Capital Flows and Currency Exchange

Posted by PITHOCRATES - March 10th, 2014

Economics 101

(Originally published July 30th, 2012)

Before we buy a Country’s Exports we have to Exchange our Currency First

What’s the first thing we do when traveling to a foreign country?  Exchange our currency.  Something we like to do at our own bank.  Before leaving home.  Where we can get a fair exchange rate.  Instead of someplace in-country where they factor the convenience of location into the exchange rate.  Places we go to only after we’ve run out of local currency.  And need some of it fast.  So we’ll pay the premium on the exchange rate.  And get less foreign money in exchange for our own currency.

Why are we willing to accept less money in return for our money?  Because when we run out of money in a foreign country we have no choice.  If you want to eat at a McDonalds in Canada they expect you to pay with Canadian dollars.  Which is why the money in the cash drawer is Canadian money.  Because the cashier accepts payment and makes change in Canadian money.  Just like they do with American money in the United States.

So currency exchange is very important for foreign purchases.  Because foreign goods are priced in a foreign currency.  And it’s just not people traveling across the border eating at nice restaurants and buying souvenirs to bring home.  But people in their local stores buying goods made in other countries.  Before we buy them with our American dollars someone else has to buy them first.  Japanese manufacturers need yen to run their businesses.  Chinese manufacturers need yuan to run their businesses.  Indian manufacturers need rupees to run their businesses.  So when they ship container ships full of their goods they expect to get yen, yuan and rupees in return.  Which means that before anyone buys their exports someone has to exchange their currency first.

Goods flow One Way while Gold flows the Other until Price Inflation Reverses the Flow of Goods and Gold

We made some of our early coins out of gold.  Because different nations used gold, too, it was relatively easy to exchange currencies.  Based on the weight of gold in those coins.  Imagine one nation using a gold coin the size of a quarter as their main unit of currency.  And another nation uses a gold coin the size of a nickel.  Let’s say the larger coin weighs twice as much as the smaller coin.  Or has twice the amount of gold in it.  Making the exchange easy.  One big coin equals two small coins in gold value.  So if I travel to the country of small coins with three large gold coins I exchange them for six of the local coins.  And then go shopping.

The same principle follows in trade between these two countries.  To buy a nation’s exports you have to first exchange your currency for theirs.  This is how.  You go to the exporter country with bags of your gold coins.  You exchange them for the local currency.  You then use this local currency to pay for the goods they will export to you.  Then you go back to your country and wait for the ship to arrive with your goods.  When it arrives your nation has a net increase in imported goods (i.e., a trade deficit).  And a net decrease in gold.  While the other nation has a net increase in exported goods (i.e., a trade surplus).  And a net increase in gold.

The quantity theory of money tells us that as the amount of money in circulation increases it creates price inflation.  Because there’s more of it in circulation it’s easy to get and worth less.  Because the money is worth less it takes more of it to buy the same things it once did.  So prices rise.  As prices rise in a nation with a trade surplus.  And fall in a nation with a trade deficit.  Because less money in circulation makes it harder to get and worth more.  Because the money is worth more it takes less of it to buy the same things it once did.  So prices fall.  This helps to make trade neutral (no deficit or surplus).  As prices rise in the exporter nation people buy less of their more expensive exports.  As prices fall in an importer nation people begin buying their less expensive exports.  So as goods flow one way gold flows the other way.  Until inflation rises in one country and eventually reverses the flow of goods and gold.  We call this the price-specie flow mechanism.

In the Era of Floating Exchange Rates Governments don’t have to Act Responsibly Anymore

This made the gold standard an efficient medium of exchange for international trade.  Whether we used gold.  Or a currency backed by gold.  Which added another element to the exchange rate.  For trading paper bills backed by gold required a government to maintain their domestic money supply based on their foreign exchange rate.  Meaning that they at times had to adjust the number of bills in circulation to maintain their exchange rate.  So if a country wanted to lower their interest rates (to encourage borrowing to stimulate their economy) by increasing the money supply they couldn’t.  Limiting what governments could do with their monetary policy.  Especially in the age of Keynesian economics.  Which was the driving force for abandoning the gold standard.

Most nations today use a floating exchange rate.  Where countries treat currencies as commodities.  With their own supply and demand determining exchange rates.  Or a government’s capital controls (restricting the free flow of money) that overrule market forces.  Which you can do when you don’t have to be responsible with your monetary policy.  You can print money.  You can keep foreign currency out of your county.  And you can manipulate your official exchange rate to give you an advantage in international trade by keeping your currency weak.  So when trading partners exchange their currency with you they get a lot of yours in exchange.  Allowing them to buy more of your goods than they can buy from other nations with the same amount of money.  Giving you an unfair trade advantage.  Trade surpluses.  And lots of foreign currency to invest in things like U.S. treasury bonds.

The gold standard gave us a fixed exchange rate and the free flow of capital.  But it limited what a government could do with its monetary policy.  An active monetary policy will allow the free flow of capital but not a fixed exchange rate.  Capital controls prevent the free flow of capital but allows a fixed exchange rate and an active monetary policy.  Governments have tried to do all three of these things.  But could never do more than two.  Which is why we call these three things the impossible trinity.  Which has been a source of policy disputes within a nation.  And between nations.  Because countries wanted to abandoned the gold standard to adopt policies that favored their nation.  And then complained about nations doing the same thing because it was unfair to their own nation.  Whereas the gold standard made trade fair.  By making governments act responsible.  Something they never liked.  And in the era of floating exchange rates they don’t have to act responsibly anymore.

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Currencies, Exchange Rates and the Gold Standard

Posted by PITHOCRATES - June 17th, 2013

Economics 101

Money is a Temporary Storage of Value that has no Intrinsic Value

Giant container ships ply the world’s oceans bringing us a lot of neat stuff.  Big televisions.  Smartphones.  Laptop computers.  Tablet computers.  The hardware for our cable and satellite TVs.  Toasters.  Toaster ovens.  Mixers and blenders.  And everything else we have in our homes and in our lives.  Things that make our lives better.  And make it more enjoyable.  These things have value.  We give them value.  Some have more value to one than another.  But these are things that have value to us.  And because they have value to us they have value to the people that made them.  Who used their human capital to create things that other people wanted.  And would trade for them.

When we first started trading we bartered with others.  Trading things for other things.  But as the economy grew more complex it took a lot of time to find someone who had what you wanted AND you had what they wanted.  So we developed money.  A temporary storage of value.  So we could trade the valuable things we created for money.  That money held the value of what we created temporarily while we looked for something that we wanted.  Then we exchanged the money we got earlier for something someone had.  It was just like trading our thing for someone else’s thing.  Only instead of spending weeks, months even years meeting hundreds of thousands of people trying to find that perfect match we only needed to meet two people.  One that exchanges money for the thing we have that they want.  And another who has what we want that they will exchange for our money.  Then that person would do the same with the money they got from us.  As did everyone else who brought things to market.  And those who came to market with money to buy what others brought.

Money is a temporary storage of value.  Money itself doesn’t have any intrinsic value.  Consider that container ship full of those wonderful items.  Now, which would you rather have as permanent fixtures in your house?  Those wonderful things?  Or boxes of money that just sit in your house?  You’d want the wonderful things.  And if you had a box of money you would exchange it (i.e., go out shopping) for those wonderful things.  Because boxes of money aren’t any fun.  It’s what you can exchange that money for that can be a lot of fun.

Devaluing your Currency boosts Exports by making those Goods less Expensive to the Outside World

So there is a lot of value on one of those container ships.  Let’s take all of that value out of the ship and place it on a balancing scale.  Figuratively, of course.  Now the owner of that stuff wants to trade it for other stuff.  But how much value does this stuff really have?  Well, let’s assume the owner is willing to exchange it all for one metric ton of gold.  Because gold is pretty valuable, too.  People will trade other things for gold.  So if we put 1 metric ton of gold on the other side of the balancing scale (figuratively, of course) the scale will balance.  Because to the owner all of that stuff and one metric ton has the same value.  Of course moving a metric ton of gold is not easy.  And it’s very risky.  So, instead of gold what else can we put on that scale?  Well, we can move dollars electronically via computer networks.  That would be a lot easier than moving gold.  So let’s put dollars on the other side of that scale.  Figuratively, of course.  How many will we need?  Well, today gold is worth approximately $1,380/troy ounce.  So after some dimensional analysis we can convert that metric ton into 32,150 troy ounces.  And at $1,380/troy ounce that metric ton of gold comes to approximately $44.4 million.  So that container ship full of wonderful stuff will balance on a scale with $44.4 million on the other side.  Or 1 metric ton of gold.  In the eyes of the owner they all have the same value.

Moving money electronically is the easiest and quickest manner of exchanging money for ships full of goods.  These ships go to many countries.  And not all of them use American dollars.  But we can calculate what amounts of foreign currency will balance the value of that ship.  Or one metric ton of gold.  By using foreign exchange rates.  Which tell us the value of one currency in another currency.  Something that comes in pretty handy.  For when, say, an American manufacturer sells their goods they want American dollars.  Not British pounds.  Danish kroner.  Or Russian rubles.  For American manufacturers are in the United States of America.  They buy their materials in American dollars.  They pay their employees in American dollars.  Who pay their bills in American dollars.  Go shopping with American dollars.  Etc.  For everyday American transactions the British pound, for example, would be un-useable.  What these American manufacturers want, then, are American dollars.  So before a foreigner can buy these American exports they must first exchange their foreign currencies for American dollars.  We can get an idea of this by considering that container ship full of valuable stuff.  By showing what it would cost other nations.  The following table shows a sampling of foreign exchange rates and the exchanged foreign currency for that $44.4 million.

foreign currencies and exchange rates

If we take the US dollars and the Exchanged Currency for each row and place them on either side of a balancing scale the scale will balance.  Figuratively, of course.  Meaning these currencies have the same value.  And we can exchange either side of that scale for that container ship full of valuable stuff.  Or for that metric ton of gold.  Why are there such large differences in some of these exchange rates?  Primarily because of a nation’s monetary policy.  Many nations manipulate their currency for various reasons.  Some nations give their people a lot of government benefits they pay for by printing money.  Which devalues their currency.  Some nations purposely devalue their currency to boost their export sector.  As the more currency you get in exchange for your currency the more of these exports you can buy.  Most of China’s great economic growth came from their export sector.  Which they helped along by devaluing their currency.  This boosted exports by making those goods less expensive to the outside world.  But the weakened yuan made domestic goods more expensive.  Because it took more of them to buy the same things they once did.  Raising the cost of living for the ordinary Chinese.

The Gold Standard made Free Trade Fair Trade

Some economists, Keynesians, approve of printing a lot of money to lower interest rates.  And for the government to spend.  They think this will increase economic activity.  Well, keeping interest rates artificially low will encourage more people to buy homes.  But because they are devaluing the currency to keep those interest rates artificially low housing prices rise.  Because when you devalue your currency you cause price inflation.  But it’s just not house prices that rise.  Prices throughout the economy rise.  The greater the inflation rate (i.e., the rate at which you increase the money supply) the higher prices rise.  And the less your money will buy.  While the currencies at the top of this table will have exchange rates that don’t vary much those at the bottom of the table may.  Especially countries that like to print money.  Like Argentina.  Where the inflation is so bad at times that Argentineans try to exchange their currency for foreign currencies that hold their value longer.  Or try to spend their Argentine pesos as quickly as possible.  Buying things that will hold their value longer than the Argentine peso.

Because printing fiat money is easy a lot of nations print it.  A lot of it.  People living in these countries are stuck with a rapidly depreciating currency.  But international traders aren’t.  If a country prints so much money that their exchange rate changes every few minutes international traders aren’t going to want their currency.  Because a country can’t do much with a foreign currency other than buy exports with it from that country.  A sum of highly depreciated foreign currency won’t buy as much this hour as it did last hour.  Which forces an international trader to quickly spend this money before it loses too much of its value.  (Some nations will basically barter.  They will exchange their exports for another country’s exports based on the current exchange rate.  So that they don’t hold onto the devalued foreign currency at all.)  But if the currency is just too volatile they may demand another currency instead.  Like the British pound, the euro or the American dollar.  Because these stronger currencies will hold their value longer.  So they’ll buy this hour what they bought last hour.  Or yesterday.  Or last week.  There is less risk holding on to these stronger currencies because Britain, the European Central Bank and the United States aren’t printing as much of their money as these nations with highly devalued currencies are printing of theirs.

This is the advantage of gold.  Countries can’t print gold.  It takes an enormous expense to bring new gold to the world’s gold supply.  It’s not easy.  So the value of the gold is very stable.  While some nations may devalue their currencies they can’t devalue gold.  A nation printing too much money may suffer from hyperinflation.  Reducing their exchange rate close to zero.  And when you divide by a number approaching zero the resulting amount of currency required for the exchange approaches infinity.  Weimar Germany suffered hyperinflation.  It was so bad that it took so much money to buy firewood that it was easier and less expensive to burn the currency instead.  This is the danger of a government having the ability to print money at will.  But if that same country can come up with a metric ton of gold that person with the container ship full of wonderful stuff would gladly trade it for that gold.  Even though that person will not trade it for that country’s currency.  This was the basis of the gold standard in international trade.  When nations backed their currencies with gold.  And kept them exchangeable for gold.  Forcing nations to maintain stable currencies.  By maintaining an official exchange rate between their currency and gold.  If that nation devalued its currency the market exchange rate will start to move away from the official exchange rate.  For example, say the official rate was $40/troy ounce.  But because they printed so much of their currency they devalued it to where it took $80 to buy a troy ounce on the open market.  So a nation could take $80 dollars of that devalued currency and exchange it for 2 troy ounces of gold from that nation.  The official exchange rate forcing the nation to give away 2 troy ounces of gold for $80 when the real market exchange rate would only have given them 1 troy ounce.  So devaluing your currency would cause gold to flow out of your country.  And the only way to stop it would be to decrease the size of your money supply.  Undoing the previous inflation.  To bring the market exchange rate back to the official exchange rate.  Which is why the gold standard worked so well for international trade.  Nations could not manipulate their currency to get a trade advantage over another nation.  Making free trade fair trade.  Something few say today.  Thanks to currency manipulators like China.

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The U.S. and Japan assailed Argentina’s Mercantilist Trade Policies at the World Trade Organization

Posted by PITHOCRATES - August 26th, 2012

Week in Review

International trade can be a funny thing.  For mercantilist ways of the past are hard to give up.  Especially the misguided belief that a trade deficit is a bad thing.  Some nations are better at some things than other nations.  And have a comparative advantage.  And it would be foolish to try and produce something another nation can produce better.  It would be better for nations to do the things they are best at.  And import the things that others are better at.  Just as David Ricardo proved with his law of comparative advantage.  Still everyone still wants to export more than they import.  Still believing that their mercantilist policies are superior to the capitalistic policies that are characteristic of advanced economies.  While mercantilist policies can rarely advance beyond emerging economies.  Case in point Argentina (see Argentina says to file WTO complaint against U.S by Tom Miles and Hugh Bronstein posted 8/21/2012 on Reuters).

The United States and Japan assailed Argentina’s import rules as protectionist at the World Trade Organization on Tuesday, putting more pressure on the country to revamp policies that many trading partners say violate global norms.

The two complaints mirrored litigation brought by the European Union in May and triggered a swift reaction from Argentina’s center-left government, which vowed to challenge U.S. rules on lemon and beef imports.

Argentina is seen by many fellow Group of 20 nations as a chronic rule-breaker since it staged the world’s biggest sovereign debt default in 2002. It remains locked out of global credit markets and relies on export revenue for hard currency.

They have inflated their currency so much that it is nearly worthless.  They can get little of foreign currency in exchange for it.  So they depend on the foreign currency buying their exports for their money needs.  For they can’t destroy foreign currency with their inflationary policies.  Only the wealth and savings of those in Argentina who don’t have access to these foreign currencies.

In the old days the mercantilist empires brought gold and silver into their countries.  They had their colonies ship raw material back to the mother country.  The mother country manufactured them into a higher valued good.  Then exported it for gold and silver.   Today we don’t use gold and silver anymore.  So Argentina just substituted foreign currency into the formula.  While keeping the rest of it in place.

Argentina began requiring prior state approval for nearly all purchases abroad in February. Imports have since fallen compared with last year’s levels, boosting the prized trade surplus but causing some shortages of goods and parts and sharply reducing capital goods imports.

EU and U.S. officials say Argentina has effectively restricted all imports since the new system came into place…

On Monday, Argentina hit the EU with a separate WTO complaint, alleging discriminatory treatment by Spain against Argentine shipments of biodiesel.

“This measure, like others taken by the European Union and other developed countries for decades, effectively aims to keep our industries from rising along the value chain, limiting the role of developing countries to the provision of raw materials,” the Foreign Ministry said in a statement…

Latin America’s No. 3 economy relies heavily on a robust trade surplus, which is used to help fatten central bank foreign reserves tapped to pay government debt. The government has also moved to curb imports to protect local jobs, while imposing capital and currency controls to keep dollars in the country.

“Import growth has halted, which we should have done long before,” Foreign Trade Secretary Beatriz Paglieri was quoted as saying on the presidential website last weekend…

Argentina has also been criticized for a policy of “trade balancing,” which forces an importer to guarantee an equal value of exports. That has spawned offbeat deals whereby a car producer, for example, must ship a large amount of rice out of the country in return for a consignment of vehicle components.

Mercantilist to the core.  Which will forever trap them into being an emerging economy.  For they’ve been doing this for decades.  And they’re still an emerging economy.  Juan Peron rose to power with the same mercantilist arguments.  He was a Justicialist.  Today’s president is a Justicialist.  President Cristina Fernandez.  And little has changed since World War II.  Argentina is still an emerging economy.  Thanks to their mercantilist policies.  If they’d only give capitalism a chance their economy would explode with economic activity.  At least, based on history.  For the most advanced economies today are NOT based on the current Argentine model.  They’re based on the free trade of capitalism.  And David Ricardo’s comparative advantage.

In countries with free trade people enjoy higher standards of living.  Their governments give them this good life by doing as little for them as possible.  Letting the free market shower them with wealth and happiness.  Which brings us back to the funny part about international trade.  The countries that try to do the most for their people by restricting free trade give their people a lower standard of living.  Except, of course, for the few in power.  Or for those connected to power.

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Federal Reserve System, Great Depression, Banking Crises, Gold Reserves, Gold Exchange Standard, Interest Rates and Money Supply

Posted by PITHOCRATES - July 31st, 2012

History 101

The Gold Exchange Standard provided Stability for International Trade

Congress created the Federal Reserve System (the Fed) with the passage of the Federal Reserve Act in 1913.  They created the Fed because of some recent bad depressions and financial panics.  Which they were going to make a thing of the past with the Fed.  It had three basic responsibilities.  Maximize employment.  Stabilize prices.  And optimize interest rates.  With the government managing these things depressions and financial panics weren’t going to happen on the Fed’s watch.

The worst depression and financial panic of all time happened on the Fed’s watch.  The Great Depression.  From 1930.  Until World War II.  A lost decade.  A period that saw the worst banking crises.  And the greatest monetary contraction in U.S. history.  And this after passing the Federal Reserve Act to prevent any such things from happening.  So why did this happen?  Why did a normal recession turn into the Great Depression?  Because of government intervention into the economy.  Such as the Smoot-Hawley Tariff Act that triggered the great selloff and stock market crash.  And some really poor monetary policy.  As well as bad fiscal policy.

At the time the U.S. was on a gold exchange standard.  Paper currency backed by gold.  And exchangeable for gold.  The amount of currency in circulation depended upon the amount of gold on deposit.  The Federal Reserve Act required a gold reserve for notes in circulation similar to fractional reserve banking.  Only instead of keeping paper bills in your vault you had to keep gold.  Which provided stability for international trade.  But left the domestic money supply, and interest rates, at the whim of the economy.  For the only way to lower interest rates to encourage borrowing was to increase the amount of gold on deposit.  For with more gold on hand you can increase the money supply.  Which lowered interest rates.  That encouraged people to borrow money to expand their businesses and buy things.  Thus creating economic activity.  At least in theory.

The Fed contracted the Money Supply even while there was a Positive Gold Flow into the Country

The gold standard worked well for a century or so.  Especially in the era of free trade.  Because it moved trade deficits and trade surpluses towards zero.  Giving no nation a long-term advantage in trade.  Consider two trading partners.  One has increasing exports.  The other increasing imports.  Why?  Because the exporter has lower prices than the importer.  As goods flow to the importer gold flows to the exporter to pay for those exports.  The expansion of the local money supply inflates the local currency and raises prices in the exporter country.  Back in the importer country the money supply contracts and lowers prices.  So people start buying more from the once importing nation.  Thus reversing the flow of goods and gold.  These flows reverse over and over keeping the trade deficit (or surplus) trending towards zero.  Automatically.  With no outside intervention required.

Banknotes in circulation, though, required outside intervention.  Because gold isn’t in circulation.  So central bankers have to follow some rules to make this function as a gold standard.  As gold flows into their country (from having a trade surplus) they have to expand their money supply by putting more bills into circulation.  To do what gold did automatically.  Increase prices.  By maintaining the reserve requirement (by increasing the money supply by the amount the gold deposits increased) they also maintain the fixed exchange rate.  An inflow of gold inflates your currency and an outflow of gold deflates your currency.  When central banks maintain this mechanism with their monetary policy currencies remain relatively constant in value.  Giving no price advantage to any one nation.  Thus keeping trade fair.

After the stock market crash in 1929 and the failure of the Bank of the United States in New York failed in 1930 the great monetary contraction began.  As more banks failed the money they created via fractional reserve banking disappeared.  And the money supply shrank.  And what did the Fed do?  Increased interest rates.  Making it harder than ever to borrow money.  And harder than ever for banks to stay in business as businesses couldn’t refinance their loans and defaulted.  The Fed did this because it was their professional opinion that sufficient credit was available and that adding liquidity then would only make it harder to do when the markets really needed additional credit.  So they contracted the money supply.  Even while there was a positive gold flow into the country.

The Gold Standard works Great when all of your Trading Partners use it and they Follow the Rules

Those in the New York Federal Reserve Bank wanted to increase the money supply.  The Federal Reserve Board in Washington disagreed.  Saying again that sufficient credit was available in the market.  Meanwhile people lost faith in the banking system.  Rushed to get their money out of their bank before it, too, failed.  Causing bank runs.  And more bank failures.  With these banks went the money they created via fractional reserve banking.  Further deflating the money supply.  And lowering prices.  Which was the wrong thing to happen with a rising gold supply.

Well, that didn’t last.  France went on the gold standard with a devalued franc.  So they, too, began to accumulate gold.  For they wanted to become a great banking center like London and New York.  But these gold flows weren’t operating per the rules of a gold exchange.  Gold was flowing generally in one direction.  To those countries hoarding gold.  And countries that were accumulating gold weren’t inflating their money supplies to reverse these flows.  So nations began to abandon the gold exchange standard.  Britain first.  Then every other nation but the U.S.

Now the gold standard works great.  But only when all of your trading partners are using it.  And they follow the rules.  Even during the great contraction of the money supply the Fed raised interest rates to support the gold exchange.  Which by then was a lost cause.  But they tried to make the dollar strong and appealing to hold.  So people would hold dollars instead of their gold.  This just further damaged the U.S. economy, though.  And further weakened the banking system.  While only accelerating the outflow of gold.  As nations feared the U.S. would devalue their currency they rushed to exchange their dollars for gold.  And did so until FDR abandoned the gold exchange standard, too, in 1933.  But it didn’t end the Great Depression.  Which had about another decade to go.

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Capital Flows and Currency Exchange

Posted by PITHOCRATES - July 30th, 2012

Economics 101

Before we buy a Country’s Exports we have to Exchange our Currency First

What’s the first thing we do when traveling to a foreign country?  Exchange our currency.  Something we like to do at our own bank.  Before leaving home.  Where we can get a fair exchange rate.  Instead of someplace in-country where they factor the convenience of location into the exchange rate.  Places we go to only after we’ve run out of local currency.  And need some of it fast.  So we’ll pay the premium on the exchange rate.  And get less foreign money in exchange for our own currency.

Why are we willing to accept less money in return for our money?  Because when we run out of money in a foreign country we have no choice.  If you want to eat at a McDonalds in Canada they expect you to pay with Canadian dollars.  Which is why the money in the cash drawer is Canadian money.  Because the cashier accepts payment and makes change in Canadian money.  Just like they do with American money in the United States.

So currency exchange is very important for foreign purchases.  Because foreign goods are priced in a foreign currency.  And it’s just not people traveling across the border eating at nice restaurants and buying souvenirs to bring home.  But people in their local stores buying goods made in other countries.  Before we buy them with our American dollars someone else has to buy them first.  Japanese manufacturers need yen to run their businesses.  Chinese manufacturers need yuan to run their businesses.  Indian manufacturers need rupees to run their businesses.  So when they ship container ships full of their goods they expect to get yen, yuan and rupees in return.  Which means that before anyone buys their exports someone has to exchange their currency first.

Goods flow One Way while Gold flows the Other until Price Inflation Reverses the Flow of Goods and Gold

We made some of our early coins out of gold.  Because different nations used gold, too, it was relatively easy to exchange currencies.  Based on the weight of gold in those coins.  Imagine one nation using a gold coin the size of a quarter as their main unit of currency.  And another nation uses a gold coin the size of a nickel.  Let’s say the larger coin weighs twice as much as the smaller coin.  Or has twice the amount of gold in it.  Making the exchange easy.  One big coin equals two small coins in gold value.  So if I travel to the country of small coins with three large gold coins I exchange them for six of the local coins.  And then go shopping.

The same principle follows in trade between these two countries.  To buy a nation’s exports you have to first exchange your currency for theirs.  This is how.  You go to the exporter country with bags of your gold coins.  You exchange them for the local currency.  You then use this local currency to pay for the goods they will export to you.  Then you go back to your country and wait for the ship to arrive with your goods.  When it arrives your nation has a net increase in imported goods (i.e., a trade deficit).  And a net decrease in gold.  While the other nation has a net increase in exported goods (i.e., a trade surplus).  And a net increase in gold.

The quantity theory of money tells us that as the amount of money in circulation increases it creates price inflation.  Because there’s more of it in circulation it’s easy to get and worth less.  Because the money is worth less it takes more of it to buy the same things it once did.  So prices rise.  As prices rise in a nation with a trade surplus.  And fall in a nation with a trade deficit.  Because less money in circulation makes it harder to get and worth more.  Because the money is worth more it takes less of it to buy the same things it once did.  So prices fall.  This helps to make trade neutral (no deficit or surplus).  As prices rise in the exporter nation people buy less of their more expensive exports.  As prices fall in an importer nation people begin buying their less expensive exports.  So as goods flow one way gold flows the other way.  Until inflation rises in one country and eventually reverses the flow of goods and gold.  We call this the price-specie flow mechanism.

In the Era of Floating Exchange Rates Governments don’t have to Act Responsibly Anymore

This made the gold standard an efficient medium of exchange for international trade.  Whether we used gold.  Or a currency backed by gold.  Which added another element to the exchange rate.  For trading paper bills backed by gold required a government to maintain their domestic money supply based on their foreign exchange rate.  Meaning that they at times had to adjust the number of bills in circulation to maintain their exchange rate.  So if a country wanted to lower their interest rates (to encourage borrowing to stimulate their economy) by increasing the money supply they couldn’t.  Limiting what governments could do with their monetary policy.  Especially in the age of Keynesian economics.  Which was the driving force for abandoning the gold standard.

Most nations today use a floating exchange rate.  Where countries treat currencies as commodities.  With their own supply and demand determining exchange rates.  Or a government’s capital controls (restricting the free flow of money) that overrule market forces.  Which you can do when you don’t have to be responsible with your monetary policy.  You can print money.  You can keep foreign currency out of your county.  And you can manipulate your official exchange rate to give you an advantage in international trade by keeping your currency weak.  So when trading partners exchange their currency with you they get a lot of yours in exchange.  Allowing them to buy more of your goods than they can buy from other nations with the same amount of money.  Giving you an unfair trade advantage.  Trade surpluses.  And lots of foreign currency to invest in things like U.S. treasury bonds.

The gold standard gave us a fixed exchange rate and the free flow of capital.  But it limited what a government could do with its monetary policy.  An active monetary policy will allow the free flow of capital but not a fixed exchange rate.  Capital controls prevent the free flow of capital but allows a fixed exchange rate and an active monetary policy.  Governments have tried to do all three of these things.  But could never do more than two.  Which is why we call these three things the impossible trinity.  Which has been a source of policy disputes within a nation.  And between nations.  Because countries wanted to abandoned the gold standard to adopt policies that favored their nation.  And then complained about nations doing the same thing because it was unfair to their own nation.  Whereas the gold standard made trade fair.  By making governments act responsible.  Something they never liked.  And in the era of floating exchange rates they don’t have to act responsibly anymore.

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Mercantilism, Royal Navy, Napoleon, Pax Britannica, Corn Laws, David Ricardo, Comparative Advantage, European Union and NAFTA

Posted by PITHOCRATES - May 22nd, 2012

History 101

Mercantilism gave Britain the Royal Navy which Ushered in the Pax Britannica

Great Britain had a rough go of it at the end of the 18th century.  They lost their American colonies in the American Revolutionary War.  A war that started over the issue of taxation to pay for the previous Seven Years’ War.  So instead of securing new revenue to pay down old debt they incurred new debt.  The French Revolution closed out the century.  Causing concern for some in Britain that their monarchy may be the next to fall.  It didn’t.  For the constitutional monarchy and representative government in Britain was a long cry from the absolute monarchy that they had in France.  So revolution did not come to Britain.  But war did.  As the French expanded their revolution into a European war.  Pulling the British back into war with their old enemy.

With a large conscripted French Army and the concept of total war France made total war.  Napoleon Bonaparte won a lot of battles.  Conquered much of Europe.  Even marched back and conquered Paris.  Proclaimed himself emperor of France.  And continued waging war.  Including an ill-conceived invasion of Russia.  Which marked the beginning of the end for Napoleon.  And the French Empire.  Weakened from war France saw her old nemesis, Great Britain, rise as the first superpower since the Roman Empire.  And like the Romans’ Pax Romana Britain entered a century of peace.  Pax Britannica.

The reason the British could do this was because of their mercantile past.  They set up colonies and international trade networks.  And they used the proceeds from that lucrative trade to finance the greatest naval power then in the world.  The Royal Navy.  And the Royal Navy would help keep the peace in the Pax Britannica.  She became the world’s policeman.  Making the world safe for trade.  Especially on the high seas.  But then something interesting happened.  She broke from her mercantile past.  Because they saw the shortcomings of mercantilism.  One of which produced wealthy landowners at the expense of a hungry population.

When the British repealed the Corn Laws in 1846 Food Prices fell and the Standard of Living Rose 

The British Corn Laws were a series of laws protecting those who grew cereal crops.  The stuff we grow that has edible grains.  Corn, rice, wheat, barley, etc.  What we call staple crops as they form the basic sustenance of humans everywhere.  We grow these in greater abundance than all other foods.  And when you look at the grain size you come to one realization.  It takes a lot of land to grow these crops.  And who owns large tracts of land?  The landowning aristocracy.  A small group of people with a lot of wealth.  And a lot of political influence.  Hence the Corn Laws. 

The Corn Laws were legislation with one goal.  To prevent the British people from buying less expensive food.  By either forbidding any importation of cheaper grains until the domestic price had reached a certain price level.  Or adding tariffs to the less expensive imports so the landowners could still sell their grains at higher prices.  Thus preserving their wealth.  And they made specious arguments about how lower-priced food was actually bad for the people.  For it was just a way for manufacturers to maximize their profits.  For if food was cheaper they could pay their workers less.  Being the greedy bastards that they were.  So the only fair thing to do was to keep food prices high.  To keep the living wage high.  To force manufacturers to pay their workers more.  You see, the only way to help the poor and middle class was to let the wealthy landowners become even wealthier.  By keeping the price of the food they sold high.

Opposition grew to the Corn Laws.  People studied the works of their fellow countrymen.  Adam Smith and David Hume (both Scottish).  And the Englishman David Ricardo.  All great economists and thinkers.  Who were all proponents of free trade.  Ricardo’s Comparative Advantage basically proved the case of free trade over the protectionism of mercantilism.  Eventually the political power of the landowners could not overcome the economic arguments.  Or a famine in Ireland.  And, in 1846, they repealed the Corn Laws and adopted free trade.  Food prices fell.  Leaving people with more disposable income.  To purchase the goods the Industrial Revolution was making.  Increasing their standard of living.  While small famers had to leave their farms being unable to farm efficiently enough to pay their bills at the prevailing prices.

The Success of NAFTA proves David Ricardo’s Comparative Advantage

Mercantilists and other opponents to free trade like to point at the human costs.  Small farmers losing their farm.  Just so they can preserve some semblance of privilege to protect the high prices in their industry.  But it was becoming more and more difficult to make the argument that the masses were better off paying higher prices.  Because they’re not.  Lower consumer prices increase the standard of living for everyone.  Higher living standards create healthier living conditions.  And reduces child mortality.   For the greatest killer of children in the world is poverty.

The British were both a military and an economic superpower during the 19th century.  But someone was chasing her.  The Untied States.  Who was feeling her economic oats.  Her economy would catch up and surpass the British.  Making it the mightiest economic power of all time.  How did this happen?  Two words.  Free trade.  The United States was the largest free trade zone in the world.  The economic advantages of all those states trading with each other freely across their state borders made Europe stand up and take notice.  And in response created treaties that ultimately led to the European Union and the Eurozone.  To replicate the large free trade zone of the United States.

Back across the Atlantic the Americans, Canadians and the Mexicans took it up a notch.  And created the North American Free Trade Agreement.  NAFTA.  Extending the free trade that existed in each of their countries across their international borders.  The mercantilist fought against this.  Because protectionism, restrictions and tariffs helped the privileged few protect the high prices in their industry.  In America they talked about a great sucking sound as all American jobs went to low-wage Mexico.  Some manufacturers did move to Mexico.  Primarily because like the small farmers in Britain after the repeal of the Corn Laws they could no longer sell at prices to meet all of their costs.  But it was not as the mercantilists predicted.  Yes, imports increased.  In 2010 they were up 235% from pre-NAFTA 1993.  But exports were up, too.  Some 190% for the same period.  Proving Ricardo’s Comparative Advantage.  By focusing on what we do best and trading for everything else all countries do better.

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Mercantilism

Posted by PITHOCRATES - May 14th, 2012

Economics 101

Wealth is the Stuff we use our Talent and Ability to Make

Mercantilism gave us the United States.  For it was because of these policies that the British established colonies in North America.  And it was those same policies that led to American Independence.  Because those polices pissed off the Americans. 

The mercantile system came into being as nation states arose from feudal estates.  Kings arose and consolidated these estates into larger kingdoms.  Then one king arose to consolidate the kingdoms into a nation.  Creating Spain, France, the Netherlands, England, etc.  Enlightened thinking and better technology created food surpluses.  With food surpluses a middle class of artisans arose.  And manufactured goods.  People met in markets to trade their food and goods.   These markets grew into cities.  All of this economic activity created wealth.  Food.  And manufactured goods.  That we bought with money.  Often silver and gold. 

There was wealth.  And there was money.  Two different things.  Wealth is the stuff we use our talent and ability to make.  Food and manufactured goods, for example.  And the more food and manufactured goods a nation has the wealthier that nation is.  This is a critical point.  And the mercantile policies ultimately failed because those policies mistook money for wealth.  But money is not wealth.  It’s a temporary storage of wealth.  To make our trading of food and manufactured goods easier.  By reducing the search costs to find people to trade with.  Which is why the barter system failed in a complex economy.  It just took too long to find people to trade with.  Money solved that problem.  Because you could trade what you had for money.  Then trade your money for what you wanted.

England used the Positive Flow of Bullion to Finance the Building of the Royal Navy

Mercantilism focused on the money.  And used wealth to accumulate it.  Instead of the other way around.  The way most advanced nations do today.  These European nations accumulated money with international trade.  Beginning in the 15th century they started looking at the balance of trade between nations.  And did everything they could to maintain a positive balance of trade.  Meaning they tried to export more than they imported.  Why?  Well, nations often did trade with each other.  So they owed each other money.  And when you settled your account if other nations owed you more than you owed them there was a net flow of money to you.  Bullion.  Silver and gold.  Which is what they wanted.

To maintain a positive balance of trade the government actively intervened into the economy.  It set up monopolies.  It provided subsidies for manufacturers who exported their goods for bullion.  It placed tariffs on imports.  Or simply blocked the importation of any goods that they produced domestically.  They set up colonies to harvest raw materials to ship back to the mother country.  Which would use those raw materials in their factories to produced higher valued finished goods.  That they would export.  Especially to their colonies.  Which were convenient captive markets for their finished goods.  On the mother country’s ships.  Through the mother country’s ports.  Where they, of course taxed it.  Guaranteeing that at every step of the way they added to the positive bullion flow back to the mother country.

And it worked.  To a certain extent.  England used that positive flow of bullion to finance the building of the Royal Navy.  Which proved invaluable in the wars that followed in the mercantile world.  For mercantilism is a zero-sum game.  For every winner there had to be a loser.  Which is why this era was an era of world war.  To wrest control of those colonies.  And those sea lanes.  Great Britain came out the victor.  Thanks to their Royal Navy.  But it wasn’t all good.  For Spain found gold in the New World.  And they took it.  Shipped it back to the Old World.  Just like a good mercantilist would.  Which caused problems in the Old World.  Because money is not wealth.  It’s a temporary storage of wealth.  And when they inflated their money supply it took more of it to hold the same amount of value it once did.  Because there was so much of it in circulation.  And what happens during inflation?  Prices rise.  Because the money is worth less it takes more of it to buy the same things as it did before.  So by hording bullion to create wealth they actually destroyed wealth.  With wealth-destroying inflation.

With the Boston Tea Party the Americans Renounced Mercantilism and Demanded Free Trade

Spain was one of the greatest mercantile nations of the era.  But they quickly became a shadow of their former self.  Even though they had more bullion than their European neighbors.  For it turned out that those mercantile policies hindered economic growth.  Which is the true source of wealth.  Economic growth.  Where people use their talent and ability to create things.  That’s where the true value lay.  Not the money that held that value temporarily.  All those mercantilist policies did was raise domestic prices.  And allocated scarce resources poorly. 

It turned out free trade was the secret to wealth.  For free trade can increase wealth.  For both nations.  Thanks to something we call comparative advantage.  Instead of both nations manufacturing all of their goods they should only manufacture those goods that they can manufacture best.  And trade for the goods they can’t manufacture best.  This more efficiently allocates those scarce resources.  And produces a greater total amount of wealth.  By allowing people to buy lower cost imports they have more money left over to buy other stuff.  Increasing the overall amount of economic activity.  Which is why when Great Britain adopted free trade in the 19th century the British Empire went on to rule the world for a century or so.  And led the Industrial Revolution.  By creating wealth.  Goods and services people created with their talent and ability.  That changed the world.  And ushered in the modern era.  Something no amount of bullion could do.

But before Britain adopted free trade they were struggling with one of their belligerent colonies.  Their British American colonies.  Who were unhappy over taxation without representation in Parliament.  And the mother country forcing them to buy only British tea shipped on British ships at higher prices than they could get from the Dutch.  The British thought they found a solution to their problem.  By permitting their British East India Company monopoly to ship their tea directly to America without passing through an English port.  The tea was cheaper because of this.  But it also would set a precedent for taxation without representation.  Something the Americans weren’t about to accept.  So they threw that tea into Boston Harbor.  What we affectionately call the Boston Tea Party.  Renouncing mercantilism.  And demanding the right to engage in free trade.  Which they got after winning their independence.  And the mother country would follow suit in a few decades.  Because they, too, would learn that free trade was better than mercantilism.

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Keynesians, Gold Standard, Consumer Price Index, Money Stock, Nixon Shock, 1973 Oil Crisis, Gasoline Prices, Hidden Tax and Wealth Transfer

Posted by PITHOCRATES - April 24th, 2012

History 101

With the Increase in the Money Supply came the Permanent Increase in Consumer Prices that Continues to this Date

Keynesians hate the gold standard.  Because it puts a limit on how much money a government can print.  Keynesians believe in the power of government to eliminate recessions.  And their cure for recession?  Inflation.  The government prints money to spend in the private economy.  To make up for the decline in consumer spending.  But it turned out this didn’t work.  As the Seventies showed.  They printed a lot of money.  But it didn’t end the recession.  It just raised consumer prices.  Because there is a direct correlation between the amount of money in circulation and consumer prices.  As you can see in the following graph. 

 Source: M2, CPI

 The consumer price index (CPI) data comes from the U.S. Department of Labor.  The data is at 5 year intervals.  The CPI is a ‘basket’ of prices for a selection of representative goods and services divided by another ‘basket’ of prices from a fixed date.  The resulting number is a price index.  If you plot these for a period of time you can see inflation (a rising graph) or deflation (a falling graph).  M2 is the money stock (seasonally unadjusted).  M2 includes currency, traveler’s checks, demand deposits, other checkable deposits, retail MMMFs, savings and small time deposits.

The Breton Woods system established fixed exchange rates for international trade.  It also pegged the U.S. dollar to gold.  The U.S. government promised to exchange U.S. dollars for gold at a rate of $35/ounce.  Making the U.S. dollar as good as gold.  This set the rules for international trade.  Made it fair.  And prevented anyone from cheating by devaluing their currency to make their exports cheaper to gain an economical advantage in international trade.  The system worked well.  Until the Sixties.  Because of the Vietnam War.  And LBJ’s Great Society.  These increased government spending so much that the U.S. government turned to printing money to pay for these.  Which depreciated the dollar.  Making it not as good as gold anymore.  So our trading partners began dumping their devalued dollars.  Exchanging them for gold at $35/ounce.  Which was a problem for the Nixon administration.  For that gold was far more valuable than the U.S. dollar.  They could print more dollars.  But once that gold was gone it was gone.  So Nixon acted to keep that gold in the U.S.

On August 15, 1971 Nixon decoupled the dollar from gold.  Known as the Nixon Shock.  Reneging on the solemn promise to exchange U.S. dollars for gold.  And ramped up the printing presses.  Which you can see in the graph.  After August 15 the money supply began growing.  And continues to this date.  With the increase in the money supply came the permanent increase in consumer prices that, also, continues to this date.  In lockstep with the growth of the money supply.

Prior to the Nixon Shock Gasoline Prices were Falling at a Greater Rate than the Rate Consumer Prices were Rising 

Since August of 1971 the U.S. has maintained a policy of permanent inflation.  Which caused a policy of permanently increasing consumer prices.  Those high prices we complain about, then, are not the fault of greedy businesses.  They’re the fault of government.  And their easy monetary policy.  In fact, if it was not for government’s irresponsible monetary policy the high price we hate most would not be as high as it is today.  In fact, because of the efficiency of the industry bringing us this one product its price has not followed the general upward trend in consumer prices.  And what is this product?  Gasoline.  Which, apart from two spikes in the last 60 years or so has either been falling or holding steady in comparison to consumer prices.

 Source: CPI, Gas $/Gal

 These prices are from DaveManual.com.  And reflect generally the price at the pump over this time period.  Using at first leaded gasoline.  Then unleaded gasoline.  Using inflation adjusted average prices.  Then chained 2005 dollars.  These prices are not exactly apples-to-apples.  But the trending information they provide illustrates two major points.  The two spikes in gas prices were due to demand greatly outpacing supply.  And that even with these two spikes gasoline prices would be far lower today if it wasn’t for the government’s policy of permanent inflation.

Note that prior to the Nixon Shock gasoline prices were falling at a greater rate than the rate consumer prices were rising.  These trends stopped in the Seventies for two reasons.  The Nixon Shock.  And the 1973 oil crisis.  When OPEC punished the U.S. for their support of Israel in the Yom Kippur war by cutting our oil supply.  These two events caused gasoline prices to spike.  But then something interesting happened with these high prices.  It brought a lot of oil producers into the market to cash in on those high prices.  This surge in production coupled with a falling demand due to the U.S. recession in the Seventies caused an oil glut in the Eighties.  Bringing prices back down.  Where they flat-lined for a decade or so while all other consumer prices continued their march upward.  Until two of the most populous countries in the world modernized their economies.  India and China.  Causing a spike in demand.  And a spike in prices.  For it was like adding another United States or two to the world gasoline market.

Inflation is a Hidden Tax that Transfers Wealth from the Private Sector to the Public Sector

Keynesians love to talk about how great the economy was during the Fifties when the high marginal tax rate was 91-92%.  “See?” they say.  “The economy was robust and growing during the Fifties even with these high marginal tax rates.  So high marginal tax rates are good for the economy.”  But they will never comment on how instrumental the gold standard was in keeping government spending within responsible limits.  How that responsible monetary policy kept inflation and consumer prices under control.  No.  They don’t see that part of the Fifties.  Only the high marginal tax rates.  Because they don’t want to return to the gold standard.  Or have any restrictions on their irresponsible ways.

Keynesians believe in the power of government to manage the economy.  And they really like to tax and spend.  A lot.  But taxing too much has consequences.  People don’t like paying taxes.  And don’t tend to vote for people who tax them a lot.  Which is why Keynesians love inflation.  Because it’s a hidden tax.  The higher the inflation rate the higher the tax.  Because government also borrows money.  They sell bonds.  That we buy as a retirement investment.  But if there’s been a good amount of inflation between the selling and redemption of those bonds it makes it a lot easier to redeem those bonds.  Because thanks to inflation those bonds are worth far less than they were when the government issued them.  Even Keynes noted that inflation was a way to transfer a lot of wealth from the private sector to the public sector.  Without many people understanding that it was even happening.

If you ever wondered why it takes two incomes to do what your father did with one income this is why.  Inflation.  This never ending transfer of wealth from the private sector to the public sector.  Leaving us less to retire on.  Making it harder to save for our children’s college education.  Not to mention the higher cost of living that shrinks our real wages.  While they tax our higher nominal wages at ever higher income tax rates (income tax bracket creep is another inflation phenomenon).  Everywhere we turn the government takes more and more of our wealth.  All thanks to LBJ increasing the government spending (for his Vietnam War and his Great Society).  And Richard Nixon decoupling the U.S. dollar from gold.  Instead of doing the responsible thing.  And cutting spending.  But much like high taxes you don’t win any friends at the voting booth by cutting spending.  So thanks to them we’ve had permanent and significant rising inflation and consumer prices ever since.  And as a result a flat to a falling standard of living.  Where soon our children may not have a better life than their parents.  Thank you LBJ and Richard Nixon.  And thank you Keynesian economics.

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Marine Insurance, General Average, Mesopotamia, Genoa, Middle Class, Capitalism, London Coffeehouses and Lloyd’s of London

Posted by PITHOCRATES - April 3rd, 2012

History 101

It was in Genoa that Marine Insurance became a Standalone Industry

Risk management dates back to the dawn of civilization.  Perhaps the earliest device we used was fire.  Fire lit up the caves we moved into.  And scared the predators out.  As we transitioned from hunting and gathering to farming we gathered and stored food surpluses to help us through less bountiful times.  To avoid famine.  As artisans rose up and created a prosperous middle class we also created defensive military forces.  To protect that prosperous middle class from outsiders looking to plunder it.

As we put valuable cargoes on ships and sent them long distances over the water we encountered a new kind of risk.  The risk that these cargoes wouldn’t make it to their destinations.  So we created marine insurance.  Including something called ‘general average’.  An agreement where the several shippers shared the cost of any loss of cargo.  If they had to jettison some cargo overboard to save the rest of the cargo or to save the ship.  Some of the proceeds from the cargo they delivered paid for the cargo they didn’t deliver.  Some merchants who borrowed money to finance a shipment paid a little extra.  A risk ‘premium’.  Should the shipment not reach its destination the lender would forgive the loan.

So how long has marine insurance been around?  A long time.  Some of these practices were noted in the Code of Hammurabi (circa 1755 B.C.).  For ancient Mesopotamia was a trading civilization.  That shipped on the Tigris and Euphrates and their tributaries.  Out into the Arabian sea.  And beyond.  Following the coasts until advances in navigation and sail power took them farther from land.  The Greeks and Romans insured their valuable cargoes, too.  As did the Italian city-states that followed them.  Who ruled Mediterranean trade.  And it was in Genoa that marine insurance became a standalone industry.  No longer bundled with other contracts for an additional fee.

As the British Maritime Industry took off so did Lloyd’s of London

But the cargoes got larger.  And the voyages went farther.  Until they were crossing the great oceans.  Increasing the chances that this cargo wasn’t going to make it to its destination.  And when they didn’t the financial losses were larger than ever before.  Because the ships were larger than ever before.  So as the center of shipping moved from the Mediterranean to the ocean trade routes plied by the Europeans (Portugal, Spain, France, the Netherlands and England) the insurance industry followed.  And took the concept of risk management to new levels.

With trade came a prosperous middle class.  Where wealth was no longer the privilege of landholders.  Capitalism transferred that wealth to manufacturers, bankers, merchants, ship owners and, of course, insurers.  You didn’t have to own land anymore to be rich.  All you needed was skill, ability and drive.  It was a brave new world.  And these new capitalists gathered together in London coffeehouses to discuss business.  Including one owned by Edward Lloyd.  On Tower Street.  Where those particularly interested in shipping came to learn the latest in this industry.  And it was where shippers and merchants came to find underwriters to insure their ships and cargoes.

This was the birth of Lloyd’s of London.  And as the British maritime industry took off so did Lloyd’s of London.  As the British Empire spread across the globe international trade grew to new heights.  The Royal Navy protected the sea lanes for that trade.  The British Army protected their far-flung empire.  And Lloyd’s of London insured that valuable cargo.  It was a very symbiotic relationship.  All together they made the British Empire rich.  To show their appreciation of the Royal Navy making this possible Lloyd’s set up a fund to provide for those wounded in the service of their county following Lord Nelson’s victory over the combined French and Spanish fleets at the Battle of Trafalgar.  They continue to provide support for veterans today.  In short, Lloyd’s of London was the place to go to meet your global insurance needs.  From marine insurance they branched into providing ‘inland marine’ insurance needs.  Providing risk management to property beyond ships plying the world’s oceans. 

The Purpose of Insurance is to Let Life Go On after Unexpected and Catastrophic Events

Cuthbert Heath led Lloyd’s in the development of the non-marine insurance business.  Underwriting policies for among other things earthquake and hurricane insurance coverage.   And Lloyd’s helped to rebuild San Francisco after the 1906 earthquake.  With Heath ordering that they pay all of their policies in full irrespective of their policy terms.  They could do that because they were profitable.  Which is a good thing.  Insurers need to be profitable to pay these large claims without being forced out of business.  Which is why when the Titanic sunk in 1912 they were able to pay all policies in full.  And to continue on insuring the shippers and merchants that followed Titanic.  To allow life to proceed after these great tragedies.  And they would do it time and again.  Following 9/11.  And Hurricane Katrina.

This is the purpose of insurance.  Risk management.  So unexpected and catastrophic events don’t end life as we know it.  But, instead, it allows us to carry on.  Even after some of the worst disasters.  Because life must go on.  And that’s what insurance does.  Even people who rely on a particular body part for their livelihood have gone to Lloyd’s to buy insurance.  Perhaps the most famous being Betty Grable.  Who insured her legs for $1 million in 1940.  Pittsburgh Steeler Troy Polamalu has a lucrative endorsement with a shampoo company.  And insured his long hair for $1 million.  Rolling Stones guitarist Keith Richards insured his hands for $1.6 million.  America Ferrera (Ugly Betty) has an endorsement deal with a toothpaste company.  And they insured her smile for $10 million.  Even ‘the Boss’ Bruce Springsteen insured his voice for $6 million. 

People hate insurance companies.  Because they don’t understand how insurance works.  For they only know that they pay a lot in premiums and never receive anything in return.  But this is the way risk management is supposed to work.  And we need risk management.  We need insurance companies.  And we need insurance companies to be profitable.  Meaning that most of us will never see anything in return for all of our premium payments.  So these companies can pay for the large losses of the few who sadly do see something in return for all of their payments.  For insurance companies protect our wealth.  And earning potential.  So life can go on.  Whether we’re raising a family and planning for our children’s future.  Or taking precautions for some unforeseen accident to one of our body parts that may limit our future earning potential.

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France may be next to go in Crisis as the Weight of the Crushing Costs of her Social Democracy threatens the Euro

Posted by PITHOCRATES - March 31st, 2012

Week in Review

France is in big trouble.  Or is about to be.  For they have put the ‘social’ in social democracy.  And the French people are about to learn how all that government largess can kill an economy.  And take with it all the social benefits they’ve come to enjoy (see A country in denial posed 3/31/2012 on The Economist).

France has not balanced its books since 1974. Public debt stands at 90% of GDP and rising. Public spending, at 56% of GDP, gobbles up a bigger chunk of output than in any other euro-zone country—more even than in Sweden. The banks are undercapitalised. Unemployment is higher than at any time since the late 1990s and has not fallen below 7% in nearly 30 years, creating chronic joblessness in the crime-ridden banlieues that ring France’s big cities. Exports are stagnating while they roar ahead in Germany. France now has the euro zone’s largest current-account deficit in nominal terms. Perhaps France could live on credit before the financial crisis, when borrowing was easy. Not any more. Indeed, a sluggish and unreformed France might even find itself at the centre of the next euro crisis.

It is not unusual for politicians to avoid some ugly truths during elections; but it is unusual, in recent times in Europe, to ignore them as completely as French politicians are doing. In Britain, Ireland, Portugal and Spain voters have plumped for parties that promised painful realism. Part of the problem is that French voters are notorious for their belief in the state’s benevolence and the market’s heartless cruelty. Almost uniquely among developed countries, French voters tend to see globalisation as a blind threat rather than a source of prosperity.  With the far left and the far right preaching protectionism, any candidate will feel he must shore up his base.

In America they say no president can win a reelection with unemployment at 8%.  The French have been 1% below that rate for 30 years.  Their banking system is not that far away from cascading bank runs.  Their big cities are surrounded by tinderboxes of unemployed youth just waiting for something to set them off.  And a large current account deficit means they are uncompetitive in international trade.  Which means that their economy is not about to create a lot of new jobs to employ the unemployed.  And with the government already spending over half of their GDP they’re not going to be able to throw much at the unemployed youth to keep them from expressing their discontent at being unemployed.  And with France’s history of generous state benefits the unemployed will not take kindly to any austerity programs.  Nor will those who have jobs.

Could France be the country to break the Euro’s back?  Perhaps.  For they are definitely too big for Germany to save.  And if France goes the grand experiment of the common currency will come to an end.  For a common currency without a political unity is doomed to fail.  For there is no way to stop a member state from not meeting the requirements of the Maastricht Treaty (which created the Euro).  So their financial problems are everyone’s financial problems.  Because of the common currency.  And if you think the French are going to take austerity orders from Germany you don’t know the French.  Or Franco-German history.  For they will cooperate.  But one will never subordinate themselves to the other.

So don’t be surprised if the next round of austerity fills the streets of French cities and towns with discontent.  For it looks like it will soon be their turn in this unfolding saga of the decline and fall of the Euro.  Pity to see this befall such a great people.  For much of the Enlightenment came from French thinkers.  And to see her collapse under the weight of her social democracy is painful to watch indeed.

www.PITHOCRATES.com

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