A 300-year bubble worth remembering: South Sea Bubble

By Edward Chancellor

LONDON (Reuters Breakingviews) - 

Next year marks the 300th anniversary of England’s most notorious speculative mania. The South Sea Company owned the monopoly rights to trade with South America but never made much from those activities. It was the Company’s offer in 1720 to acquire 32 million pounds of Britain’s national debt, in exchange for its own shares, that juiced its returns. Between January and August of that year, the price of South Sea stock traded in London rose sevenfold. At its peak, the Company’s market worth was around twice the total value of land in all of England. The South Sea bubble contains lessons for contemporary investors - even if many of the tales told about the affair are the stuff of legend. 

Sir Isaac Newton, when asked about South Sea stock in the spring of 1720, famously declared that he “could calculate the motions of the heavenly stars, but not the madness of people”. The trouble with the great mathematician’s comment is that it was first recorded, in slightly different form, three decades after his death in 1727. Newton did, however, lose a great deal of money in the bubble – possibly as much as $20 million in current terms - having sold his South Sea stock at an early stage, later re-entering the market and investing his entire fortune in the Company. Although Newton died a rich man, his niece said that he hated being reminded of these losses. 

It’s possible to calculate precisely how irrational Newton and his contemporaries became during 1720. Since England was then at war with Spain, the Company’s South American trading monopoly was basically worthless. Its entire income derived from the fixed interest payments it was set to receive from holding government debt. A highly numerate parliamentarian, Archibald Hutcheson, published a pamphlet in June 1720 arguing that the stock could not possibly be worth more than 200 pounds – just one-fifth of its peak value and roughly the level to which the shares subsequently fell. Some shrewd investors didn’t lose their heads. Bookseller Thomas Guy sold his entire South Sea holding at an average price of 416, and later used his enormous profits to establish the London hospital that still bears his name. Guy also shorted South Sea stock. 

During the early months of 1720, dozens of new companies were floated on London’s Exchange Alley. The most commonly cited of these ventures - a “company for carrying an undertaking of great advantage, but nobody to know what it is” – never actually existed. This mythical venture was merely a satire on the crazy schemes that abounded at the time. Nearly 200 “bubble companies” were launched at the time. Not all of them were scams: of the four survivors, two insurers, the Royal Exchange and London Assurance, later enjoyed great success. 

The companies, the startups of their day, were deeply unpopular with the directors of the South Sea Company, who wanted all the speculators’ capital for themselves. The directors persuaded Parliament to pass a law banning the trade in unauthorised shares. This backfired. After writs were issued in August against several illegal companies, a panic appeared in Exchange Alley; the collapse of market confidence doomed both the mini-bubbles and the South Sea Company itself. By early autumn, its stock was down 80%. Several banks failed, including the Sword Blade Bank which had provided loans against South Sea shares. Distressed speculators took their lives, leading to a large rise in the number of reported suicides. Writing in February 1721, the Earl of Oxford reported that “all credit in trade is stopped”. 

The collapse of the bubble is widely believed to have produced a severe economic downturn. Yet records show only a small increase in bankruptcies and a slight decline in overseas trade. The collapse of the South Sea stock caused a public uproar, however. The directors of the Company, led by former lottery promoter Sir John Blunt, had used numerous tricks to boost the shares. Their main sleight of hand was not to specify the number of shares to be issued for the conversion of the government debt. What this meant was that the higher the South Sea stock climbed, the fewer shares needed to be issued in exchange for the debt and the greater the Company’s profit. To this end, the Company provided loans to speculators, issued partly paid shares with only 10% down payments, secretly repurchased its own shares and promised impossibly large dividends. 

The connection between the Company and the ruling class was close - King George I served as its Governor-General and several directors held government offices. It was later discovered that the Company had spent vast sums bribing members of the establishment. King George, his mistresses, several ministers and dozens of lawmakers were allocated shares at low prices for which they paid nothing. During the bubble months, insiders including the king, Chancellor of the Exchequer Sir John Aislabie and the nefarious Blunt cashed out large fortunes. A House of Commons investigation concluded that the Company’s directors had engaged in “the raising and supporting of the imaginary value of the stock at an extravagant and high price, for the benefit of themselves, and those who were in secret with them”. After the collapse, the directors were forced to disgorge their profits and several ministers lost their jobs. 

In 1720, the word “bubble” didn’t refer to an overpriced asset but to a confidence trick. The South Sea swindle was the greatest of them all. Yet financial practices haven’t improved much over the past three centuries. Bubbles arguably proliferate among the unicorns of Silicon Valley and in the murky world of cryptocurrencies. A revolving door whirrs between Wall Street and Washington. Companies are floated which don’t reveal their ultimate purpose – today they’re called SPACs. Directors still use company funds to boost their stock price and enrich themselves. Thomas Guy’s intellectual heirs, now styled value investors, continue to avoid bubbles and lose money shorting them. But when markets crash, the cries of outrage from those who’ve been “bubbled” will be as loud as in Newton’s day. 

From Reuters

Central-bank Interest rates and Interbank rates in Europe or Fed funds rates in the U.S.

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

 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 Multiplier Effecct

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.

The main tool for fighting uncontrolled inflation: reduce the money supply

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 versus Deflation

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.

Deflation

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 once interest rates have been reduced to zero

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.

Negative interest rates

In times of negative interest rates depositors are essentially being charged to store their money in the bank.

Negative interest rates has been the case in the past, in countries including Switzerland and Denmark.

This encourages consumers and businesses to put their money in the economy at large by buying additional goods and services.

Quantitative easing: how is this done?

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.

How populist leaders use your economic and political illiteracy?

Populist leaders

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.

Autocratic leaders

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.

International Migrants Day 18th December 2020

Immigration has become the number one issue for many voters and governments around the world.

By the end of the 2010s, more than 250 million people were living in places other than their country of birth, twice as many as in 2000.

• 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.

Complains against immigration

The most common complaint against immigration, especially of low-skilled workers, is that immigrants take jobs away.

Secondary reasons include anything from concern for how immigrants 

• 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.  

Many of those voting for anti-immigration parties are sometimes less worried about losing their job to foreigners than they are worried that immigrants and those of other ethnic backgrounds will surpass them on the economic ladder, leading to a decline in social status.

It is often the case that the work immigrants perform - at least in the beginning of their careers in their new host countries - are jobs that locals simply prefer not to do.

Work,  is not a zero-sum game.  When one job is taken, it doesn't mean that more jobs won't be created.   The arrival of new workers tends to expand an economy by creating a need for more housing, food preparation, haircuts and countless other goods and services.

Immigrants tend to stimulate the economy as a whole.

By expanding output, immigrants tend to stimulate the economy as a whole.  

• 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.

Immigrants with university degrees and special skills - especially tech skills - have been shown to provide a particularly powerful stimulus to local economies.  

• 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.

Even local workers without college degrees can benefit because, like most everything in our interconnected world, what happens in one area of the economy ends up having an effect on another.  A new business or factory often means an increase in a wide array of jobs at all skill levels.

Japan chooses to severely restrict immigrants

Many economists point to Japan, which has chosen to severely restrict immigrants for social as well as economic reasons, as an example of how the fear of immigration can cause a wide array of economic problems.  

• 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.

Competitive edge of a culturally diverse workforce

A culturally diverse workforce often translates into a competitive edge for companies and businesses on an international level.  

A study in the Harvard Business Review found that businesses with a high level of diversity - including, among other things, national origin - had a higher level of innovation and consequently higher levels of profitability.

Summary

Although immigration isn't always problem-free, it is clear that in most cases, it ends up stimulating the economy and expands a country's opportunities by providing the manpower, skills and diversity required for companies to compete in the new global economy.

Additional notes:

The seemingly unrestricted flow of immigrants into Europe during the Syrian civil war and families crossing the Mexican-U.S. border over the past decades have made immigration the number one issue for many voters and governments around the world.  Many observers have seen the Brexit vote and 2016 U.S. election as primarily influenced by voters' fear of immigration.

2020  70th year of UNHCR

https://www.facebook.com/WHO/videos/744822976117339/

https://youtu.be/Dg09MMA54Ac

WHO Media briefing on COVID-19 and Migrants Day

The EU withdrawal process facing the United Kingdom.

 The EU withdrawal process facing the United Kingdom.

Options

1.  No deal.

2.  Preferential access to the EU markets

"No deal"

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.  

 Preferential access

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.

The decision on which path to take became so intractable at one point that it was feared that the United Kingdom would exit the EU with no deal at all, putting the UK at the same level as every other country in the world economy without any preferential trade agreement.

Trade wars end up hurting everyone, including the countries starting them.  Protectionist measures with the imposition of tariffs would certainly be met by retaliatory measures from other countries, leading to the loss of many more jobs than those "saved."

Understanding Brexit

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.

Post-Brexit Britain

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.

US unilaterally imposing tariffs on many foreign imports in 2018

 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.

Bilateral Free-Trade Agreements (FTAs) and World Trade Organization (WTO)

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.

Barriers to world trade: tariffs, quotas and subsidies

The three forms of trade barriers

There are 3 forms of barriers to trade:

• tariffs,
• quotas, and 
• subsidies.

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.

Multiparty trade system. Current account is balanced by the country's capital account.

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.

What gets spent never stays in one place

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 

• banking
• entertainment, 
• tourism, and 
• technology platforms.  

A few lucky countries, such as U.S., have the privilege of receiving massive amounts of money every year in the form of investments from abroad.

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

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?

Trade wars in the past

 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.

How do we rank countries?

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.  

Countries that pay a lot of attention to quality-of-life issues like education and health care - like Norway, Australia and Switzerland - appear high on the list.

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!"