Bad days for trade

The Doha Round of trade is dead or at least it has been pronounced dead once again. While this does not seem to be on the radar screen of many traders, trade is a very relevant issue if we are going into a global recession. The current breakdown is related to agricultural subsidies. The only bright spot in the US economy has been exports. The EU is much more export driven than the US. Emerging markets have been driven by their ability to export to the G10. Trade is the basis for much of the gains in growth.

However, the first guilty party for lost jobs in most countries is trade and global competition. Restrictions on trade may seem to have a positive effects for saving some jobs but the impact of lost trade is real and substantive.

A movement toward multilateralism or bilateral trade agreements only makes the world more complex and reduces trade flexibility across regions. The threat of tariffs or other restrictions like the 1930's debacle is real.

An additional trade issue is the announcement that Russia plans to control their grain export business through a state grain trading company. Russia is the fifth largest exporter of grain and the current price spike is causing a new level of mercantilism around the world. We have moved from talk of grain OPEC to action by some countries. State control of grain trade will only slow to movement from those who have grain to those that may need it. State considerations may be more important than price.

We are already seeing the terms of trade for grain exporters improve relative to those who are importers. This movement in terms of trade will continue if grain prices remain at current levels.

Inflation is a global problem

Federal Reserve Bank economists in Chicago studied closely the inflation phenomena globally and found some interesting results. Inflation is a global issue. While this does not seem likely a surprising result, the size of the common variance is higher than what many would expect. Additionally, because the common factor is so high, it is hard to isolate the relative inflation effects across countries.

Approximately, 70% of the variance of inflation is associated with a common factor. We are already seeing this common effect with the kind of food and oil shocks around the world. Singular global shocks will cause the high common variance. Additionally, if the monetary policy response around the world i similar there will be a high common factor. If there is a loose monetary policy in response to shock there will be more common inflation.

Yet, there is a mean reverting or error correction component to the inflation rate so that inflation in individual countries will revert back to the longer–term global rate. Any inflation impact in a single country will not be sustainable relative to the rest of the globe. This mean-reversion is affected by the level of openness around the globe and the fact that exchange rates and capital will respond to these differences. The pattern of behavior is very much the same with a real shock in the short run followed by monetary behavior which will drive the inflation action in the longer-run. Inflation shocks and monetary developments are closely intertwined and really cannot be separated.

You cannot separate the inflation in one country from what is happening in the global economy. We can also say that high inflation countries will not sustain this behavior and being a buyer of high real and nominal rates versus a seller of low rates makes sense. This means that carry trades can still exit but the risks are different. Clipping coupons and picking up yield have to be substituted for duration plays where the expectation is that yields will fall or rise with inflation reversion.

The echo effect and the current economy

The echo effect is a well know phenomena in many sciences. Some shock to a system may dissipate through time but may cause secondary effects as the initial impact moves through time and disrupts other parts of a system. You get feedback and distortion. Think of the old wave machine in physics where an initial wave will have new and more complex effects as it comes in contact with other objects. This stylized idea of echo effects and the timing impact of shocks and the subsequent reaction is a concern in the current economy.

The problems of 2007 and 2008 are a result of the action from the last bubble in 2000. The dot.com debacle caused a Fed monetary policy reaction of lowering interest rates to maintain economic growth. The 2001 recession was short-lived because of the swift and strong reaction of the Fed. This set-up the housing market excesses between 2002 and 2007. With rates taken down to such low levels, it was inevitable that some borrowers and lenders would try and exploit the attractive rates and increase leverage.

Given rates were set at lower levels and never really had a chance to grow to the levels that would reduce housing speculation, the US economy’s current problems were potentially exacerbated. The Fed again lowered rates in 2007 but from a lower starting point. We are now at 2% Fed funds but our policy choices are now restricted. This is no different from what happened in Japan during their “lost decade”. A reaction to the first downturn caused limitations in policy choices later on. However, in the case of Japan, the lack of swift action meant a deeper problem later. In the case of the US, swift reaction during the dot.com debacle has generated over speculation in other markets which have to now be dampened. We are affected by our past choices.

The vicious Fed funds capital regulation trade-off

Banks are expected to have a minimum amount of capital in order to be in business. This is for the protection of shareholders, depositors and the economy in general, but the current credit cycle creates a problem where maintaining a minimum capital base will restrict the potential growth of credit even if there are low interest rates from the monetary authority. The Fed has lowered rates, we have an upward sloping yield curve and the Fed a balance sheet is available, but the amount of lending going on in the US is actually decreasing.

It is hard to lend if your capital base is declining and your capital base will continue to decline if you show mounting losses and no new profits to shore up capital. Hence, the current crisis has capital requirements in conflict with the objectives of the Fed which is to have more lending activity. This is a problem in a deleveraging world.

Regulation needs to be in place that will stop the erosion of capital through less marking of losses on existing loans or some relief on capital standard so that new lending can occur. You can lower rates, but that does not mean that loans will be made. This is a variation on the classic liquidity trap problem. The credit crisis will be with us for some time.