Trade and Economic Development

There has been a backlash against international trade in developed countries and developing countries alike since the radical trade liberalization policies of the 1990s. Developed countries lost jobs in manufacturing and services to developing countries and the benefits of free trade have not been equitably distributed within countries leading to rising income inequality. Moreover, trade liberalization was not conditioned on sound environmental and labor policies in developing countries resulting in the export of negative externalities to the developing world from the developed countries. Developed economies, in particular United States, became consumers of goods and services produced in developing countries, leading to large trade deficits and government indebtedness in developed economies with the exception of export-oriented countries such as Germany and Japan. China became the hub of global manufacturing, while India turned into an exporter of information technology services.

Free trade has been driven by David Ricardo’s principle of comparative advantage which states that countries export goods and services where they have comparative advantage and import the rest even though they are capable of self-sufficiently producing all goods and services in autarky. The supply chain or value chain has now become global with the introduction of the principle of technological competitive advantage: developed economies are now focused on excelling in innovation while outsourcing all the work that does not require innovation such as low-end manufacturing and parts assembly, and technical programming work in information technology to low wage countries around the world, shifting those jobs from developed countries to developing countries permanently leading to job dislocations and increased pressure on the welfare systems in developed countries. Important development needs such as superior infrastructure, sanitation and beautification which characterize the developed world are not being met in the developing countries. Except in the case of China where the government has made it its objective to climb up the value chain and grow from a low income country to a middle income country, development of developing countries is not happening because of free trade because important sectors such as infrastructure and sanitation continue to remain status quo. Then what should trade policy be to ensure job losses at the lower end of the value chain do not occur in developed countries and developing countries rise up the development value chain? Autarky may provide the answer.

Since the rise of the mercantilist East India Company in 1600, the multinational corporation is now commonplace. Global companies such as the East India Company and imperialism by the governments of countries to which corporations such as East India Company belonged traded in raw materials and finished goods especially after the Industrial Revolution: for example, cotton was imported from India and finished cloth was exported back to India from Britain. India was not efficient in the production of cloth because it lacked the mechanization of the mills of Britain. In a regime of autarky, India could have been self-sufficient in cloth if only it had the British technology of textile mills. Britain could also have been self-sufficient in cloth by importing Indian cotton and both countries could have been better off. Assuming labor productivity in both the countries is the same, abundance of labor in India would produce cloth cheaper than in Britain. There would be a price difference between the two countries for the same cloth, but cloth would not be exported or imported by either country. It is important to reiterate here that the precondition for such a state of autarky in both countries is the initial sharing of textile mill technology by Britain with India. Both British-owned and Indian-owned textile mills would operate in the Indian market and the technology of textile mills could be improved just as likely by Indian companies as by British companies.

Such a model of autarky is, in fact, true in today’s pharmaceutical market where licenses to produce some drugs are given by patent-owning developed country companies to companies in developing countries. Drug prices are lower as a result in developing countries such as India for the same drugs. Both the technology sharing country and the technology receiving country would be better off and, as with cloth, it is just as likely that new drugs could be invented over time by developing countries as by developed countries.

For trade to produce economic development, therefore, it is important that global corporations which innovate must, in a model of autarky, produce for the markets of various countries in those countries by sharing technology and by employing the labor of those countries and importing natural resources which the countries lack for the production. This model does not export jobs but creates jobs locally in the various countries. Same products will have different prices in different countries and there will be more competition in the marketplace both to innovate and to produce leading to robust economies.

Today’s Ricardian model of international trade does not lead to development as efficiently as is necessary. A global-local model of quasi-autarky with open technology transfer and trade in natural resources will lead to more efficient economic development.

Can Artificial Intelligence in Finance Overcome Herd Behavior?

Artificial intelligence (AI), using evolutionary computing and deep learning techniques, is beginning to be used for trading stocks, commodities, currencies and bonds. The idea is to keep trading rational by having a computer program decide on which trades to engage in so that human emotion is kept out of the process.

John Maynard Keynes, in the aftermath of the Great Depression, had coined the term “animal spirits” to describe human emotion in the financial markets. Since the Great Depression of 1929-39 in the United States – which began with the stock market crash on Black Tuesday, October 29, 1929 after stock prices started falling around September 4, 1929 – many financial crises struck the U.S and world economies: the Black Monday, October 19, 1987 crash, the bursting of the technology bubble in 2000, and the housing bubble in 2007-2008 are all examples of the action of animal spirits in finance. Human emotion not only leads to financial panics and crashes out of fear but also causes bubbles to form because of euphoria. While Keynesianism, or expansionary fiscal policy, became the standard doctrine of economic policy to recover from the Great Depression, nearly a century later, a radical monetary policy experiment of negative interest rates is underway to deal with the Great Recession of 2007-2008 and the subsequent economic recovery that began in 2009.

Collective euphoria and fear are what behavioral economists call ‘herd behavior’ among financial market participants. Herd behavior is the tendency of individuals to mimic the rational or irrational actions of others, though independently they may not necessarily make the same choice. Social pressure of conformity and the belief that a large group cannot be wrong lead to herd behavior. The tech bubble in the late 1990s was formed because venture capitalists invested in startups with unsound business models because everybody was doing the same. That bubble burst in 2000. The housing bubble from 2002-2007 happened because of unsound lending practices to boost the housing market, again because everybody was doing the same. The housing crisis was worse because the government also tacitly encouraged such behavior with policies to promote housing ownership among the population.

It is clear that automated trading systems (ATS) could neither contain the euphoria nor stanch the fear during the 2007-2008 stock market collapses. Then, the question arises if the new generation of AI-ATS can prevent euphoria and fear from taking hold. Can AI-ATS learn in real time that the market mood is euphoric or is besieged by fear by discerning a pattern in current data when compared to past data and neither act in euphoria nor out of fear? Or will AI-ATS choose to ride the euphoria, sense a turning point in the market at the top and then exit to maximize the trading profits for its human owners? Will there be euphoria and fear at all if a majority of trades in the market are performed by AI-ATS and human beings are out of the picture? Moreover, if AI-ATS are available not just to institutional investors but to a majority of retail, day-to-day investors, will market returns, by the law of averages, come down because the trading opportunities are arbitraged out quicker than when human traders are engaged?

AI-ATS are still new and their inventors are quite thoughtfully keeping them discreet to preserve the competitive advantage of their clients. The proliferation of AI-ATS to replace human traders has some ways to go. If AI-ATS agents become common place, it is indeed likely that the financial markets could be less volatile and more stable. But that is yet to be seen.

Will the Reserve Bank of India Further Cut the Policy Rate?

India currently is a goldilocks economy and the envy of the rest of the world. The Indian economy expanded 7.3 percent year-on-year in the last three months of 2015, slowing from an upwardly revised 7.7 percent growth in the previous quarter but in line with market expectations. Consumer prices increased 5.18 percent year-on-year in February of 2016, lower than 5.69 percent in January and below market expectations of 5.6 percent. More importantly, since the Reserve Bank of India (RBI) and the Ministry of Finance agreed in February 2015 to institute an inflation target of 4 percent increase in the Consumer Price Index (CPI) plus or minus 2 percent, inflation has hewed to the target range of 2-6%. In 2013, the CPI replaced the wholesale price index (WPI) as a main measure of inflation. Then, to spur growth even more, will the RBI cut the policy rate again, as seems to be the expectation of the Indian government, after cutting the repo rate four times by a total of 1.25 percent in 2015 to 6.75%?

The governor of the independent central bank – RBI – Raghuram Rajan, has laid out his conditions to the Indian government about what it will take for him to further lower the policy rate to support investment and, hence, growth. This was before Finance Minister Arun Jaitley presented his budget for fiscal year 2016-17 to the parliament. Rajan’s message was that India needs structural reforms that raise government spending in some areas to boost growth while holding back spending in other areas to keep the budget deficit under control. Fiscal rectitude, inflation control, reducing subsidies on fuel and food, increase in spending on infrastructure and other government programs such as swach bharath and Digital India, and making it easier to do business in India for attracting capital inflows to make programs such as Make in India successful would, according to Rajan, indeed be a recipe for sustained growth of the Indian economy where less expensive capital from the central bank can be put to productive use.

In the budget Jaitley delivered what Rajan wanted, at least partially but in important areas: India’s fiscal deficit will stick to the target of 3.9% for FY 2016-17 and to 3.5% for the following year. The Indian budget has increased infrastructure spending, reduced subsidies on oil (convenient given the current low oil prices. Reducing agricultural subsidies would be politically difficult.), allocated funding for swach bharath and has tweaked tax and investment policies to make it attractive for foreigners to invest in infrastructure, Digital India and Make in India initiatives.

The February 2nd Sixth Bi-monthly Monetary Policy Statement of 2015-16 says “[g]oing forward, under the assumption of a normal monsoon and the current level of international crude oil prices and exchange rates, inflation is expected to be inertial and be around 5 per cent by the end of fiscal 2016-17.” There is, however, some uncertainty that could affect this forecast if the assumption does not hold true.

The RBI may wait to ensure that the monsoon season is normal, assuming approximately status quo conditions on crude oil prices and exchange rates, before cutting rates again. Therefore, the policy rate may not be cut until August 2016, until after the coming of the monsoon.

Should the U.S. Federal Reserve Continue to Raise Rates?

The divergence between the large economies of the world cannot be more apparent than it is now. United States and India are growing. Japan, Brazil, Russia and South Africa are shrinking.

Europe is stagnating, with a few countries such as Ireland and Germany showing confident growth, while the rest of the countries in the euro area and the European Union are eking out only modest increases in their gross domestic product (GDP) threatened by deflation and burdened by high unemployment.

China is in the midst of an economic restructuring to a consumer and services driven economy rather than the real investment, manufacturing and export oriented economy it has been for the past 30 years. This reorientation of the Chinese economy is slowing growth in a manner commensurate with the new structure even as it is facing the rising risk of high indebtedness in its corporate sector which is a mix of the state owned enterprises (SOE) it wants to reform and private firms. China wants to try all the macroeconomic policy measures of monetary policy, fiscal policy and structural change to reach its growth and per capita income targets between now and 2020. This is a strong reassurance to the financial markets about the future of the Chinese economy though the world must get used to the fact that China’s growth looking forward, as the country reforms to a more market-oriented economy, will never be near its growth in the past decades.

As the largest open economy in the world, the focus is on the United States and its currency – the dollar. U.S. unemployment is at full employment and growth is still below potential, hovering between 2 and 2.5 percent annually, but healthy including in 2016 forecasts. U.S. central bank, the Federal Reserve (the Fed), has begun, very gradually, raising the rate at which its member banks borrow funds from each other overnight from their federal reserve accounts – the federal funds rate – at its December 2015 meeting. The idea is to preemptively manage inflation to hew to the central bank’s target of 2% in the medium term without hurting growth.

The domestic debate in the U.S., given the turmoil in the rest of the global economy primarily because of the China slowdown (albeit still at a high enough growth rate) and European stagnation, is whether the Federal Reserve should continue to raise rates in policy divergence with other central banks of the world which are all cutting interest rates.

Salutary growth in the U.S. has strengthened the dollar against other currencies, cheapening U.S. imports and making U.S. exports expensive for other countries. U.S. net exports (the difference between exports and imports), however, are only a small component of the GDP. Most of U.S. output comes from domestic consumption. Therefore, as long as the domestic U.S economy is doing well, global economic conditions should not affect how U.S economic policy is made. This numerical fact nixes any worries about the effects of the rest of the global economy on the U.S.

Those who are suggesting that the Fed should stop raising rates for the rest of 2016 because of the market turmoil with which the year began, despite its causes elsewhere in the world, are pointing to the decline in corporate earnings since the third quarter of 2015. In fact, the financial markets have reduced the probability that the Fed will raise rates in 2016 to negligible. And, not only that, they are looking warily at the prospect of a recession in the U.S. because of what is known as an earnings recession which is defined as two consecutive quarters of decline in corporate earnings. J.P. Morgan’s Qualitative Macro Index (QMI) which measures business conditions shows “a cycle that remains in contraction (weak and decelerating) over the coming months.” Such recession talk is questioning the ability of the Fed to be potent in its response should a recession materialize because the federal funds rate is already so low around 0.25 percent. There is speculation if the Fed would go the way of the Bank of Japan and the European Central Bank by implementing negative interest rates.

Contrary to J.P. Morgan’s concerns, Federal Reserve Bank of Atlanta’s GDPNow forecast for the second quarter of 2016 for the U.S. is at a moderate 2.5 percent annual rate (as of June 3rd) and the Federal Reserve Bank of Atlanta’s GDP-based recession indicator index is at 10 percent which indicates that the U.S economy is still in an expansionary phase. According to the recession indicator index, U.S economy cannot be considered to have entered a recession unless the index rises above 67 percent.

The mere fear among some analysts that the current expansion has entered its seventh year to prompt a recession is unfounded. Further, as of May 2016 the core consumer price index (CPI) inflation rate is 2.2% and as of April 2016 the core personal consumption expenditures (PCE) inflation rate – the preferred inflation measure of the Fed – is 1.6%. Both core CPI and core PCE measures of inflation are near the Fed’s 2% target which bolsters the case for continuing to gradually raise the federal funds rate. The current U.S unemployment rate is 4.7%. To reach the pre-recession low of 4.4%, unemployment still has room to fall 0.3% which could be inflationary.

The U.S. Federal Reserve should continue to raise the federal funds rate, except if growth slows significantly, very gradually to normalize monetary policy conditions and it may raise the rate, if not at the March 2016 meeting, at the June 2016 meeting.

Responsible Investment

International trade, climate change and the 2007-2008 financial crisis are forever changing the landscape of investing. As advocated by free market economists such as Milton Friedman, the notion that the purpose of the firm is to maximize profit – its bottom line, irrespective of any negative impacts of the firm’s activities on the environment and society – has come under severe scrutiny over the past decade.

Negative externalities in the operation of a firm, which are many, have not thus far been factored into the cost of production of goods and services and hence into their prices. Impacts such as pollution, climate change, exploitation of labor in the global supply chain, and adverse consequences of a firm’s operations to employee and people’s health and safety have largely been dealt with in the judicial system, with the cost of such litigation eventually finding its way into prices.

There have been no attempts until the turn of the century to prevent the harmful consequences of the activities of the firm, to deal with them ex ante rather than ex post through the legal process, because the financial markets did not punish such behavior. In fact, risky financial market behavior in investing was encouraged by the government in the name of not interfering with financial innovation leading to the housing crisis in the United States and the consequent Great Recession that is still reverberating around the world. The financial crisis has put the spotlight on corporate governance and on the ability of financial institutions to weather economic downturns and any crises caused by their actions so that tax payers do not foot the bill of rescuing systemically important financial institutions and real sector corporations while also enduring loss of livelihoods, homes and jobs as a result of such crises.

The systemic negative consequences of the activities of the firm have spurred change to take the approach of strengthening the triple bottom line rather than merely the single bottom line of profit: corporate sustainability is now beginning to mean operating at the intersection of the economy, environment and society. Now more corporations are publishing annual corporate citizenship or sustainability reports along with their annual financial reports. The movement is toward publishing integrated annual reports of corporate finance and sustainability because the ability of public corporations to raise capital in the financial markets is increasingly becoming dependent on the triple bottom line. Moreover, the triple bottom line will determine the market capitalization of firms.

Investing in firms, public and private, is beginning to incorporate the medium and long term sustainability (or Environment, Society, Governance – ESG) performance of corporations along with the short term because of the financial materiality of ESG issues in strategic planning. Some examples are the financial impacts of the Deep Water Horizon Spill on BP and the Libor scandal on Barclays. “Responsible investment,” says the United Nations supported Principles for Responsible Investment (UNPRI), “requires investors and companies to take a wider view, taking into account the full spectrum of risks and opportunities facing them, in order to allocate capital in a manner that is aligned with the short and long-term interests of their clients and beneficiaries. This analysis should inform asset allocation, stock selection, portfolio construction, shareholder engagement and voting.”

The six UNPRI principles for responsible investment that UNPRI signatories adopt are:

Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.

Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.

Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.

Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.

Principle 5: We will work together to enhance our effectiveness in implementing the Principles.

Principle 6: We will each report on our activities and progress towards implementing the Principles.

Widespread adoption of responsible investing is a first step toward financial and corporate sustainability to achieve the Quadruple Bottom Line (QBL) of incorporating the future vis-a-vis the environment, social and governance actions in the present.