Thursday, 24 December 2020
Tuesday, 22 December 2020
Central-bank interest rates
Reducing interest rates has also been shown to be a valuable tool to control economic growth.
When a central bank decides that an economy is growing too slowly, it can simply reduce the interest rate it charges on loans of central bank funds to banks, referred to as the discount rate in the U.S.
When banks get this "cheaper" money, they are able to make cheaper loans to businesses and consumers, providing an important stimulus to economic growth.
Likewise, by raising interest rates, a central bank can slow down the economy by making it more "expensive" for businesses and consumers to borrow money, consequently reducing purchases of homes, cars, vacations, and factories.
Interbank rates (Europe) or Fed funds rates (U.S.)
The central-bank interest rates tend to change the interest rates throughout the economy at large.
The interest rates on loans made between banks - called interbank rates in Europe and Fed funds rates in the U.S. -
- will rise whenever banks have to pay more to borrow from the central bank and
- will fall when they have to pay less.
The higher cost of money is almost always passed on to consumers and businesses in the form of higher interest rates on every other form of loan in the economy.
A bank's ability to provide loans is limited by only 2 things:
- the amount of its deposits and
- its reserve requirements.
The reserve requirements are determined by the central bank or monetary authority.
Most banks are required to put a minimum percentage of their funds - 10% of deposits, for example - on reserve and are prohibited from lending these funds back to customers.
If a central bank increases the reserve requirement, it effectively reduces the money supply, since banks then have less to lend to businesses and consumers.
On the other hand, by reducing the reserve requirements - as several central banks around the world did during the Great Recession of 2008 - they allow the country's banks to lend more, stimulating the economy and releasing even more money for lending.
The reason central bank monetary policy works so well is because of the multiplier effect.
Basically, money we deposit in our banks doesn't just sit there collecting dust.
The bank can and does lend that money to someone else.
A hundred dollars deposited in a bank in in A, for example, may end up being loaned to an individual or a business in B.
After setting aside a small portion of each deposit as a reserve, banks are free to lend out the remainder.
The effect is to increase the money supply without any extra currency being printed.
What gets loaned out ends up in another bank to be subsequently loaned again.
Saturday, 19 December 2020
The main tool for fighting uncontrolled inflation is for the government and local monetary authorities to reduce the money supply.
Since most easily accessed money is in the form of bank deposits, the most efficient way for a central bank to control the money supply is by regulating
- bank lending and
- reserve requirements.
Essentially, when banks have more money to lend to customers, the economy grows And when banks reduce their lending the economy slows.
The reason central bank monetary policy works so well is because of the multiplier effect.
Inflation and hyperinflation
By the time the popular Venezuelan government called for next economic measures to end rampant hyperinflation at the end of 2018, the local currency had become virtually worthless.
After 80,000% inflation over the previous year, it took more than 6 million bolivars to buy a loaf of bread - that is, if you could find a store that had a loaf of bread in stock.
After more than a decade of economic mismanagement, the financial meltdown has become so bad that by the late 2010s, clean water distribution had slowed to a trickle, and gravely sick citizens were dying in make-shift hospitals, unable to get the treatments that were keeping people alive in almost every other country in the world.
It is nearly impossible to index prices and salaries in the chaotic world of hyperinflation, and consequently, no one is left untouched by uncontrolled inflation.
- From the top 1% to the poorest of the poor, an economy in crisis eventually hurts virtually everyone.
- But it's the most vulnerable who suffer the most. When the cost of a loaf of bread exceeded the total monthly minimum salary in Venezuela, those at the bottom of the economic ladder had to face the worst aspect of economic hardship: starvation. Millions ended up fleeing across the border as economic refugees to Colombia and Brazil.
Hyperinflation has ravaged countries as diverse as Germany, Mexico and Argentina - even China during the Yuan dynasty, where too much paper money in circulation led to uncontrolled inflation. In Germany's postwar Weimar Republic, in 1923, inflation became so bad that the government had to resort to issuing postage stamps worth fifty billion marks and people had to use wheel barrows to carry enough cash to make simple household purchases.
The economic crisis in Japan at the beginning of the twenty-first century was marked by severe deflation, where a chronic decline in prices led to decades of sluggish economic growth.
When deflation was accompanied by a sharp decline in consumers - with the total population in Japan expected to decline precipitously by 2050 - the crisis in Japan appeared to be just as intractable as the inflationary crises in Venezuela and other parts of the world.
- In a country with persistent deflation, consumers will simply stop buying goods and services as prices decline expecting to get a better price at some point in the near future.
- Likewise, companies also tend to delay investments in new plants and machinery when they think prices for their products will soon decline.
- In deflationary environments, companies try to find ways to reduce input costs, often leading to a reduction in salaries. The lower salaries then translate into even lower consumer spending, completing the vicious circle of deflationary economic crisis.
The solution is to change long term expectations
The problem with too much deflation, just like to much inflation, is that growth screeches to a halt because of the economic uncertainty both problems create.
In periods of crisis, however, central banks are often unable to change the perception in the minds of consumers and business-people that there will be no end to the vicious cycle of inexorably rising or declining prices.
The solution for deflation, as for hyperinflation, essentially involves finding a way to change long-term expectations - not an easy task in an economy out of control.
Neither too hot nor too cold
Like the Three Bears' porridge, an economy should be neither too hot nor too cold.
Neither acute inflation nor acute deflation are positive for sustainable economic health.
Despite the desire of some populist leaders to have a high inflation rate of 3 or even 4%, most economists recommend a "just right" inflation rate of about 2% per year.
Fighting excessive deflation is in some ways more difficult than fighting hyperinflation.
During inflationary times, there is basically no limit to how much central banks can raise interest rates.
But in the battle against deflation, once interest rates have been reduced to zero, there is little that central banks can do to stimulate further growth.
The two things that can be done once interest rates reach zero are:
- negative interest rates or
- quantitative easing.
Central banks use quantitative easing to create money
Faced with the economic meltdown following the 2008 crash, some central banks opted to stimulate their moribund economies via quantitative easing.
Quantitative easing uses the unlimited purchasing power of central banks to buy large quantities of bonds in the open market to pump cash into the economy.
Central banks use quantitative easing to create money where previously none existed.
How is this done?
A central bank "creates" money every time it dips into its "vaults" - essentially a black hole of unlimited financial resources - to buy existing bond from banks or other investors.
These purchases, often referred to as open market operations, inject new money into the economy.
The bank, instead of holding bonds, is now holding the "cash" it got from the central bank.
This money can now be made available for loans to consumers and individuals, thereby stimulating economic growth.
Solving the economic crises was presented as the reason for expanding government power and limiting citizens' rights.
Marginalised workers usually don't want to hear arcane economic arguments when confronting low wages, unemployment and job insecurity.
Countries are increasingly being governed by radical popular politicians keen to exploit the average voter's fear and insecurities.
Economic and social turmoil have led voters to allow the democratic process to be severely eroded.
In many countries, the media has become a tool of the ruling party or leader, leaving virtually no possibility of disseminating opposing viewpoints or critical arguments domestically.
Once populists have gained power, a typical tactic is to attack the press or the justice system as being part of the problem, not the solution.
In extreme cases, the populists become true autocrats by stifling any form of opposition, pointing out that they, and only they, are able to solve the economic problems in a way that will benefit the average worker.
Autocratic leaders often enrich themselves and their families at the expense of the voters or workers they are ostensibly there to protect.
The dirty little secret of autocratic leaders is that many are more interested in protecting their own interests, such as protecting selected political supporters or an inner circle of oligarchic businesspeople, so they play to the fears of average citizens, manipulating them into voting against the economic interests of the country as a whole.
- Many, approximately 65 million have been forcibly displaced by war, violence or natural disasters.
- Most immigrants simply move to a neighbouring country, often not much better off then the one they left.
- Only a small fraction of the world's most vulnerable migrants succeed in moving to the rich countries in Europe, Oceania, or North America.
- could overwhelm schools and other public services
- to the nativist - if not racist - view that immigrants of a different ethnic background will threaten social cohesion and security.
- Most of the money that immigrants earn is recycled into the local economy, even if a portion is sent back to their families in their home country.
- And through the payment of payroll taxes and sales taxes, immigrants end up supporting the activities of local governments - which could, for example, use some of that money to provide skills training and other forms of additional education to enable locally born workers to move up the economic ladder.
- Immigrants also tend to save at a much higher rate than local workers do, and their money gets deposited in local banks, which can then use that money to extend loans to homeowners and businesses in the local economy.
- By investing in local start-ups or even setting up start-ups of their own, highly skilled immigrants have created hundreds of thousands of jobs in North America and Europe.
- While immigrants represent about 15% of the American workforce, they account for approximately 25% of the entrepreneurial investment in the U.S. economy.
- Japan's extremely low birthrate in recent decades has led to a shrinking population with virtually no low-skilled immigrants - only 1.5% of the current population was born abroad - resulting in a severe labour shortage.
- This along with such other factors as deflationary monetary policy, caused the Japanese economy to seriously underperform when compared to countries with more lenient immigration policies.
Friday, 18 December 2020
The EU withdrawal process facing the United Kingdom.
1. No deal.
2. Preferential access to the EU markets
This most extreme option required the United Kingdom to revert tot he status of a normal third-party EU trading partner, where trade is organized according to a set of basic guidelines set out by the WTO.
This radical option did not include any preferential access to the EU whatsoever - meaning that all EU borders, including the one dividing the Republic of Ireland with the UK's Northern Ireland, would have to be respected as if the UK were a foreign nation, with onerous restrictions on the movement of goods and people.
To have preferential access to the EU markets, three variations were considered:
- signing a basic free-trade agreement,
- continuing to be part of the customs union, or
- remaining in the EU single market, implying full acceptance of EU norms.
Brexit referendum of 2016 in UK: To stay or to leave the European Union?
Arguments for leaving the EU
United Kingdom had been paying to the EU billions of euros in extra funds - to support everything from agricultural subsidies to infrastructure construction in the poorer countries. This money would return to make Britain a better place.
Arguments for staying in EU
The loss of access to preferential trade with the rest of Europe would, in fact, decrease economic growth and reduce the amount of money available to pay for health care and everything else.
Around the world, electorates were shaken by everything from increased immigration to interference from supranational institutions.. This has led to countries calling for limits on trade, immigration and almost everything else that seems foreign. The problem is that in the twenty-first century economy - which is based largely on cooperation and free exchange of goods, services and ideas - going it alone almost always has negative economic consequences.
One of the immediate effects of the referendum vote was a sharp decline in the value of the British pound.
- Investors sold the currency because of the country's diminished economic outlook.
- Without access to the EU market, exports were expected to decline precipitously, reducing income from foreign sales and making the country's currency less attractive.
- In addition, the reduced purchasing power of the local currency meant higher prices for imported goods.
- Overall, inflation quickly went from 0.4% at the time of the referendum to more than 3% in less than 2 years.
All other things being equal, trade halves as distance doubles
European Union was Britain's major trade partner, accounting for more than 40% of all British exports.
The entire EU trading area Britain was being asked to leave, in fact, encompassed more than 30 countries, including the non-EU members, Iceland, Norway and Switzerland.
One of the axioms of trading with other countries is that, all other things being equal, trade halves as distance doubles.
- Generally, trade with neighbouring countries is naturally much greater than trade with countries on the other side of the world.
- By turning its back on its gigantic neighbour, the UK was opting for an economic path with dubious potential for economic success.
The head of the Bank of England saw the Brexit vote as an example of "deglobalization, not globalization" and predicted higher prices for consumers and the necessity of higher interest rates to keep inflation under control.
In 2018, the American government began unilaterally imposing tariffs on many foreign imports.
This tactic was seen as a direct affront to the agreement that all trade disputes be settled around a table at the WTO.
The U.S. claimed it was only protecting national security, a claim that was hard to take seriously since the "threat" was coming from longtime allies, such as Canada and the U.K.
The European Union and Canada immediately responded with calls to limit U.S. imports.
- They targeted Kentucky bourbon, Levi's jeans, an a vast array of other American products - not necessarily tied to national security but quite strategic in the sense that many of the targeted products were from the American Midwest, an area populated by many isolationist voters.
Failure of the Doha Round of free-trade talks
The Doha Round of free-trade talks languished during the first years of the twenty-first century.
This was primarily because of the reluctance of rich countries to lower barriers to trade on agricultural goods, bowing to their farmers' insistence on having protected markets.
These policies, however, ended up destroying the possibility for farmers from poor countries to increase agricultural exports and earn the income they needed to survive.
Another cause for the failure of the Doha Round was the growing reluctance of developing-world countries to open their markets to manufactured goods in order to protect inefficient local industries.
Bilateral Free-Trade Agreements (FTAs)
In the end, most countries decided to start small, by signing bilateral free-trade agreements (FTAs), which are easier to negotiate and easier to sell to isolationist electorates because
- the benefits are more tangible and
- domestic businesses don't necessarily have to give up their subsidies.
World Trade Organization (WTO)
Once FTAs are in place, some sort of mechanism is needed to ensure that countries respect the promises they have made.
Commissions were set up to monitor bilateral trade.
A worldwide trade watchdog, the World Trade Organization (WTO) resolves disputes in an organized forum based in Geneva, Switzerland.
The role of WTO is actually quite limited.
- The WTO was never meant to be more than a global round table where disputing parties could meet to air their grievances and try to resolve trade disputes.
- All WTO decisions are made by consensus, with the member nations working together to decide which countries are allowed to impose sanctions.
- The WTO has no power to force a country to do anything against its own national interests.
- Its real power lies in permitting countries that have suffered from trade barriers that exceed those authorized by existing trade agreements to erect barriers of their own, usually in the form of tariffs.
The three forms of trade barriers
There are 3 forms of barriers to trade:
- quotas, and
Tariffs are a form of tax. Taxes of any form end up being paid for by the end consumer.
By imposing a quota, a country simply limits the quantity of foreign products that can be imported.
Both quotas and tariffs raise the price of foreign-made goods.
Governments can also use taxpayers' money to provide a subsidy to local producers, making the price of local goods artificially lower than the price of equivalent imported goods.
Why does a country impose trade barriers unilaterally?
Most trade barriers are imposed unilaterally by one country acting on its own to limit imports from abroad.
These barriers are usually designed to "temporarily" protect local producers from foreign competition, and in theory allow them to improve their productivity.
The problem is that local producers, once given the comfort of a protected market, rarely make the sacrifices necessary to improve their products or lower their prices.
Competing in the International Markets
Historically, developing countries have been some of the strongest proponents of reducing trade barriers, primarily because their only hope for sustainable growth is to have access to international markets.
Those that have insisted on putting up trade barriers, such as Brazil and India, usually remain in a low-productivity trap that ensures their goods are not competitive on the international markets, and they consistently run up large trade deficits.
Countries with low trade barriers, such as Switzerland and Singapore, not only consistently run trade surpluses - even with strong local currencies - they also provide their citizens with the benefit of free access to low-cost products from around the globe.
Thursday, 17 December 2020
Multiparty trade system
In any multi-party trade system, there will always be imbalances, deficits or surpluses in the monetary value of goods and services traded.
These imports, if not made up for in an equal number of exports, are "paid for" by sending something else abroad - usually paper assets, such as stocks and bonds.
The purchase of U.S. dollar securities is the way most countries have compensated for the imbalances in trade with the United States.
- Many countries, in Asia and the Middle East especially, have used their earnings from exports to purchase trillions of dollars' worth of U.S. Treasury bonds to use as a store against future uncertainties - or to buy U.S. goods and services in the future.
In the interconnected global economy, what gets spent never stays in one place. What India earns from its many call centers can be spent on South Korean televisions, and what South Korea earns from its exports can be spent on Brazilian chickens or American tractors. In the end, it all adds up.
Deciding to start a trade war because you run a deficit against any one country is like saying you want to punish the country that sells you what you really want.
Trade deficits and Trade surpluses
The economic terms used by most politicians when beating the drums for trade wars are trade deficits and trade surpluses, which focus mainly on the trade in physical goods.
But many countries are making more and more money exporting services like
- tourism, and
- technology platforms.
Trade Balance: Current account is balanced by the country's capital account
The obsession with trade deficits is misplaced because the deficit and surplus in goods and services is offset by monetary transfers.
Most economists, therefore, look at the total trade in goods and services, referred to as the current account, which also includes such financial transfers as money sent home by citizens working abroad and interest paid on foreign debt.
This current account is balanced by the country's capital account, which adds up all investments - mainly international purchases and sales of financial assets.
These two measures, when added together, always add up to zero. One balances out the other. Which is why the total measure of trade is referred to as the trade balance.
The benefits of free trade outweigh the disadvantages
Politicians who speak of "winning" and "losing" in trade don't understand that all trade in goods and services is balanced by monetary transfers moving in the opposite direction.
Essentially, all the global trade in goods and services and flows of money between countries add up to zero, but trade is not a zero-sum game, where one country's loss is necessarily another country's gain.
The benefits of free trade outweigh the disadvantages
- While free trade does expose a country, and its workers, to foreign competition - which can lead to layoffs and idle factories - putting up barriers to imports from abroad can destroy far more jobs as the rest of the world's economies respond with trade barriers of their own.
All-out Trade War
An all-out trade war usually ends up hurting almost everyone in a given economy, even those segments the politicians say they are trying to help.
1. 2018 U.S. instigated trade war
Farmers and workers in the American Midwest were shocked to see that China and other countries retaliated to the opening salvos of the 2018 U.S instigated trade war by massively increasing tariffs of their own on American wheat, soybeans, and a variety of other goods produced in the Midwest, including Harley-Davidson motorcycles.
2. 1929 stock market crash massive trade barriers
The U.S. put up massive trade barriers after the stock market crash of 1929. It led to a serious decline in economic activity and the loss of millions of American jobs when the rest of the world responded in kind. The result was a worldwide depression.
The goal of free trade
The goal of free trade is ostensibly to provide a level playing field, permitting individuals and companies to have the opportunity to sell their goods and services in foreign lands.
In theory, when every country in the world is allowed to do what it does best, the world economy prospers, and almost everyone is better off.
In general, trade increase income and with access to imports, companies and consumers have more of a choice about what to do with their increased income.
But what happens when one country imports more than it exports, leading to job losses?
Is the answer simply to close off the country to trade?
1. Opium Wars
Trade wars in the past have sometime ended with actual military conflict.
The Opium Wars between the Qing dynasty and the British Empire in the mid-1800s. This ended up forcing the Chinese to remove virtually all its onerous import duties as well as to give up Hong Kong to British rule. By the time Hong Kong was returned to China in 1997, it was one of the most successful trading centers in the world.
2. Banana Wars
The occurred between United States and several European countries at the end of the twentieth century. These centered on removing European barriers to Latin American banana producers, which were mainly owned by U.S. companies.
3. Pasta Wars
In the mid-1980s, Reagan administration tried to open up markets for American lemons and walnuts in Europe by placing punitive tariffs on imports of European-made pasta.
Both the Banana and Pasta Wars disputes were resolved amicably with the warring parties gradually removing the disputed tariffs.
Economic Growth and Happy Electorate
Economic growth did not necessarily translate into a happy electorate.
- Political leaders around the world in the late 2010s were stunned to see that economic growth did not necessarily translate into a happy electorate. Many political leaders were seeing public approval ratings reach record lows.
- On the other hand, many authoritarian leaders of countries with declining economies were reelected with record levels of support.
GDP and GNP
GDP is the traditional measure of the total output of goods and services per year. Basically, GDP adds up the money we as consumers and companies and government entities spend over the course of the year.
GNP - gross national product - picks up where GDP leaves off and includes international expenditures in its summary of economic growth.
- Money coming from foreign sales of products or services, make GNP a broader summary of a given economy.
- Also included are payments and income from foreign stocks or interest payments on bonds that one country's government has sold to another. This is an important consideration in the twenty-first century economy, where exporting nations like China and Saudi Arabia hold trillions of dollars in U.S. Treasury bonds.
GNP>GDP or GDP>GNP
Sometimes GNP is bigger than GDP, and sometimes it is the other way around.
- Countries like Ireland, which has a lot of foreign-owned companies, tend to give the country smaller GNP than GDP because the payments to foreign owners are deducted from the GDP figures.
- On the other hand, since British, U.S. and Swiss residents tend to own a lot of companies abroad, their GNP is usually larger than their GDP because it includes income from foreign production that is not included in the domestic summary.
How do you compare GDP among countries with different currencies?
It is difficult, because the value of economic activity in each country is denominated in currencies that are constantly changing in value.
One method is simply take the value of each country's GDP at the end of the year and translate it into one common currency using official exchange rates.
- Unfortunately, using official currency exchange rates gives a skewed idea of many countries economic health.
- Since the cost of similar goods and services isn't the same in every country, the total value of each countries' goods and services can vary widely.
Most economists and statisticians, try to adjust each country's GDP using a "real world" exchange rate.
- This is commonly referred to as purchasing power parity or PPP.
- It is an important calculation for anyone wanting to get a clear understanding of the real economic value of every country.
- To determine which economy is the biggest in the world, for example, you have to adjust nominal GDP figures using PPP; otherwise the figures are of little value.
PPP is a simple calculation.
One country's currency, such as the U.S. dollar, is chosen as the base currency.
The dollar value of a selected basket of goods and services is then compared to the value of the same items in another country using traditional exchange rates. In most cases, the two values won't be the same.
It is often difficult to come up with a perfectly reliable PPP. The choice of items to be included in the basket used to determine PPP has to be made carefully.
The Big Mac Index
The Economist magazine, somewhat jokingly, came up with a PPP using the costs of Big Macs around the world.
Since the Big Mac is identical in every country, and sold all over the world, the Big Mac Index has now become a reliable tool to see how prices vary around the world.
GDP per capita
It can also be useful to relate a country's total GDP to the number of inhabitants, giving us a more realistic view of how wealthy a country really is.
GDP per capita, is often used to compare economic power among countries.
By dividing each country's total economic output by the number of people living in the country, we get a more accurate idea of who is richer.
Impossible to capture the complete picture
No measure of economic growth and economic power, however, is able to capture the complete picture.
Quality of life
Quality of life, for example, isn't included in traditional measures of GDP.
The GNP does not allow for the health of our children, the quality of their education, or the joy of their play.
Neither GNP nor GDP gives us a truly complete picture of our economic health.
UNHDI measures of Economic well-being (most popular)
The most popular accepted measure of economic well-being is the United Nations Human Development Index (UNHDI), which rates countries according to their levels of health, education, and income.
The UNHDI measures such areas as
- life expectancy,
- access to education and adult literacy,
- years of schooling,
- equitable distribution of income,
- GDP per person adjusted by PPP,
- health care and
- gender equality.
Gross National Happiness Index
Some countries, such as Bhutan, have tried to look less at tangible measures and more at happiness, instituting a Gross National Happiness measure in 1972.
Although happiness and well-being are notoriously difficult to measure, tracking opinion polls, search request data, and social media activity give us valuable information that can be used to determine which country can justifiably chant, "We're number one!"
Wednesday, 16 December 2020
Bretton Woods Conference (end of World War 2)
One of the major accomplishments of the Bretton Woods Conference was the plan to link virtually all the world's major currencies to the U.S. dollar in a sort of fixed-exchange system, with the dollar serving as an anchor to global economic activity
The value of the dollar, in turn, would be linked o a fixed amount of gold - one ounce for every thirty five dollars.
The Bretton Woods system allowed countries from Japan to Germany and from France to Brazil to grow and prosper. But when the U.S. began running huge deficits - printing enormous sums of money to pay for everything from Asian wars to Great Society antipoverty programs - the rest of the world began to lose confidence
Abandoning the Gold Standard
In late 1960s, France began losing confidence in the system and started asking for the actual gold that had been backing up the U.S. dollar, and other nations followed the example. Soon, more than half of the U.S. gold reserves had been transferred abroad.
The American government decided that the only solution was to abandon the gold standard. From 1971 onward, the U.S. dollar and virtually all currencies in the world became fiat currencies, backed by nothing than the faith of the people using them.
From that moment on the Bretton Woods system of fixed exchange rates was transformed into a system of freely floating currencies, with their values determined by the foreign exchange markets.
Interest rates and Money supply
Interest rates and money supply are the major tools the Fed and other central banks have traditionally used to control economic growth; the key is in how the tools are applied.
A country's economy is regulated by its money supply, which determines interest rates. And each country's money supply is controlled by its central bank. These quasi-public institutions are set up by governments but are then given the independence to keep an economy under control without undue interference from dabbling politicians.
How to measure and monitor growth and inflation in an economy?
Despite the tendency of the media to concentrate on the latest major economic statistic, such as GDP growth or unemployment, there is no one single indicator that tells us
- how fast an economy is growing or
- if that growth will lead to inflation down the road.
In addition, there is no way to know how quickly an economy will respond to changes in monetary policy.
- If a country's central bank allows the economy to expand too rapidly - by keeping too much money in circulation, for example - it may cause bubbles and rampant inflation.
- But if it slows down the economy too much, an economic recession can result, bringing financial turmoil and severe unemployment.
- When economic stagnation coincides with high inflation, sometimes referred to as stagflation, a worst-case scenario is created.
Central bankers, therefore, need to be prescient and extremely careful - keeping
- one eye on inflation, which is usually a product of an overheating economy, and
- one eye on unemployment, which is almost always the product of a slowing economy.
In the twenty first century, with the amount of capital flowing around the world dwarfing many countries' money supplies, it is almost impossible to know with certainty what the effect of any one monetary decision will have on a local economy, let alone on the world.
Fiscal policy or Massive deficit spending
Given the extremely low inflation rates in the 2010s, some have called for alternative methods for controlling economic growth. Instead of using the central banks' authority to raise tor lower interest rates, referred to as "monetary policy," another solution would be to use "fiscal policy" to alter the money supply - essentially allowing governments to circumvent central banks by printing massive amounts of money to increase the money supply, for example.
The use of a government's ability to issue new currency to influence economic growth, commonly referred to as Modern Monetary Theory (MMT), is not unproblematic in that inflation can come roaring back at a moment's notice.
Many governments may misuse the power of MMT to pay for massive deficit spending in ways that lack the prudent guidance provided by the world's central banks.
Unforeseen and unpredictable events
Sometimes financial crises are caused by - and sometimes solved by forces - entirely unconnected to the original problem.
Most of the recent financial meltdowns,
- from the stock market crash of 1987,
- to the bursting of the dot-com bubble in 2000,
- to the market collapse following the terrorist attacks of September 11, 2001,
were exacerbated by economic and sociopolitical forces well outside the control of any one country and greatly affected markets around the world.
- The market for subprime mortgages really took off when the banks and mortgage companies figured out that they could repackage these dubious mortgages and sell them as bonds to investors through-out the world economy - mainly to cash-flush banks and financial institutions.
- With hundred of billions of dollars' worth of mortgage-backed securities traded annually by 2007, the market for subprime debt had become bigger than the entire market for U.S. Treasury bonds - the biggest bond market in the world at the time.
U.S. dollar as the world's main reserve currency
Almost a third of foreign central banks hold the U.S. dollar as their main reserve currency.
- The U.S. enviable position as the owner of the world's most sought-after currency, has provided many advantages over the years, not the least of which is having the ability to easily borrow abroad to finance wars and deficit spending at home.
- The disadvantage is that countries with reserve currencies tend to run trade account deficits, mainly because the higher value of their currencies makes their products more expensive to export.
These persistent trade deficits, led the U.S. president in 2018 to begin a series of trade wars, hoping to keep the benefits of holding the world's reserve currency while using the threat of global trade wars to eliminate the deficits, come what may..
An isolated event in one part of the world can have an immediate effect on markets worldwide.
Global investors who are losing money in one sector often tend to sell investments in another sector, or another part of the world, to cover their losses.
- When stocks fall sharply in New York or London, emerging market funds from Brazil to India can decline sharply as investors rush to sell their shares abroad in order to raise needed cash to pay their debts at home.
- For no fault of their own, markets - especially those in developing countries - can be punished for something over which they have no control.
It works in the opposite way for countries that have currencies that are considered safe havens in time of economic turmoil.
- The Japanese yen, the Swiss franc, and the U.S. dollars, for example, tend to benefit enormously when markets crash.
- Even though it was the U.S. economic meltdown that caused the worldwide crash leading to the Great Recession in 2007, the first reaction of most global investors was to buy American dollars.
Today's news is peppered with economic terms, but rarely is any attempt made to help us cut through the complex jargon we are being bombarded with.
Essentially, the world economy is no more complicated than the domestic economy that we navigate daily. Sound economic judgement is one of the most needed skills in the world today. We need to have the tools to be able to make sense of future economic events - good or bad.
Many of us are bewildered by a fast changing global economy that seems too big and too complicated for us to understand. So we let the politicians make our decisions for us. Unfortunately, the politicians are not always going to do what is best for us. They are going to do what is best for them and their re-election chances.
Politicians care about what voters think, especially voters in blocks, and not a shred about what economists think. Talking to politicians about economics is therefore a waste of time. The only way to make governments behave as if they were economically literate is to confront them with electorates that are.
Monday, 14 December 2020
Value investing rests on three key characteristics of financial markets:
1. The prices of financial securities are subject to significant and capricious movements.
2. Despite these gyrations in the market prices of financial assets, many of these assets do have underlying or fundamental economic values that are relatively stable and that can be measured with reasonable accuracy by a diligent and disciplined investor.
3. A strategy of buying securities only when their market prices are significantly below the calculated intrinsic value will produce superior returns in the long run.
Think of this formula as the master recipe of Graham and Dodd value investing:
- Selecting securities for valuation;
- Estimating their fundamental values;
- Calculating the appropriate margin of safety required for each security;
- Deciding how much of each security to buy, which encompasses the construction of a portfolio and includes a choice about the amount of diversification the investors desires;
- Deciding when to sell securities.
These are not trivial decisions. To search for securities selling below their intrinsic value is one thing, to find them quite another.
Friday, 11 December 2020
Investment is the critical spending driver of growth and a high and rising level of investment is normally a good sign.
For a country, investment running
- below 20% of GDP foretells of shortages and gridlock;
- above 40% is excessive and often presages a serious slowdown.
The sustainable sweet spot for investment is between 25% to 35% of GDP, and it can last for many years, particularly if the investment is going to projects that generate growth in the future.
Link between weak investment and weak growth is clear and it is so common.
If investments is too low as a share of GDP, around 20% or less for emerging countries, and stays low for a long period, it likely to leave the economy full of holes that make rapid growth unlikely.
Weak investment tends to degrade both the supply network and respect for the government.
If a nation's supply chain is built on inadequate road, rail and sewer lines, supply cannot keep up with demand, which drives up prices.
In this way, weak investment is a critical source of inflation - a cancer that has often killed growth in emerging nations.
Best and worst investments
The most productive investment binges are in
- technology, and
- infrastructure, including roads, power grids and water systems.
- real estate, which often rings up crippling debts and
- commodities, which often have a corrupting influence on the economy and society.
Although a case can be made that services will come to rival manufacturing as a catalyst for sustained growth, that day has yet to arrive.
For now, the best investment binges are still focused on manufacturing and technology.
In Malaysia, investment peaked in 1995 at 43% of GDP, the second-highest level ever recorded in a large economy, behind China today.
Guided by an autocratic prime minister, the country poured money into some projects that proved useful, like a new international airport and many that did not.
The prime minister's grand vision included a new government district called Putrajaya, which today is home to just a quarter of the 320,000 people it was designed to house. This is another classic case of a bad binge that left behind little of value.
For much of the last decade, wealth has been rising all over the world, from the United States and Britain to China and India, mainly because of massive gains for the very rich.
The rich are gaining faster than the poor and the middle classes. Rising wealth inequality is an increasing threat to social stability and economic growth. It is worth tracking seriously.
As the number of billionaires rises, the data are becoming more significant as a statistical sample and as a tool for identifying countries where the balance of wealth is skewing too sharply to the super-rich.
Quality: The Good versus ad Billionaires
Looking at the scale of billionaire fortunes is not enough to reveal the extent of their political vulnerabilities.
New names on the billionaire list can be a favourable sign, but only if they are good billionaires, emerging outside "rent-seeing industries" such as construction, real estate, gambling, mining, steel, aluminum, oil, gas, and other commodity sectors that mainly involve digging resources out of the ground.
In these businesses, major players often spend their time extracting maximum rents from limited national resources by bribing politicians if necessary, not growing national wealth in innovative ways.
Compare the total wealth of tycoons in these corruption-prone businesses to that of all billionaires in the country. This comparison yields the share of the wealth generated by "bad billionaires." This label no doubt miscasts many honest mining and oil tycoons, but even in nations where these industries are relatively uncorrupt, they tend to make weak contributions to productivity, and to tie the economy to the volatile swings of commodity prices.
"Good billionaire" label is reserved for tycoons in industries that are known to make the largest contributions to growth in productivity, or that make popular consumer products like smartphones or cars. These "good" industries are the ones least likely to generate backlashes against wealth creation they include technology, manufacturing, pharmaceuticals and telecoms, as well as retail, e-commerce, and entertainment.
Real-time evidence how nations are generating wealth
Anecdotally, billionaire analysis generates real-time evidence of how nations are generating wealth. Among the largest developed economies, as of 2019, bad billionaires controlled the smallest share of billionaire wealth in Italy (7%) and France (8%) - a good sign for both countries
Tracking billionaire wealth can provide insight into whether an economy is creating the kind of wealth that will help it grow - or trigger revolt - in the near future.
Tracking it by scale, share of inherited wealth and share of bad billionaires ensures that none of these potential sources of political resentment will be missed.
It is a bad sign if the billionaire class controls too fat a share of national wealth, becomes an entrenched and inbred elite, and builds fortunes mainly from politically connected industries.
A healthy economy needs an evolving cast of productive industrialists, not a fixed cast of corrupt tycoons. Creative destruction drives growth in a capitalist society and because bad billionaires have everything to gain from the status quo, they are enemies of wider prosperity and lightning rods for populist revolts pushing to redistribute rather than grow the economic pie.
Emerging countries often grow in torrid streaks, only to fall into major crises that wipe out all their gains.
That is why among the nearly 200 economies currently tracked by IMF, only 40 have reached the "developed class".
- The last to make it was South Korea, two decades ago.
- The rest are emerging, and most have been emerging forever.
Economic trends are impermanent; churn and crisis are the norm.
All the rules aim, one way or another, to capture the delicate balances of debt, investment, inflation, currency values and other key factors required to keep an economy growing steadily faster than its peers
These are the basic principles. Remember that economic trends are impermanent; churn and crisis are the norm.
Recognize that any economy, no matter how successful or how broken, is more likely to return to the long-term average growth rate for its income class than to remain abnormally hot or cold indefinitely.
Watch for balanced growth and focus on a manageable set of dynamic indicators that make it possible to anticipate turns in the economic cycle.
Modern economies follow a cycle - exploding in crisis, only to reform and revive before dying out once again.
The likely timing and direction of change depends in part on where a country stands on the cycle of crisis, reform, boom and decay.
In general, the fortunes of a nation are
- most likely to turn for the better when a new leader rises in the wake of a crisis, and
- most likely to decline when a stale leader is in power.
This cycle explain why so few booms last long enough to vault developing economies into the developed ranks and why those that make the leap are called "miracles": they have defied the natural complacency and decay that kills most long booms.
Deflecting popular revolt by creating the welfare state
The fact that crisis and revolt can force elites to reform has been clear at least since the early critiques of Marx, who thought capitalism would collapse in a series of increasingly violent attempts to defend the upper classes.
Instead, leaders proved capable of reforming capitalism, deflecting popular revolt by creating the welfare state, starting in Germany and Britain.
Political complacency means economic "miracle" cases are rare.
The link between boom times and political complacency is well documented.
- Modern Japan and Europe are often described as too comfortably rich to push tough reform.
- What is less well recognized is that even in normal periods, the cycle turns, constantly reshaping economies for better or worse.
The cycle of crisis, reform, boom and decay, turns erratically, even in democracies where elections are regularly scheduled.
Nations may wallow in complacency for years, which helps explain why the "lost decades" in Africa and Latin America lasted longer than a decade.
On the other hand, strong-willed leaders have been known to keep pushing reform for decades - but only in the rare "miracle" cases, including Korea, Taiwan and Japan before it fell off the miracle path in the 1990.
Workplaces evolve to incorporate machines, and people find a way to fit in.
Over the past quarter century, about a third of the new jobs created in the United States were types that did not exist, or barely existed, twenty-five years ago.
In the next transformation, humans are likely to replace jobs lost to automation with new jobs we cannot yet imagine.
And economists may start counting growth in the robot population as a positive sign for economic growth, the same way that today they analyze growth in the human population.
To assess whether population trends are pushing a nation to rise or to fall, look
- first at growth in the working-age population, which sets a baseline for how fast the economy can grow.
- Then track what countries are doing to bring more workers into the talent pool, quickly. Are they opening doors to the elderly, to women, to foreigners, even to robots?
Thursday, 10 December 2020
The feel of the currency is the simplest real-time measure of how effectively a country can compete for international trade and investment.
"The currency feels too expensive"
If a currency feels too expensive, a large and sustained increase in the current account deficit can result, and money will start to flow out of the country.
The longer and faster a current account deficit expands, the more risk there is of an economic slowdown and a financial crisis.
Traditionally, that warning light flashed when the current account deficit had been growing at an average rate of 5% of GDP for five years.
But the recent deglobalization of banking has made it more difficult to finance current account deficits, so the new red line may be around 3%.
Beginning or the end of currency trouble, follow the locals
To spot the beginning or the end of currency trouble, follow the locals. They are the first to know when a nation is in crisis or recovery, and they will be the first to move. If the local millionaires are fleeing, so should you.
Once a crisis begins, watch for the current account to bounce back to surplus, which usually means that a cheap currency is drawing money back into the country. It helps if the financial environment is stable, underpinned by low expectations of inflation, which further encourages investors to return.
Meddling by the government to artificially cheapen the currency
If the government tries to artificially cheapen the currency, markets are likely to punish this meddling, particularly if the country has substantial foreign debt or does not manufacture exports that can benefit from a devaluation.
Cheap is good only if the market, not the government, determines the feel of a currency.
A cheap currency is an advantage in global competition. It might seem smart for national leaders just to devalue the currency. But this is a form of state meddling that has proved increasingly ineffective.
Since the crisis of 2008, many nations have tried to improve their competitive position by devaluing currencies, but none have managed to gain an advantage.
The central banks of the United States, Japan, Britain and the Eurozone have pursued policies that effectively amount to printing money, in part as a way to devalue their currencies. But each has achieved at best a brief gain in export share, because rivals quickly match each other's policies.
The rise in 2016 of Donald Trump, who keeps a hawkish watch on the moves of foreign central banks, made it increasingly difficult for any nation to devalue its currency without being called to account for it.
By 2019, many emerging countries had seen sharp currency depreciation, but with little boost to growth.
- One reason was foreign debt; since 1996, in the emerging world, the debt owed by private companies to foreign lenders had more than doubled as a share of GDP, reaching 20% or more in Taiwan, Peru, South Africa, Russia, Brazil and Turkey. For these countries, devaluation made it more expensive for private companies to service foreign debt, and forced them to spend less on hiring workers or investing in new equipment.
- Another factor that can derail devaluations is heavy dependence on imported food and energy. In this case, a cheaper currency will make it more expensive to import these staples, driving up inflation, further undermining the currency and encouraging capital flight. This is a recurring syndrome in nations like Turkey, which imports all its oil, but the problem is spreading.
- These days, even manufacturing powers are mere cogs in a global supply chain, relying heavily on imported parts and materials. They thus find it harder to capitalize on a cheap currency because devaluation raises the prices they pay for those parts and materials.
A rare occasion when devaluation worked
China, in 1993, was one of the rare devaluations that worked.
China had little foreign debt, it did not rely too heavily on imported goods, and its already strong manufacturing sector grew faster after Beijing devalued the renminbi.
But this was an exception that proves the rule in general you cannot devalue your way to prosperity.
Devaluation is increasingly less likely to work
Moreover, devaluation is increasingly less likely to work, even in China, which has grown to command 13% of global exports, the largest share any economy has reached in recent decades. It is just simply too big to expand much further and if it does devalue, others retaliate.
In late 2015, China devalued the renminbi by 3%, and many emerging nations responded immediately, erasing any competitive gain that Beijing hoped to achieve.
China is also making increasingly advanced exports, which are less price sensitive and gain less from a cheap currency.
In Korea, Taiwan, and China, technology and capital goods make up a rising share of exports.
The more advanced the economy, the less of a boost it gets from devaluations.
Is the government meddling more or less?
To spot whether the state is meddling more, or less
1. Look first at trends in government spending as a share of GDP.
2. Then check whether the spending is going to productive investment or to give-aways.
3. Finally, look at whether the government is using state companies and banks as tools
- to pump up growth and contain inflation, and
- whether it is choking or encouraging private businesses.
In certain environment, less meddling is best
In recent years, many countries have been
- raising the government share of the economy,
- steering bank loans to big state companies,
- subsidising cheap gas for the privilege classes and
- enforcing insensible rules in an unpredictable way.
Even low income countries like India are rolling out full-service welfare systems, a luxury that the Asian miracle economies began to adopt only much later in their development. At that point, countries like South Korea and Taiwan had already invested heavily in factories and transport networks, and they could well afford inclusive pension and health programs.
In contrast, many states are now managing the economy in ways that effectively retard growth, thereby
- fueling disrespect for establishment politicians, and
- the rise of radical populists.
As a country grows wealthier, spending by the government tends to increase.
Is the government spending much higher (or lower) as a share of the economy than in other nations at the same income level?
The worst case is a fat state getting fatter, compared to its peers.
Among the top twenty developed economies, the king of this class has long been France.
The French government spends an annual sum equal to 56% of GDP, more than any other country, barring the possible exception of Communist like North Korea.
- France's spending level is 18% above the 39% average for developed nations - the biggest gap in the world.
- Over the last decade, the tax burden required to support this state was driving businesspeople out of the country in droves.
- France's own president, Georges Clemenceau, in the early 20th century described it as "a very fertile country: you plant bureaucrats and taxes grow."
Many European states have been under pressure to cut back since the crisis of 2008, particularly where their spending amounts to more than half of GDP. Led by France, that list includes Sweden, Finland, Belgium, Denmark, Italy and until recently, Greece. Greece has been moving in a positive direction - with state spending falling from 51$ to 47% of GDP - in part because its creditors forced Athens to make painful cuts in civil service jobs and salaries.
Prior crises had already started to erode the welfare state in Europe in the late 1990s. Scarred by the crisis of 2008 and its aftermath, other European nations will remain under pressure to keep the size of the state in check.
The lighter spenders in the developed world include the United States, Austria and Australia, with government spending amounting to between 35 and 40% of the GDP. Switzerland was even lower, at 33%.
Emerging Big Spenders
Among the twenty largest emerging nations the outlier for many years was Brazil, where official government spending amounted to more than 40% of GDP, a level more typical of a rich European welfare state than a middle-class nation.
- In recent years, under a controversial right-wing government, that figure has come down to 38%, still well above the 32% average for nations with a per capita income of around $12,000.
- Brazil had by 2019 fallen behind Poland (42%) and Argentina (39%) for the title of the emerging world's biggest, most bloated spender.
- Brazil's recent turn reflects the growing realization that it could not keep spending like a rich European welfare state, as well as growing frustration with the dysfunctional system.
Emerging Small Governments
The large emerging countries with the smallest governments include Indonesia, Nigeria, South Korea and Taiwan.
The East Asean (South Korea and Taiwan) success stories were built on a model that, until very recently, delayed the development of welfare programs, kept government spending around 20% of GDP or less and focused that spending on investment in infrastructure and manufacturing.
Even today, only 30% of Asia's population is covered by a pension plan, compared to more than 90% in Europe.
Taiwan's public healthcare system did not exist in 1995 but now covers nearly 100% of the population and costs just 7% of GDP; that compares well to spotty coverage costing 18% in the United States.
Governments in the Andean countries of Columbia, Peru and Chile all look relatively undersized, as does Mexico, with government spending equal to 25% of GDP, 7% below the average for its income class. It is mainly on the Atlantic coast - in Brazil, Venezuela and Argentina - that governments suffer from bloat.