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Common Currency: Arbitrage a 'magic lever' in market creation, function

Alan Zemek

One of my favorite concepts in economics and finance is the concept of arbitrage, because it is one of the great unseen forces at work in the discovery and equalization of market prices.

Arbitrage helps to both create markets and allow markets to function, by communicating information about opportunities for profit as well as incentives and disincentives to expand or contract production and consumption. Arbitrage is the magic lever that creates wealth through risk taking, ingenuity, and sometimes just plain dumb luck.

Arbitrage is commonly defined as the purchase of currencies, securities or commodities in one market for resale in another market in order to profit from unequal prices. Major financial institutions have rooms full of super computers that do nothing but track prices of currencies and commodities all over the world, so the market price of coffee, government bonds or the exchange rate of the Yen is the same everywhere, because if it isn't, their super fast computers running super sophisticated mathematical formulas will fire off a buy/sell trade order to snap up the difference, make a small profit, and equalize the price.

It takes enormous quantities of money to play in that league and survive on the tiniest discrepancies in market prices around the world.

But I have always been fascinated by examples of arbitrage that you can find all around you in everyday life, which sometimes take on surprising and unusual forms.

Arbitrage is why an American college student traveling in eastern Europe in the cold war years of the 1980's could trade a $10 pair of worn out jeans for $100 on the black market, due to an artificial shortage of jeans in eastern European markets because of the consequences of poor government policy choices based on ideology, instead of sound economics.

I came across an example recently of a very clever form of arbitrage, that I find both illuminating into the ingenuity of everyday people, and a cautionary tale for the unintended consequences of well meaning policy choices gone awry.

As a result of the last recession and structural changes in the economy, more people than ever today rely upon some form of government benefit to make ends meet, including such things as food stamps, which of course, are supposed to be used to buy food, but not such non essential items such as alcohol or cigarettes.

In California, as in many states, beverage containers such as beer bottles, soda cans, and plastic water bottles have a cash redemption value to encourage recycling. Each container returned to a recycling center is worth between 5 and 15 cents each. These are commonly located right next to major supermarkets, often in the same parking lot. And, apparently, it is perfectly legal to buy bottled tap water at a grocery store with food stamps.

If you have been paying attention, you have already figured this one out. Some ingenious fellow figured out you could take your food stamps, buy a case of bottled water, walk out the door, open up all the water bottles and dump them out, redeem the now empty containers for cash on the spot, walk back in and purchase cigarettes with his cash profit on the deal.

Now it is certainly not my intent to disparage the many people who truly and fairly need a little extra help making it week to week to keep food on the table. That is not the point here. If this guy was on Wall Street, they would give him a bonus for creating a new market.

I find it much more appalling that tap water is considered a food, than the fact this guy was clever enough to beat the system by realizing the arbitrage opportunity to turn food stamps into bottled water, and then into a carton of cigarettes. This is pure ingenuity: human behavior responding to an unanticipated opportunity.

Economics is the study of markets and forces, but it takes the objective ability to suspend your own prejudices and passions, conservative or liberal alike, to appreciate how profoundly inventive and resourceful is human behavior. The moral of the story is, never under estimate the insights of average people, and surprising opportunities are always out there in unexpected places.

By the way, the opportunity to profit by recognizing an arbitrage trade is often caused by short term anomalies in the market place that often disappear as quickly as they appear. "Water dumping" is now a crime. Who knew?

Alan J. Zemek is a Park Rapids area developer and author of "Generation Busted: How America Went Broke in the Age of Prosperity." You can follow his blog, or comment on this article on his website, www.generation