Two Cheers for Bernanke’s Speech on Trade

I was thrilled to see that Ben Bernanke’s speech today (here, courtesy of Mark Thoma) addressed the trade deficit, and whether trade imbalance might bear upon the case for international trade:

Although many readily accept that balanced trade does not reduce aggregate employment, some might argue that the United States’ current large trade deficit must mean that the number of U.S. jobs has been reduced on net. However, the existence of a trade deficit or surplus, by itself, does not have any evident effect on the level of employment. For example, across countries, trade deficits and unemployment rates show little correlation. Among our six Group of Seven partners (the world’s leading industrial countries), three have trade surpluses (Canada, Germany, and Japan). However, based on the figures for February of this year, the unemployment rates in Canada (5.3 percent) and in Germany (9.0 percent) are significantly higher than the 4.5 percent rate in the United States; and Japan’s unemployment rate, at 4.0 percent, is only a bit lower.7 Factors such as the degree of flexibility in the labor market, not trade, are the primary source of these cross-country variations in unemployment.

Though I found much to quibble over in Bernanke’s very orthodox defense of trade, this one paragraph made the whole speech worthwhile. I do agree with it. There’s no reason to think that unbalanced trade should have any effect on unemployment rates. But that’s not why I was so pleased. I was excited just to see the question of imbalance addressed, to see America’s huge trade balance actually grappled with in a major policy speech on trade. So often the fact of persistent imbalance is just ignored, maybe mentioned with a quick cough, but let’s move on and pretend we are all living in some Ricardian paradise.

Perhaps in future speeches, Bernanke could address the trade imbalance and its effect on the character of domestic investment — that is, whether persistently unbalanced trade results in a skewing of physical and human capital out of tradable sectors. He might touch upon how these dynamic effects bear on the United States’ future ability to repay its growing international debt with real goods or services. In his role as Fed chief, Bernanke could comment on whether managing the sizable debt associated with unbalanced trade might someday require a more accommodative monetary stance than would be expected under inflation targeting. (This would be a good opportunity to celebrate the US central bank’s famous dual mandate!)

Bernanke could discuss housing and asset bubbles, and future price volatility should patterns of international capital flow change or Americans become more reluctant to increase their debt load. With respect to employment, Bernanke could muse on whether and to what degree unbalanced trade affects wages, if it does not affect unemployment rates. He might offer some insight on whether the combination of sluggish wage growth, low tradables prices, unusually easy credit, and booming financial markets — all related to current trade patterns! — have anything to do with declining labor force participation in the United States.

It could happen. A boy can dream, can’t he?

So two cheers for Ben Bernanke, and his speech today on trade. May it be the first of many.

p.s. Bernanke deserves a full three cheers for a famous speech several years ago. His suggestion of a “global savings glut” was a profoundly useful contribution to the conversation on globalization and international trade. It’d be great to see a follow-up on why it is or ought to be the United States that does the world the service of accommodating that glut, and what if any limits there are or ought to be on America’s willingness to borrow the world’s copious savings.

Morality, Nationalism, Trade, and Debt

Alex Tabarrok has a very nice post on the morality of trade. You should read the whole thing. It is concise and artful. Here’s a taste:

Peter and Jose [individuals who desire an exchange] presumptively are better off from trade otherwise they wouldn’t trade so the individualist economist (the economist who takes Peter and Jose as the relevant moral community) will support free trade. The liberal internationalist will also support free trade because there is a strong argument from positive economics that trade increases total wealth (comparative advantage, specialization, competition etc.).

In between, we have the nationalist economist for whom it depends. The case for trade for the nationalist economist is pretty good – after all the individuals involved benefit and the world benefits – so the case is reasonably strong that Peter and Joe [a co-national of Peter] taken together will also benefit especially if we consider many trade pacts on some of which Joe benefits directly. Nevertheless, Rodrik is correct that when you exclude Jose it is possible to come up with examples where Joe’s losses exceed Peter’s gains.

I would argue, however, that economists are too quick to take the nation as the relevant moral community. It is quite possible, for example, for Peter to benefit from trade but for Peter’s city to be harmed, for Peter’s state to benefit but for his region to be harmed, for his country to benefit but for his continent to be harmed… Indeed, geography is not the only way we can define the moral community. Why not ask whether English speakers benefit from free trade or Christians or left handed people?

Here are a few responses:

1) How certain are we that “the world” benefits from free trade?

Alex writes, “The liberal internationalist will also support free trade because there is a strong argument from positive economics that trade increases total wealth (comparative advantage, specialization, competition etc.).” That may usually be true, but if the claim is that a liberal internationalist will always support free trade, it is false. The whole point of the current debate is to suggest caveats to that “strong argument from positive economics that trade increases total wealth”. Those of us saying that “free trade” is not always good don’t just mean that it is not always good for every country. There are circumstances in which it might reduce welfare for nearly everyone.

Here’s an extreme example, but it does illustrate the point. Suppose a person who dislikes New York has enough money to purchase an atomic weapon and a delivery system. Suppose there is an actor (friend of dictator?) with the legal ability to sell a weapon, and who doesn’t much mind what happens to New York. It is difficult to say precisely what the result to the world will be from this free exchange, but I think we can mostly agree that it will be bad, for almost everyone, although the two parties to the exchange might come out pleased. We, reasonably and uncontroversially, make an exception to “free trade” with respect to exceedingly dangerous weapons. But none of the standard models or strong arguments of economics addresses this case. There is no algorithm we can use to quantify, “yes, this trade is welfare increasing” or “no, this trade is bad” when, in the lingo, large externalities exist.

Externalities exist in more normal cases. Recent trade-skepticism in developed economies has largely to do with unbalanced trade. Persistently unbalanced trade involves creating debt, that is uncertain promises of providing goods and services in the future in exchange for goods and services today. Any trade involving debt creates the risk that the debt will not be satisfied, in which case the parties to the trade themselves (who may be more than two) lose in the aggregate. But more importantly, when debts are repudiated or means of payment devalued, there can be large negative externalities for parties uninvolved in the original exchange. Credit risk is much like pollution, and presents challenges to libertarianism and standard arguments for trade.

Standard arguments for trade are undermined by debt in yet another way. Most models of trade, from Ricardo on down, presume that economies will specialize in producing the tradable goods for which they have comparative advantage. We make cheese, they make chocolate, and the world benefits from more of both. Empirically, this assumption fails to hold, at least over the medium term. The “strong argument from positive economics” really has nothing, and certainly nothing good, to say about the case when they make chocolate and we make debt.

There are circumstances under which “the world” will not benefit from free trade, particularly credit-based free trade.

2) Are nation-states more relevant than other groupings as determinants of human welfare?

I dislike tribalisms, including nationalism. In Alex’s story I’d be a “nationalist economist”, but in reality I’m neither. Frankly, under this prickly skin I’m a utopian who’d prefer to see all borders disappear.

But we’re not there yet. In this real world, doesn’t the welfare of nations have more to do with well-being than ones city, handedness community, even religion or ethnicity? It sucks that Ohio is suffering economically, but the barriers preventing an Ohioans from moving to Silicon Valley are far less than those holding back a Bangladeshi. In the United States, there is not (and I hope there doesn’t come to be) the level of ethnic cohesion and the sort of institutions that would allow for coercive policy at an ethnic level to be plausible and effective. If there were, we would have to deal with that.

Suppose left-handers and right-handers really did segregate, cohere, and belong to distinct political organizations with the power to compel compliance among members. Suppose the right-handers organized very carefully, and policed group behavior very strategically, in order to maximize the welfare of right-handers regardless of any effect on lefties. Would it necessarily be a good strategy for left-handers to ignore those facts, and pretend group identity doesn’t matter? It might be, depending on the behavior of the cohesive righties. More probably it would not be. It is a game-theoretical matter that demands analysis, not an ideological or moralistic claim about what would be best.

Again, in my dreams, I would like to see nation-state politics become as hypothetical as handedness wars. But ignoring the actual relevance of nation-states, or failing to act strategically within some nation-states while others behave very strategically, is not a solution. Nation-states will not disappear just because we might will them to do so, and the interests of real people who live in nation-states will not be improved my merely pretending they don’t matter.

Update History:
  • 30-Apr-2007, 1:02 p.m. EDT: Made a few minor changes and grammatical fixes. Modified response to the first question to conclude in terms of “the world” rather than liberal internationalists.

Getting real about trade…

Dani Rodrik’s wonderful post on free trade and prices has started an extraordinarily candid conversation among economists. Economists sometimes rudely pretend that critics of free trade simply fail to understand “Ricardo’s Difficult Idea“, and that skepticism amounts either to ignorance, a kind of literary snobbishness, or simple corruption. In doing so, despite protestations to the contrary and rich nuances hidden in journals, economists as a group have grown doctrinaire in policy arguments regarding trade. All of a sudden, thanks to Dani Rodrik, they’ve begun to fess up.

Tyler Cowen’s recent addition to the conversation is worth highlighting (emphasis mine):

More empirically, having your export prices bid up is a wonderful driver of growth more than it is a distributional or efficiency nightmare. The net externalities of that process are usually positive rather than negative, even without firm- or industry-level increasing returns in the traditional sense. The exports help build a middle class and in the long run make democracy and rule of law possible. The dynamic effects are the key to the benefits of trade, and neither the Ricardian nor the Heckscher-Ohlin model is satisfactory. The best simple (ha!) model has trade bringing more innovation, new goods with high consumer surplus, greater reason to work hard and get ahead, greater domestic inequality, a growing middle class, and new and usually more liberal political coalitions.

Empirically, the troubled cases of trade typically involve exports of oil or diamonds and subsequent corruption. The relevant problem with trade is not higher prices for home consumption, in fact home consumption of those commodities is usually quite low. How much oil does Guinea-Bisseau use? We’re left with Mexico and corn prices as a possible example, but note that Mexico would have much lower corn prices with free trade in corn. And it is U.S. government subsidy, not the market, bidding up the price of corn in the first place.

What is extraordinarily about the bit of text in bold is the admission that what’s great about trade is not the deterministic result of some well-established, you-may-not-understand-it-but-it-is-definitely-true theorem. “Dynamic effects” here means things that we’ve observed over time, but that aren’t captured by simple, standard models. Tyler is making a case based on human judgement, not rocket science. (I’m sure there is some rocket science somewhere to support his intuition, but you won’t find the wall of obeisance any mention of Ricardo provokes.)

I agree with everything Tyler writes here. But note that his analyisis offers no simple prescription. He has become a two-handed economist, thank goodness. Unfortunately, he tries to shove one hand back in his pockets at the end of the post:

I don’t disagree with Rodrik’s claims about positive economics, although they don’t quite “shade” as I might wish. I would have liked to have seen the sentence: “The early 20th century trade theorists discussed by Jacob Viner and Gottfried Haberler knew about these problems, but they also realized they did not, when viewed in a realistic context, weaken the case for free trade.”

Yet Tyler himself describes some realistic contexts (oil, diamonds) where the bad effects of trade arguably trump the good. If we were debating a specific policy proposal, it would strike me as normal to worry about the “shading” of other peoples’ true statements. But getting upset that comments on trade in general don’t “shade” sufficiently towards “free trade” is odd. There seems to be a strong norm among economists to “shade” towards a simple view on trade that is known within the profession to be inadequate, theoretically and in some real-world contexts.

If you haven’t followed this debate and you care about this stuff, here are some things to read:

Among God’s jokes is that one always sins in precisely the ways one accuses others of sinning. In accusing “economists” of strongly shading towards a caricatured view of trade, I myself have caricatured economists. There are, of course, economists who consistently engage the public with nuanced views of trade. Any list I could write would be unforgivably spotty, but I’ll send some love to Dean Baker and Brad Setser. Recently Alan Blinder and of course Dani Rodrik have deviated from what I allege to be the party line. I am sure there are many others.

Here, by the way, is a synopsis of my own views:

  1. International trade is usually a fantastically good thing, because of Ricardo-esque efficiency gains and Tyler-Cowen-esque dynamic effects, and also for cultural and aesthetic reasons.
  2. Nation-states are still important units of analysis and determinants of human welfare. So long as this is true, enthusiasm for trade in general must be tempered by caveats about balance and national portfolio diversification. At this moment, I think these concerns are sufficiently pressing in the United States that a policy response is required.
  3. Neither blinding people with equations nor presenting tendentious simplifications as scientific truth are adequate approaches to policy debates. Yes, models are always simplifications, but a good model captures relevant complexity, while a bad one is scientific window-dressing around a preconceived result. Having a secret good model doesn’t excuse pawning off a bad one that gives the right answer as “science”. Largely false simplifications that capture important insights are essential pedagogical tools. But they should be presented as thought experiments rather than models, and qualified with some discussion of their inadequacies.
Update History:
  • 29-Apr-2007, 7:21 p.m. EDT: Changed an “on” to an “in” ‘cuz it sounds better.

Relative Prices, Trade, and Inflation (oh my!)

I really like new econoblogger Dani Rodrik. He asks, “Does Free Trade Bring Lower Prices?“, and comes up with a good answer. (The right answer, in economics as in life, is always “it depends”. A good answer is one that offers its receiver some intuition just what “it depends” upon.) Rodrick writes:

Advocates of globalization love to argue that free trade lowers prices, and the argument seems sensible enough. Think of all the cheap goods from China that we can buy at Wal-Mart. But anyone who understands comparative advantage knows that free trade affects relative prices, not the price level (the latter being the province of macro and monetary factors). When a country opens up to trade (or liberalizes its trade), it is the relative price of imports that comes down; by necessity, the relative prices of its exports must go up! Consumers are better off to the extent that their consumption basket is weighted towards importables, but we cannot always rely on this to be the case.

Americans may forget this, since the price of the consumer items we export (movies, software) is more affected by economies of scale than resource and capacity constraints. But Mexicans who can’t afford corn for tortillas because of the United States’ bizarre corn-ethanol fetish may have noticed.

Does the fact that prices of Mexico’s staple food have skyrocketed count as inflation in Mexico?

Old fave econoblogger Mark Thoma recently suggested no, it shouldn’t. Mere changes in the relative prices of goods and services cannot constitute inflation:

I’ll use some hypothetical numbers for illustration. Suppose that when the price of oil is $28, the price level is 100, and also suppose that when the price of oil increases to $60, the price level increases to 120 all else equal (again, these are not intended to be realistic numbers).

Now, let the spike in oil prices happen quickly, but due to sluggish wage and price adjustment suppose the resulting 20% increase in the price level takes more time, say 2 years. During this two year period, as the price level rises from 100 to 120, inflation will be reported in the news.

But this is not what economists mean by inflation when they say, for example, that “inflation is always and everywhere a monetary phenomena.” To see this, suppose that the change in oil prices and the price level are both instantaneous rather than having the change in the price level drawn out over two years as before. That is, the price level jumps from 100 to 120 instantaneously and stays at the higher level from then on.

In this case, there is no inflation. Prices were stable before the instantaneous jump in the price level, and prices are stable afterward. From that day forward prices remain at 120 and do not increase any further. There is no inflation.

The question of whether changes in prices in and of themselves constitute inflation is a tiresome, and fundamentally definitional question. But I did find it a bit irksome when, after two posts arguing that changes in prices aren’t inflation, Mark excerpted without comment a long speech by San Francisco Fed President Janet Yellin which talked a great deal about price changes as a source of inflation, particularly the price of labor:

While the possibility of slower underlying productivity growth raises uncertainties about how to interpret the puzzle and the associated implications for inflation, it also has a more direct and distinctly pessimistic implication for inflation. In particular, a slowdown in the trend rate of productivity growth means that firms’ trend unit labor costs will rise more rapidly unless compensation growth declines in tandem. Absent such a moderation in compensation growth, firms may adjust to more rapid cost pressures by passing them into the prices consumers pay for their products, placing upward pressure on core inflation, at least for a time.

We cannot afford to go back to a world similar to the 1970s, where shocks that should have had only a transitory impact on inflation—whether due to oil prices, rents or movements in the dollar—shift longer-term inflation expectations and touch off a self-fulfilling wage-price spiral.

If inflation is “always and everywhere a monetary phenomenon”, than changes in the price of human work relative to other inputs should not be considered inflationary. Fed officials often view increases in the price of such minor inputs as food and energy with equanimity (in this era of “anchored expectations”), but are eternally vigilant to the danger that the cost of human care may be bid up. Sometimes it seems that the expectation the Fed wants “anchored” in workers’ psyches is not to expect to be paid very well.

If the “always and everywhere a monetary phenomenon” thing is for real, couldn’t the Fed just take care of the money stuff, and let a free market determine the cost of labor? Wage-price spirals and inflation expectations wouldn’t be a problem if the Fed, like, refused to accommodate unreasonable expectations.

I am aware of reasons why the Fed claims wage volatility is more worrisome than commodity price volatility. Commodity prices adjust rapidly, but overpriced wages are “sticky downward”, and may remain mispriced for a long time, harming economic efficiency and potentially requiring a costly inflation to adjust. (Makes you wonder why the Fed was so blasé about home-price inflation, as house prices are sticky downward as well.) I’m open to arguments that failing to accommodate expectations may be as damaging as inflation, and that the Fed would prefer not to be put in the bind of having to choose between the two. But, given a regime that in practice sees relative price increases as tolerable for anything other than wages, is it surprising that workers’ share of GDP has been relentlessly falling, while the share going to corporate profits has been rising? Are there no stable monetary regimes that wouldn’t bias the game against wage earners?

p.s. another reason i really like Dani Rodrik’s blog are two of his tags: Economist’s blindspots and (it only seems fair) Non-economist bloopers.

p.p.s. knzn has a nice post that reminds us that debt is money, and that a government that increases its debt over time indefinitely through fiscal policy ought produce monetary inflation (as opposed to relative price changes) as effectively as the Fed’s printing press. knzn might correct me, but I think increases in sufficiently liquid private sector debt would count as increases in money in his model, provoking inflation as well.

Dutch Disease in the USA

It may be strange to say it, but the financial sector in the US has come to resemble the oil industry.

Traditionally, the financial sector’s role has been informational and intermediary — capital markets, rating agencies, insurers, investment banks, brokerages, and savings institutions all observe economic facts, convert weighings of risk and reward into estimations of value, and grease the conduits through which investors purchase claims on firms at prices consistent with those valuations. Sure, every day since the first hustler stood under a buttonwood tree on lower Manhattan, there has been scandal. But the financial sector as a whole has been something of a humdrum affair, an old fashioned sort of eBay where suppliers and demanders of capital meet on roughly even terms, and marketmakers take a small cut for their troubles.

Over the past few years, though, the financial sector’s role has changed owing to a single, simple fact. Debt has been mispriced. It is too expensive. Purchasers of debt, the lenders, have not asked their agents on Wall Street (or in the City) to drive a hard bargain for them. They’ve simply offered to purchase a wide variety of debt at whatever the going price is, regardless of whether that price has been inflated by the impact of their own continuous demand. Who are these easygoing lenders? Read Brad Setser a lot and you’ll figure it out. But we don’t much care. All that matters is that they are foreign. Americans aren’t the ones overpaying for debt.

The mispricing of debt has created richer opportunities on Wall Street than taking small cuts off of essentially fair deals. Instead, the difference between the “right” price of a debt security by traditional valuation models and what price-insensitive purchasers are willing to pay has become a source of profit. This is one way that Wall Street has come to look like the oil industry. Just as Shell profits from the spread between what it costs to extract oil and what the market will pay for it, financial firms now profit from the difference between the interest rates a fair borrower would expect to pay and the unusually low interest rates lenders are actually receiving. That spread is taken in a lot of pieces. A large fraction of it is taken by the borrowers themselves, and the rest is divided among financial intermediaries. But like oil wealth, from the perspective of the domestic economy, that entire spread is free money. It is real wealth, exchangeable for external goods and services, that is not taken from any domestic player.

Debt is similar to oil also in the sense that it must be prospected before it can be extracted, refined, manufactured, or sold. Wall Street knew it had a potential fountain of wealth when it discovered limitless, price-insensitive demand for debt. But in order to actually drink from that fountain, players had to produce debt to supply that demand. And that’s not easy. Foreign purchasers of debt may be price-insensitive, but they won’t buy just anything. They won’t cut a check to your grandma in exchange for a handwritten IOU. They want liquid debt securities with good ratings, maybe government or agency-backed, etc. The wildcatters of today’s great debt rush are the innovators who find ways to supply that voracious demand, and thereby get a piece of that rich spread. Innovation is not dead in America, and the variety of techniques and schemes out there for getting a cut from debt-mispricing is enormous. They include the much ballyhooed excesses of the mortgage industry (persuade people to borrow and refi as much as possible against homes, concede great rates to sophisticated borrowers but get what you can from fools, securitize all the paper in a form that price-insensitive buyers will take or that price-sensitive buyers find more appealing than overpriced alternatives). The current private-equity and M&A booms are means of manufacturing borrowers who profit from the sale of overpriced debt. Abnormal returns to hedge-funds result from leverage taken on at costs not commensurate with the risks. The alphabet soup of structured finance. The list goes on and on. (As a side-effect, in order to capture the surplus created by the mispricing of debt, American firms and households have had to borrow more money than they might have otherwise. That creates risks, but that’s not our concern here.)

The result of all this activity for the American economy has not been dissimilar to what natural gas famously did for the Dutch in the Sixties. The sudden, exogenous wealth in a single tradable (debt) provokes capital inflows that bolster America’s currency, and hurt the competitiveness of other US industries in world markets. [1] Labor markets begin to skew towards the booming tradable sector (debt and finance), while layoffs mount in other tradables industries. Nontradable services surge from the injection of exogenous wealth, and are drawn to serving the booming finance sector, the source of it all.

All in all, I think it is accurate to claim right now that the United States is suffering from “Dutch Disease”, with a little twist. America’s “resource curse” doesn’t come from some newfound ocean of oil. (Thank goodness for that.) Our curse is that our paper is suddenly unusually valuable, and that we are skewing our economy towards mining, packaging, and exporting ever more of the stuff. Unlike oil, our capacity to produce paper will never be exhausted. But the strange circumstance whereby American IOUs command a high price in real goods from abroad may end as suddenly as it began. Or it may continue for a long time. A repricing of US paper is an event far less predictable than the exhaustion of an oilfield. Unfortunately, our capital markets don’t seem to know how to price or hedge that kind of risk.

It is nice, in the moment, to be overpaid for something. But I hope we are not overpaid for too long. A resource curse is still a curse.

Update: A quick Google search indicates this is not a novel idea. An anonymous reader of Steve Sailor’s website makes the same point, more sharply and concisely than I have, and in January 2005! (You’ll have to search for “dutch” to find it on the long page; the direct link is broken. I think the anonymous reader’s piece on Dutch Disease is quite good, but don’t endorse the rest of the content.)

[1] An obvious, and true, objection is that the US dollar has been depreciating against currencies that float, not appreciating. But the capital inflows — the purchases of overpriced debt — are coming from countries that control their dollar exchange rates. The argument is that dollar’s nominal stability represents an appreciation, given that increases in the relative purchasing power of currencies from the debt-purchasing nations fail to result in the expected nominal dollar decline.

Update History:
  • 26-Apr-2007, 3:10 p.m. EDT: Added update with reference to an earlier piece quite similar to this found via Google.

Forests often missed for the trees

Here are two comments from professional economists that are delightful, because they state plain and obvious truths that most professional economists won’t fess up to. Dean Baker and Brad DeLong are both wonderful writers and thinkers. (Though I do sometimes taunt them, as here. Everyone deserves a good taunting now and again.)

First, Dean Baker on China:

Measurements of PPP are very imprecise, but China already dwarfs the U.S. as a producer of steel, gives out more college and advance degrees in science and engineering each year, has more cell phone users and almost as many Internet users. Does this sound like an economy that is one fifth the size of the U.S. economy (the relative GDPs using the exchange rate measure)?

Baker notes that “if China sustains a 10 percent growth rate, it will pass the U.S. as the world’s largest economy some time in 2010.”

Brad DeLong comments on financial markets:

I think we are pretty certain why the configuration of asset prices does not match our economists’ intuitions about what asset prices should be in a world of well-functioning markets given our estimates of preferences and technologies. It doesn’t match because our financial markets are not well-functioning. They do a lousy job of mobilizing the risk-bearing capacity of society. And they appear to be profoundly myopic in the sense that average opinion has a hard time peering into the future when calculating what average opinion expects average opinion to be. As I result, I think, we shouldn’t be surprised that there are asset pricing puzzles out there… And we shouldn’t take those puzzles to disable our ability to think long-term about issues like global warming.

DeLong’s “we” suggests there is a consensus in his profession that financial markets are poorly functioning and myopic. I wish I believed that were true. If it were true, rather than chiding reform of other countries’ financial systems, there would be a consensus that we ought to reform our own. Our financial markets are making consequential, long-term decisions for us. And they are erring.

Carry Trade in Wonderland

Morning after note: This post is a good example of why booze and blogging shouldn’t mix.

I’m a bit drunk. I’m supposed to be working, but my wife is a tease, she’s plying me with red wine, telling me, “Go! Take your laptop and work! You know I can’t help but distract you if you’re here!” She promises to take back the wine. The wine is still here, next to my keyboard. Well, half of it is still here.

Maybe it’s just the wine, my space-time continuum starts to go all lava-lampy when I read stuff like this Bloomberg article.

Pound Rallies Above $2 for First Time Since 1992 on Inflation

By Aaron Pan and Agnes Lovasz

April 17 (Bloomberg) — The pound leapt above $2 for the first time in 15 years as a U.K. report showed inflation unexpectedly quickened, prompting traders to bet the Bank of England will raise interest rates twice more this year.

Now, back when I was studying this stuff, I learned that, ceteris paribus (as the big dogs say), high inflation means a weak currency. After all, the cost of peanuts must be the same everywhere. If the price of peanuts in Liverpudlian pounds doubles, but the price in dollars stays the same, that means a dollar is worth twice as many pounds, no? Sure the “arb” (as the fast dogs whine) in peanuts is less than liquid, transaction costs are high with all that moisture and aflatoxin on the high seas. But still. Remember hyperinflationary currencies? They were never the rage with the FX and cocaine crowd.

But, truly, this is the new millennium. Inflation, it seems is the best thing ever that could happen to a currency. Now I’m not complaining. I own a few Liverpudlians meself, thank-yuh-very-much. Can I buy you a drink?

But let’s think this through, shall we? Here inside the rabbit hole high inflation provokes a rise in the nominal exchange rate. Now maybe this is old-think, but I used to learn that inflation, if not accompanied by an expected depreciation in nominal FX, amounts all on its own to an increase in the real exchange rate. Inflation plus nominal appreciation, that’s like a double whammy, coffee-grounds and meth snorted through a likeness of the Queen, from a real-exchange rate perspective. Not that I’d know. Anyway. The real value of a Brit’s salary has shot to levels formerly associated with Russian businessman. I heard on the radio that beggars from Kings Cross were hopping “the pond” on a week’s score of spare change just for the unforgettable, if unprofitable, experience of panhandling Park Avenue.

That’s all well and good. I like visitors, and their accents are charming. But, I’d like to be rich too. That’s why I’m asking Ben Bernanke to SIN. That is, “Surge Inflation Now!” Since the value of a dollar now increases with inflation, dat’s like mintin’ free money for the people!

Okay. I know. If Big Ben were to drop rates, the Carry Traders of Wonderland would flee. No, he’d have to be more subtle. Manufacture inflation by purchasing long bonds, hold the FF rate high by selling short-duration debt. No one cares about an inverted yield curve no more anyway. Ben’s a smart guy. He can make inflation and high interest rates all at once. Dr. Helicopter, or how I learned to love stagflation. He could just enlist GWB to spend more cash on “domestic initiatives”, while the man clucks sternly and “tightens”. Loose fiscal, tight monetary. That’d work too. It’s so orthodox.

Sure. Okay. There’d be no investment here. It’d be rough for business with those high rates and all. But we don’t need no stinking investment. We can buy stuff really cheap from “emerging markets”. What a wonderful world!

Now this sweet Kentucky wine may not be as good as I’d hoped. Because I’m already beginning to think about the hangover. If inflation rates and nominal exchange rates are now mutually reinforcing (thanks to our modern, sophisticated central banks, envy of the world), what would happen if we really did, you know, get inflation under control? The Fed would drop rates, our carry trade friends would sell our money, start using the greenback (or the pound) for funding rather than carry. We’d look just like Japan. Except they still know how to manufacture and sell stuff, so that even when their money is worthless, they can earn a lot of other peoples’ money. We Americans (#1, yo), and you Brits too, we won’t have that luxury. All we make is paper, the glossy kind, ‘cuz we stuck a tariff on China. So there.

But that’s tomorrow, and my bottle isn’t empty. A hangover is just bad science fiction until you actually wake up. In the meantime, god bless the carry trade! Let’s have more inflation! More sticky nominal rates (viz the countries that actually make stuff). More free money seeking yield! Let’s light it all on fire and suck it through a straw. Purchasing power parity is an urban myth, a wives tale told by fuddyduddies just to keep us from having fun. Be a scientist. Run a regression. In this new millennium, a peanut in Peoria can purchase a peasant in Patpong, that’s just how it is, learn to live with it, learn to love it, have a good time. They be some funky peasants in Patpong. Just get into that. Sanctimoious cant about sustainability, or justice, that stuff is just a downer. I hate thinking about that stuff.

My wife just poured me another glass. Sweet, cheap, Kentucky wine. I tried to say no. Really I did. Oh well.

Update History:
  • 20-Apr-2007, 12:20 p.m. EDT: Minor spelling and grammer fixes. This entire piece is an embarrassment, though. Added “Morning After Note”.

Derivatives: A Catechism

Felix Salmon and Jesse Eisinger are having a little debate on whether we should worry about derivatives. Regular readers should be able to guess that, yes, I think we should worry. Regular readers should also write me with tips on dietary fiber.

“Derivative” is a vague term that covers everything from options and futures traded on public exchanges to interest-rate swaps and credit-quality bets negotiated in private. Two features unite all derivatives: 1) They are contracts that compel cash-flows between two parties based on changes in the price of some underlying security or asset; and 2) The theoretical justifications for their use have been far outpaced by developments in real-world markets. What follows is a catechism for the virtuous, that you may use to correct error in those who have been led astray, and to protect yourself when confronted by those who would deceive you into some state other than sheer panic.

Question: Do we need to worry that the “notional principal” of derivatives outstanding is several times the wealth of the entire world? Isn’t “notional principal” meaningless, since actual cash flows between parties are mere fractions of this principal?

It is true that, when everything goes right, most derivatives compel cash flows that are small fractions of notional principal per year. But some common and ever-more-popular derivatives (e.g. CDSs, forwards and futures) can provoke sharp cash flows whose magnitude approaches the notional liabilities. More importantly, even “balanced” derivatives like vanilla fixed/floating interest rate swaps can subject parties to liability for the full notional principal, should one party default and enter bankruptcy, if the lawyers haven’t been careful to write watertight “netting” agreements. Even where the legalese is solid, the credit-risk assumed by the “in-the-money” party to a derivative contract is proportional to notional principal. The hazard associated with a large notional principal is not primarily associated with the cash-flows that would be triggered by parties fulfilling their contractual obligations. Notional principal is a measure of the mayhem that would result should counterparties fail to meet their obligations in significant numbers.

Question: Isn’t much of the so-called notional principal is tied up in offsetting positions that cancel one another? Doesn’t that mitigate the risk?

No, not really. Offsetting increases credit risk, whereas genuinely closing positions diminishes it. Consider the following scenario: You and I enter into an interest rate swap with a notional principal of a billion dollars. I’m going to receive a fixed rate of interest for five years, and pay LIBOR to you, on that notional billion. After two years, the market has moved against me, the fixed rate I’m receiving is low compared to market rates, and I think it’s only going to get worse. I want out, and am willing to pay you the market value of your “in-the-money” position to escape. But you are a bastard. We had a five year deal, you say, and cackle evil-ly. So what do I do? I go to someone else, who agrees to pay me LIBOR on 1B, and I pay a (high) fixed rate, offseting the original contract and locking in my loss at a value equivalent to what I should have had to paid you to cancel the contract, if you hadn’t been a bastard. That is what offsetting means. The notional principal outstanding is now 2B, as there are two 1B swaps in play. But “really” there is only one swap between you and my new counterparty. I’m just a middle-man who passes funds along, but I no longer have any sensitivity to changes in interest rates. So, the 2B of notional principal is overstated, right? Well, let’s compare credit risk in the two scenarios. Originally, you were only exposed to my credit risk — I might go under, and be unable to make continued payments to you, depriving you of your gains. (Absent a netting agreement, I might even deprive you of the notional principal.) Now, you are exposed to my credit risk, and that of my new counterparty. That’s not true, you say. If my new friend goes under, that’s not your problem. It’s still me you have on the hook. Technically, that’s right. But in reality, since I’ve already booked a fixed loss and moved on, I may have taken on a lot of new leverage elsewhere. When my counteraparty defaults, and the “offset” contract comes at me like a ghost, it will hit you as well, my friend. Complicated networks of offsetting positions increase the likelihood that a credit event involving one market participant will cause cascading problems for other participants who may not have known they had such complicated exposure. An intelligent market would not have man-in-the-middle offsets, but would find ways to close out exposures. Public futures markets, designed so that contracts are written against a central clearing house, have this worthy feature. Those trillions and trillions in outstanding swaps do not, so offsetting positions contribute both to notional principal and systemic credit risk.

Question: Derivative markets are a zero-sum game, right? Somebody’s gain is somebody else’s loss, wealth is never destroyed, only moved around, right? Why should we care which “play-ah” wins or loses? In the aggregate, the markets and the public are whole. Right?

Wrong. When a party goes bankrupt and defaults, both parties lose. Absent the possibility of credit events, derivatives are a zero-sum game in terms of cash flow (leaving transaction costs aside). In the real world, where counterparties do sometimes default (and where transaction costs exist), derivatives are a negative sum game. Derivatives proponents are right that in real economic terms, derivatives can add wealth, by enabling economic activity through the sharing and mitigation of risk. But the expected negative value of credit losses and transaction costs must be weighed against the positive value of risk mitigation. When the notional principal of credit default swaps against some firm or issue far exceeds the value of actual bonds outstanding, it’s hard to claim that positive-sum risk mitigation is motivating the trade.

Question: Are derivatives bad?

No. Forwards and futures, options, various swaps and insurance contracts all have their uses, and represent very real innovations. But whatever their value to an individual market participant, their value to the economy in aggregate depends on the degree to which they hedge real economic risks, and is diminished by any credit, valuation, and liquidity risks they introduce. The financial community has done a good job at inventing useful contracts and describing the ways that they could indeed hedge real risks. The community has done a poor job, unfortunately, at cataloging the ways that they introduce new risk, and characterizing the conditions wherein derivative markets are likely to do more harm than good in the aggregate. As participants have focused on the well understood positive side of the ledger and neglected the poorly understood downside, it is unsurprising that these instruments have grown popular. But it should also not be surprising if the ill-defined costs we’ve not bothered to quantify someday turn out to be greater than we can easily afford.

The questions in this catechism are largely inspired by Felix’s defense of the trade. Credit, and clucking, where it is due…

Update: jck of the very excellent Alea takes me to task (in a comment here) for suggesting that vanilla fixed/floating swaps could provoke liability by a party for full notional principal if one party goes bankrupt, absent solid netting agreements. A swap can be viewed as a cross-sale of bonds, and if parties to a swap did write their contracts that way, it is true, as I claimed, that one party to the swap could be left holding the bag for the full notional principal should a counterparty gain bankruptcy protection. But swaps are not typically written like that. My claim is more uncontroversially true with respect to currency swaps, where the “notional principal” is not in fact notional, and must be delivered by the parties, unless some formula for netting is explicit. In any case, I had not intended to rest my argument on lawyers’ mistakes. Even when all i’s are dotted and the netting is good, notional principal matters, as it determines the size of the credit risk the winning side of a swap will be forced to bear. There is an unknown degree of legal risk out there. Despite the efforts of ISDA and others, swaps and many other derivative arrangements are private contracts with untested idiosyncracies. To the degree there is legal risk, it is proportional to notional principal. But even if legal risk turns out to be negligible, credit risk — the risk that parties will fail to meet even fully netted cash flows — is undeniable, and proportional to notional principal outstanding.

It’s also worth noting that in an essay about “derivatives” writ large, “notional principal” is a very imprecise term. For swap within a single currency, it’s fairly clear what “notional principal” means. In a currency swap, or a swap synthesized via offsetting bond agreements, the principal is not notional at all, but might still be referred to that way. With respect to forward contracts, futures, and options, notional principal is simply an incorrect term. One might talk about “open interest”. I use the term “notional principal” in this essay loosely to mean the value of the underlying assets upon which derivative cash flows are based.

Update History:
  • 18-Apr-2007, 1:20 p.m. EDT: Changed “I’m no longer have…” to “I no longer have…”
  • 19-Apr-2007, 1:31 a.m. EDT: Added an explanatory update, in response to comments by jck.
  • 19-Apr-2007, 8:46 a.m. EDT: Changed “single currency swap” to “swap within a single currency” in he update, for clarity.

Mommy, when I die…

…can I go and live where the economists live? It must be a Better Place.

I like Brad DeLong. I really do. But, this is “grasping reality with both hands”?

You see, trade balances. What we buy equals what we sell, in value. What we buy and what we sell can be goods, services, or property, but it balances. If we have a comparative advantage in nothing — and export nothing — then we necessarily have a comparative disadvantage in nothing — and import nothing. Trade is thus an opportunity for us to move workers out of occupations where we are least and into occupations where we are most productive.

Now, don’t get me wrong. I’m a believer. I’m sure that, eventually, trade does balance. Moments — like now — where it does not are imperceptible flashes beneath the serenity of the stars. Just a comma, you might say.

But, you know, a nanosecond in the eyes of God is long enough for many of the former comparative advantages of a few little countries to, you know, disappear.

“Balderdash!”, the economists will tell you, from their better place. Comparative advantage can never disappear. That is what the weasel-word “comparative” is about. Look on the bright side! If you are comatose and drooling, you have a real opportunity-cost advantage! Your comparative advantage as a human paper-weight is unassailable!

When the “comparative advantage” of the places in the world accustomed to considering themselves wealthy, enlightened, and civilized shifts from inventing stuff and building airplanes to the supply of migrant labor, back-office services, and environmentally costly natural resources, we will thank the economists for their foresightedness. For they are already in a better place, and as it is written, in the long run, we are all dead.

Update History:
  • 3-Apr-2007, 2:32 p.m. EDT: Changed an ungrammatical “much” to “many”.

Does it matter what currency oil is priced in?

It’s a perennial question attached to a conspiracy theory. Does the United States reap some great advantage owing to the fact that oil is priced and traded in dollars?

The naive conspiracy theory is concisely described by Dave Chiang (commenting on Brad Setser’s blog):

World trade is now a game in which the US produces dollars and the rest of the world produces things that dollars can buy. The world’s interlinked economies no longer trade to capture a comparative advantage; they compete in exports to capture needed dollars to service dollar-denominated foreign debts and to accumulate dollar reserves to sustain the exchange value of their domestic currencies.

This phenomenon is known as US dollar hegemony, which is created by the geopolitically constructed peculiarity that critical commodities, most notably oil, are denominated in dollars. Everyone accepts dollars because dollars can buy oil. The recycling of petro-dollars is the price the US has extracted from oil-producing countries for US tolerance of the oil-exporting cartel since 1973. By definition, dollar reserves must be invested in US assets, creating a capital-accounts surplus for the US economy.

The standard rejoinder, described recently by Steven Kyle (and with which I mostly agree), is that it absolutely doesn’t matter what currency a commodity is priced in, so long as there are liquid FX markets. If the US prints dollars, that doesn’t result in creating new buying power for oil as the dollar hegemonists assert. The newly printed greenbacks simply reduce the value of a dollar in terms of oil and other currencies, driving up the dollar price of oil, but not its effective price in euro or yen. Rational third-parties with a need to purchase oil or commodities would not accumulate dollars under these circumstances. They would accumulate assets expected to hold their value, and purchase oil by converting to dollars transiently on an as-needed basis.

Brad Setser recently took up the question. While not disagreeing with the standard argument, his take is that it might, in fact, matter a bit that oil is priced in dollars, if one considers that oil exporting nations peg their currencies to the dollar. It is dollars that are wired into oil exporting countries; policymakers would have to proactively trade to convert those dollars into some other currency or commodity. They could sell those dollars for euros, for example. But that would weaken the dollar against the euro, and by extension the buying power of their own currencies for the European goods they consume. So they don’t, and hold more dollars than they might have, if they hadn’t been paid in dollars.

Brad’s argument is subtle and interesting, though it’s worth pointing out that it is fundamentally a political or behavioral-finance explanation rather than one based on rational actors. Dollar-pegged oil exporters who wish to maintain the buying power of the dollar against the euro ought to be indifferent to the currency for which their oil is initially sold. Receiving euros and selling hem for dollars would be equivalent to receiving dollars in the first place and just holding them. Brad’s argument hinges on status quo bias — that oil importers are willing to enhance the buying power of their currencies by not acting in ways that they would not if the same policy required affirmative market interventions.

There is another subtle reason why I think it does matter, some, that oil is priced in dollars: Firms who hedge oil price risk in public markets are required, by the fact that the contracts are written in dollars, to take on USD currency risk, which they may hedge by accumulating dollars. Consider, as an example, a medium-sized European firm in an energy-intensive manufacturing industry. The firm wishes to take on no speculative position with respect to the future price of oil, but it does wish to plan for profitable operations over the next year. To avoid the risk that a spike in the price of oil would send it into the red, this sort of firm is likely to purchase oil forward, using public futures markets, effectively locking in a known price today for the coming year’s energy needs. Since the futures contracts are USD denominated, though, the firm has locked in a price in dollars, although its accounts and expenses are in euro. The firm has exchanged oil price risk for USD price risk. It must now hedge the latter, either by purchasing and holding sufficient dollars to cover the USD prices it has locked in, or by purchasing USD/EUR futures (which only shifts the USD/EUR price risk to some other party, who will need to hedge by holding dollars).

So, in fact, I think the dollar hegemonists have a bit (but just a bit) of a point with respect the the denomination of oil and other commodity contracts. To the degree that commodities are purchased forward by actors primarily concerned with hedging risk (rather than maximizing return via speculation), the currency in which futures contracts are traded determines the currency they will have to accumulate to fund their purchases.

But I don’t think this argument holds much water as an explanation for central bank USD reserve growth. It only makes sense to the degree that entities have binding forward obligations in the currencies they are accumulating. Even if one considers nations as consolidated entities, and let central banks implicitly hedge the risks of private commodity consumers, I’m pretty sure that the scale of emerging-market reserve accumulation dramatically outstrips any plausible estimate of forward purchases. (If anyone has decent data, country-by-country foreign purchases of USD-denominated commodities, it would be fun to run some regressions, though.)

Update History:
  • 31-Mar-2007, 2:32 p.m. EDT: Small gramatical and punctuation clean-ups. Added the phrase “…and just holding them” to clarify the equivalence between oil-exporters buying dollars under euro-priced oil and holding dollars under dollar-piced oil.