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.


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