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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Abenomics appears to have Failed in Japan just as Keynesian Economics has Failed everywhere it has been Tried

Posted by PITHOCRATES - March 9th, 2014

Week in Review

The Keynesians were applauding Shinzō Abe’s economic plans for Japan.  To end the never-ending deflationary spiral they’ve been in since the late Nineties.  His Abenomics included all the things Keynesians love to do.  And want to do in the United States.  Expand the money supply through inflationary monetary policy.  Devalue the yen to make their exports cheaper.  Lower interest rates into negative territory.  Quantitative easing.  And lots of government spending.  The kinds of things that just makes a Keynesian’s heart go pitter pat.

They kicked off Abenomics in 2013.  And how are things about a year later?  Not good (see Japan’s deficit hits record as economic growth slows posted 3/9/2014 on BBC News Business).

Japan’s current account deficit widened to a record 1.5tn yen ($15bn; £8.7bn) in January, the largest since records began in 1985.

In further bad news, the country’s economic growth figures were also revised downwards…

The sluggish growth and growing deficit come just before a planned sales tax increase, scheduled to take effect in April.

They did weaken the yen.  Making it worth less than other currencies so those currencies could get more yen when they exchanged their currencies to buy those Japanese exports.  Of course, when Japanese exchanged their yen for those other currencies they got less of those other currencies in return.  Requiring more yen to buy those now more expensive imports.  Thus increasing their trade deficit.

Japan is an island with a lot of people.  They have to import a lot of their food, energy and natural resources as they have little on their island.  So the weaker yen just made everything more expensive in Japan.  Which, of course, lowered GDP.  As those higher prices reduced the amount of buying their consumers could do.

Japan’s greatest problem is her aging population.  And they have just about the oldest population in the world.  As the youth have slammed the brakes on having children.  So you have massive waves of people leaving the workforce the government is supporting in retirement.  And fewer people entering the workforce to pay the taxes that support those retirees.  Which, of course, forces higher tax rates on those remaining in the workforce.  Further reducing the amount of buying their consumers can do.  And no amount of Abenomics can change that.

Abenomics did not deliver what the Keynesians thought it would.  Because Keynesian economics (aka demand-side economics) just doesn’t work.  If it did Japan never would have had a Lost Decade to begin with.  For it was Keynesian economics that gave Japan that asset price bubble in the first place.  Which burst and deflated into the Lost Decade.

What Japan needs is a return to classical economic principles.  Focusing more on the supply side.  Lower tax rates and reduce regulation.  Let the market set interest rates.  Restore the policies that introduced ‘Made in Japan’ to the world.  They need to make their capitalism more laissez-faire.  If they do they can create the kind of economic activity that just might be able to support the generation who created the ‘Made in Japan’ label in their retirement.  But you must have robust economic activity.  So robust that lower tax rates can produce greater tax revenue.  The supply-side economics way.

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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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Comparative Advantage and Free Trade

Posted by PITHOCRATES - May 21st, 2012

Economics 101

Mercantilism benefited only Protected Industries which Profited Handsomely from Higher Consumer Prices  

The Age of Discovery ushered in the era of mercantilism.  An era of trade.  But protected trade.  Tariffs, quotas, protectionism, restrictions, subsidies, etc.  You name it they used it.  To favor their trade position and their domestic industries.  And to restrict that of everyone else.  For mercantilism was a zero-sum game.  You only did well if others did not.  A thought that still has traction today.  Especially in older, inefficient industries.  That cannot compete with international competition that provides better quality at lower prices.  Such as textiles.  Steel.  Automobiles.  The Americans protected these industries in the face of better foreign competition.  Which only hastened their decline.

A protected industry has no incentive to improve.  When protective tariffs raise prices of lower-priced and higher-quality imports consumers buy the inferior domestic goods.  Because the tariffs make the better goods more costly.  So when a business has a captive audience their only focus is in maintaining that protectionism giving them that advantage.  Not improving their quality.  Or improving their productivity to lower their prices.  Why?  Because they don’t have to.  So prices continue to rise to pay for inefficient labor and management.  And quality continues to decline due to the lack of real competition forcing them to continually provide a better product.  By improving designs.  Production methods.  And making capital investments in new machinery and equipment.

This is the cost of protectionism.  Poorer quality and higher prices.  Because of the misguided belief in the zero-sum game of mercantilism.  There was a reason why mercantilism was abandoned for free trade.  Because free trade was better.  For consumers.  Giving them lower prices and higher quality.  Whereas mercantilism benefited only those protected industries which profited handsomely from those higher consumer prices.  And the government officials who granted those favorable protectionist policies.

The Consumer gets Lower Prices AND Higher Quality thanks to the Division of Labor, Specialization and Comparative Advantage

As civilization advanced so did the division of labor.  People began to specialize.  Instead of growing our own food, making our own tools, spinning our own pottery, etc., we did only one thing.  And did it well.  Then we traded the things we made for the things we didn’t make.  This division of labor created a middle class.  And this middle class would take their goods to market to trade with other middle class artisans.  At first bartering with each other.  Trading good for good.  Then they introduced a temporary storage of value into the economy.  Money.  Making those trades easier by reducing search times.  Trading your goods for money.  And your money for goods.  Making life a lot simpler at the market.

Let’s take a closer look at the division of labor.  Let’s consider two artisans.  A toolmaker.   And a potter.  Both are skilled craftspeople.  And can make an assortment of goods.  But each excels at one particular skill.  The toolmaker can make 10 plows a day.  But if he makes 2 pottery bowls he can only make 4 plows in that same day.  The potter can make 12 pottery bowls in a day.  But if he makes 3 plows he can only make 5 pottery bowls in that same day.  Each can make more of their specialty.  But when they try to make other things in addition to their specialty they can’t make as much of their specialty as before.  So there is a cost to the toolmaker to make pottery.  To make 2 bowls cost the toolmaker 6 plows.  And there is a cost to the potter to make tools.  To make 3 plows cost the potter 7 bowls.  So the economy as a whole is better off when the toolmaker and the potter focus all of their energies in their own specialty.  When they do we get 10 plows and 12 bowls in one day.  When they don’t we only get 7 plows and 7 bowls.

We call this economic principle comparative advantage.  Where we look at economic output.  Which is what matters.  The more we bring to market the better it is for consumers.  Because greater quantities mean lower prices.  And when these skilled craftspeople focus on their specialty they improve the overall quality of the goods they bring to market.  So the consumer gets lower prices AND higher quality.  Thanks to the division of labor.  Specialization.  And comparative advantage.

We will always Have Jobs regardless the Size of our Imports for Having a Job is the Only Way to Buy those Imported Goods

If you multiply this over and over again to represent all the individual economic exchanges throughout the world you see why free trade is better than the protectionist policies of mercantilism.  Because it provides consumers with greater economic output at lower prices and higher quality.  This is why nations practicing free trade have the highest standards of living.  Because their people can walk into large department stores and fill their carts with inexpensive, high quality goods on a moderate paycheck.  Which could never happen if the mercantilists had their way.

The old inefficient industries want tariffs to increase the costs of those goods we fill our shopping carts with.  Including the food we eat.  And the cars we drive.  They use lofty arguments about protecting American jobs.  But those protectionist policies destroy jobs by increasing costs for businesses throughout the supply chain.  Raising consumer prices everywhere.  Reducing the amount of things we can buy.  Meaning businesses can’t grow and create new jobs.  Or they have to cut back production and eliminate existing jobs.

There’s also a lot of talk about the balance of payments.  Which actually meant something during the days of the gold standard.  For any trade deficits had to be paid for with gold.  But we don’t have the gold standard anymore.  Governments everywhere abandoned it in favor of irresponsible government spending.  So we don’t have to pay for trade deficits with gold.  Most money today is just electronic entries in a computer.  International capital flows have never been greater.  There are currency markets where people actively trade the world’s currencies.  So trade deficits don’t mean the same thing they once did in the mercantile world.  Then there’s the argument that if all our manufacturing jobs go overseas there will be no jobs for Americans.  If we import everything and export nothing there will be jobs everywhere but here.  Sounds like a problem.  But can that happen?  Not unless we get those imports for free.  So we will always have jobs regardless the size of our imports.  For having a job is the only way to buy the imported goods in those department stores.

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The Gold Standard

Posted by PITHOCRATES - March 12th, 2012

Economics 101

As long as Imports equal Exports the Balance in the Trade Account is Zero and there is no Trade Deficit or Surplus 

Imagine two wine shops in an affluent suburb.  Let’s call one Fine Wines.  And the other The Wine Shoppe.  They both feature a wide selection of wines from around the world.  And each specializes in wines from a specific region.  So they sell much of the same wines.  But some of the most exclusive and most expensive wines can only be found at one store or the other.  Now wine retailers typically have a loyal clientele.  There is a relationship between proprietor and customer.  To enhance the wine drinking experience.  So proprietors will cater to their customers to keep them as customers.  And provide whatever wine they wish.  Even if they don’t stock it.  Or don’t have a normal purchasing channel to the wine they wish to buy.

Both stores have similar relationships with their clientele.  And they share something else in common.  The wines one seller doesn’t sell the other seller sells.  Which produces a special relationship between these two stores.  They buy and sell wines from each other as needed to meet the needs of their customers.  So customers at either store can purchase any wine they sell in both stores.  Allowing each store to maintain their special proprietor-customer relationship.  Without losing customers to the other store.

Most of the time the value of the wine they buy and sell from each other in these inter-store sales net out.  Sometimes one store owes the other.  And vice versa.  But it usually isn’t much.  And the stores take turns owing each other.  The overall cost for this inter-store trade is negligible.  And pleases customers at both stores.  So maintaining this trade is a win-win.  With no negative impact on either store’s business.  As long as ‘imports’ equal ‘exports’.  And the balance in this ‘trade account’ is kept close to zero.  So they continue to ‘trade’ bottles of wine.  Without exchanging any money.  Most of the time, that is.  Until a trade deficit develops.  

If the Currency is Backed by Gold the only way to create new Dollars is to put more Gold into the Vault 

Let’s say for whatever reason Fine Wines runs a trade deficit.  Fine Wines sells more of The Wine Shoppe wines than The Wine Shoppe sells of theirs.  Which means Fine Wines imports more from The Wine Shoppe than they export to The Wine Shoppe.  Creating the trade deficit.  They’re not trading bottles for bottles anymore.  Fine Wines delivers one case of wine to The Wine Shoppe and returns with 3 cases.  And now has an outstanding balance owed to The Wine Shoppe.  Which they must settle by sending money to The Wine Shoppe.  If sales continue like this Fine Wines will become a net importer and run chronic trade deficits.  While The Wine Shoppe will become a net exporter.  And have a running trade surplus.

If the clientele of Fine Wines keeps buying the imported wine from The Wine Shoppe instead of the ‘domestic’ Fine Wines, Fine Wines will have cash problems.  Because they owe their distributors for the wine they bought and stocked.  But when they sell The Wine Shoppe’s wine it doesn’t bring any cash into their store.  Because Fine Wines has to give that money to The Wine Shoppe.  For it was, after all, The Wine Shoppe’s wine that Fine Wines sold.  That they sold as a courtesy to their customers.  To keep them loyal customers.  So a portion of their total sales doesn’t even count as income (income = total sales – imports).  And if Fine Wines divides their income by the total number of bottles they sold they see a sad truth.  The impact of those imports has lowered the average price per bottle of wine.  This price deflation will make it very difficult to pay the bills they incurred before this deflation.  As they are now selling wine at lower prices than they paid for it from their distributors.

And that’s similar to how the gold standard works.  We back the money in circulation (i.e., the money supply) by gold.  Which we lock away in some vault.  To increase the money supply you need to increase the gold supply.  To decrease the money supply you need to decrease the gold supply.  This makes it very difficult for governments to be irresponsible and print money.  Because if the currency is backed by gold the only way to create new dollars is to put more gold into that vault.  Ergo, responsible government spending.  And an automatic mechanism to fix trade deficits.

Fixed Exchange Rates based on Gold made International Trade Simple and Fair

This is where our wine stores example comes in.  If a government runs a trade deficit under the gold standard gold moves between countries.  Just like money did between the two wine stores.  And a net exporter of gold (a net importer of goods paying for the resulting trade deficit with gold) will see a reduction in price levels.  Just like Fine Wines did.  (And the net importer of gold will see the opposite).  But here’s what else happens.  Those lower prices now make the importer more cost competitive.  (And the higher prices make the exporter less competitive).  Because people prefer buying less expensive things.  So the net importer’s sales increase thanks to lower prices.  While the net exporter’s sales decrease because of higher prices.  Moving the balance in the trade account back towards zero.  Where it will always try to be under normal market conditions. 

This built-in responsibility didn’t stop governments from misbehaving, though.  And some have printed more money than they had the gold reserves to back it.  For governments like to spend money.  Especially when they’re trying to buy votes.  So they have turned on those printing presses at times.  And increased the money supply.  Without putting more gold into the vault.  The result?  A larger money supply backed by the same amount of gold?  It depreciated the currency by inflating the money supply.  Which can be a problem when the money is backed by gold.  Especially when you have an exchange rate based on gold.

To buy goods from a foreign country you first exchanged your currency for theirs.  Because you buy foreign goods in the foreign currency.  And you based this exchange rate on gold.  And fixed each currency to an amount of gold.  Which made this currency exchange simple.  And fair.  Unless someone was depreciating their currency by printing it without putting more gold into the vault.  But if they did other nations would find out.  And stop exchanging their currency for the depreciated currency which would buy less.  They, instead, exchanged the foreign currency they had for gold instead.  So they could buy more.  Exchanging a depreciated currency at an exchange rate based on a non-depreciated currency.  Leaving the nation with a swollen money supply full of a depreciated currency.  And no gold.  Giving the nation runaway inflation.  And a crashed economy.  A very strong incentive not to depreciate your currency while on a gold standard.

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Japan shutters 52 of 54 Nuclear Reactors because of Fukushima, Energy Imports cause Trade Deficit

Posted by PITHOCRATES - March 11th, 2012

Week in Review

The two oil crises in the Seventies hurt Japan’s economy.  Because the Japanese have little domestic energy sources.  Which means they have to import most of their energy.  Coal.  Natural gas.  And, of course, oil.  After suffering the economic fallout of two oil crises in one decade they made a decision to prevent that from happening a third time.  By diversifying their energy industry.  And going nuclear.  Increasing the amount of electricity produced by nuclear power to almost 25%.  Which helped to insulate them from another economic shock.  But that all changed with the 2011 Fukushima nuclear disaster (see Japan reports record current account deficit posted 3/7/2012 on BBC News Business).

Japan has reported a record current account deficit because of rising energy imports, as the country’s economic recovery remains fragile…

In the aftermath of the 11 March 2011 tsunami and earthquake that triggered a meltdown at the Fukushima nuclear reactor, Japan shut 52 out of 54 reactors.

This led to shortages of fuel for generating electricity, which meant more of it had to be imported…

The yen slipped to trade at 81.26 to the US dollar, as the trade deficit raised fears about how long Japan would be able to manage its large public debt.

The massive earthquake created the massive tsunami.  The tidal surge of the tsunami caused the Fukushima nuclear disaster.  An extremely rare event.  It has only happened once in the era of nuclear power.  In fact, the nuclear part of the reactor survived all of this.  It was the old technology that didn’t.  The electrical distribution equipment.  Because it was located in the basement.  Which became flooded with sea water.  Which disabled the electrically driven cooling pumps from operating.  Despite backup generator power being available. 

The technology exists to move electrical distribution equipment to higher ground.  And to waterproof it.  There exists power cables rated for underwater use even.  There is no technological hurdle preventing the kind of electrical updates to prevent another extremely rare event causing another electrical failure like at Fukushima again.  And they’re simple projects, really.   Build new distribution equipment on high ground where a tidal surge can’t reach it.  And rerouting critical systems to this new distribution equipment.  You could do this.  Or you could shut down 52 of your 54 reactors for political reasons.  And import more fossil fuels (coal, natural gas and oil) to make up for the energy shortfall.  Increasing your trade deficit.  And risking your ability to pay one of the highest debt loads of any state (as a percentage of GDP).

One thing you can’t do, though, is make up this energy shortfall with solar or wind power.  Because the cost of building the infrastructure to produce that much energy is prohibitive.  And the power it produces is too unreliable.  For sometimes the sun doesn’t shine.  And sometimes the wind doesn’t blow.  So to please the antinuclear environmentalists who fear another extremely rare event from happening they have to replace clean energy (nuclear generated) with dirty energy (fossil fuel-generated).  Which doesn’t make a lot of sense.  Then again, political decisions rarely do.

To put this into perspective consider this.  Your odds of lightning striking you are greater than you winning the lotto.  Yet your chances of winning the lotto are greater than another Fukushima from happening.  And people will buy lotto tickets.  But they shun nuclear programs.  Unless, that is, a rogue regime is using it to enrich uranium that could also be used to make a nuclear bomb.  And that regime is Islamist.  Which wants to conquer the world.  Strange how Japan has to shut down their nuclear program while Iran doesn’t.  A country, incidentally, that sits on huge petroleum reserves.  And doesn’t need nuclear power.

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Japan Oil Imports increase and Exports of Manufactured Goods decrease resulting in First Trade Deficit in 31 Years

Posted by PITHOCRATES - February 19th, 2012

Week in Review

Japan sets another record.  The country that once could do no wrong in its export market sees its first trade deficit in 31 years (see Japan logs record trade deficit in January by Rie Ishiguro posted 2/19/2012 on Reuters).

Japan posted its biggest ever trade deficit in January…may undermine the country’s ability to finance its debt.

The trade deficit stood at 1.475 trillion yen ($18.59 billion), against median market forecast for 1.468 trillion yen, marking a fourth straight month of deficit, as weak global demand and a strong yen hurt exports and robust fuel demand boosts imports.

Japan doesn’t have a lot of oil.  They have to import most of it.  And as domestic oil demand rises and demand for their manufacturing exports fall their trade deficit increases.  If Japan had more domestic oil fields to exploit they probably wouldn’t have a trade deficit.  Even with their falling exports.  

You know, I can think of another country with a trade deficit.  Who has a far greater land mass than Japan.  And far more coast line.  With who knows how much oil beneath.  And they, too, have an oil-thirsty economy.  But they, too, import most of their oil.  Not because they have no other choice.  But because of anti-oil policy keeping that oil undiscovered.  And unrefined.  Can you name that country?  Here’s a hint.  Its initials are U.S.A.

The Obama administration stimulus of 2009 saved millions of jobs.  Though there is no way to actually measure this the administration claimed it nonetheless.  Because they have a magical crystal ball.  Just like the one I have.  And when I look into it I see remarkable things.  In particular I see the future where we exploit our domestic oil reserves.  In that future there is a trade surplus.  Millions of jobs saved.  And millions of new jobs added monthly bringing the unemployment rate below 5% (i.e., full employment).  A federal budget surplus.  A triple-A credit rating from all the credit rating agencies.  A strong U.S. dollar.  And a very low inflation rate.  A nice future.  A very nice future indeed.  And a future that can be supported by the math.

If we bring new domestic oil to market all of these things will happen.  How do we know this?  Because when we bring less domestic oil to market the exact opposite happens.  As the Obama administration has proven by their policies.

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A Limping U.S. Economy gets no help from WTO Ruling, Inflation or Entitlement Spending

Posted by PITHOCRATES - May 18th, 2011

The WTO Rules against the US/Boeing in favor of EU/Airbus

Government subsidies are costly.  In more ways than one (see WTO Airbus ruling leaves both sides claiming victory by the BBC posted 5/18/2011 on the BBC News Business).

“This report confirms for decades the European Union… [has] provided massive amounts of market-distorting launch aid and other subsidies that are inconsistent with WTO rules.”

However, Airbus’ Mr Enders claimed the decision meant Germany, France, the UK and Spain could continue providing funding for Airbus via public-private partnership arrangements…

Earlier this month in a separate case, Boeing was found guilty of receiving over $5bn of unlawful subsidies from Washington.

Ever price a Boeing 747?  If you’re looking to buy one today it’ll set you back some $300 million.  Each.  It’s a big plane with a big price tag.  But it’s a money maker.  Once upon a time she ruled the skies.  It was every airline’s long-haul choice.  Because it could carry more people than anything else out there.  And the more people you pack into an airplane the more money you make.  Economies of scale.  That’s why the Concorde is no longer in service.  It didn’t make money.  Seating only 100 people it couldn’t charge enough in ticket prices to offset the great costs of flying it and make a profit.  So it was only a prestige thing for British Air and Air France.  And a toy for the super rich.

The 747 soon faced competition from Airbus.  First the A330 and A340.  Then the double-decker A380Boeing lost sales to Airbus.  And not always fairly.  According to them.  The consortia that made up Airbus (Germany, France, the UK and Spain) subsidized Airbus.  Thus making Airbus planes more cost competitive than those from rival Boeing.  Why does this matter?  Look again at the price of a 747.  It’s the biggest U.S. export product.  And in a nation with a declining manufacturing base and an increasing trade deficit, anything that reduces sales of Boeing planes hits their balance of trade hard.  So much so that even the U.S. government tries to subsidize Boeing to help them compete against Airbus.

With the WTO ruling, Airbus subsidies will continue.  Cutting more into U.S. manufacturing.  And increasing the trade deficit.  Not good economic news for the Americans.  Among other bad news.

Unemployment and now Inflation

Ben Bernanke has been trying to resuscitate a flat-lining U.S. economy with free money.  Hasn’t improved the numbers much.  The unemployment rate just went up.  The economy isn’t looking good.  And now this (see Inflation concerns dominate April Fed meeting by the Associated Press posted 5/18/2011 on the Los Angeles Times).

The Federal Reserve last month began debating how it should start reversing policies that pumped billions of dollars into the economy during the recession. Some members said the Fed might need to start boosting interest rates this year to guard against inflation…

Some members thought the Fed would need to start signaling that record-low interest rates would need to rise. A few members believed the Fed might need to boost its key interest rate or start to sell some of the assets in its portfolio later this year. Both moves would lead to tighter credit and higher rates on consumer loans.

Inflation.  Like the Americans didn’t have enough to worry about with a declining manufacturing base, a growing trade deficit, high unemployment and a recession that doesn’t end.  And if that wasn’t bad enough, entitlement spending just keeps piling on the woe in large deficits.  That adds to the debt.  Forcing the Americans to borrow ever more.  So much so that Standard and Poor’s took notice and lowered their outlook for the U.S. economy.  Not a good thing when you’re trying to sell treasury bonds.  Things are getting a little difficult in the United States.

Entitlement Spending Heralding the end of the Republic?

Thankfully, America has a representative republic.  Where there are responsible, disinterested wise people between the people and the treasury.  Because the masses don’t understand public finance as well as these wise people, the wise can step in and protect the people from themselves.  For as Benjamin Franklin warned, once the people learn they can vote themselves the treasury it will herald the end of the republic.  So they, the wise, will step in and address the entitlement spending problem.  Per the responsible, disinterested Founding Fathers‘ design (see Healthcare ills infect 2012-bound Republicans by Patricia Zengerle posted 5/18/2011 on Reuters).

The Republican budget plan passed by the House of Representatives last month would repeal the Obama healthcare law, scale back spending on the state/federal Medicaid healthcare program for the poor and implement the plan from Ryan, chairman of the House Budget Committee.

With polls showing two-thirds of Americans prefer to keep Medicare in its current form, Democrats have been rushing to take political advantage…

“Candidates already are capitalizing on this issue and using it to say Republicans are outside the mainstream,” said Darrell West of the Brookings Institution think tank.

Or not.  Some will take the low road.  And politicize the crisis for personal gain.  Even knowing full well that today’s gains could very well destroy Social Security, Medicare and Medicaid for future recipients.  This would be the polar opposite of the selfless Founding Fathers.  Who tried to build a nation that would stand the test of time.  Unlike the selfish of today who are just looking out for themselves.

The Here and Now versus Tomorrow

Everyone knows there is an entitlement spending problem.  And some are more than willing to trade a hard future for an easier today (see FEULNER: Saving the American dream by Ed Feulner posted 5/16/2011 on The Washington Times).

America is on the verge of becoming a country in decline – economically stagnant and permanently debt-bound, heavily regulated and bureaucratic, less self-governing and less free…

To get our fiscal house in order, we must address Social Security, Medicare and Medicaid, the three so-called “entitlement” programs that together account for 43 percent of federal spending…

Almost half of the federal budget is entitlement spending.  And it’s growing.  Baby boomers are now retiring.  Living far longer into retirement than anyone guessed.  And because they’re living longer into retirement they’ve consuming far more health care than anyone guessed.  They cannot sustain this spending.  It’s why GM went bankrupt.  It was those generous union contracts that did her in.  Pensions and health care.  Spent on people no longer working.  Now America is GM writ large.  And anyone who thinks it can end differently is in denial.

Edmund Burke reminds us to think of our time on this earth not as an individual and temporary event, but rather as a partnership “between those who are living, those who are dead and those who are yet to be born.”

Those in Washington are not looking to the past or the future.  Apparently, all they care about is the here and now.  And as long as they get theirs they don’t care about tomorrow.  If you listen closely, that sound you hear is the tears of the Founding Fathers.  Or the cursing.  For I understand that George Washington had quite the temper.

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