Are Trade and currency openness complementary?

The recurring discussion about US-China trade deficit and the resultant "currency war" left me wondering about a different solution. Can we link trade and currency openness?

The principle is simple, a country should be allowed as much freedom in trade as it allows freedom in pricing exchange rates. If a country has restrictive exchange rates, it should have trade restrictions as well. In a sense, this should prevent countries creating too-big-to-fail currency problems like China has.

With its asset boom, ghost cities, empty offices, China should have eased up a lot earlier. Given the artificial controls on its currency, the markets could not (or did not) adjust the balance accordingly. The question I pose, essentially a hypothesis, is, doesn't this indicate that the two freedoms, that of currency and trade, be complementary?

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My book "Subverting Capitalism & Democracy" is available on Amazon

Why some imbalances are more important than others?

I am linking to Scott Sumner again. He has a post that identifies the current account imbalances between countries. And he is right, in terms of imbalances, nordic countries have highest per capita surplus than others. However, surplus of some countries hurts us more than others. 

As I mention in my book, the net impact of surplus or deficit depends on the skill profile of the nation as a whole. If the skill profile of two nation matches then the current account surpluses have detrimental impact on the one with deficits. The problem with large nations is that even if the profile of nation as whole is not alike the amount of overlap is significant.

It is because of this mismatch that US is losing jobs. Further, US has not invested in the "next big thing" whatever that is, to create alternative employment for those who lose jobs. 

Links

TheMoneyIllusion � Where are the biggest “imbalances?”

Comeptitive devaluations - Krugman, Sumner and Yglesias

Scott Sumner remarks on Paul Krugman's post "Worst economist in the world". Krugman is not impressed with the logic, neither is Sumner. Sumner also points to Matt Yglesias who dissects the argument. But the journalist's argument has merit. It is slightly different but I would give it a benefit of doubt. Let me explain:

In normal circumstances, "competitive devaluation"results in inflation. Inflation is OK if income distribution mechanisms are working. So if employment is robust, economic engines are operating, then the transmission of higher oil prices into higher incomes creates a balancing effect by creating higher ability to spend. 

Currently, those mechanisms are not working. So "other things being equal" does not apply today. Thus, higher oil prices will impair the household balance sheets further. At the same time, the increase in input costs will either weigh in on corporate performance or get transmitted to households again. Thus, the rise in oil prices is ominous for households.

However, they have no bearing on international trade. It cancels out.

Meanwhile, there is an argument about commodities being store of value. We need to understand the argument carefully. Store of value has to be independent. Commodities are co-dependent on the economy. Commodities carry value because of the demand. At higher prices, elasticities tend to affect demand and hence the value. The commodity prices may reach higher but will have to come back to demand-supply equilibrium. 

Thus, commodity prices contain two intersecting variables. A measure of value and price as indicated by demand supply balance. Since these two variables are finely mixed up we cannot separate one from other. Thus it is inappropriate to draw conclusions from the prices of commodities.

Links

TheMoneyIllusion � Surely Krugman can do worse than this?

Forecasting equity prices in turbulent times

The markets have been very volatile over the past few years. Investing in these times has been fraught with risks. In such a market, it is very difficult to make investment decisions based on valuation models. Almost always these models indicate that stocks are over priced. Equity fund houses are adding to the confusion with their near-random buy-sell ratings. There seems to be little logic behind these recommendations.

However, there is a method wherein we can logically explain the variations in valuations. We can look at equity prices as composed of two components, a value component and an asset inflation component.

Value component can be expressed as a price band based on fundamental assumptions. The output of most models is usually a price band. These assumption are dependent on the company and economic situation. As we tweak these assumptions for a base case, bull case and bear case we end up with a price band. The price or value is based on various valuation models such as sum-of-parts, residual income, etc. Normally, prices should vary within these bands and the inflation component should be bare minimum. However, in recent years the prices have moved out of the valuation range.

The movement is because of asset inflation because of the high liquidity being pumped into the market. Those are not the only reasons and each market has a different variables that influence the asset inflation for that market. The role of equity analyst, therefore, also includes forecasting the expected asset inflation. From a first principles, in a market influenced by foreign capital flows, average daily volume should be a good indicator. For example, in India, the asset inflation component for large cap stocks with high volumes could be to the tune of 35-40%. For mid-caps or firms out of favour the range may be 20-30% while small caps may have inflation factor of 10%. As the global picture changes, the macro analyst can thereafter adjust the asset inflation component at the country level. I believe this is a better way to present equity research prices.

Let us take an example.  Let us say that the value component for stock like Bharti Airtel comes to INR 300 per share. Now telecom as a sector is a little out of favour and the inflation factor for Bharti Airtel would be lower than usual 35-40% for large-cap stocks. Let us say it is 20-25%. Therefore, the expected price range for Bharti Airtel will be INR 360-375.

Disclaimer

Long Bharti

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My book "Subverting Capitalism & Democracy" is available on Amazon

The Foreclosure Mess and justice

In the blog "The big picture", David Kotok has a very interesting article on the foreclosure mess. In the context of that article I would like to make a few comments. 

Before the comments, I must state that the issue, like all other in this crisis, straddles the political, legal, social and financial sectors. As a preamble, we must look out for the interest of individual as that is the primary responsibility of the courts and the governance mechanism. We must, like I say in my book, differentiate between real living citizens and firms that have acquired citizenship. It is time for the congress, government and legal apparatus to stand behind the interest of individual. Here are my comments:

First, both the defaulting lender (genuine defaults) and the institutions that misplaced the promisory note are at fault. However, the court has to evaluate the gravity of the situation and that depends on the relative bargaining power of the two parties. The question of relative bargaining power is very important as I discuss in my book Subverting Capitalism and Democracy. The bargaining power equations are clearly favoring the institute. The responsibility of the court is, therefore, to protect the interest of the weak i.e. the individual. Even if it means, in some cases, rewarding the mistakes of individual. Further, the individual will obviously pay for the mistake through higher taxes and loss of jobs. In all fairness, she will pay no matter what the outcome of the foreclosure.

Second, if the chain of title is broken, the person who can defend the title should have the right to initiate foreclosure. However, the person must show unequivocal demonstration of the title. In all probability, an institution within the chain of title cannot establish this without dispute for those downstream will challenge their claim either as fraud or will stake their claim to title. In the light of this claim, it is unreasonable to ask the individual to make a payment.

Third, if it was a matter of making payments, courts could have ordered payments into an escrow account to be allotted to those who can establish rightful ownership. The interest rate or size of payments should be in accordance with the agreement, or if the agreement fails to establish clear rate of interest, it should be at the interest rate set by the Fed. Similarly, courts can initiate a suo-moto foreclosure in cases where it is clear that borrower willfully defaulted and recover the money through auction of the property. The recovered money can then be transferred to escrow account waiting to be claimed by rightful owner.

Fourth, in all fairness, courts must set out limitation date for the title to be clarified. Without a limitation, the process can drag along for years. It is unjust to the individual.

Finally, in all the situations the outcome for banks, mortgage brokers and investors in mortgages are grim. Either way, we have a problem on our hand. It clearly means that banks and other intermediaries will need a bigger capital buffer than what they are currently carrying. Further, approximate estimates peg the capital requirement to be much higher than during 2008 Lehman episode.

It appears that the financial institutions may have realized this and initiated a global pull-back of capital. It is possible the recent correction in global equity markets are a result of this problem.

Notes

The Foreclosure Mess | The Big Picture

Subverting Capitalism and Democracy