ARBITRAGE WILL OUT. In the Union of Soviet Socialist Republics, bread could be obtained more cheaply from the bakery than feed grains could be obtained from the Ministry of Agriculture storehouses. Collective farms purchased the bread for use as animal feed, contributing to bread shortages. (On .pdf, scroll down to page 3.)

In the Sweet Land of Subsidy, things work a little bit differently, according to a Washington Post report linked by Marginal Revolution's Alex Tabarrok.

When a drought left pastures in a handful of Plains states parched in 2003, ranchers turned to the federal government for help. Officials at the U.S. Department of Agriculture quickly responded with what they considered an innovative plan.

They decided to dip into massive stockpiles of powdered milk that the agency had stored in warehouses nationwide as part of its milk price-support program. Livestock owners could get the protein-rich commodity free and feed it to their cattle and calves. The milk would help ranchers weather the drought while the government reduced its growing stockpile.

But within months, the program spawned a lucrative secondary market in which ranchers, feed dealers and brokers began trading the powdered milk in a daisy chain of transactions, generating millions of dollars in profits. Tens of millions of pounds of powdered milk intended solely for livestock owners in drought-stricken states went to states with no drought or were sold to middlemen in Mexico and other countries, a Washington Post investigation found.

This activity was completely illegal.

One government inspector stumbled upon huge cargo containers being loaded with the milk at the Port of Houston. The destination: Europe. A New Zealand official complained to USDA officials that American brokers were flooding her country with the powdered milk, undercutting local dairy suppliers. Still other records show the milk going to the Netherlands and the Philippines.

"The milk was being bought and sold, bought and sold. Some of it was probably ending up in dog food and pet food," said Matthew J. Hoobler, a Wyoming official who oversaw the distribution of more than 60 million pounds of powdered milk in that state. That trading was possible, he said, because "there was no enforcement."

Tons of the surplus milk entered the commercial market in one of two ways. Some states ended up ordering more powdered milk than ranchers could use and then auctioned the rest to brokers. And ranchers sold powdered milk they didn't want or need back to feed dealers, who marked it up and sold it to other dealers or brokers.

In its contracts with eligible states, the Agriculture Department required that the milk be used to feed cattle within the state's borders. The trading itself was not illegal, but shipping the milk outside of the states violated the rules.

Even when agriculture officials learned that the product was being diverted, however, there was little they could do. The USDA had allocated the milk directly to the states, and state officials did not have the resources to track the middlemen. In any case, penalties were nonexistent.

Your law. My arbitrage opportunity. Penalty? Discuss.