Lemon economics: Why some people are always better off than the rest

Lemon is an American slang for a lousy car – the sale of low quality products get sold in the market because of asymmetric information. A popular example of this phenomenon is in the second-hand car market, where sellers know that their car is a lemon, but where buyers cannot make that judgement without running the car or may not have the knowledge to ascertain the quality at the point of sale and merely relies on gut instincts to make the purchase. The lack of information about its quality creates conditions for sellers to exploit the buyer. In all cases, the seller is always better off than the buyer.

Information acts as an arbiter in any economic transaction. When pertinent information is withheld by any economic actor, the other party makes an adverse or negative selection. Adverse selection can also take place when choices are limited through regulation as in state run pension programs or when government conducts business exclusively with interrelated entities. Social and economic inequality sets in when the bulk of the population or the government continues to make adverse selections for prolonged periods of time which leads to instability.

A case in point is when the government purchases solely from state-run companies, it runs the risk of stifling innovation through chronic adverse choices and crowds-out other better players in the market. This result in low-productivity levels, low efficiency and low throughput and it is akin to buying lemons; in this case, the buyer makes the selection based on affiliation rather than quality. Temasek Holdings, which owns major enterprises in Singapore, has been returning 17% annually since it was established in 1972. During the same period, the economy has been growing at an average growth rate of 7%. This shows that the Temasek has out-performed economic indicators such as GDP growth. While the government has been proudly boasting its achievements, the policy makers have failed to realize that it has achieved growth at the cost of other privately run local businesses. Mathematically, if the GLC’s grew faster than the economy, then it would have taken a larger slice of the economic pie.

The other inherent problem in our economy is that small medium businesses will have to content with peripheral business opportunities and cannot compete effectively with the GLCs due to the lack of capital and funds. The GLCs, in this situation, have access to fiscal surpluses and CPF funds as low-cost capital. Again there is evidence of crowding-out whereby Temasek and GLCs utilize public funds to fuel their internal growth and at the same time leaving too little to stimulate private sector growth. Take CPF our state-run pension funds as another example, where both employers and employees make mandatory contributions. Until 2002 the funds were exclusively managed by the government since 1955. The rate of returns consistently underperformed GDP growth rates. The investment choices and interests rates were arbitrarily set by the government because it knew it best. The government has also channelled these funds through its sovereign wealth funds abroad leaving little capital to fund local enterprises. Our monies have been utilized to develop other economies at the expense of our own local enterprises being under developed. Majority of CPF account holders are not even aware of how their funds are being utilized and contribution is enforced strictly by the state.

There is also an interest rate arbitrage at work here; the government gets low-cost capital from CPF and on top of that, fiscal surpluses which are utilized as the capital base for the investments both locally and abroad. It is imperative to note at this juncture that, while Temasek has been making an investment return of 17%, the CPF account holder makes a modest 2.5% per annum. Suppose if you had invested S$20,000 with Temasek in 1980, you would have made a whopping S$2.2M by now. Conversely, at the current rates of 2.5% per year, your CFP savings would have only grown to a paltry $42,000.

In the book ‘The Age of Turbulence’, Alan Greenspan said, “Chronic surpluses are as destabilising as chronic deficits.” All our wealth is accumulated in two companies, Temasek and GLC and it is like putting all our eggs in one basket. Should these entities fail, much of our reserves will be wiped out. There is also the dilemma of ‘moral hazard’ whereby executives of these sovereign funds have no liability or any risk, as their losses are underwritten by the citizens. The wealth of our nation is controlled by a closed network of elite, which may destabilize the socio-political situation of the country. There is also empirical evidence from other wealthy nations in the Middle East to indicate that structural surpluses can stifle innovation and productivity.

The state continues to make all the economic choices, which limits our capability and what we are able to achieve as a country and as a people. It is clear that we have yet to achieve our true potential. The fundamental root cause is because the people here have limited freedom of speech, civil liberties and access to information. It is only when we have unbiased press and freedom of expression that we will be able to surface issues in a cordial and civil manner.