Settlement is a crucial part of a functioning trade system. Of course that's true, most people might say, as they expect settlement for deals that they undertake in their daily life. Most deals people engage in are settled almost immediately, like when you make a cash purchase at a store. The cash is paid and the item is handed over to the customer, at which point the deal is settled. Other transactions aren't settled for some time such as credit card purchases where products and services are purchased, but the bill isn't paid until several weeks later. Only when that bill is paid in full are the purchase transactions settled. The one event that many people experience that is actually called settlement is closing the purchase of a house. When all the details are worked out and the funds are available the parties go to settlement. There the payments are made and the deed to the house handed over to the buyer with the keys. The element that is the same in all these familiar transaction settlements is that they are accomplished by exchanging the good or service for money. Handing over money for the purchase settles the transaction.
But why would someone take money for settlement? This might seem and odd question because we do it so often that we hardly even think about it. But at other times people did think about this question when being offered cash for settlement. Such as in US colonial times when the cash offered was from another colony, or in Weimar Germany when cash was plentiful, but the value of that cash was in question. This last example may be the ideal reason why someone might question taking money in settlement. The reason is that its not the money that someone wants, rather its the goods and services that the money can buy that the person wants. The only reason that money is taken in settlement is that it can be exchanged for goods and services. The goods and services have real value, while the money is merely a medium of exchange that promises to deliver those goods and services in the future. Money is, in a sense, an IOU for goods and services in the future.
To make this clearer, consider the possibility of using a different currency then the one used in your country. For example in the US we use the USD. What if we decided to use a different currency? But not just any currency, rather one that everyone around the world recognizes, is in plentiful supply, is easily divisible, is fairly durable (I've had some for nearly fifty years). That currency is Monopoly money; from the Parker Bros. toy company game of the same name. Everyone has played Monopoly at least once if not many, many times. So, wouldn't that be a great new currency? Imagine you go into work tomorrow and your boss says "we're going to start paying you with Monopoly money". You get the same pay as you did in USD, but now it is in Monopoly dollars instead. Would you take that money as pay? Probably not, because in spite of being in wide spread circulation and readily recognizable, Monopoly money has little actual value. You couldn't exchange it for goods or services, which we've already said have real value.
Being paid in your local currency is generally considered safe as all transactions happen in that currency, and all debts and taxes are paid in that currency. In a sense, the deal isn't really settled until you've spent that money on other goods and services as those have the real value. And most of the money that is transacted is then spent soon after on another transaction. Some money, but not much, is saved as cash for future use, so in that same sense most transactions are quickly settled in daily life.
Which brings me to settlement of trade. We said previously that trade is the exchange of goods and services from one country for goods and services from another country. And that what we do today for trade are multi-currency purchase and sale transactions. So, unlike transactions we experience in daily life, trade transactions are not settled by exchanging money for goods and services. Rather the money is like that IOU which is held expecting to be exchanged in the future for goods and services from the money's country of origin. The value of the money is the countries ability to produce goods and services to exchange for that money. As long as the money from trade is outstanding the goods and services haven't been produced for the foreign entity so, the trade isn't settled. With outstanding money there is still an expectation of getting goods and services from the other country. When a deal is truly settled, there are no outstanding expectations. The transaction is complete and they parties have no further interaction.
Large trade deficits are therefore, large numbers of unsettled transactions. Only when the money is exchanged for goods and services from the money source nation can the trade be said to be settled. The US has been running massive trade deficits for many years totaling around $10trillion of trade debt. That really constitutes a massive lack of trade settlement. Settlement that will have to be made one day. The only way for the US to settle this debt is to start producing the goods and services that the holders of the debt will buy with the outstanding money they hold. When will this happen? and how? Those are key questions as to what will happen in the US economy in the future.
Thursday, August 29, 2013
Friday, August 23, 2013
We HAD a Trade Settlement System - What Happened to Bretton Woods???
At the end of WWII the world was greatly changed and needed a new mechanism for managing trade. The system put in place was the Bretton Woods accord, which provided for settlement of trade between nations on a periodic basis.
The system specified the US dollar as the world reserve currency, where member countries would specify a fixed exchange rate to the US dollar called the "peg". Thus any currency was exchangeable into any other currency by comparing the pegs of the two countries. Most importantly, a provision specified the value of the US dollar in terms of gold, which was set to $35/oz, and the guarantee by the US government that it would convert US dollars into gold on request. The US could make this guarantee because by the end of the war the US had acquired a large reserve of gold. This system essentially specified convertibility of all currencies in terms of gold. The US dollar was pegged to gold and all international transactions could be viewed as made in terms of gold, as any currency could be ultimately converted to gold.
The importance of the peg to gold is the key to this system. Gold is a commodity which has all the properties of a stable currency. It holds value, is acceptable everywhere, is sub-dividable, durable, scarce, and easily transported. These properties are why gold has been accepted as money for millennia everywhere in the world. The peg to gold also means that the value of currency is not set arbitrarily by persons or nations with widely varying interests and goals. The value of currencies are, in a sense, protected from meddling to a great extent.
To manage this new system two institutions were set up, the IMF and the World Bank. The IMF was tasked with managing the exchange of currencies and the settlement of trade deficits. The mechanism put in place is somewhat complicated involving subscriptions to the IMF and loans of foreign currencies, thus allowing member nations to run trade deficits for a few years at a time. Nonetheless, despite these loans, the nations would ultimately need to settle ether in gold or member foreign currencies which was typically the US dollar.
Member nations that had balanced trade would see the inflow and outflow of their national currency equal out and their account at the IMF was stable. These nations were free to print their own currency in whatever amount they wanted, but when that currency was used for foreign purchases it would need to be repatriated via the IMF settlement system. Thus the debtor nation would either have to rebalance its trade or pay into the IMF gold or foreign currency.
The main effect of the Bretton Woods mechanism was that trade was continually balanced. If a deficit occurred for one nation, it was settled by transferring foreign currency or gold to the surplus nation. The currency transferred was convertible to gold, so the settlement was the same as sending gold from the deficit nation to the surplus nation. In other words, its as if the deficit nation executed a true trade of its gold for the imported goods with no currencies involved. After the gold is transferred the trade is settled, and the accounts are balanced. Note that no nation had to accept a foreign currency based on good will or faith because all were ultimately backed by gold.
So what happens if a nation perennially runs a trade deficit? In this case, through the machinery of the IMF that allows some delays in settlement, the deficit nation will steadily over time transfer gold to the surplus nation to settle its trade deficit. The trade will be settled and the accounts at the IMF balanced. Eventually, the deficit nation will run low on gold, what happens then? Well, if you're a small country you are in trouble, although the IMF is supposed to intervene before that becomes a problem with various programs and policies to restore a balanced trade. But, if you are the USA which is the dominant economic nation on earth and your currency is the reserve currency for the whole system, the result is somewhat different. This is exactly what happened to the US, it was running low on gold by the end of the 1960's.
What did the US and IMF do? Instead of rebalancing trade or continuing to transfer gold out of the US, the US government made a fateful decision, one that we operate under to this day. In 1971, the US decided to withdraw from the Bretton Woods system that it had set up and let the US dollar float on the, small but now rapidly growing, international currency exchange market. The US dollar was no longer pegged to gold at a fixed rate, and the exchange rate of the dollar to other currencies varied daily. This was the "free market" solution which proponents believed would allow the market to determine the value of currencies relative to each other and ultimately result in balanced trade as the values adjusted accordingly.
Unfortunately, it hasn't quite worked out that way. Forty years later and the US is still running a massive trade deficit that is vastly larger than back in 1971. The cumulative of these deficits, the trade debt, now totals nearly $10trillion!! This is $10trillion of unsettled trade. That's a lot of trade deficit to resolve. Perhaps this deficit has something to do with the loss of millions of manufacturing jobs in the US over the last few decades? The "free trade" system clearly is not working for floating currencies, and a return to a Bretton Woods system is needed to restore settled trade among nations.
The system specified the US dollar as the world reserve currency, where member countries would specify a fixed exchange rate to the US dollar called the "peg". Thus any currency was exchangeable into any other currency by comparing the pegs of the two countries. Most importantly, a provision specified the value of the US dollar in terms of gold, which was set to $35/oz, and the guarantee by the US government that it would convert US dollars into gold on request. The US could make this guarantee because by the end of the war the US had acquired a large reserve of gold. This system essentially specified convertibility of all currencies in terms of gold. The US dollar was pegged to gold and all international transactions could be viewed as made in terms of gold, as any currency could be ultimately converted to gold.
The importance of the peg to gold is the key to this system. Gold is a commodity which has all the properties of a stable currency. It holds value, is acceptable everywhere, is sub-dividable, durable, scarce, and easily transported. These properties are why gold has been accepted as money for millennia everywhere in the world. The peg to gold also means that the value of currency is not set arbitrarily by persons or nations with widely varying interests and goals. The value of currencies are, in a sense, protected from meddling to a great extent.
To manage this new system two institutions were set up, the IMF and the World Bank. The IMF was tasked with managing the exchange of currencies and the settlement of trade deficits. The mechanism put in place is somewhat complicated involving subscriptions to the IMF and loans of foreign currencies, thus allowing member nations to run trade deficits for a few years at a time. Nonetheless, despite these loans, the nations would ultimately need to settle ether in gold or member foreign currencies which was typically the US dollar.
Member nations that had balanced trade would see the inflow and outflow of their national currency equal out and their account at the IMF was stable. These nations were free to print their own currency in whatever amount they wanted, but when that currency was used for foreign purchases it would need to be repatriated via the IMF settlement system. Thus the debtor nation would either have to rebalance its trade or pay into the IMF gold or foreign currency.
The main effect of the Bretton Woods mechanism was that trade was continually balanced. If a deficit occurred for one nation, it was settled by transferring foreign currency or gold to the surplus nation. The currency transferred was convertible to gold, so the settlement was the same as sending gold from the deficit nation to the surplus nation. In other words, its as if the deficit nation executed a true trade of its gold for the imported goods with no currencies involved. After the gold is transferred the trade is settled, and the accounts are balanced. Note that no nation had to accept a foreign currency based on good will or faith because all were ultimately backed by gold.
So what happens if a nation perennially runs a trade deficit? In this case, through the machinery of the IMF that allows some delays in settlement, the deficit nation will steadily over time transfer gold to the surplus nation to settle its trade deficit. The trade will be settled and the accounts at the IMF balanced. Eventually, the deficit nation will run low on gold, what happens then? Well, if you're a small country you are in trouble, although the IMF is supposed to intervene before that becomes a problem with various programs and policies to restore a balanced trade. But, if you are the USA which is the dominant economic nation on earth and your currency is the reserve currency for the whole system, the result is somewhat different. This is exactly what happened to the US, it was running low on gold by the end of the 1960's.
What did the US and IMF do? Instead of rebalancing trade or continuing to transfer gold out of the US, the US government made a fateful decision, one that we operate under to this day. In 1971, the US decided to withdraw from the Bretton Woods system that it had set up and let the US dollar float on the, small but now rapidly growing, international currency exchange market. The US dollar was no longer pegged to gold at a fixed rate, and the exchange rate of the dollar to other currencies varied daily. This was the "free market" solution which proponents believed would allow the market to determine the value of currencies relative to each other and ultimately result in balanced trade as the values adjusted accordingly.
Unfortunately, it hasn't quite worked out that way. Forty years later and the US is still running a massive trade deficit that is vastly larger than back in 1971. The cumulative of these deficits, the trade debt, now totals nearly $10trillion!! This is $10trillion of unsettled trade. That's a lot of trade deficit to resolve. Perhaps this deficit has something to do with the loss of millions of manufacturing jobs in the US over the last few decades? The "free trade" system clearly is not working for floating currencies, and a return to a Bretton Woods system is needed to restore settled trade among nations.
Wednesday, August 21, 2013
Another Fact Supporting the Stability of Social Security
Recently, Bill McBride of http://www.calculatedriskblog.com/ posted a graph that brought a new perspective to the Social Security debate. For may years now we have heard that Social Security is unsustainable because the ratio of the number of retires to the working population is growing. Therefore eventually there will be too many retirees for the working age population to support. Or, even if they could support them, it wouldn't be fair to take so much from working people and give it to retirees. The assumption in this argument is that the percent of the population that is working will decrease over time so that fewer workers will support a greater share of the non-working population. The argument then implies that a remedy for this supposed problem is needed. And that this remedy can only be a combination of raising the retirement age and reducing benefits for retirees. There is no other choice we are told, because its a mathematical certainty.
The graph that Bill McBride created may lead to a rethinking of that certainty. In the graph, reproduced here, we can see that the population of 25 to 54 year olds and 25 to 59 year olds as a fraction of the overall population has remained fairly stable over the last 100 years, and is projected to remain at about the same levels for the next 50 years.
The graph that Bill McBride created may lead to a rethinking of that certainty. In the graph, reproduced here, we can see that the population of 25 to 54 year olds and 25 to 59 year olds as a fraction of the overall population has remained fairly stable over the last 100 years, and is projected to remain at about the same levels for the next 50 years.
The importance of these two age ranges is that these are the primary working years for most people. That is, most people in these age ranges are employed and are earning a significant portion of their life long income. So, the workers in these age brackets earn most of the income that supports those in the population that do not work. Well, if the population is aging how can this level stay so steady? The answer is that the other end of the population spectrum is shrinking. There are fewer children born today per family than 100 years ago, and those that are born are more likely to live to adulthood and old age. All those efforts to improve health, nutrition, sanitation, and health care have worked! We now have much lower infant and child mortality, and much longer life spans than 100 years ago. So, there are as many working people as a fraction of the population as has ever been and this fraction will likely continue to stay stable into the future. The change over these years is that the working population supports fewer children and more elderly people.
However, one key difference is households composition. Children usually live with their parents in one household. They therefore reap the benefits of the efficiency of many people living together, such as shared common areas, shared meals, shared utilities, etc. While the retirees likely have their own home and would like to continue to live in that home as a separate household. Maintaining a separate household is more expensive than sharing one, so the costs of a growing aged population would be larger than that of a growing child population. But we can see that there is no shortage of workers to support those that don't work. Perhaps the solution is to have retirees move into their children's homes to live in extended households. Many are likely doing that already. In past generations having elderly parents in the home was more the norm. Perhaps it will be again.
Saturday, August 17, 2013
Foreign Currency Exchange
In the previous post John and Luigi both made purchases in their domestic markets using their domestic currencies, and sales in foreign markets for the foreign currency. They did this because they knew that their bank would exchange the foreign currency for their respective local currencies. Most likely they checked on the exchange rate before they made the sales so they would know how much of their domestic currency they would get for the foreign currency. So, for each of them, when they converted the foreign currency to their domestic currency is was just like they had sold their goods at home. Luigi sold soccer balls and ended up with Euros, and John sold lamps and ended up with US dollars. Both of them counted on getting the expected exchange rate when they traded their currencies. In this simple example the exchange of currencies exactly balanced out, 700 EUR for 1000USD, so all currencies returned to their country of origin. This point is crucial, the currencies came from their country of origin and then were traded back to their country of origin so that none remained overseas. But what happens if this exchange doesn't balance out?
Today currencies are exchanged by large international banks, such as Deutche Bank, Barclays, and Citi, on free floating "over the counter" foreign currency exchanges (FOREX), in direct deals between the banks, without a central exchange. The Bank of International Settlements estimates that $4trillion a day of currencies were traded in 2010 (1). This market is generally unregulated, but most transactions are posted for others to see on the biggest markets, such as in London. The rate of exchange changes continuously on these markets due to demand for certain currencies and the desire to divest of others. John and Luigi's local banks did not likely participate in one of these major markets, rather they delt directly with a major bank in their home country to execute the exchange. Clearly the exchange of currencies and the rates of these exchanges have a major impact on trade between nations, as the currency exchange rate determines the equivilent price of goods and services in foreign markets. That is, as the value of your domestic currency increases relative to a foreign currency, goods and services from that country appear cheaper to buy and your goods and services appear more expensive to sell, with the converse also being true.
Notice that the exchange of currencies is independent of the trade of goods. That is, the banks had no idea where Luigi got USD or John got EUR, they just execute the exchange. Notice also that the exchange rate could have change between the time John and Luigi checked the exchange rates and decide to sell and when they too their foreign sales money to the bank for exchange. If this happens then one of them will get a bit more than expected, but the other will get a bit less. Perhaps that will influence their decision to buy and sell in the future.
What if John decides he wants more soccer balls but Luigi doesn't want more lamps? John does the same as before and buys soccer balls from Luigi for USD. Luigi takes the USD and trades them for EUR, but this time there are no EUR in the US bank to exchange because Luigi didn't buy lamps. The USD stays in the foreign bank and the trade is unsettled. For a small exchange like this the bank handles the exchange from its reserve of currency it keeps on hand. But the imbalance remains, in that Luigi's bank now has an extra USD1000 on its balance sheet in a country where noone uses USD. Well, letting that money just sit there doesn't make the bank happy, so it buys a USD bond with it so it will at least earn some interest. But this doesn't remedy the currency imbalance. Indeed, it just makes it worse, if the money is there earning 5%, at the end of the year there is USD1050 sitting in the account. And that increased sum represents the sale of the same soccer balls the previous year. The imbalance has only gotten worse! What if this one sided sale is repeated over and over again? Then a large imbalance builds up. Potentially tens or hundreds of billions of US dollars a year.
According to the popular theory in economics an imbalance in currencies and trade should only be transient as the market will take care of these imbalances by altering the exchange rates such that the trade will once again be in balance. In the above example the value of the USD should have fallen after John purchased soccer balls in USD but Luigi didn't buy lamps in EUR. This is because the European bank wanted to get rid of its excess USD1000 and acquire EUR. So, perhaps it is willing to take EUR600 for the USD instead of the previous EUR700. Maybe then a US bank with EUR agrees to the exchange and the USD are repatriated to the US. But the trade isn't really settled as the US bank drew from its foreign reserves of Euros to make this exchange rather than getting them from bank customers who sell to Europe. Thus this pool is limited and these kinds of trades can only be made for a short time baring some other intervention.
Again, according to the popular theory, the lower exchange rate for USD to EUR should induce Luigi to buy something in the US as its now cheaper relative to before the rate change. That these sales will provide the Euros to the US bank to exchange, because John brought them in to exchange for USD, and that the trade will once again be balanced. In other words, according to current theory, only very small trade and currency fluctuations can ever exists, and no significant deficit can build up over many years.
Yet, the US has accrued a $9887B (2)(3) trade deficit over the last 30 years! How can that be if the popular theory is correct? And what does that mean for US production of goods and services?
(1) http://www.bis.org/press/p101201.htm
Today currencies are exchanged by large international banks, such as Deutche Bank, Barclays, and Citi, on free floating "over the counter" foreign currency exchanges (FOREX), in direct deals between the banks, without a central exchange. The Bank of International Settlements estimates that $4trillion a day of currencies were traded in 2010 (1). This market is generally unregulated, but most transactions are posted for others to see on the biggest markets, such as in London. The rate of exchange changes continuously on these markets due to demand for certain currencies and the desire to divest of others. John and Luigi's local banks did not likely participate in one of these major markets, rather they delt directly with a major bank in their home country to execute the exchange. Clearly the exchange of currencies and the rates of these exchanges have a major impact on trade between nations, as the currency exchange rate determines the equivilent price of goods and services in foreign markets. That is, as the value of your domestic currency increases relative to a foreign currency, goods and services from that country appear cheaper to buy and your goods and services appear more expensive to sell, with the converse also being true.
Notice that the exchange of currencies is independent of the trade of goods. That is, the banks had no idea where Luigi got USD or John got EUR, they just execute the exchange. Notice also that the exchange rate could have change between the time John and Luigi checked the exchange rates and decide to sell and when they too their foreign sales money to the bank for exchange. If this happens then one of them will get a bit more than expected, but the other will get a bit less. Perhaps that will influence their decision to buy and sell in the future.
What if John decides he wants more soccer balls but Luigi doesn't want more lamps? John does the same as before and buys soccer balls from Luigi for USD. Luigi takes the USD and trades them for EUR, but this time there are no EUR in the US bank to exchange because Luigi didn't buy lamps. The USD stays in the foreign bank and the trade is unsettled. For a small exchange like this the bank handles the exchange from its reserve of currency it keeps on hand. But the imbalance remains, in that Luigi's bank now has an extra USD1000 on its balance sheet in a country where noone uses USD. Well, letting that money just sit there doesn't make the bank happy, so it buys a USD bond with it so it will at least earn some interest. But this doesn't remedy the currency imbalance. Indeed, it just makes it worse, if the money is there earning 5%, at the end of the year there is USD1050 sitting in the account. And that increased sum represents the sale of the same soccer balls the previous year. The imbalance has only gotten worse! What if this one sided sale is repeated over and over again? Then a large imbalance builds up. Potentially tens or hundreds of billions of US dollars a year.
According to the popular theory in economics an imbalance in currencies and trade should only be transient as the market will take care of these imbalances by altering the exchange rates such that the trade will once again be in balance. In the above example the value of the USD should have fallen after John purchased soccer balls in USD but Luigi didn't buy lamps in EUR. This is because the European bank wanted to get rid of its excess USD1000 and acquire EUR. So, perhaps it is willing to take EUR600 for the USD instead of the previous EUR700. Maybe then a US bank with EUR agrees to the exchange and the USD are repatriated to the US. But the trade isn't really settled as the US bank drew from its foreign reserves of Euros to make this exchange rather than getting them from bank customers who sell to Europe. Thus this pool is limited and these kinds of trades can only be made for a short time baring some other intervention.
Again, according to the popular theory, the lower exchange rate for USD to EUR should induce Luigi to buy something in the US as its now cheaper relative to before the rate change. That these sales will provide the Euros to the US bank to exchange, because John brought them in to exchange for USD, and that the trade will once again be balanced. In other words, according to current theory, only very small trade and currency fluctuations can ever exists, and no significant deficit can build up over many years.
Yet, the US has accrued a $9887B (2)(3) trade deficit over the last 30 years! How can that be if the popular theory is correct? And what does that mean for US production of goods and services?
(1) http://www.bis.org/press/p101201.htm
Saturday, August 10, 2013
What is Trade?
A lot of discussion of trade is heard in the media, from pundits, from economists, and those in the financial sector. But what exactly are they talking about? And are they all taking about the same thing? Unfortunately, what passes for trade today isn't really trade, and this fundamental misunderstanding is at the root of many of our trade problems today.
Trade: "An exchange of property usually without use of money". That's the classic dictionary definition. It's pretty simply really. Its just like when you traded baseball cards as a kid. I'll give you Micky Mantle for that Babe Ruth (we wished ;). Or if you go to a swap meet. I'll trade that casserole dish for that crock pot. When applied to nations trade is fundamentally the same, but with a slightly different mechanism to execute the trade. Trade between nations is the exchange of goods and services produced in one nation for some goods and services produced in another nation. For example, let's say John in the US produces lamps and Luigi in Italy produces soccer balls. John wants some Italian soccer balls and Luigi wants some cool American lamps. So, they get together and agree on a trade, John will trade 10 lamps for 50 soccer balls, to which Luigi agrees. They make the exchange and the goods are delivered. The trade is then settled, with each side getting what it agreed to. This is key, the trade is settled. There are no outstanding claims and their business is done.
Trade between nations is a bit more complicated than the previous example as it is very difficult to match up two parties that have exactly the goods each other wants. In practice this never happens. Instead, trade between two nations is performed using the currencies of the two nations involved. Trade between nations isn't an exchange of property as in the definition above, rather trade is a set of two-currency purchase and sale agreements. In other words, the financial sector is interposed between every trade. That is, banks and currency exchanges participate in the trade, and this is the source of most of our trade problems today. Let's revisit the example of John and Luigi. Under this new method, John still has lamps he wants to get rid of and get soccer balls, and Luigi still has soccer balls he wants to part with to get lamps. The sequence of events changes however with the introduction of money. Now, John exports his lamps to Italy and sells them for EU700 to, as it happens to Luigi, but John doesn't want Euros as he lives in the US, he wants dollars. Luigi exports his soccer balls to the US and sells them for $1000, which John then buys, but similarly Luigi doesn't want dollars because he lives in Italy, he wants Euros. At this point both sides have sold of the goods that they have to trade, and purchased the goods they wanted. But, they both had to dig into their savings in their own currency to buy the goods, and they are sitting with the foreign currency in hand for the goods they sold. Why would they agree to do this?
Because they know that they can exchange the foreign currency for their home currency. In this case, $10 exchanges for EU7, so the $1000 Luigi has is exchanged for EU700 that he wants, and similarly for John. They both go to a local bank or currency exchange and exchange the foreign currency for their local currency which they can use. Both of them then replenishes their savings accounts and the trade is settled. That is the key here. The trade is only settled when the goods are exchanged AND the money accounts are balanced. Until that happens the trade is NOT settled. This is the major part of the trade problem of the US today. We have a large, ongoing unsettled trade, known as the trade deficit. That will be dealt with in a future post.
Trade: "An exchange of property usually without use of money". That's the classic dictionary definition. It's pretty simply really. Its just like when you traded baseball cards as a kid. I'll give you Micky Mantle for that Babe Ruth (we wished ;). Or if you go to a swap meet. I'll trade that casserole dish for that crock pot. When applied to nations trade is fundamentally the same, but with a slightly different mechanism to execute the trade. Trade between nations is the exchange of goods and services produced in one nation for some goods and services produced in another nation. For example, let's say John in the US produces lamps and Luigi in Italy produces soccer balls. John wants some Italian soccer balls and Luigi wants some cool American lamps. So, they get together and agree on a trade, John will trade 10 lamps for 50 soccer balls, to which Luigi agrees. They make the exchange and the goods are delivered. The trade is then settled, with each side getting what it agreed to. This is key, the trade is settled. There are no outstanding claims and their business is done.
Trade between nations is a bit more complicated than the previous example as it is very difficult to match up two parties that have exactly the goods each other wants. In practice this never happens. Instead, trade between two nations is performed using the currencies of the two nations involved. Trade between nations isn't an exchange of property as in the definition above, rather trade is a set of two-currency purchase and sale agreements. In other words, the financial sector is interposed between every trade. That is, banks and currency exchanges participate in the trade, and this is the source of most of our trade problems today. Let's revisit the example of John and Luigi. Under this new method, John still has lamps he wants to get rid of and get soccer balls, and Luigi still has soccer balls he wants to part with to get lamps. The sequence of events changes however with the introduction of money. Now, John exports his lamps to Italy and sells them for EU700 to, as it happens to Luigi, but John doesn't want Euros as he lives in the US, he wants dollars. Luigi exports his soccer balls to the US and sells them for $1000, which John then buys, but similarly Luigi doesn't want dollars because he lives in Italy, he wants Euros. At this point both sides have sold of the goods that they have to trade, and purchased the goods they wanted. But, they both had to dig into their savings in their own currency to buy the goods, and they are sitting with the foreign currency in hand for the goods they sold. Why would they agree to do this?
Because they know that they can exchange the foreign currency for their home currency. In this case, $10 exchanges for EU7, so the $1000 Luigi has is exchanged for EU700 that he wants, and similarly for John. They both go to a local bank or currency exchange and exchange the foreign currency for their local currency which they can use. Both of them then replenishes their savings accounts and the trade is settled. That is the key here. The trade is only settled when the goods are exchanged AND the money accounts are balanced. Until that happens the trade is NOT settled. This is the major part of the trade problem of the US today. We have a large, ongoing unsettled trade, known as the trade deficit. That will be dealt with in a future post.
Glass-Steagall - A Cornerstone of Our Financial System
Glass-Steagall was a cornerstone of our regulatory structure which served to ensure the stability and safety of our financial system by separating depository banks from investment banks and brokers. The original law was put in place in 1933 as part of the overhaul of regulations that followed the Great Depression. This law functioned extremely well at preventing a repeat of that crisis until it was repealed in 1999 at the urging of Sanford Weil of Citicorp and others. Since this repeal we have experienced another financial crisis of a magnitude that rivals that of the Great Depression. Since the repeal Mr. Weil has said that repealing Glass-Steagall was a mistake and that it contributed to the current financial crisis.
Crucially, the law separated depository institutions which are insured by the Federal government, from investment banks which make speculative investments. Depository banks take deposits and make conservative loans against good collateral. The conservative nature of these loans is critical to the stability and safety of the system as these are origination loans, which means they create money in our economy. Money creation is a fundamental function of depository institutions. Indeed, more that 95% of the money supply is created by these loans. Loans of created money puts the entire financial system at risk if a large fraction of these loans are not repaid.
Investment banks often make use of leverage, or borrowed money, to make investments, thus putting the lender at the same risk as the investor. With the repeal of Glass-Steagall the investment banks were able to combine with depository institutions to create banking conglomerates like Citicorp. In principle, the depository bank side of the business should continue to make conservative loans against good collateral like real estate and factories, but internal forces in the combined banks have encouraged loans to the investment banking side to fund speculative investments. The investments undertaken by these banks are not simply funding new or expanding businesses, as is the primary purpose of such banks, but lately these investment have includes funding speculative purchases of securities which include exotic derivative securities.
These derivatives, as their name implies, are derived from other assets or securities, with the hope that the construction of the derivative has greater value than the components. This claim alone is suspect, but the real risk to the financial system comes from the great leverage applied in funding their purchases. Often, leverages of 10-1 or more are applied. In these cases the derivative security itself if put up as collateral for the loan to fund their purchase. Such high leverage and speculative valuations of these securities puts the loan from the depository institution at great risk and thus the deposits and the money supply at risk. Risk that the Federal government then insures, which passes those risks to the American people.
These risks have been realized in the current financial crisis with trillions of dollars lost by the big financial institutions and trillions more of bailouts and guarantees provided by the Federal Reserve and Federal government to these banks in hope of stabilizing the system. In the long run most of these losses will be born by the American taxpayer rather than the speculators and risk takers who fomented the crisis. Action must be taken to ensure that this kind of crisis does not happen again. We know that the Glass-Steagall law works, we should restore it immediately.
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