U.S Unemployment and Fed Policy

Unemployment in the United States has fallen to 4.7 percent in May but the number of non-farm payroll jobs created in May was a paltry 38,000, far below the expectation of about 160,000. The low unemployment number is thus not because more people found jobs but because people dropped out of looking for jobs and, therefore, were not counted among the unemployed. A measure of unemployment which includes those who dropped out of searching for jobs stood at 9.7 percent.

Fed policy makers, including Fed Chair Janet Yellen, in public remarks, expressed the opinion that the Federal Open Market Committee (FOMC) could raise the federal funds rate sometime this summer because the U.S economy is growing and the labor market is tightening. Many now think that the May jobs report clouds the outlook for any interest rate increase in the coming three months because far fewer jobs than expected were created and the labor participation rate has decreased.

The decision facing the FOMC for the June meeting is to interpret the May jobs report as whether far fewer jobs than expected were created because the economy is at full employment or aggregate demand has weakened, substantially slowing hiring.

U.S GDP growth during the first quarter of 2016 was at a modest 0.8 percent while reliable forecasts for the second quarter – based on incoming data by both the Federal Reserve Bank of New York and Federal Reserve Bank of Atlanta – are exceeding 2 percent. In fact, the Federal Reserve Bank of New York’s “Nowcast” for the third quarter of 2016 is also exceeding 2 percent. U.S GDP outlook for the next 2 quarters based on incoming data, including personal consumption expenditures, is thus looking more robust than the GDP growth for the first quarter and is close to the potential growth rate for the United States. The forecast data does not portend a slowdown. Further, inflation is hovering close to but below the Fed’s target of 2 percent.

Though consumer sentiment presents a mixed picture for the summer months with data coming in below expectations, consumers are engaging in precautionary saving behavior and household wealth has increased because of a rise in home prices. Personal consumption expenditures and consumer sentiment do not point to any upcoming weakness in aggregate demand.

Given the data, the best interpretation of the May jobs report seems to be the behavior of the economy at full employment. Unless broader economic conditions deteriorate, the Federal Reserve can stay on course to raising the federal funds rate sometime this summer because, despite any small increase, monetary accommodation would continue to remain extraordinary.

Wages and Inflation

Disinflation and deflation have characterized the group of seven (G7) economies since the financial crisis of 2007-2008 despite the environment of extraordinary monetary easing. The rate of increase of prices slowed (disinflation) or prices fell (deflation) while the expectation of policy makers has been that more money chasing the same goods and services would drive up their prices for the overall inflation to reach the inflation targets of the central banks.

With the G7 economies stuck in a liquidity trap, cash from the very loose monetary policies is being hoarded with the central banks by the member banks of central banks.

Corporations are raising cash by issuing corporate bonds at very low yields and buying back their stocks with the cash and with their profits to increase their stock prices and valuations.

More money is thus not chasing the same goods and services to raise prices but it is either being unused in the vaults of central banks or is raising the stock prices of public corporations. In the United States there is also fear of a bubble in the venture capital market because of sky high valuations of startup companies.

In the real sector, inflation is rising slowly because of low energy prices due to slow growth of the global economy. The issue of the times is how to increase inflation back to the targets of the G7 central banks.

Technological change is causing capital to substitute for labor. Machines and robots are replacing or are increasingly complementing the work force. This is a trend that has only just begun. It is keeping a lid on wages and, hence, on prices. Labor has less bargaining power and corporations are not feeling upward pressure on wages.

It is possible that the structure of the economy is fundamentally changing in the G7 countries in a manner that is structurally containing inflation by constraining wages and prices. There is no incentive for corporations to raise wages which is, therefore, slowing price increases.

While wages in the financial and technology sectors are high relative to other sectors but not necessarily rising, wages in the rest of the economy are flat. Advancing technology is making every sector, including finance, ripe for disruption in a manner that brings goods and services to the masses at low prices.

Wages, the primary driver of inflation, are not rising and so is not inflation.

Exploiting the Inefficiencies in the Stock Market

Efficient market hypothesis has been widely accepted by academic financial economists while financial market participants have been trying to predict future prices of stocks from past stock data or from fundamental analysis, which is the analysis of financial information such as company earnings and asset values to pick “undervalued” stocks, for the investors to achieve returns greater than those that could be obtained by holding a randomly selected portfolio of individual stocks, at least not with comparable risk.

The idea of “random walk” is associated with the efficient market hypothesis. Random walk characterizes a price series where subsequent prices randomly depart from previous prices. The logic of random walk is that if the flow of information is unimpeded and the information is reflected in the stock prices without delay, past stock prices would be uncorrelated to future stock prices because new information is unpredictable. Therefore, because prices of stocks immediately incorporate all known information, uninformed investors buying a diversified portfolio will obtain a rate of return comparable to that obtained by experts.

The stock markets, however, are not perfectly efficient. If they were there would not be any incentive for professionals to uncover the information that gets so quickly reflected in market prices. Market participants make mistakes and are not perfectly rational in their judgments resulting in pricing irregularities and even predictable patterns in stock returns which could persist for short periods of time. Though such departures from efficiency of the stock markets should not be misunderstood as the abandonment of the efficient market hypothesis, increasingly sophisticated mathematical and statistical techniques are being used by experts to exploit the temporary market inefficiencies for financial gains that beat the market.

Despite the proliferation of quantitative analysts in the past two decades and the digital computing (DC) power that is being employed in the pursuit of returns, some problems in computational finance are intractable for digital computers. Examples of such problems are dynamic portfolio optimization, clustering, scenario analysis, and options pricing. Quantum Computing (QC) offers the promise of solving these problems in a matter of days rather than in years.

Every time a large asset manger rebalances his portfolio, investors lose considerable money in transaction costs and in price impact or slippage. QC could find a portfolio that is globally optimal over multiple investment horizons thus significantly reducing the need for rebalancing and its associated losses. Further, QC can starve high frequency algorithms that prey on rebalancing. QC can not only compute faster than DC, in fact, DC cannot solve, for example, the rebalancing problem.

QC will disrupt finance in a few years just as DC transformed finance decades ago.

Will a Recession Occur Under Extraordinary Monetary Accommodation? Lessons From the Case of Japan

The Japanese economy is once again skirting a recession despite the extraordinarily accommodative monetary policy from the Bank of Japan. Investors have preferred the flight to safety of Japanese Government Bonds (JGBs) even though the buyers of the bonds have to pay the Japanese government to hold them because of the current regime of negative nominal interest rates. On the demand side, consumers are not spending, depressing aggregate demand.

Japan is stuck in a liquidity trap where holding cash appears to be safer than investing it given, in particular, the external environment of the global economy which is weak to sustain an exporter such as Japan. Raising the value added tax (VAT) did not help because it amounted to contractionary fiscal policy and depressed growth.

A lack of wage increases is making inflation both too high and too low at the same time: it is high enough to eat into the purchasing power of workers’ wages which are not rising and it is low enough to push the economy back into deflation if consumers do not spend.

The case of Japan tells us that even an environment of extraordinary monetary expansion – in the overall economic context described above – cannot prevent an economy from slipping back into a recession. The three arrows of Abenomics – fiscal expansion, monetary easing and structural reform – can only take hold if they complement each other to achieve specific economic goals.

The macroeconomic policy experience of Japan applies to Europe as well which is in a similar situation with low inflation and low growth. Europe needs its own version of Abenomics led by Germany.

Absent external shocks, with oil prices being low, no bubble in financial asset prices, and little dependence of the US economy – unlike Germany, China or Japan – on exports, the highly accommodative monetary policy in the US should continue to enable the 83-month old expansion though there are some symptoms of the emergence of a liquidity trap in the US because of very high excess reserves of banks with the Fed.

To prevent a liquidity trap, while continuing to very gradually raise interest rates, the Fed must stop paying interest on excess reserves. It must also stop rolling over treasuries upon their maturity to begin, extremely gradually, shrinking its large balance sheet.

Japan’s experience shows that it is not sufficient to simply provide an extraordinarily accommodative monetary policy environment in a context of deflation or potential deflation. Without public investment it would not have been sufficient had the US Fed during the Great Depression provided monetary stimulus.

The only way to achieving economic recovery and the inflation target for any country is for monetary and fiscal policies to work in tandem to raise private and public investment in the economy while keeping the budget in check.

Expectations and Monetary Policy

Monetary policy has been in unchartered territory since the global financial crisis of 2007-2008. Interest rates in the Group of Seven (G7) countries have been cut by the central banks to zero or near zero since 2008 and have remained at that level until now. Besides the lowest level of interest rates, G7 central banks have engaged in massive financial asset and government bond purchases to continue to increase money supply at the zero bound while rescuing financial institutions which were impacted adversely by the crisis.

New regulations have been put into place with the intent of preventing future such crises and to ensure the solvency of financial institutions should a crisis occur again. Stress tests of systemically important financial institutions have concluded that the financial institutions are better prepared for any future crisis.

In spite of extraordinarily accommodative monetary policy and new regulatory regimes to contain the possibility of crises again, economic recovery has been slow and gross domestic product (GDP) growth rates have been, at best, moderate and, at worst, modest with low potential growth rates.

The Japanese economy remains mired in low or recessionary growth, continuing to be in an economic condition that began with the lost decade of the 1990s when its real estate bubble burst. It is now feared that, absent unconventional monetary policies, looking forward, the other G7 countries could face the same fate as Japan.

It has been argued that the interest rate sensitivity of G7 economies has gone down because of the large service sectors in G7 countries which are less sensitive to interest rate changes compared to agricultural and industrial sectors. It is unclear if the G7 economies are more sensitive to interest rates when interest rates are on the rise during monetary tightening than they are during monetary easing. In the United States consumer spending on durable goods and on residential fixed investment after the crisis has also been found to have become less sensitive to decreasing interest rates because consumers have withheld spending to make their debt-to-income ratios better. The question arises, however, as to why ever lower interest rates are being expected by market participants before investment and consumer spending can fully recover? Expectations could provide an answer.

Though the conduct of monetary policy has been discounted as a reason for muted interest rate sensitivity of the economy since 1984 in the United States, it must be remembered that the expectation of preemptive easing before economic downturns and especially during crises and preemptive tightening to avert higher levels of inflation has become the norm since the coming of the Greenspan Fed in 1987. Market participants expect the central bank to keep cutting interest rates until recovery indicators surface and, therefore, consumers hold back spending on big ticket items such as durable goods and residential fixed investment, and businesses hold back on capital spending waiting for lower interest rates. Likewise, as inflation begins to rise, with the expectation that the central bank will raise interest rates, market participants will borrow and spend before rates rise further.

Monetary policy response and, in particular, central bank signaling of the health of the economy, therefore, plays a critical role in setting and managing the expectations of consumers and businesses.

To Brexit or Not to Brexit

The word “Brexit”, a portmanteau of the words “Britain” and “Exit”, refers to the possible exit of the United Kingdom (U.K) from the 28-member European Union (EU). The British people will vote on June 23rd in a referendum to decide if Britain should remain in the EU or leave it. The referendum attains special importance because of the current economic problems in the eurozone. To be evaluated by the voters, therefore, before voting, is the impact of Brexit on the U.K, and more broadly the impact of Brexit on the EU and the western bloc of countries in Europe.

Britain always had an uneasy relationship with continental Europe. Not part of the Treaty of Rome in 1957 which formed the European Economic Community (EEC) and after its applications to join the EEC were vetoed by France’s Charles de Gaulle, Britain eventually joined the EEC in 1973. Yet, the U.K has profound reservations about giving up its currency, the pound sterling, which it equates with its sovereignty, and adopt the euro.

Sovereignty has been, in fact, a key negotiating point between Britain and the EU for continued membership of Britain in the bloc: the U.K wanted supersession of a vote in the British parliament over any EU legislation and regulations. The EU agreed to such a special status for Britain where the non-commitment of the U.K to further political integration into the EU (or to ever closer union) will be incorporated into the Treaties governing the Union.

A sticking point for the U.K in Prime Minister David Cameron’s negotiations with the EU has been the in-work benefits for EU migrants to Britain. While Britain wanted a ban on these benefits, what was agreed upon at the end was the idea of an emergency brake where a member state could apply to the European Commission for permission to suspend benefit payments if they were placing too much burden on the social services of a member state. It was agreed that such an emergency brake can last for 7 years. Likewise, on child benefits to children of EU migrants, instead of a total ban as Britain wanted, it was agreed that the payments would be indexed to what the migrants would get in their home countries and that the change will be phased in for existing claimants from 2020.

Even though Mr Cameron has negotiated the above changes in Britain’s relationship with the EU, those who want Britain out of the EU – the Brexiteers – see as benefits the annual net contribution of about $12 billion to the EU budget that the U.K will no longer have to make and flexibility in not having to conform to EU regulations, particularly in product and labor markets and over the free movement of people across borders.

The Brexiteers have a lot of precedence on their side. Over long periods of time, gross domestic product (GDP) per capita has risen steadily and it did not much deviate from this underlying trend even during shocks to the British economy such as joining the EEC in 1973 or leaving the Exchange Rate Mechanism (ERM) in 1992. Only war and the mistake of contractionary monetary policy during the Great Depression have affected this long term trend in the growth of GDP per capita. So, the Brexiteers argue that as in the past, exiting from the EU should not cause a dent in the long term growth of the U.K. It can also be argued, therefore, that staying in the EU will not likewise harm Britain given the underlying trend in Britain’s long term growth rate. So, at a minimum, on balance, staying is no better or worse than leaving. Then why leave but to be politically quixotic?

Looking to the future, however, arguments for staying in the EU are stronger. The much larger U.K trade with the closer EU countries than with the far away countries of the Anglosphere or the emerging markets will most certainly be negatively impacted in the short run until Britain has in place new trade deals to at least compensate for the access it had to the common EU market. The pound sterling could be under severe pressure to depreciate against the currencies of Britain’s biggest trading partners in Europe, that is primarily against the euro. It is unclear at this point how long it will take to make the new trade deals. Moreover, the City of London’s de facto role as Europe’s financial center will also be challenged in the short run.

British voters on June 23rd must ask themselves if the short term risks are worth taking by leaving the EU than by being a part of it and reforming it to make the Union work for the U.K and the rest of Europe.

The Future of the Chinese Economy

China is on everyone’s mind, particularly because of its economy and the increased interdependence between the rest of the world and China. After roaring growth since Deng Xiaoping initiated the policy of reform and opening up in 1978, China’s economy began slowing down to an annual rate of gross domestic product (GDP) growth target of between 6.5% and 7% in 2016. The longest period of vigorous and continuous economic growth with the exception of a hiccup in 1989 and 1990 seems to have come to an end in 2015 when China recorded an annual real GDP growth rate of 6.9% meeting its growth target of around 7% for the year.

The next 5 year plan, China’s thirteenth, from 2016-2020 has set as its objective China’s climb up the value chain. China wants to engage in what it calls “supply side restructuring” aimed at boosting economic growth to double the standard of living, as measured by per capita income, by 2020 and to eliminate poverty which is defined as living on an annual income of $354 or less a year.

“Supply side” is a term intended to distinguish the new policies from traditional demand side policies of easy money and a higher fiscal deficit to boost economic activity. Important among the supply side policies is the reduction of overcapacity in state-owned coal and steel industries which will displace about four million workers, or about 0.5% of China’s workforce, from their jobs. The government is setting up a special fund to assist those who remain unemployed after the restructuring. More restructuring of the bloated state-owned enterprise sector is needed where some firms are consolidated and some are allowed to fail which will create more unemployment, so the government is starting small to see how it works and to monitor the public’s response.

Investment in infrastructure will continue with the proposed building of 50 new airports and thousands of miles of roads and railroads as millions of people will be shifted from low-productivity agricultural areas to dozens of new cities. The proposed One Belt, One Road initiative to open up China to other countries in Central Asia and Asia and perhaps Europe with a network of ports, railroads, and highways linking China to these other parts of the Asian continent and the world could also provide an opportunity to export some of China’s excess industrial capacity.

While the gradual restructuring of the heavy industry-based ‘old China’ economy and continued investment in infrastructure and housing is meant to prevent a hard landing of the Chinese economy, the key policies are targeted to stimulate innovation through research and development including by lowering tax rates for high-technology firms. China’s value-added tax will also be extended to the service sector. Financial reforms will bring China closer to a market economy by eliminating limits on interest rates that banks can pay on deposits and charge on loans.

An important part of the reform process will be to deal with the outsize debts of the state-owned enterprises and the excess debts of local governments. China will be able to deal with these potential bad debts by transferring them to the central government in Beijing because government debt is very low – around 17% of GDP – at this time.

In the big picture, China’s productivity or output per worker will have to rise to achieve higher GDP growth in the new economic structure. Overtime, beyond the next five years, a large part of the GDP growth will be borne by consumption and low-end to high-end services as spending on infrastructure, housing, and industrial capacity bottoms out. Productivity will increase through automation especially as the working-age population declines through 2030. However, this increase in productivity will require upgrading the skills of the workforce to offset the need for large scale unemployment in the short to medium terms.

Productivity and innovation are the two key requirements for China to become a developed, high-income country by 2030. As more of the population becomes involved in the innovation sector and productivity rises through high-end manufacturing where China is no longer assembling parts but is designing and manufacturing from scratch aided by increased automation, the displacement of the workforce due to automation will be partly offset by the retiring workers because China’s working age population has peaked. In this context, a key reform is the establishment of a robust social safety net to assist the retiring and displaced workers.

Contrary to fears of a hard landing, execution of reforms, as China has done so far, and not short term monetary and fiscal policies, can relatively smoothly transition China into a high-income developed country by 2030.

Why is Inflation So Low?

Inflation, contrary to Milton Friedman, is after all a real and not a monetary phenomenon.

The intersection of the aggregate demand (AD) and aggregate supply (AS) curves determines the price level. Change in the price level or inflation, therefore, is dependent on the shifts in the AD and AS curves. Economic slowdown in China due to its structural transformation from a manufacturing and exports-based economy to a consumption and services-based economy and the slow economic recovery in Europe after the 2007-2008 financial crisis have considerably reduced the pricing power of businesses. With aggregate demand falling globally during the Great Recession due to the financial crisis, the aggregate demand curve has shifted to the left, lowering the price level, causing disinflation. Excess supply of commodities because of competition for market share among commodity suppliers has caused a steep decline in commodity prices worldwide, putting greater downward pressure on the overall price level.

Central banks of the Group of Seven (G7) countries, whose currencies command the most market share in international trade, have lowered interest rates to zero or near-zero level to revive their economies. At the zero bound they also engaged in buying massive quantities of bonds, known as Quantitative Easing (QE), to inject cash into the economy, and in the process grew their balance sheets enormously.

To spur investment and growth central banks not only lowered short-term interest rates but also long term rates by buying long bonds and other long term financial assets on a large scale. Such an increase in money supply should theoretically cause inflation by raising prices because more money chases the same amount of goods and services available in an economy when the cash is not used for real investment. In fact, even though central banks increased the money supply, the money is sitting as excess reserves in the central bank accounts of the banks and is not circulating in the real, non-financial sector of the economy to cause inflation (various financial asset prices could be inflated instead).

The G7 countries are in a ‘liquidity trap’ – the cash is not being used for raising real investment because financial institutions, in a low (zero nominal interest) rate environment, prefer hoarding cash instead of lending out the money for real investment when the aggregate demand is low. The more the money supply at zero or near-zero nominal rate of interest, the more the cash hoarding and inflation in the financial sector leading to bubbles in the financial markets. This is made worse when, for example, the Federal Reserve in the United States is paying interest on excess reserves (IOER) creating an incentive for banks not to lend out the excess reserves.

In the absence of targeted fiscal incentives to raise real investment, the G7 countries are operating well below their potential growth rates causing low inflation. The eurozone and Japan have now opted for negative interest rates to flush the hoarded cash out of the central bank accounts of banks into the real economy to ignite real investment, employment, aggregate demand, growth and hence, inflation. This, however, cannot be done by the central banks alone. Fiscal incentives and perhaps even higher public spending are necessary if – instead of higher public spending from government tax receipts or budget deficits – monetary policy refuses to be even more unconventional by directly lending to targeted industries in the economy to raise real investment, employment, aggregate demand, growth and hence, inflation.

Why is Monetary Policy Appearing Impotent in Restoring Growth and Raising Inflation?

The financial crisis of 2007-2008 has seen an unprecedented monetary policy response across the world to prevent what was feared could be a depression. The U.S Federal Reserve (Fed), Bank of England (BoE), Bank of Japan (BoJ), and the European Central Bank (ECB) slashed interest rates to zero or close to zero, engaged in quantitative easing by purchasing government bonds to increase money supply, and BoJ and ECB have now deployed negative interest rates to spur investment, growth and inflation. As a consequence, the reserves held by banks at their central banks have ballooned into trillions of dollars, yen and euros without those funds circulating in their economies and in the global economy as real investment.

Global growth is continuing to slow and commodity prices are at their bottom especially because China is executing a structural transformation of its economy from one of real investment and exports to consumption and services. India, despite strong growth, is taking further measures to ensure that monetary policy easing is indeed transmitted to the economy to raise real investment to create jobs and more growth.

Such extraordinary monetary expansion not achieving the desired goals of growth and inflation in the global economy is leading central bankers to conclude that monetary policy alone cannot be expected to achieve those goals and that fiscal and structural policies are necessary. But the question of why such a monetary expansion has proved to be ineffective begs to be examined.

Many of the G20 countries are exercising caution in deploying expansionary fiscal policy to produce growth. Many of them, with the exception of a few such as Germany, already have high debt-to-GDP ratios and are being, therefore, careful to borrow more. Structural reforms such as setting and meeting fiscal targets; trade liberalization, that is, lifting restrictions on imports and exports; removing price controls and state subsidies; encouraging more investment (for example, by encouraging foreign direct investment, FDI, and foreign institutional investment, FII, flows); and improving governance and fighting corruption are being put into place to create a favorable climate for real investment. But these take time. So, it is necessary to think out of the box about the fiscal and monetary policy mix that is necessary to attain the goals of restoring growth and producing inflation.

Growth to get out of the Great Depression came because of government public works and World War II, not because of monetary policy. However, nothing precludes monetary policy from supporting fiscal incentives to provide targeted money supply to increase real investment in specific sectors and industries in an economy. China has achieved historic growth rates doing precisely that: the People’s Bank of China (PBOC) supplied money for initiatives targeted by government planners. Monetary, fiscal and structural policies in China have executed industrial policy.

There has been an outright rejection of monetary policy executing industrial policy in the United States and in the Group of Seven countries (G7) in general because doing so goes against the grain of the economic orthodoxy of free market capitalism. Banks have been bailed out during the 2007-2008 financial crisis with the central banks engaging in industrial policy in the financial sector but it has been left to the financial markets to figure out where and when in the real sector to invest and how much (the U.S government had to bail out General Motors using tax payer money and not the Fed despite the Federal Reserve Act allowing it to do so). The result is poor monetary policy transmission. The monetary expansion instead is being used by corporations to raise money in the markets through the issuance of corporate bonds, raise venture capital for start-ups based on outlandish evaluations, for appreciating stock values, and by using stock buybacks with declining revenues and earnings (profits) to boost stock prices. Also, cost cutting in an environment of declining revenues is boosting stock prices. Stock prices are ceasing to be truly reflective of corporate performance. In this scenario it is doubtful when the global economy will fully recover to healthy growth.

It is time to dispense with economic orthodoxy and let monetary policy do industrial policy around the world by supporting prudent fiscal and structural policies.

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.