Guild of Democracies

“If you want to understand economics, study ecology”, I told my daughter, a biology major.  For most people economics is a social science.  My view… economics is a dynamic equilibrium system.  Quantitatively, scientists create econometric models to calibrate parameters describing the change in the social dynamic. These models are incredibly unreliable and prone to statistical error as there is never enough data to accurately pin down the coefficient of elasticity of innumerable supply and demand curves. Even if enough data exists in a collection of correlated times series, the modeling of changing tax laws, social norms and other technological advances is such a massive simultaneous equation that the end results are usually suspect.  Regression coefficients are an average over a previous time period. The parameters do not reflect the present moment.

Consider a physical model of the elevation of Lake Michigan over sea level.  A hydrological study, might study the actual contours of the lake, the average rainfall of the lakes watershed, average water temperature, evaporations rates, the flow of water from rivers and leading into the Lake and the flow of water leading out to Lake Huron and the Chicago River.  A trained hydrologist must be sure to consider the flow from the Ogoki diversion of from the headwaters, and the watershed, of the Whitewater and Wabakimi Lakes in Ontario.  It is an incredibly daunting challenge to understand—more difficult to model.

Or… a simple farmer might just stick a pole at a constant point on the lake shore and jot down the change in height from last year. Common sense often trumps statistical science.  But a farmer cannot accurately measure the emotions of economic market.

A quick joke about a farmer, an accountant and a statistician busily counting cows in a barn.  A farmer will poke his head in the barn and count the number of heads and conclude there are 120 heifers, an accountant will count the number of legs standing on the barn floor and divide by four.  A statistician will count the number of legs, divide by four but then worry about the possibility of three legged cows and conclude that there might be 119 plus or minus 3 heifers.

Simple axioms we understand and are always true. More sophisticated analyses are prone to considerable modeling error.  Perhaps the most powerful axiom of economic theory is that of purchasing power parity and exchange rate equilibrium.  A simple example: my favorite beer in Germany costs 2 Euros per liter.  In Chicago the same beer might cost me $7.0 per liter.

I might infer, all things being equal, the exchange rate must be roughly $3.50 per Euro.  In fact the Euro is trading at $ 1.2500 per Euro.  The Phoenician art of arbitrage is well over 3000 years old and with that exchange rate, enterprising sailors will sell dollars to buy Euros at $1.2500, buy the 2 Euro beer in Germany at an equivalent of $2.5 per liter, and ship the beer to US to sell at $7.0. A tidy dollar profit is thus realized. Ignoring transaction and transportation costs, competitive pressures should increase the price of Euros, increase the Euro price of beer in Germany and reduce the dollar price of beer in the US until equilibrium is achieved. These sailors, or traders, are the forces which tame economic disequilibrium across oceanic distances.

 Today traders arbitrage the price of physical products over geographical space. With the internet traders instantly demolish the archipelagos of technical expertise.  Lower cost but highly trained radiologists in metropolitan Mumbai diagnose fractures for a patient in a rural clinic of Wyoming.

I quote from Milton Friedman’s and Anna Schwartz’s book ‘A Monetary History of the United States, 1867-1960.  Here the authors discuss the arbitrage price differential between the growing industrial power the United States and the established superpower Britain

‘Yet, despite these changes, despite two world wars, and despite the statistical errors in the price-index numbers, the adjusted price ratio expressed on a base which makes 1929 = 100 was between 84 and 111 in all but one of the 79 years. The exception was 1932.’

My prediction is that with the introduction of internet, the maximum pricing parity differentials of 84/111 between liberal trading powers will fall to 95/105. Competition will force a common equilibrium in pricing of services and products across vast geographical distance at remarkable speeds.

Our arbitrage axiom explains virtually all macroeconomic phenomena.  Extreme price differentials, from regulated markets, often lead to criminal activity.  Consider the drugs wars in Mexico and Latin America.  The differential price of retail cocaine in America versus the cheap availability of the coca leaf in the jungles of Peru leads to enormous profits for criminal arbitrageurs. Criminal you might suggest, but a disinterested scientist would merely note that one economic actor is just supplying a product to meet the desired demands another actor.

Today considerable political finger pointing is going on who is to blame for the ‘housing’ bubble of the early 2000s. One party insists that all those pesky fair housing laws encourage people to finance homes they could ill-afford through fraud and deceit from uninformed bankers.  Another party argues that greedy bankers and mortgage brokers took advantage of the financially illiterate. Both arguments may true on a individual scale but hardly true on a collective to create a bubble.

 My contention is that current economic the crisis in American is an inevitable consequence of global arbitrage. The sound and fury of our political talking heads is a tale told by idiots ---signifying nothing. The political discussion is missing a salient point. 

During the 1990s, President Bill Clinton took a chance and encouraged Congress to allow China to enter into the World Trade Organization.  After 10 year of negotiations, China was officially entered the WTO on Dec. 11, 2001.  President Clinton gambled that China will become a more democratic and humane society through normalized trade relations.  An ancient arbitrage barrier is now broken.  The supply of labor in China remained locked behind a great wall of oppression and political isolation for over three centuries.  The arbitrage price differential of American and European wage earners relative to the Chinese labor was and is still staggering.  Furthermore, the seemingly endless supply of Chinese workers makes equilibrium price adjustment exceedingly slow or inelastic.  “Since 2000, the trade deficit with China has surged by 173 percent, from $83 billion in 2000 to $227 billion in 2009. The United States has lost more than one-third of all its manufacturing jobs…” reports manufacturingnews.com. 

Our arbitrage axiom demands that wages and prices must decline in the United States and in other Liberal Western countries until they eventually equal the now rising wages of the Chinese worker.  The solution: we want China to get rich really fast --- more importantly more democratic. 

However, for an annual cost of $227 billion in cash out flows, history is not kind to the prediction of a democratized China.  China now challenges sovereign states surrounding its territory, it claims the entire China Sea as a private lake (recall the forced landing of a US navy spy plane).  Domestic thugs terrorize blind activists, praying monks in Tibet, and peasants are striped from their meager property rights.  It despises any challenge to its autocratic rule.   China’s holdings in US government securities rival the Treasury holdings of the US Federal Reserve Bank.  Which country is in charge of our monetary policy?  Incredibly, just last week the US Treasury Department granted the Chinese central bank an equivalent of the popular ‘USTreasuryDirect’ card.

Six months ago I noted the following headline: “US wage levels at 1996 equivalent’.  The onslaught of Chinese labor and arbitrage pressured US wages to predicable lower and stagnant level.  Labor apologists note that the resulting lower price of US imports more than offsets the the wage declines. Hardly credible as I argue that increasing prices of certain domestic economic sectors unaffected by China labor price differentials create stress fractures with those meager wages.  Most notably in housing, education and health care.  The current financial crisis manifests itself early in the housing sector as it is the most highly leveraged of the three. Interestingly enough, the second most leveraged sector, student loans, appears to be the next crisis on the radars of our bumbling policy makers. 

Blame game players parry on the enormous budget deficits incurred by federal and state governing authorities. One party blame the spenders, the other the tax cutters. Wages and entitlements of government employees and entitlement dependents rarely decrease.  Generally entitlement spending automatically increased as a percentage of the CPI and not to a domestic wage index. Entitlement and government wages did NOT decline to 1996 levels.  Hence we have the so called ‘structural deficits’.  Private sectors wages quickly and forcibly adjusted to arbitrage forces of overseas wages.  Tax revenues declines naturally coincide -- that is basic math.  Thus by statute, Government spending policies are in disequilibrium with the income derived from the underlying revenue source – the US wage earner.

The increasing state of crisis in governmental finances will continue.  Government actors are by nature egotistical creatures and like pre-revolutionary France during the reign of Louis XVI will increase taxes to meet any shortfall in revenue.  They deny the economic forces faced by the common wage earner.  The Tea Party does not have its Robespierre -- yet. 

The Guild of Democracies

In 1960 Nikita Khrushchev pounded his shoe on the table at the UN and threatened to bury the United States with its own superior production.  The Genie of autocratic economies in the WTO is now out of the bottle.  Much of our production of important rare earths and high technology products are now produced in China.  Nor are they necessarily produced by local private entrepreneurs but more often by military leaders who siphon cheap loans from state captured banks and depositors.

Autocratic economies are not market based.  The question is ‘How much are we willing to erode our own democracies only to see the rise of autocratic China, Russia and the Middle East.

There is an economic concept call regulatory capture.  Regulators become so enamored with their regulated industries that they honor their demands and ignore their failings.  The US Congress is now subject to ‘monetary capture’ of autocratic countries.  Chinese and Middle Eastern Central Banks now own and fund a substantial portion of the budget of the US Government.  Every year the US Treasury signs off on a report to public stating that the Yuan is not a manipulated currency.  This reports lacks credibility as the volatility of the Chinese Yuan to the US dollar is less than 3 percent and over 10 percent between liberal democracies—this differential is visible and tangible evidence of exchange rate manipulation.  We have a Treasury Department deliberately allowing the exchange rate mechanism is to remain in disequilibrium with the US labor market.  The destabilizing forces of this policy will constantly damage the US economy.

The WTO does not favor the principles of our founding fathers.  We need to establish a Guild of Democracies where countries with democratic and western ideals trade with each other without the threat of autocratic institutional encroachment.  I believe this concept is the rallying cry the ‘occupiers’ are trying to elucidate. ‘Globalization’, a nebulously defined phenomena, occurs when  foreign powers exert monopoly pricing power on the liberal western worker.  We cannot see the wind but we can certainly feel it. The young and the unemployed are subject to undemocratic forces offshore.   Like a game of musical chairs, every year a predictable number of living wage jobs are removed from the economy and residual workers are left scrambling to survive by cobbling together two or three part time jobs. 

American and other democratic nations need to create a Guild of Democracies to rebuild the faith of its workers and more importantly preserve the inalienable rights of its citizens.