WTO's Pascal Lamy Challenges Protectionists

In a speech before the Paris School of Economics, WTO director Pascal Lamy dispels mercantilist myths and calls protectionists to an open debate.

Here is the Mr. Lamy's speech: [all black and blue bold highlights including italics-mine]

It is a great pleasure for me to be here today. I can think of no better place than the Paris School of Economics for what I wish to discuss today — facts and fictions about international trade economics.

Economists have long analysed and helped us understand trade, why nations needed it to prosper, and what governments had to do to reap the gains while managing the costs. The many theories you and your predecessors have developed leave no doubt about the importance of trade to growth and economic development.

But if the economics of trade policy are clear, the politics of trade are highly complex. Trade policy, like so many other areas of policy, has ramifications on how resources are distributed, and this inevitably creates competing interest groups within society. Pressures exerted by such groups mean governments must balance these interests in ways that do not necessarily conform to what economic analysis might prescribe.

The public debate that inevitably accompanies contested policy formulation challenges the notion that open trade brings overall societal benefits. At the same time, contested policy provides a fertile field for the growth of urban legends and falsely premised ideas with popular appeal.

In my comments today, I wish to identify and address some of these fallacies. We need to bring sound economic analysis to centre-stage in this debate. Secondly, I want to locate trade policy in a wider policy setting because it is at our own peril that we take trade policy and all its political complexities out of their proper context.

Fallacy #1: Comparative advantage does not work anymore

At the outset, let me recognize Paul Krugman’s intellectual contribution to international trade theory — the so-called “new trade theory” — in which he shows that, even in the absence of productivity differences between two countries, trade benefits them both. He focuses on the presence of increasing returns to scale, in which a firm’s average cost per unit declines as production increases and underscores that consumers value variety in consumption. While the new trade theory reduces the role played by comparative advantage, it identifies new sources of benefits from trade that were not emphasized or recognized by the classical economists. More trade benefits all countries because specialization in production reduces average cost and consumers gain access to a wider variety of products. In contrast, traditional theories of trade assume the variety of goods remains constant even after trade-opening.

We often hear the claim that the principle of comparative advantage and mutually beneficial exchange may have been true in the past, but it no longer applies in the 21st century — where, among other changes we see the seemingly inexorable rise of countries like China and India.

There are those who now call into question Ricardo's theory that differences in relative productivity between countries lead to their specialization in production and to trade. Doubt has arisen that this specialization based on comparative advantage results in higher total output, with all countries benefiting from the increased production.

There is a much-cited paper by Paul Samuelson in the Summer 2004 issue of the Journal of Economic Perspectives which showed theoretically how technical progress in a developing country like China had the potential to reduce the gains from trade to a developed country like the United States. This paper appeared to be a dramatic about-face against the idea that open trade based on comparative advantage is mutually beneficial.

I emphasize the word “appeared” because subsequent analysis by Jagdish Bhagwati, Arvind Panagariya, and T. N. Srinivasan contradicted this view. In that paper, starting from autarky, China and the United States open up to trade and experience the usual gains based on comparative advantage. In the following part of the paper, Samuelson considers how technological improvements in China will affect the United States. In the case where China experiences a productivity gain in its export sector, both countries benefit. China gains from the higher standard of living brought about by the increase in productivity while the United States gains from an improvement in its terms of trade. In the case where China experiences a productivity gain in its import sector, there is a narrowing of the productivity differences between the countries which reduces trade; and as trade declines, so too do the gains from trade.

So what Samuelson has showed is not that trade along lines of comparative advantage no longer produces gains for countries. Instead, what he has shown is that sometimes, a productivity gain abroad can benefit both trading countries; but at other times, a productivity gain in one country only benefits that country, while permanently reducing the gains from trade that are possible between the two countries. The reduction in benefit does not come from too much trade, but from diminishing trade. Furthermore, even in this case, Samuelson himself does not prescribe protectionism as a policy response since, as he put it ,“what a democracy tries to do in self defense may often amount to gratuitously shooting itself in the foot”.

In my view, the analysis by Bhagwati, Panagariya and Srinivasan should convince us that the principle of comparative advantage, and more generally, the principle that trade is mutually beneficial, remains valid in the 21st century.

Fallacy #2: It is unhealthy for trade to grow faster and faster compared to output

After the Second World War we have seen a marked expansion of international trade, with trade growing much faster than world production. The ratio of international trade to the value of world GDP has risen from 5.5 per cent in 1950 to over 20 per cent today. There are those who argue that this trade expansion poses a danger to the health of the global economy.

I would argue this is a reflection of the international fragmentation of production and the rise of trade in intermediate products. Reductions in transport costs, the information technology revolution, and more open economic policies have made it easier to “unbundle” production across a range of countries. The parts and components that make up a final product are manufactured in different countries around the globe, many of which are developing countries. These intermediate goods may cross national borders several times before they are assembled as a final product. Some of what passes for international trade is in reality intra-firm trade, exchanges of intermediate inputs and goods for processing between establishments belonging to the same company. By allowing each country that is a member of the supply chain to specialize in the part or component in which it has a comparative advantage, the internationalization of supply chains creates enormous economic benefits.

This growth in the trade of parts and components means that import statistics will overstate the degree of competition that comes from one’s trade partners. In international trade theory, trade in goods is seen as a substitute for the movement of factors of production. Thus, a country's imports of goods from its trade partner are seen as additional supplies of the partner country's labour and capital, which competes with the importing country's own workers and entrepreneurs. But the share of value added by factors of production of the origin country in traded products is considerably lower than in the past.

Take the example of an iPod assembled in China by Apple. According to a recent study, it has an export value of $150 per unit in Chinese trade statistics but the value added attributable to processing in China is only $4, with the remaining value added assembled in China coming from the United States, Japan, and other Asian countries. Now I know we tend to use statisticians like lamp posts — both for support and for illumination — but I find these statistics very enlightening. The degree to which a given volume of imports implies competition between the factors of production in the country of origin and the importing country's factors of production will be overstated. Focusing on gross values of trade or imports coming from a particular country also understates the degree to which the importing country’s own firms benefit from trade because part of their output is incorporated in the imported good.

So bilateral trade statistics may not correctly reflect the origins of traded products. To go back to the example of the $150 dollar iPod imported from China, it turns out that less than 3% ($4 out of $150) of the value of the product reflects China’s contribution, with the bulk of the product’s value being made by workers and enterprises in the United States, Japan and other countries. And yet current trade statistics would attribute $150 to Chinese exports.

Relying on conventional trade statistics also gives us a distorted picture of trade imbalances between countries. What counts is not the imbalances as measured by gross values of exports and imports, but how much value added is embedded in these flows. Let us take the bilateral trade between China and the United States as an example. Based on data from the Institute of Developing Economies (IDE-Jetro) and WTO estimates, in 2008 the domestic content comprised 80% of the value of the goods exported by the US. The comparable figure was 77% in the case of Japan, 56% for Korea and 42% for Malaysia and Chinese Taipei, meaning that about half the exported value originated from other countries. Using conventional trade statistics would overestimate the US bilateral deficit vis-à-vis China by around 30% as compared to measuring in value added content. The figures would reach more than 50% when the activity of export processing zones are fully taken into account. Does it make sense for us to start measuring trade in value added rather than on gross value as is the case today!

Fallacy #3: Current account imbalances are a trade problem and ought to be addressed by trade policies.

Imbalances are a natural and widespread economic phenomenon, if we only care to observe it. If we examine the flows of spending and income between Aix en Provence and the city of Paris, or between the 16ème and 5ème arrondissements of Paris for that matter, the flows are not balanced. But we do not think this is a problem and make no big deal of it. Yet we worry about imbalances between countries.

I think one legitimate reason why one may be more concerned about imbalances between countries is that they may be governed by a different set of economic institutions and regulations. Fiscal and monetary policies are likely to be different. Regulations, particularly in the financial sector, could also differ even among neighbours. Exchange rate systems may vary significantly as well. These differences may introduce “distortions” and thus provide a legitimate reason to pay greater attention to imbalances among countries. Another reason for paying attention to imbalances is when the amounts are large, in absolute and relative terms, and there is fear that they could have significant spillover effects on other countries.

Current account imbalances between countries are primarily a macroeconomic phenomenon, a sign of international differences in aggregate savings and investment behaviour and have little to do with trade policy. A current account deficit of a country reflects dissaving by domestic residents — an excess of total expenditures, both private and public, over national income. A current account surplus, on the other hand, represents savings by domestic residents with national income exceeding total expenditures.

Put in another way, a current account surplus is created if domestic savings exceeds domestic investment, which means that the country is a creditor to the rest of the world. A current account deficit ensues if domestic savings is less than domestic investment, in which case, the country is drawing on savings provided by foreigners.

The growth of global imbalances in the last decade reflects in part the greater integration of financial and capital markets. This has made it easier to accommodate big differences in savings propensities and investment opportunities across countries. Domestic residents can afford to save less because citizens of other countries are saving more, and with few restrictions on capital flows, those foreign savings can be made available at lower cost to domestic residents.

In the absence of policy distortions, imbalances provide a means to better allocate capital internationally. Imbalances are a sign that savings in one country are being deployed or used in another country. If investment prospects are plentiful in a country, but its residents are unable to generate a sufficient amount of saving to exploit them, foreign savings can fill the gap. The domestic economy benefits from being able to undertake the profitable investment project while foreign investors get a higher return than what they can obtain in their own country.

Given that current account deficits and surpluses originate in differences in savings propensities and investment opportunities across countries, trade restrictions will not permanently reduce deficits since they do not alter the underlying conditions driving the imbalances. In fact restrictions could make matters worse. First, they can trigger retaliatory action by those affected by the import restrictions. Second, import restrictions create economic inefficiency, not least in the country applying the restrictions. As Abba Lerner taught us a long time ago, policymakers often fail to recognize that one undesirable, but irrefutable consequence of applying import restrictions is that such restrictions also discourage exports.

Given that differences in savings behaviour between countries lie at the root of current account surpluses or deficits variations in exchange rates will not correct chronic imbalances.

Exporters, moreover, often do not fully pass through the effect of an exchange rate appreciation or depreciation to the selling price in export markets. There is an extensive economic literature that documents this “less than full pass through” to prices of exchange rate changes in a wide variety of industries from automobiles to photographic film to beer. This may explain why empirical studies about the impact of exchange rate changes on imbalances tend to show only limited or ambiguous effects and why adjustment in exchange rates may have little effect on imbalances.

My arguments assume that exchange rates are allowed to adjust freely to their equilibrium levels as determined, for example, by long-term inflation differentials as in the so-called purchasing power parity theory, or by interest rate differentials as in the classic Mundell-Fleming explanation. I know that the lack of exchange rate flexibility in some countries has been raised as a problem in the context of global imbalances. The only thing I can say about this issue is that it is difficult to talk about the optimal exchange rate system for a country — whether completely flexible or fixed — without addressing the much broader question of what the appropriate international monetary system must be.

Fallacy #4: Trade destroys jobs

The problem with the argument that trade destroys jobs is that it sees only the threat posed by imports to jobs but does not take into consideration how jobs may be created in the export sector as a consequence of trade opening. It also fails to take into account that trade opening can increase the rate of economic growth, and therefore improve the ability of the economy to create new jobs.

I recognize that traditional trade models assume full employment so that more trade in those models does not result in the creation of new employment. Jobs are merely reallocated from shrinking to expanding sectors. Nevertheless, even if trade opening does not necessarily create new jobs, the re-allocation of labour is valuable. It means workers are moving from sectors where their marginal product is lower to those where it is higher, resulting in productivity gains to the economy and increased output.

More open trade can increase the rate of economic growth by increasing the rate of capital accumulation, speeding up technological progress through innovation or knowledge creation, and improving the quality of institutions. A country that opens up trade may become more attractive to foreign investors with more foreign capital flowing to its shores. Since technology is often embodied in goods, trade can be a very effective means of diffusing technological know-how.

Another way in which trade can increase productivity is “learning-by-exporting”, whereby participation in world markets enables producers to lower costs or move up the value-added chain over time. This diffusion of technology through trade is important because of the skewed distribution of research and development expenditures around the world, which is even more skewed than the distribution of world income. For example, the G-7 countries accounted for 84 per cent of global R & D expenditures in 1995 but only 64 per cent of global GDP. Finally, international trade can have a positive impact on the quality of a country's institutions, such as the legal system, which in turn improves economic performance. A faster growing economy will be able to absorb more workers than a slow-growing or stagnant economy, a point that may be particularly important for poor countries with large or rapidly expanding populations.

Trade opening can today contribute to economic growth and through that to creating much needed jobs. The stimulus package of the Doha Round is there to be taken.

Fallacy #5: Trade leads to a race to the bottom in social standards.

Some have argued that more trade will drive governments in rich countries to lower their social or labour standards. More trade would hurt workers in rich countries. The problem with this argument is that there is very little empirical basis for it. It is difficult to find examples where countries have lowered social or labour standards in response to trade competition.

One variant of this argument has been used by Emmanuel Todd who claims that open trade between developing countries such as China and industrial countries is the reason for the economic crisis. In his view, the competition coming from low-wage countries has put pressure on wages in industrial countries and caused a deficiency in aggregate demand.

I would argue that differences in wages largely reflect differences in labour productivity. There is a fairly close correlation between wages and productivity across countries with some estimates going so far as to suggest that 90 percent of wage differences between countries can be explained by productivity differences. While wages in many developing countries may be low, labour productivity in these countries is also a fraction of western levels.

A more fundamental problem with Todd’s analysis of the causes of the economic crisis is his presumption that trade is a zero sum game, that what one nation gains, another country loses. But we know from economic theory that trade is mutually beneficial and that there are overall gains to countries who are involved in trade. Hence, trade should increase incomes of trading countries and, consequently, increase demand rather than lead to a deficiency in demand.

The rise of China and India meant the integration of tens, if not hundreds, of millions of Chinese and Indian workers into the global economy. What is astonishing is that this integration occurred at the same time unemployment rates in OECD and Euro zone countries were declining. Between 1998 and 2008 for example, the average unemployment rate in the Euro area fell from 9.9% to 7.4% while the corresponding reduction in the OECD countries was from 6.6% to 5.9%. Surely, if the zero sum argument is correct, the rise of China and India would have thrown millions of workers in developed countries out of work.

Finally, some also argue that trade has been responsible for the observed widening of the gap in the wages of skilled and unskilled workers in industrial countries. However, much of this gap can be explained by skill-biased technological change rather than by trade. Skill-biased technological change refers to improvements in technology, such as the information technology revolution, which increased demand for skilled workers relative to unskilled workers. In the United States, this technological change combined with the slowdown in the relative supply of college-equivalent workers led to the expansion of wage differentials between skilled and unskilled workers. While industrial countries have experienced greater trade openness during the same period, trade has not played a big role in rising wage inequality. Empirical studies that have attempted to measure the contribution that trade has made to inequality give estimates of only between 4% and 11% to 15%.

Fallacy #6: Opening up trade equals deregulation

There is a tendency to confuse trade opening with deregulation of the economy. One way to distinguish between the two is that trade opening refers to a reduction in trade barriers or a reduction of those measures that discriminate against foreign goods and services. A country that opens up to trade does not compromise its ability to regulate, provided of course those regulations do not discriminate in an unjustifiable manner against foreign goods and services, thus contradicting opening commitments.

There are many good reasons why governments intervene in the economy and why such intervention needs to continue even while trade is being opened. The production or consumption of a good may generate pollution (an environmental externality) as a by-product. The market for a good or service may be characterized by information asymmetry, with sellers being more informed about the quality or safety of their product than buyers. Firms may be restricting competition by colluding or abusing their dominant position. There may be moral hazard, i.e. excessive risk taking, in the banking system because of the existence of deposit insurance. In all these cases, regulations may form part of the public policy response to the underlying market failures. Moreover, there are very legitimate distributional reasons for governments to intervene in markets with a view, for example, to improving poor people's access to public services or to ensure equitable access to such services across all regions of a country. WTO rules do not constrain governments' ability to pursue such regulatory objectives.

To see the difference between trade opening and deregulation, I would like to take financial services in the North American market as an example. The North American Free Trade Agreement (NAFTA) opened up cross-border trade in financial services between Canada and the United States, but otherwise allowed each country to retain its system of financial governance. I believe this is one reason why despite freer trade in financial services, the financial systems of Canada and the United States had radically different experiences during the financial crisis. Lax regulations in the U.S. mortgage market contributed to the resulting sub-prime crisis. Meanwhile, on the other side of the border, for Canadian banks, which were more tightly regulated, sub-prime loans in 2006 accounted for less than 5% of new mortgages in Canada, compared to 22% in the United States. They were hardly touched by the crisis. In the midst of the global crisis in late 2008, they remained liquid and had an average tier 1 capital ratio that was significantly above the regulatory minimum.

The issues I have touched upon today are crucial to get the economics of trade right. But they can also contribute to a more informed political debate on trade. We need debate, and informed choices, because trade has an impact on our lives, whether as workers or as consumers.

But I also wish to avoid getting stuck in the old policy rut that simply promotes greater trade openness as a matter of virtue or as the secret of a nation's economic success. Debunking fallacies about trade is not enough. We should always remind ourselves that trade is but one element of the story, an element from which it is possible to expect too much as well as too little.

The benefits from open trade will only be realized if the overall policy context is right. This is why I believe that what I have referred to as the “Geneva Consensus” is so important. The essence of this consensus is that trade openness can — and I stress CAN — contribute to economic well-being and political harmony in important ways, but only if other conditions are met. What are these conditions?

Firstly, we need sound macroeconomic policy, and not a doctrine that sees trade policy as a quick fix for over-arching economic fundamentals.

Second, trading opportunities created by openness are worth little, and perhaps even unwelcome, if price signals do not reach their destination because this is made impossible by a lack of physical infrastructure and functioning markets. These elements are part of a basic development agenda, one in which the international community certainly has a role. This is why I have placed so much emphasis on the Aid-for-Trade initiative. This programme is firmly grounded in the belief that facilitating trade in the broadest sense is part of a grand international bargain. I should emphasize that arguing for pre-conditions to make trade openness work is not to make the case for eschewing trade openness. On the contrary, it is the case for creating conditions to embrace openness.

Finally, governments have a responsibility to address the distribution of the benefits from trade. If trade opening is perceived as benefiting a small privileged group, quite possibly at the expense of others in society, then it loses its political legitimacy. Spreading the benefits from trade is no easy matter, especially for poor countries. Challenges arise both in terms of adjustment costs associated with changes in relative prices, as well as in a more fundamental sense which has to do with creating social infrastructure and personal opportunity.

These are just a few facts that I wanted to share with you and I would like to thank you very much for your attention.

Let the public debate commence now.

Burt Folsom On The Franklin D Roosevelt Myth

Professor and author Burt Folsom Jr. argues in Wall Street Journal why President Franklin D. Roosevelt's perceived heroism is a myth.

Quoting Professor Folsom: (bold highlights mine)

``Let's start with the New Deal. Its various alphabet-soup agencies—the WPA, AAA, NRA and even the TVA (Tennessee Valley Authority)—failed to create sustainable jobs. In May 1939, U.S. unemployment still exceeded 20%. European countries, according to a League of Nations survey, averaged only about 12% in 1938. The New Deal, by forcing taxes up and discouraging entrepreneurs from investing, probably did more harm than good.

``What about World War II? We need to understand that the near-full employment during the conflict was temporary. Ten million to 12 million soldiers overseas and another 10 million to 15 million people making tanks, bullets and war materiel do not a lasting recovery make. The country essentially traded temporary jobs for a skyrocketing national debt. Many of those jobs had little or no value after the war.

``No one knew this more than FDR himself. His key advisers were frantic at the possibility of the Great Depression's return when the war ended and the soldiers came home. The president believed a New Deal revival was the answer—and on Oct. 28, 1944, about six months before his death, he spelled out his vision for a postwar America. It included government-subsidized housing, federal involvement in health care, more TVA projects, and the "right to a useful and remunerative job" provided by the federal government if necessary.

``Roosevelt died before the war ended and before he could implement his New Deal revival. His successor, Harry Truman, in a 16,000 word message on Sept. 6, 1945, urged Congress to enact FDR's ideas as the best way to achieve full employment after the war.

``Congress—both chambers with Democratic majorities—responded by just saying "no." No to the whole New Deal revival: no federal program for health care, no full-employment act, only limited federal housing, and no increase in minimum wage or Social Security benefits.

``Instead, Congress reduced taxes. Income tax rates were cut across the board. FDR's top marginal rate, 94% on all income over $200,000, was cut to 86.45%. The lowest rate was cut to 19% from 23%, and with a change in the amount of income exempt from taxation an estimated 12 million Americans were eliminated from the tax rolls entirely.

``Corporate tax rates were trimmed and FDR's "excess profits" tax was repealed, which meant that top marginal corporate tax rates effectively went to 38% from 90% after 1945.

``Georgia Sen. Walter George, chairman of the Senate Finance Committee, defended the Revenue Act of 1945 with arguments that today we would call "supply-side economics." If the tax bill "has the effect which it is hoped it will have," George said, "it will so stimulate the expansion of business as to bring in a greater total revenue."

``He was prophetic. By the late 1940s, a revived economy was generating more annual federal revenue than the U.S. had received during the war years, when tax rates were higher. Price controls from the war were also eliminated by the end of 1946. The U.S. began running budget surpluses.

``Congress substituted the tonic of freedom for FDR's New Deal revival and the American economy recovered well. Unemployment, which had been in double digits throughout the 1930s, was only 3.9% in 1946 and, except for a couple of short recessions, remained in that range for the next decade."

Media Indicators And Market Reversals

It is said that media coverages could somehow portend the flows and ebbs of the financial markets. The reason for this is that media tends to highlight on the most dominant trend, or the extremes of public sentiment.

For instance, in the past, major market inflection points have been 'captured' by the so-called "magazine cover indicator".

As wikipedia.org defines,

``The Magazine cover indicator is a somewhat irreverent economic indicator, though sometimes taken seriously by technical analysts, which says that the cover story on the major business magazines, particularly BusinessWeek, Forbes and Fortune in the United States is often a contrary indicator.

``A famous example is a 1979 cover of BusinessWeek titled "The Death of Equities". The '70s had been a generally bad decade for the stock market and at the time the article was written the Dow Jones Industrial Average was at 800. However, 1979 roughly marked a turning point, and stocks went on to enjoy a bull market for the better part of two decades. Even after the financial crisis of 2007–2010, stocks remain far above their 1979 levels. Using the Magazine Cover Indicator, Business Week's projection that equities were dead should have been a buy signal. By the time an idea has had time to make its way to the business press, particularly a trading idea, then the idea has likely run its course. Similarly, good news on a cover can be taken as an ill omen. As Paul Krugman has joked "Whom the Gods would destroy, they first put on the cover of Business Week.""

Has the recent upbeatness of markets as revealed by this magazine cover forebode an upcoming reversal?

picture courtesy of The Economist

I am not sure about the consistency or infallibility of this indicator though.

What has been framed has been the coincidences which has exhibited "the right timing" between magazine covers and market inflection points in the past.

What has not been shown has been the success ratio or the statistical 'batting averages' between the general incidences of sentiment revealing magazine covers and market inflection points.

Picking a point or two can be "selective perception" to enforce a bias, rather than applying objective analysis.

Although based on the behavioral framework, there could be some support for this; as mentioned above, the dominant sentiment could mean "overconfidence" or recklessness or deeply entrenched view from the prevailing trend, which is common during bubble tops.

Next, I find another spook story from Business Insider.

It's about the attempt to connect market performance with the upcoming sequel of the 1987 movie-Wall Street II.

This from the Business Insider,

``Some have wondered whether the forthcoming release of Wall Street II movie by Oliver Stone portends a market crash, considering that the last Wall Street was released right before the crash of 1987.

``Actually, this line of reasoning understates the case.

``There was actually another movie called Wall Street that came out in 1929. Of course, the market collapsed that year, too."

Again, correlation doesn't imply causation. It doesn't mean that "Wall Street" type movies would automatically result to another market crash from which the authors tries to imply. It's more representative of the their bias than of a logical argued conclusion.

Nevertheless, given the market's overbought conditions, a retrenchment is likely in the cards.

How Moralism Impacts The Markets

``Man, on the other hand, does not now possess a like set of instinctual do-nots: built-in prohibitions. Instead, he must enjoy or suffer the consequences of his own free will, his own power to choose between what's right and what's wrong. In a word, man is more or less at the mercy of his own imperfect understanding and conscious decisions.” -Leonard E. Read Find the Wrong, and There's the Right

WHENEVER someone quotes passages from the Holy Scriptures, in social media or in articles, in order to preach their version of morality, I would almost cringe out of cynicism. Quoting the Bible per se isn’t what I am averse at, but it is the excerpts meant to pontificate on one’s perceived sense of virtues.

Fundamentally, that’s because morality or our sense or perception of right or wrong has massive political implications. And being no stranger to the Bible, which is a daily fare for me, it is my understanding that “sacred words” can be construed or interpreted differently.

Moralism As False Reality

One of the worst things we see from self-designated moralists is reductionism, i.e. the oversimplification of reality as solely operating based on morally redeeming actions.

This view myopically ignores the role of scarcity (resources, time and spatial constraints), prices, individual scale of values, distinctive perception and interpretations of information depending on the sources or the accounts of events, cost of decisions (opportunity costs), cognitive biases, the impact of social mores, rules and regulation and authority, peer influences and the role of human action in adapting to a constantly changing environment.

It would always seem plausible to argue from a generalized standpoint on abstractions as honesty, fairness, equality and etc., but from a case to case basis such applications can exposed as being muddled or twisted or vastly misunderstood. For instance, people can all be honest in their actions, but conflicting opinions, based on interpretation of events or respective interests on how to distribute resources, can lead to conflicts[1].

The fact that conflicts are frequent occurrences even among family members, among friends, associates, or in other diverse types of social interactions reveals of human frailty which is not necessarily about the lack of virtues. Yet self-designated moralists ignore this reality.

As Gene Callahan writes[2], ``Abstraction can be an entertaining and useful activity. But every abstraction falsifies reality simply because it is an abstraction – it is a one-sided emphasis on certain aspects of the real at the expense of neglecting or even denying others. That is not necessarily harmful as long as we remember what we have done. But the abstraction, being simpler and more manageable than the real world, is a seductive fantasy, and the temptation to ignore messy reality and attempt to replace it with a clean and neat dreamworld.” (bold emphasis mine)

In other words, morality as a form of escapism will simply not work.

True, moralization is always melodious to hear. That’s why moralism is the primary staple of politics. Yet, a caveat is that one should vet if the incentives guiding such moralizers matches with their actions.

That’s because morality can be used as instrument for different goals, such as to ingratiate oneself to acquire group acceptance or to promote political agenda-outside of faith alone.

Murray N. Rothbard[3] explains how these are achieved, through the lens of the founder of modern political science Niccolò Machiavelli, (all bold emphasis mine)

`` Following straightaway from power as the overriding goal, and from his realism about power and standard morality being often in conflict, is Machiavelli's famous defense of deception and mendacity on the part of the prince. For then the prince is advised always to appear to be moral and virtuous in the Christian manner, since that enhances his popularity — but to practice the opposite if necessary to maintain power. Thus Machiavelli stressed the value of appearances, of what Christians and other moralists call "hypocrisy."

More from Rothbard on the major work of “Old Nick”,

``Niccolò Machiavelli is the same preacher of evil in the Discourses as he had been in The Prince. One of the first atheist writers, Machiavelli's attitude toward religion in the Discourses is typically cynical and manipulative. Religion is helpful, he opined, in keeping subjects united and obedient to the state, and thus "those princes and those Republics which desire to remain free from corruption should above all else maintain incorrupt the ceremonies of their religion."

It’s no different when applied to many ASEAN tycoons. Author Joe Studwell argues that one of the chinks of vulnerability of the economic elite group has been insecurity. And this has led to an “obsession with status” of which religion is part of assimilative “IN” character ASEAN tycoons has toiled to attain.

``What no godfather believer suggests, but what may also be true, is that evangelical Christianity allows them to have a strongly held belief where their daily lives are all about expressing no beliefs at all unless given a cue by a political power. It is also possible to believe in religion without upsetting Asian politicians, whereas to have independent political or social views is disastrous[4].” (bold highlights mine)

In short, the need to be seen as “moral” is understandably just part of peoples’ prestige seeking intuition or can be a source of fulfilment of social esteem needs.

At worst, moralism can be used as manipulative tools to acquire and or maintain political power or privileges.

And it is the latter aspect which our revulsion is directed to.

Yet, for all its alleged angelic purity, moralizers fail to account for institutional lapses of the Church which had engaged in a nearly 200 year war known as the Crusades (This involved 9 major “Crusades” expeditions plus minor Crusades against Tatars, Balkans, Aragonese Alexandrian and Hussite[5]), the French Religious Wars[6] and even today’s controversial supposed cover up by the Pope of a priest engaged in child molestations[7] and other sex based scandals.

And one of the stated reasons of the Crusades was due to “an outlet for an intense religious piety which rose up in the late 11th century among the lay public” which ironically implies self-righteous intolerance (“us against them” concept). [Whatever happened to the doctrine of forgiveness?]

If World War II was about extremist nationalism, the earlier religion based wars accounted for fatalistic zealotry, both of which vainly fought for idealistic but demented causes aimed at the realization of the universality of morals based on the interpretations and perceptions of their leaders.

And this has been no different for the failed grandest experiment of the 20^th century: communism, whose death toll took a horrendous (estimated) 94 million lives[8], in a futile attempt at establishing a communist Utopia!

As Tibor Machan rightly avers[9] (bold highlight mine), ``Does morality need to be reconceived? If one considers what horrible deeds have been perpetrated in the name of serving others, there is little doubt that morality needs a serious reexamination. All the major tyrannies have been carried out in the name of making us serve others instead of ourselves. The very call to submit to czars and tyrants goes hand in hand with the idea that everyone needs to serve something bigger than himself in his life! That would be God or society or humanity. The individual certainly comes off as deserving little love from himself. From commencement speeches to sermons and political oratory galore, one's self doesn't much matter, only other people do. As the poet W. H. Auden quipped, "We were put here on earth to serve other people, what the other people were put here for I don't know."

Moralistic Policies of Redistribution and Inflation Nostrums

What has this got to do with markets? Everything.

Markets are simply mechanisms or platforms of social interactions, via property rights, contractual obligations and voluntary exchanges, meant to fulfil the needs and wants of individuals, which comprise a society, based on the principle of scarcity.

Where the moralists tends to fixate on certain angles, for instance in the flows of money from which exposes some or certain moral shortcoming, the desire to attain a moralist “utopia” or agenda means a call to action for political authorities to close on such gaps. Yet the political act of doing so translates to the curtailment of someone’s property rights or liberty in order to achieve a benefit for another. In short, someone’s benefit is another man’s burden or simply, redistribution.

The booming markets of today are manifestations of such redistribution.

The forcibly lowering of interest rates by global central banks punishes savers, depositors and lenders/creditors and rewards borrowers and speculators. It’s bizarre and dichotomous situation.

For the current crop of moralists, who mostly wears the hat of the regulators and their academic followers, a fixation on short term patches guided by economic theories based on government dicta of money printing and spending, essentially conditions the public’s mindset to engage in wanton immoral acts (of greed and speculation) from which they rail against. It’s like handing a child a bunch of porno magazines while telling him/her that nudity or reading sex magazines is immoral. Yet the mainstream hardly upbraids the skewed incentives provided for by today’s policymakers.

Yet since there is no free lunch, the effective price control coursed through interest rates, like the previous experience, should lead to a massive production and resource allocation distortions in the global economy, which should also be manifested on market pricing. And an eventual capital consumption would occur, following the transition of the boom-bust cycle, once the manipulations of the laws of economics becomes overstretched and snaps backs.

The central bank of Indonesia, which has determined that her markets are presently in a state of a bubble or “Whatever methodology we use” shows an excess valuation”, should be a clear example.

From Bloomberg[10], (bold highlights mine)

``Bank Indonesia board members last year discussed the risks posed by an influx of foreign funds, and the bank did a study on the feasibility of imposing capital controls, Warjiyo said. For now, the bank is “confident” Indonesia can cope.

There is “no need to put capital controls” in place now, Warjiyo said. “The existing framework of monetary policy through setting the benchmark interest rate, foreign-exchange intervention and managing expectations is able to manage monetary and financial stability.”

``At the same time, “if the market behaves irrationally, the study has some reference of measures that can be used to put sand in the wheel on capital flows on a temporary” basis, he said. Mulya said in his e-mail that the bank “reaffirms that there is no plan for capital control.” He also said the bank has a “cautious stance towards large capital inflow of late.”

While Indonesia’s central bank acknowledges that one of its primary or key policy tools is the benchmark interest rates, there will hardly be attributions that interest rates shape the public’s expectations and that the bubble cycles are manifestations of the artificially suppressed interest rates.

As you can see, policymakers are always portrayed as beyond reproach, always need to be seen in control and panders to the public’s impression that they can successfully shape or nurture the laws of economics to their whims....until the basic laws of economics unravels such pretentions.

Yet forcing savers to speculate out of the economic doctrine to spend is simply to rob the public of money, through inflation and eventual capital losses, via the said misplaced policies.

Will officials reverse the policies to curb from apparent “bubbles”? From their tones, they seem to be dithering. Hence the answer is no.

Moreover, with elevated asset prices reflecting economic “recovery”, short term triumphalism is likely to be the path dependency for the prospective actions policymakers: what worked in the recent past should work again (past performance equals future outcome)!

As you can see authorities are merely human beings subject to the same cognitive biases as everyone else.

Do policymakers really set the tone for interest rates?

We think and argue not (see figure 1)

Figure 1: Economagic: Markets Lead Policymakers In Setting Interest Rates

Using the US as example, for every bottom phase (black arrow) of the interest rates cycle, the 10 year constant maturity (red) leads the Fed Fund Rate (blue) higher. The same holds true for the inflection points of an interest rate peak, except during 1981.

In other words, authorities only respond to the rate increases as seen in the markets; they are reactive and not proactive agents. They hardly determine interest rates policy.

Why should government policies lag and not lead the markets?

The answer should be quite obvious, governments through central banks always find low interest rates as an attractive way to finance their spending through borrowing instead of taxation, thereby favor (or would be biased for) extended period of low interest rates.

As Dr. Max More wrote[11], ``The state expands its power largely through taking more of the wealth of productive individuals. Taxation provides a means for funding new agencies, programs, and powers. Raising taxes generates little enthusiasm, so governments often turn to another means of finance: Borrowing and expanding the money supply. Only a legally-enforced monopoly on currency has allowed governments to cover deficits by issuing money. Taxation and deficits are related: If tax rate categories are not adjusted for inflation, inflation pushes people into higher tax brackets: their nominal but not real income rises, giving the government a way of increasing tax revenues seemingly without raising tax rates. Unexpected inflation also reduces the real value of the government's debt.” (bold highlights mine)

In the most recent bubble cycle, the boom was financed by quasi government institutions GSEs, as Fannie Mae and Freddie Mac, which massively underwrote mortgage underwriting activities out of artificially depressed interest rates.

According to Dr. Richard Ebeling[12],

``The monetary expansion and the artificially low interest rates generated wide imbalances between investment and housing borrowing on the one hand and low levels of real savings in the economy on the other. It was inevitable that the reality of scarcity would finally catch up with all these mismatches between market supplies and demands. This was, of course, exacerbated by the Federal government’s housing market creations, Fannie Mae and Freddie Mac. They opened their financial spigots through buying up or guaranteeing ever more home mortgages that were issued to a growing number of uncredit worthy borrowers. But the financial institutions that issued and then marketed those dubious mortgages were, themselves, only responding to the perverse incentives that had been created by the Federal Reserve and by Fannie Mae and Freddie Mac.”

Lessons From The Moralists

So what have we learned from the moralists?

One, it is a misguided belief for anyone to oversimplistically think that central banks will wilfully tighten because it isn’t their interest to do so. If there is a possibility that low rates can stay forever, officials will attempt to do so, because this should be the most politically palatable among other options.

From the mainstream gospel of John Maynard Keynes[13],

``Thus, the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus leaving us in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.”

Unfortunately, at the end of the day, the universal laws of economics always prevail.

Second, the tightening of interest rates will come as reactions to the markets which has been experiencing heightened competition for resources via higher prices.

The so called “inflation expectations” are simply nonsense peddled by authorities to hoodwink the public: if the exchange value of one apple is 2 oranges, and if the number of oranges has been doubled then the new exchange ratio of one apple is 4 oranges. Just replace oranges with pesos or dollars you get the same math. The difference is that is the use of money, which functions as a medium of exchange, but does not contain the supernatural powers of Harry Potter.

Athough the moralists imagine that the “expectations” works, in reality they are only defying basic economic laws. Thus, prices will adjust accordingly overtime against their expectations.

Three, rising interest rates doesn’t necessarily or automatically mean a market collapse. Interest rates function as key integral component of business cycles. The peak and troughs of the business cycles largely depends interest rate fluctuations largely manipulated by governments for political reasons.

In a boom phase of the business cycle, markets are thus, sensitive to the rate of increase and the level of increase of the interest rates.

Since rising interest rates reflect on market forces than from government policies, the rate of increases exhibits the degree of competition for resources used on misdirected projects and by the consumers. This should reflect on the moralists’ perverse intention to create a state of permanent but unsustainable boom from unimpeded monetary expansion.

Whereas, the level of rate increases eventually exposes unviable projects to losses, which emerged into existence out of artificially suppressed rates. This will not be uniform though. The tipping point is when interest rate increases would have reached the levels where malinvestments or business errors have massively been clustered.

Fourth it’s not just interest rates. Higher commodity prices from credit or monetary inflation could also impact on the expected returns of unviable projects. Economist James Hamilton argues that an oil shock had also been a major factor in the recent crisis.

We quote Mr. Hamilton[14], ``It is also interesting that the observed dynamics over 2007:Q4-2008:Q4 are similar to those associated with earlier oil shocks and recessions. The biggest drops in GDP come significantly after the oil price shock itself. What we saw in earlier episodes was that the drops in spending caused by the oil price increases resulted in lost incomes and jobs in affected sectors, with those losses then magnifying other stresses on the economy and producing a multiplier dynamic that gathered force over subsequent quarters.” (bold highlights mine)

Today both the interest rates markets and commodities are reflecting the boom phase of what we deem as a new bubble cycle (see figure 2).

Figure 2: stockcharts.com: Broadening Inflation Signs

The commodity markets are not only influenced by expansion of credit and massive government spending but likewise influenced by government restrictions to access more supplies. With oil, 88% of global reserves are held by state and state owned companies[15].

So the missives promoted by moralizers that greed or speculation drives oil or commodity prices has hardly any merit; government owns the printing press that fosters extraordinary demand, while supply is equally constrained by government restrictions basically monopolized by governments. 1+1=2.

While there are other factors involved such as government subsidies, the export land model, strategic petroleum reserves, Hubbert Peak curve for conventional oil, lack of investments for over 2 decades (especially for gasoline refineries in the US), technology and etc.., the cocktail mix of these two forces alone are enough to send towering high energy prices.

Lastly, markets do not react mechanically. They represent human response to ever changing conditions. Today’s market has been more responsive to financial innovation given the more liberal or freer and deeper markets underpinned by rapid technology enhancements and the integration of global markets.

In the chase for the profits, today’s business cycle probably means an attendant credit cycle which would undergird interest rates.

Essentially this means a reflexive self-reinforcing feedback loop between borrowing appetite and state of collateral values-where higher prices raises the collateral value from which encourages more borrowing and vice versa.

Moreover, financial innovation is likely to compel a transition of the credit cycle to what we see as Mr. Hyman Minsky’s model of hedge, speculative and ‘ponzi’ economy.

We quote Mr. Minsky[16], (all bold highlights mine)

“Three financial postures for firms, households, and government units can be differentiated by the relation between the contractual payment commitments due to their liabilities and their primary cash flows. These financial postures are hedge, speculative, and ‘Ponzi.’ The stability of an economy’s financial structure depends upon the mix of financial postures. For any given regime of financial institutions and government interventions the greater the weight of hedge financing in the economy the greater the stability of the economy whereas an increasing weight of speculative and Ponzi financing indicates an increasing susceptibility of the economy to financial instability.”

Bubble policies are likely to encourage a transition from risk averse, to bigger risk taking appetite to outright gambling.

This means that investors at the start of the cycle will engage in hedging (borrow to expand from which the income is used to pay for outstanding interest and principal), will turn to speculators (borrow and use the income to pay only interest rates) and ultimately peak with the transformation to Ponzi phase (borrow to chase rising prices).

And guess what? As in the previous boom, this will be encouraged by the moral hazard provided by big governments.

Back to Mr. Minsky[17] (all bold emphasis mine)

``It should be noted that this stabilizing effect of big government has destabilizing implications in that once borrowers and lenders recognize that the downside instability of profits has decreased there will be an increase in the willingness and ability of business and bankers to debt-finance. If the cash flows to validate debt are virtually guaranteed by the profit implications of big government then debt-financing of positions in capital assets is encouraged. An inflationary consequence follows from the way the downside variability of aggregate profits is constrained by deficits.”

In short, all the recent government backstops would only stimulate a greater and far larger bubble, despite all the “regulatory reforms” being mulled today.

While it isn’t clearly evident where all the money has been flowing to yet or where the next concentration of misdirected investments would be, everything as we have discussed above simply points to a formative bubble.

This means that yes, markets and the global economy will likely be headed for a positive surprise for 2010. And yes, moralizers will probably achieve what they had hoped over the short to medium term. But no, this isn’t a sustainable economic growth, but a continuation or a sequel of the spectacle of serial bubbles.

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[1] See Is Honesty Enough For A Society To Succeed?

[2] Callahan, Gene; The Abstract and the Concrete, ThinkMarkets

[3] Rothbard, Murray N.; Who Was Niccolò Machiavelli? Mises.org

[4] Studwell, Joe; Asian Godfathers: Money and Power in Hong Kong and Southeast Asia, p.51. Grove Press.

[5] Wikipedia.org, Crusades

[6] Wikipedia.org, French Religious Wars

[7] New York Times, Vatican Priest Likens Criticism Over Abuse to Anti-Semitism

[8] Courtois, Stéphane et. al., The Black Book of Communism, Harvard Press Wikipedia.org

[9] Machan, Tibor, Lessons in Freedom: A Bit of Nietzsche Will Help; weblogbahamas.com

[10] Bloomberg, Indonesia Stocks in Bubble, Central Bank Study Shows

[11] More, Max; Denationalisation of Money, Friedrich Hayek's seminal work on Competing Private Currencies, Maxmore.com

[12] Ebeling Richard M. Market Interest Rates Need to Tell the Truth, or Why Federal Reserve Policy Tells Lies, Northwood University

[13] Keynes, John Maynard, The General Theory of Employment, Interest and Money (p.20-21)

[14] Hamilton, James D., Oil prices and the economic recession of 2007-08; voxeu.org

[15] See Peak Oil: Where Art Thou?

[16] Minsky, Hyman; Finance and Profits: The Changing Nature of American Business Cycles, 1980

[17] Minsky, Hyman; "Inflation, Recession and Economic Policy", 1982 (page 43)