Monday, September 30, 2013

Timescales of Interest - Important application to trade

A common metric in the natural sciences is the "timescale of interest".  This is the length of a typical period or the pertinent period of time in the system under study.  This time scale of interest is often used to evaluate effects or relevance of other effects of different time periods.  A couple examples will make this clearer.  If we are discussing geologic events such as the formation of a mountain range the typical time for this, and hence the timescale of interest, is in the tens of millions of years.  Shorter timescales, such as years or millennia, are of little interest because the mountain range changes little over this time period.  A more relatable example is that of disease.  Let's say someone has a disease that will kill them in one year.  Dying from the disease is the major issue, so the timescale of interest is also one year.  If a treatment is found that will take and average of 10 years to cure the disease, then this is interesting, but not of use to the individuals who have the disease as this time period is much longer than the time it takes the disease to kill the him or her.  A second treatment the is effective in only one month is of much greater interest because the patient will survive long enough to benefit from the treatment.  The timescale of interest, or one year, determines the relevance of the treatments based on their timescales.

An interesting exercise is to apply this idea to trade and find timescales of interest and determine what effects and actions they suggest.  One metric to look at is the time to balance the trade deficit.  That is, if left to itself as the popular school of free trade supporters suggest, how long will it take for a trade imbalance, deficit or surplus, to come into balance on its own.  Let's accept the idea that the free trade supporters suggest, that in the long run the markets will sort out imbalances and trade will eventually find a new balance where exports equal imports.  We have some data to lead us to some conclusions about trade deficits and timescales of balanced trade restoration.  Here, by balanced trade I mean settlement in the sense that has been discussed so far in previous posts.  We know that the US has been running a trade deficit (no longer settling) since the repeal of Bretton Woods in 1971, and has shown no sign of heading to a return to a balance of trade.  Indeed, trade deficits are projected to continue for more than a decade in the future.  So, the period of a continual trade deficit appears to be at least 50 years as a lower bound.  The markets have not restored a balance of trade during this period through the mechanisms of free trade.

Another time scale to look at is what period of time has to elapse for a trade imbalance to cause some effect on the economy that would otherwise have not happened?  How fast does an imbalance build up that causes an issue whether good or bad.  Of course we are most concerned with the bad, but some good might come too.  So, first we have to determine what is a large enough imbalance to cause an issue, then how fast it takes to get there, this is the timescale of interest for imbalance effects.  Put differently, if, as most admit, a return to a balance of trade is the inevitable state of trading in the long run, what can happen in the mean time while trade is out of balance.  That is what economic effects related to a trade imbalance have a timescale of interest which is less than the timescale of the trade imbalance?  In particular, what bad things can happen while we await the great rebalancing?

How would this rebalancing happen?  According to the popular idea of free trade one would have expected that the trade deficit would have been reduced and trade balance restored by a number of mechanisms.  These include a falling USD relative to other currencies, lower wages in the US, and rising wages in other countries.  Resulting in higher prices for imports and lower prices for exports.  Thus, consumers in the US should buy fewer foreign goods and foreigners should buy more US goods.  But, this has not happened in the last 40 years and is not projected to happen for many more years.  This suggest that if the market idea of free trade is true, the timescale of interest is longer than this period.  Even the most staunch opponent of free trade will concede that an imbalance can't continue indefinitely.  Thus, its not a question of if, but a question of when, which is what we are trying to estimate.  Also, according to the popular idea of free trade one would have expected that this correction or rebalancing would happen rather gradually and continuously rather than hold off for so long as it has so far.  This suggests that a correction or rebalancing when it does occur, may come rapidly over a short time compared to this timescale of interest.  A trade shock may happen over perhaps a few weeks or days as many other financial corrections have in the past?

A comparison of the fraction of the trade to total trade that makes up the deficit is a place to start.  In 2012 the total exports were $2196B and the imbalance was -$540B (1),which is almost 25% of the exports.  Certainly, 25% is a significant portion, one where people start to take notice.  So, it takes a year to reach that level.  GDP in 2012 was $16,200B (2), so the imbalance was 3.3% of GDP, again over one year.  What can happen in the economic and business world in one year?

Well, to look at events in the last few decades that have had an adverse effect that are directly related to trade, we see two effect that have had a major impact on the US economy.  They are: the transfer of manufacturing businesses and their associated jobs to so called low wage countries, and the build up of the trade debt itself.  The rational used by companies for moving their operations and the corresponding jobs overseas is that the relative high wages of US workers compared to workers in low wage countries makes manufacturing cheaper in those countries and so encourages US companies to move to those low wage countries.  This flight of companies would not have happened had the balance of trade been restored through a lower dollar, lower wages in the US, and higher wages in the foreign countries.  Balanced trade prevents the flight of companies and jobs overseas.  A balance of trade implicitly means that US companies are producing at home and trading the product to other countries.  Some movement overseas may happen but it would also be balanced by some foreign companies moving to the US.

The question then is what are the timescales of interest for the flight of US companies and jobs overseas, and for the buildup of a significant deficit?  Put another way, how long does an imbalance of trade due to dollar value and wage levels have to persist for companies to choose to leave the US? One clue is the question itself, and how long does it take to accrue a deficit which would have a noticeable effect on trade and economic activity?  We wouldn't be asking this if the effect wasn't happening, so we know that the timescale of interest is less than the 50 years of the trade deficits.  We also know that large deficits don't take long to accrue and that significant deficit now accrues in only a month.

A site that tracks the transfer of US companies to foreign countries (3) gives a good idea of the rate of this transfer, shows that about $130B worth of companies move overseas each year.  This happens through a combination of US companies moving overseas or the equivalent of US companies building operations in foreign countries and hiring foreign workers. (4)  And the trade deficit builds up over a few years to an amount comparable with the trade levels and large compared to GDP.

So, from these figures above a good first estimate of the timescale for significant effects to happen because of a trade imbalance is on the order of one to few years.  This value is over an order of magnitude less than the time we said it takes to bring trade back to balance by itself through current market effects.  In other words, the market corrective mechanism, left to itself, is too slow to prevent effects from the trade imbalance taking place while we wait for the great correction to occur.

This suggest that some additional mechanism needs to be put in place to correct these trade imbalances on the timescale they occur, of one to few years.  I'll discuss some mechanisms in future posts.


Saturday, September 28, 2013

Fed no "taper" - So I guess I'll comment too

Why is everyone so surprised that the Fed didn't "taper"?  I guess the consensus of the "in the know" was that they would, or rather that they must.  But, they didn't.  Why would they?  What has changed?  Well, not much really.

The BLS unemployment rate continues to improve with a reading of 7.3 for Aug, 2013 (1).
From this graph we can see that the rate is heading down, but is not yet back to pre-recession levels.  What is not captured in this graph is that the reason the rate is heading down has nothing to do with people finding work, rather the formulas used to calculate the value assumes that people who are not working for a certain number of months have stopped looking and are no longer part of the work force, so don't need to be counted.  A better measure is the labor participation rate which continues to fall, with a reading of 63.2 for Aug, 2013 (2), much below the pre-recession level of ~66, as seen in the graph.
This means that about 3% of the population that were in the workforce are now not.  That translates to about 9,000,000 people!  Which is consistent with the job loss estimate of 8,800,000 jobs during this recession.  For these people this is a depression not another recession.

The only good news on the jobless front is the initial claims reported by the DoL has fallen from a high of ~660,000 in Mar, 2009 to 305,000 in Sept, 2013 (3).  From this chart we can see that the level is about at the historical low level, that may suggest the job market has nearly bottomed.

What about economic growth?  In the second quarter of 2013 the BEA reported a GDP growth of 2.5% (4).  A minimally OK figure, but not signally a strong recover which would be expected coming from the depths to which the economy had plunged in the last five years.  This rate of growth is about what has been seen for the last few years.  The BEA graph shows this less than amazing growth is about all the economy could do.  All this in spite of years of "ZIRP" or near zero interest rates to major banks.  

What about the housing market?  This should be doing well as the Fed has been buying up MBS shares like crazy.  The latest Case-Shiller nominal index is up to 146 in Sept, 2013 (5)  But, this is not good news as this level is still too high as it is above the long term trend which is driven by personal incomes.  The index was below 100 until Mar, 2000 when is started its meteoric rise, and this rebound once again takes the rate of growth above the long term trend.  The increase may make some folks happy, those who own MBS' and those who bought at the peak in 2006, but for regular folks this is just a "head fake" as they say in sports.  This only make housing unaffordable for many and unsustainable again.

The stock market is doing well.  S&P index is up over 18% this year.  This is great if you own stock, of which only a few percent of American have any significant holdings.  

So, in reality there is no good reason for the Fed to "taper" as withdrawing all that juicing of the financial markets will just cause this tepid "recovery" to stall or reverse.  What will the Fed do?  Probably continue as they are until unemployment drops below 6%, and the rest of the overhang of foreclosures works its way through the system.  That will be at least another year.  In the meantime, you can play some nice trades on whether they will "taper" or not, and maybe make a few bucks from those Wall St folks, or loose some if you guess wrong.  Good luck.

PS I like having all these charts on one page.  It really gives a good survey of the state of the economy and financial markets in one look.


Wednesday, September 25, 2013

Comparative advantage no longer matters for the US

The idea of comparative advantage still gets banded about in discussions of trade as a justification for the need for free trade.  But for developed countries like the US, comparative advantage doesn't really matter anymore.

Formulated by the British liberal economist David Ricardo (1), the idea of comparative advantage states  that a country that has an advantage in producing a good, due to natural resources or environment, over that of another country should produce more of that good and trade the excess with the other country for something that is produced with an advantage over the first country.  For example, Haiti has an advantage in producing sugar compared with Canada, which has an advantage in producing Maple syrup.  If Haitians want Maple syrup and Canadians want sugar, then Haiti should produce an excess of sugar and Canada should produce an excess of Maple syrup.  Both would then trade their excesses to each other to satisfy their needs.  Ricardo showed that by this mechanism both countries would actually have more of each product than if they were to produce both products themselves.  Canada is said to have a comparative advantage over Haiti in producing Maple syrup because of Canada's climate which is ideal for growing Maple trees, whereas those trees would not grow so well in Haiti.  Thus for the same effort and resources expended, Canada can produce more Maple syrup than can Haiti.  Similarly, Haiti has a comparative advantage over Canada in producing sugar.  Thus, if each nation produces those product for which it has a comparative advantage, the total amount of goods from both nations is more than if they each tried to produce all the goods themselves.

Some other products, such as minerals, can also be subject to a comparative advantage.  For example, if one country has coal that is easy to mine because it is near the surface, while a second country has coal that has to be mined from deep underground at great expense, then the former country has a comparative advantage over the latter in producing coal.

The key to this principle is that the comparative advantage of a good is due to some native condition which is not transferable from one nation to another, or more specifically from one location to another.  E.g. the climate of Haiti can't be transferred to Canada.  The advantage is permanently
tied to the land of the controlling country.

In 1817 when Ricardo formulated these ideas much of the produce in the world was agricultural, so  comparative advantage had a major affect on what crops should be produced where and what should be traded.  In that year 87% of US exports were agricultural products, so clearly the ideas of comparative advantage dominated the discussion of what the US should produce for trade.  But, by July 2013 the fraction of agriculture that comprised exports had dropped to 7.9% (2).  Production and trade of manufactured goods has come to dominate the trade of the US.  By contrast a country like Madagascar still counts agriculture as a major component of trade, where in 2012 it comprised 44.6% of its trade with the EU. (3)  Developed countries like the US have little need for guidance in trade by the principle of comparative advantage.  Other principles like national sovereignty, self sufficiency, and maintaining the lead in producing high value-added and high tech goods are more important.

Occasionally, the idea of comparative advantage is used erroneously to describe conditions in a nation that prevail but are not themselves tied to that country.  This is sometimes done with regard to wages to insist that a country which has lower wages for a particular occupation has a comparative advantage over another country with higher wages in that occupation.  A nation may have an advantage in getting some business for some occupation at some point in time.  But this is not a condition that is tied to that country permanently or not transferable to another country.  If anything, this is an indication of relatively high unemployment in that occupation in the low wage country, which will be remedied over time by rising wages as more work flows in, and increasing emigration as the workers in that occupation move to where they can get better pay for the same work.  For instance, if a country has a surplus of engineers who are getting paid less than in another country, the first country may get more business than the second for a while, but eventually the salaries will be bid up to match the second country and engineers from the first will emigrate to countries like the second that pay better.  This is the condition today with regards to India and the US.  Salaries for engineers are rising in India and many emigrate to the US for better jobs.  Of course all of this depends on national policies on trade and immigration, but there is nothing germane about such a compensation imbalance that makes it tied to any one nation.

Comparative advantage is a principle which has relatively little application in developed, high-tech economies.  Therefore, arguments based on it are suspect when applied to developed countries.


Saturday, September 14, 2013

A Misguided Recommendation Needs a Reply

Recently, a number of leading US economists, led by Lawrence J. Kotlikoff, have called for new annual financial projections from the  US government.  That of fiscal gap analysis and generational analysis.  Fiscal gap is supposed to be a true evaluation of expected government outlays, and the generational analysis is a measure of how much cost is pasted from the current generation to future generations.

Hugo Scott-Gall interviews Dr. Kotlikoff about this, which can be found, among other sites, here:

I believe that a response of some kind is in order as this interview reveals the rational behind this call for new accounting and what I believe to be a common mindset that has taken over the economics community, which is at odds with the facts and with the best interest of the US.  This is what happens when a profession suffers from self-selection.

Kotlikoff is essentially calling for fiscal responsibility, and fiscal responsibility is a good thing.   Unfortunately the US government has chosen to not follow that path starting in 1971 with the repeal of Bretton Woods.  Then the election of Reagan and his creation of massive deficits, and the changes in how many figures like GDP, CPI, etc., are calculated.  Then Alan Greenspan in Jan, 2001 predicted that the US would pay off the national debt by 2011 (1), which was used to justify the Bush tax cuts in order to prevent the US government from running a surplus.  And finally the often quoted “deficits don’t matter” of the Dick Cheney era.  Before these events we had a functioning system.  It is unfortunate that the government saw fit to throw this system away.  Why did the US choose to go this route?

A key lesson from examining these events is that it is unwise to make budget projections more than 10 years into the future, as circumstances and events can change these values dramatically from what was projected.  The gap and generational estimates go forward many decades into the future so that their value is suspect, and their impact may be misleading.

The problem with the analysis from Kotlikoff, and similar economists, is that they choose to ignore the history of how and why we got where we are, so they don’t go back and say this choice was bad or that policy was wrong, and  do a comparative analysis of what would have happened without those choices and policies (or maybe they do many who knows).  I.e. where would we be today if we didn’t choose deficits through massive tax cuts for the wealthy, or didn’t allow massive trade deficits?  Didn’t choose abandon trade settlement? Didn't change government economic formulas?  I suspect we would not be having this conversation today.

So, having ignored this history, he goes on to imply that the problem is caused mainly by the common folks being greedy because of the cost of social programs.  He claims that 60% of the future shortfall in government budgets can be attributed to medical spending.  He then claims to be an economist, but makes predominantly financial arguments!?  His discussion is primarily about money, rather than the production and consumption of goods and services.  He don’t even mention trade policy and its effects.  The one time he does mention true economics is when he insists on limiting the fraction of public health care spending to 10% of GDP by fiat, without regards to the effect on the health of the American people.  A true economic analysis of health care would consider the population size and distribution, the likely health problems and care needs for each segment of the population, the health care facilities and staff needed to provide this care, etc.  But all of this goes unmentioned, which suggests that health care for the American people isn't a goal.  Merely constraining the cost of government spending on health care is all that matters.  (He does make an exception for the affluent who can pay for their health care from their own resources)

The main effects of deficits, and the resulting curtailment of government spending, and tax and trade policies, which has been noted repeatedly in many sources, has been to reduce the middle class, and to enrich the already wealthy.  The tax cuts have mainly benefited the very wealthy while the various bailouts and business support policies have moved their liabilities onto the public books.  Why does he ignore the multi trillion dollar bailout of Wall Street?  What about taxing them to get some of that money back?  Why does he think that the taxes must be shared equally by everyone, if a small fraction of the population caused most of the problems?   This seems to me an institutionalizing of privatizing gains and socializing losses.

His argument about a lack of national savings is somewhat irrelevant as corporations are sitting on record amounts of cash and short term assets which they choose not to invest. (2)  It is the lack of investment in capital expenditures, which he acknowledges, that is the immediate cause of insufficient growth in the US.  But why would companies invest in the US if they are induced by government policy to invest overseas instead?

What about the 8.8 million Americans who have lost their jobs since the start of the recession? (3)  What if we put them back to work in manufacturing and balanced our trade?  Wouldn't that produce an increase in the receipts of the government as those new workers paid taxes?  What if we had a national economic policy again that promotes the best interests of our nation?

Yes, all programs like health care must be weighed in terms of their economic cost.  And not all expenditures are possible.  But these are policy decisions about how the nation, acting as a nation, will allocate its resources.  If our society determines that spending 10% of GDP on health care is good, or even if spending 15% is good, then so be it.  I don’t mind the gap accounting, as that is just a guide to future costs that should be taken with a grain of salt.  However, I think that Kotlikoff and others will use it to keep claiming “we’re broke” everytime a good investment in the American people, or a program to “promote the general welfare” as the Constitution mandates, is proposed.  The Congress must return to fiscal responsibility and no gimmicks will cause that to happen.  A fundamental change in how our country sees itself and acts as a nation is needed to return to the prosperity of the past.  Only then will Congress return to valuing fiscal responsibility.


(2) for an analysis

(3)  totals the government numbers

Saturday, September 7, 2013

Trade Discussion so far: Mostly just Accounting

Most of what I've posted about trade so far is just accounting.  That is, there is not a lot of trade policy involved other than trade deals need to be settled in a timely manner.  The deals here are exchanges of goods and services from one nation for goods and services from another nation, and all the intermediate transactions that occur between the settlement of balance of trade between the two nations.  All the ideas about trade is exchange of goods and services, that money is merely an intermediary, and that trade isn't settled until the goods and services exchanged from one nation balances with the goods and services from the counter party nation.  These ideas are fundamentally based on merely keeping track of who sent what to whom, which is just accounting.

This is just like business accounting, and like business accounting there are accounts receivable for who owes you, and accounts payable for who you owe, only in trade these are called the trade surplus and the trade deficit.  But, in business there are usually terms for payment which typically are: On delivery or net 30, 60, or 90 days.  Beyond 90 days is usually considered seriously delinquent.  Late payments affect a company's cash flow, or how much cash it has on hand to pay its bills.  If many customers are seriously delinquent then the company is going to run low on cash and may not be able to pay its bill on time.  Sometimes this impedes the ability of the company to function, or worse drives the company out of business.  The US is currently decades overdue in settling its trade, as it has been carrying an enormous trade deficit, now totaling in the trillions of dollars, for those many years.  How many businesses could survive, or would stand for, settlement delinquencies of decades in length?  Probably few to none.  Its plain to see that such long dislocations of settlement can't help but affect the operations of the affected parties.  Any plans for the future would continually need to be altered as the lack of the resources that settlement would have provided comes to affect what actions can be taken.

But, a nation is not a company, and the US is not just another nation as it produces the worlds reserve currency.  So, it appears that many nations and the IMF and World Bank are happy to oblige serious delinquencies in settlement of trade.  The US is not going to run out of USD because the government can, in principle, produce as much as is needed.  That is, the US can never have a cash flow problem.  Although, from all the hype in the media one would think this was possible, alas a sovereign country controls its currency and can produce as much as needed.  As long as these nations take the intermediary of USD as an IOU for goods and services, that eventually need to be shipped from the US to those countries, this imbalance will continue.  But, how much longer will it go on?

It appears that the US policy is to run massive trade deficits, as it is completely within its power to end these deficits and bring about balanced trade.  The policies of other nations are a bit less clear as to why they would continue giving trade credit to the US.  Perhaps they don't want to jeopardize relations with the US, or in some cases want to grow their own industries via their own trade surpluses.  In any case, these nations can do accounting as well as any other, and they are quite cognizant of the massive amount of USD that they hold.  Their books are kept up to date and the lack of settlement is carried forward year after year.  Once the trade is settled, the trades and cash disappear from the accounting books, and go into the closed files.  This is the sure sign that trade is settled between countries.  And the massive current account balance that the US carries is a sure sign that the trade with other nations is not settled.