mother ships” (small freighters) with tens of tons on marijuana
which were packaged in “bales” compressed in trash compactors and surrounded by a plastic
trash bag and a burlap sack.  The bales were offloaded into smaller watercraft which could
transport the weed about 1,500 -2,000 pounds at a time. The gigantic system of canals in
South Florida created thousands of potential docks and off-loading points. The lay of the
land is such that there are, however, a limited number of access points to these canals from the Atlantic. Choking the ships at those access points was the key to making marijuana smuggling less attractive. The long-term result was that the smuggler-distribution network used to gigantic profits turned to cocaine.  The law of unintended consequences was in full force.

In the interior of Colombia local self-defense groups were established to support the somewhat
less than Democratic government’s fight against Communism.  Local government leaders were given, essentially, a choice.  Let us make you rich by giving you a share of our drug profits and, by
the way, helping you fight the political opposition or we will kill you.  Not much of a choice.

Cocaine is a big business.  It is estimated that the retail sales of cocaine is an $80 billion
business.  If this were on the Fortune 500, it would be #11.  The head of the Medellin was
Pablo Escobar.  Forbes once listed him at the 7th wealthiest person in the world. Escobar was killed in 1993 while on the lam from what was essentially his own private prison. Manuel Noriega who ran Panama accepted some $5 million from the cartel to allow cocaine to be shipped through
Panama and was snatched from Panama and convicted in U.S. court of drug trafficking.

The point is that, due to a stranglehold on the distribution of the product the cartel first the Cali cartel and subsequently the Medellin cartel was able to control the wholesale price of cocaine.  It did so through some hard work, a wllingness to murder, insight into what politicians wanted, and a set of fortuitous circumstances on he demand side created by the pot/LSD counter-culture of the '60's turning to cocaine snorting in the 1970’s.

The other agricultural product that was, for a period, cartelized is coffee.  While it is in high demand it has never been as successfully cartelized as the other 3 products herein.  Coffee cartelization has been attempted by the asociation of Coffee Producing Countries (ACPC). Coffee is a strange product because the two places in the worlds where the demand is highest
– Europe and North America cannot produce coffee. Coffee is produced in Central and South America, Africa, Hawaii and Asia. Coffee, as a crop, was introduced to America by Europeans in the 17th century who had become enamored of java which came from Arabia and Turkey.  Coffee cartelization has not been successful in recent years because there has been an
inability/unwillingness to control supply.  Strangely enough the only thing to resemble a
dominant force is Starbucks which is a chain retail distributor.

The cartel that is of the most interest in the present year is OPEC.  OPEC was created in 1960.
See its web site at: http://www.opec.org/About_OPEC/History.htm OPEC did not gain notice until the Arab oil embargo of 1973.  Until 1973 no one much cared about the price of oil.  It was cheap.  The oil embargo resulted from, shall we say, disagreement consequent to the creation of Israel and the thesis that Palestinian land had been taken to create this state. Saudi Arabia's King Faisal persuaded oil producing countries into placing an embargo on crude oil to Western nations. This was meant to punish the Western states that had supplied weapons and aid to Israel.  The retail price of gasoline went up four-fold in a few months. It sometimes took 2-3 hours to get gas.  There was simplistic gas rationing based on whether the last digit of your license place was even or odd.  OPEC made its point.  This bought us wonderful cultural institutions like al Qaeda.
Forget the testimony before the 9/11 commission earlier this week.  U.S. intelligence knew who
bin Laden was and what al Qaeda was.  We always thought that his goal, as an Islamic fundamentalist, was overthrowing the House of Saud – the corrupt, in bed with America guardians of Islam's holiest sites.  Despite the previous attempt to blow up the World Trade Center which was always portrayed as a sort of Wile E. Coyote, aren’t-these-dudes-pathetically-funny misadventure, our intelligence believed that al Qaeda would attack in the mid-East.

The first Gulf war (1991) was fought because of  the unthinkable consequences of Saddam Hussein gaining control over so much of OPEC’s oil production.  All of the brouhaha about the
current expedition aside – it is all about oil. If there were no oil in Iraq no one would care about the place. The bizarre functioning of the law of unintended consequence may be that we actually bring democracy to the place.  I am not implying that this war is merely a war for oil.  If all we wanted was oil we could merely have let Saddam start producing again. The fact was that we did not want a perceived psychopath controlling so much oil production. I think that a lot of this is psychological. By that I mean that the damage done to the U.S. economy by letting someone like Saddam screw with the price of oil would have been annoying but not tragic.  Moreover, one lesson that should be extracted is that the free market will be our salvation. If the supply is
screwed with the price will rise until at some point the demand falls and the price
starts falling again until a new market balance is achieved.  The point here is that price controls, or any form of intervention to control price other than allowing the free market to do it, will be
a waste of energy and a failure.

OPEC’s success waned in the ‘80’s, in part, because of conservation but in the new age of SUV’s OPEC has gained power and is once again reasserting itself.  What can you do about it?  Buy less gasoline and the price will go back down.

Columbian drug lords, middle-East terrorists and Juan Valdez must, however, take a seat way in the back of the cartel bus to the true champions, the people who have raised cartelization to an art form – De Beers the diamond cartel.

The concept that a diamond is an object of substantial worth is a relatively recent fabrication.  Until the late 1800’s, diamonds were found only in India and Brazil and in relative small quantities.  Until then, they were rare.  Large deposits of diamonds were found in South Africa.  The folks who financed the mining realized that if the value of diamonds was in their scarcity the party would
be over because the supply was so large compared to the demand.  They created De Beers Consolidated Mines, Ltd – the diamond cartel.  De Beers is enormously successful because it not only had control of the supply but it saw the potential value of advertising to gullible American
women that diamonds were objects of considerable value and, in fact, has made them into a very
symbol of love.  I mean, when you are getting married you are expected to spend an insanely
large amount of your savings if, in fact, you have any on an engagement ring.

In fact, these dudes are so good that they actually sold the idea of a diamond as a symbol of love to the Japanese.  Read this from The Atlantic:  “The campaign was remarkably successful. Until
1959, the importation of diamonds had not even been permitted by the postwar Japanese
government. When the campaign began, in 1967, not quite 5 percent of engaged Japanese women
received a diamond engagement ring. By 1972, the proportion had risen to 27 percent. By 1978, half of all Japanese women who were married wore a diamond; by 1981, some 60 percent of Japanese brides wore diamonds. In a mere fourteen years, the 1,500-year Japanese tradition had been radically revised. Diamonds became a staple of the Japanese marriage.”

For all I know, they are probably behind the gay marriage thing. 

Cartels are perversions of a free-market economy. They take place when supply-siders
conspire against consumers.  They do so because they have international span in a
manner that enables them to circumvent things such as anti-trust legislation.

If might serve to note that the U.S. does support agricultural monopolies. There are
numerous groups that control the production of various agricultural products.  I suppose that there is some reasonable basis for justifying the existence of these groups.  We need food and farm products are subject to large price fluctuations.  Helping to support prices serves to keep farms in business.  In reality most of these are like the result of political exigencies.  I think that, if all of these cartel-like entities were undone we would get food at lower prices and somehow manage to live through whatever supply shocks were created by a functioning law of supply and demand.

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