Friday, October 26, 2007

Information as a source for optimal allocation of resources (I)

Information availability allows economic agent the most efficient allocation for resources. Usually market competition works, on the assumption that all information is available with zero transaction cost .Otherwise , it is hard for economic agent to realize the best chances of making profit. Although information has transaction cost , rational behaviour assume that every agent ,will gather information up to the point marginal benefit = marginal cost. When it comes to goods transaction, information is self contained on each product characteristics, such as quality, value and price. If there are not perfect competition, advertising expenditures complement each product helping out to positioning itself on consumers mind with more information about its characteristics .It follows that markets is all about information as much as its institutional framework.. Given an institutional setting ,any restriction of any kind(biased reports) on information flows, will affect the efficiency of allocation of resources.
What about financial transactions ?. It apply the same. Economic agent, needs information about the quality of financial instrument available for investment decisions. However, quite on the contrary to the good case, this information is not self evident on every financial instrument as it is in the good transaction case. There is information asymmetry ,the seller of the financial instrument knows better the quality of it, because it has all the information to evaluate the present value of such asset. This situation leads to the adverse selection problem. Bad quality financial assets, are the predominant ones in markets transaction, because every investor do not have the chance of getting correct information ,any time it is needed.
Financial Markets evaluate the information available , asigning a price to each asset which match the risk associated to it. The riskier the asset the higher the return , but the lower the chance of finding a customer ready to take the risk of buying such asset, when markets behaviour turns out to be risk averse.-
Given the importance of a proper risk valuation , markets need the advise of the asset rating agencies, which classify asset according its different level of risk within a scale ranging from the top to the bottom. Those better qualified get the most ( AAA+) grade, which means low risk high profitable assets, which every one want to include on their portfolio. On the other hand ,those assets which do not get the best grade investment, are the ones which every investor would prefer to get away from. This was the case in the eighties and nineties with defaulted foreign government bond , which at that time allowed the development of the so called swap operation market.
All this discussion lead us to the current situation of mortgage sub prime market crisis, and the implications for market performance,as a case study in terms of the role of information. No matter the ignition factor, the fact of the matter it represent a market failure on two key variables: institutional framework and quality of information .From the quality of information stand point , any one in charge of asset information analisys, is the one to be questioned , about its procedures to properly grade the risk involve on this kind of sub prime transaction. Economic agent, followed and trusted the grade investment those rating agencies gave to every one of this new financial instrument and subsequent transaction.It seems that even with a weak institutional framework, proper and accurate information can make the difference between right or wrong allocation of resources .

Friday, October 19, 2007

The year 2007: Some comments

Most of forecasters are already working on their projection for the year 2008.Michael Mussa ,has said that the best friends for them is luck. At the beginning of this year, there was little concerns about issues such the sub prime mortgage markets crisis, and its expected impact on global economy. At the same time, it seemed that the US economy was getting on its way through, toward a soft landing following the upward adjustment on the interest rate. Markets were wondering what would it be like without A Greenspan as Chairman of the federal Reserve ,and the character of the incoming new boss B Bernanke, along with China stock exchange markets turbulences , after applying new regulation to reduce speculation and gambling .Most of the attention, was on oil prices behaviour . Europe heavily concentrated on environment ,set the pace on the issue for the month to come .Finally Latin America, even with deviation in some countries from macroeconomics fundamental, had the expectation of another year of economic growth.
A famous question which was done by former President Reagan, is fully applied at the end of this year: Are we better off now than what we were at the beginning?. This question matter because when it come to make forecasts , it is very important the conditions surrounding those forecast ,otherwise there is chance to be wrong on markets predictions. Therefore, any forecast for the year 2008 ,should take into account the answer to this question, otherwise who knows what the forecasters are really predicting?. If we are better off, any forecast would mean to improve even further our current conditions .If not, any forecast would mean any thing ranging to be worse off than we are right now ,or to keep the same situation at the same level it is right now. Macroeconomic data only measures the addition to current GDP value, but not the framework which influence those results. It usually appears as the “error term” in the econometric model. Well some time the “error term” make the difference, between right or wrong.
My guess is that we are not worse off now ,than what we were at the beginning . Every aspect of global economy ,is a bit better now than what it was at the beginning of the year , and above all better than what it could have been. Let checks some issues which were on the list of potentially harmful for the global economy: Volatility on global stock exchange markets ,oil prices increases (which contrary to the expected is still below U$$100 a barrel)),sub prime mortgages markets crisis, slowdown on the pace of economic growth in China, India and Europe, and protectionism threats .
How come that global economy has been so resilience, so far ?. My hypothesis is that the world economy , is moving toward a new stage with a more diversified distribution of world product. Actually, 40 % of Global GDP is produced on emerging markets, reducing the risk of global slowdown .The pace of economic growth ,of the leading economies in such a group ,is strong enough to keep the train moving forward. Global economic growth has met its fifth year of continuing growth at a 5% rate. On the other hand, it seems that a global framework is already working to protect specific issues such quality products, and that of domestic economy policy. Therefore there are better instruments and tools to solve current global economic challenges, which means that there is space for moderate optimism for the year 2008.-.

Sunday, October 14, 2007

Global Warming :The new totalitarian ideology?

The 2007 Nobel Peace Prize has made a new call for environment protection, and above all new development for decisive action .A new global institution just for environment?.
Does this means global warming might become the justification for constraining economic growth, human freedom and trade?.This is something what some analyst are afraid of.
First of all, environment protection should not be a constraint for economic growth. It is a matter of making them both complementary, instead of substitutes.-
Secondly, those countries which pursue environment protection policies, have been capable of improving both :Economic growth potential, human freedom and trade , keeping at the same time the proper attention to environment. In Latin America ,Brazil, Uruguay and Chile are good examples about that.-
Third, It is hard that a new ideology comes up from environment ,because every one is watching what it is going on with it, and the expected effect of doing nothing .On the other hand , It is not a matter of belief, it is a matter of fact. Science and scientific community although without unanimity , recognizes that human intervention has some important probability of being responsible for global warming. Even though it could also be part of a cyclical pattern, it is obvious that such a pattern in the last years has been above the trend .The Inconvenient truth documental has made it clear for all.-
Fourth. At this point ,it is too late for such an issue to become an ideology .Thus it should be the basis for a new environmental pragmatism.-
Fifth .Environment is like most of the cases of common property goods. Because nobody might claim property right about it ,there is no incentive to take care of its exploitation level. The expected outcome, is the collapse of such a resource. This a fact which applies for all resources in such a situation, underground water, river side contamonation, fishery industry and the like.
Sixth .Markets mechanism can solve a lack of property right claim, assigning such a right to every firm which contribute to reduce environment damage. Those claims are traded in secondary green markets ,with very high potential for benefit for everyone involve in such a transaction However this markets mechanism can not make the difference as fast as it is needed.-


Friday, October 12, 2007

Special interest ´s groups and economic policy

Economic policy is not neutral when it comes to analyze its distributional effect. A policy designed to reduce inflation ,in the short run might benefit some groups and hurt another. Those who get higher interest rate for their banks deposit are the “winners”, but those who lose their jobs because of unemployment increase are the “losers”. However the overall effect in the long run of such a right policy, is to increase the welfare level for all, because low inflation support economic growth. The same distributional analysis applies with taxes, exchange rates and fiscal expenditure.
These days ,there is a debate in Chile concerning the current level of the exchange rate level .The higher copper prices ,plus the interest rate differential between US and the Chilean economy(almost 100 bsp),has created such excess of foreign currency (dollars), at the rather small foreign exchange rate market, than the local currency (peso) has appreciated by roughly 6,5 %throughout the year 2007. There is also a similar situation in Brazil and Colombia.
Since the year 2000, the Central Bank has applied a “clean” flexible exchange rate policy ,allowing exchange rate instead of real variables and domestic activity, to absorb the effect of any external shock. However this free floating approach, means that sometimes exchange rates appreciates ,and sometime it depreciates.
When it appreciates consumers can get cheaper good from abroad , besides they can take more foreign vacation program. Producers can get capital good also at a cheaper price. On the other hand, the appreciation of local currency hurt exporters specially those who concentrate their export to markets in the US, assuming they export product with high price elasticity, which means substitutable products. Therefore there is a distributional effect which is no neutral because while one group win (consumers),the other one (exporter) loss . While consumers get the benefit ,exporter get the cost of the appreciation. Thus the local authority confront a cruel dilemma, which group should they support? . either one have their own weight for GDP growth , consumption on the one hand, export on the other hand. This is the reason because free floating exchange rate policy , develops the so called “fear of floating” , because there are no minor distributional effect with such fluctuations.-
But that is not the end of the story, exporters are better prepared than consumers to speak out . They are fewer than consumer, therefore they have lower transaction cost to get organize . So, they are in a better position to try to influence authorities to intervene in local markets to push exchange rate to depreciate. But if local authority do so, then economic policy is designed by special interest ´s groups, because any group with strong media influence to get their message across, will try to do the same . In such a case economic policy becomes discretionary, which no one will be in the position to anticipate, increasing the risk level for long term investment and for the country as a whole .-
What it is important in this case is to understand the overall issue. The Chilean economy is growing at a steady pace ,such that it induces to appreciate its local currency because it worth more. In fact on the long term trend ,the exchange rate has been moving downward as the economy get higher GDP level. It follows that ,the real issue is how far is the current exchange rate level form its long term trend ?.Available data suggest that it is not that much further away.-

Friday, October 05, 2007

is Inflation back in Latin America ?

Recent annual inflation rates in some countries in Latin America: Venezuela 15%,Argentina 8.5%,Brazil 4%,Chile 6% .Still the average rate of inflation for the whole bunch of countries, was 5,4% in the year 2006,quite below the average in the nineties,263% in the first half of that decade, and 17% in the second half of that decade. The trend in the years 2000,concerning inflation rate in Latin America, has been downward . Therefore it is not the case that Latin American economies are moving backward ,but it is the effect of cost pressures arising from foods and energy prices increases .Whether it is transitory or permanent is a different matter. However, it is probably the new price setting for the mid term period of time. It is going to take a while to develop new capacities to cope with world wide increasing demand for foods, very much so, when the expectations is for a steady increase in such demand. Advanced economies do not face the same kind of pressures because foods do not represent that much expenditure weight on consumption basket . The same apply for energy consumption ,and new sources of supply.-
The important issue is that most of Latin America countries in the nineties, implemented reforms in their Central Banks to give them more autonomy and independency. It follows that Latin America economies have the proper tool to cope with this prices challenge. But, a different issue is how to use this tool, and the willingness to admit that there difficult trade off to deal with along the way.
To which extent is it worthy to sacrifice economy growth with restrictive monetary policy ,whether there will be inflationary impact arising from cost pressures anyway?. Cost pressures arises from the real side of the economy, which means that it is more time demanding to cope with its impactand solution. Productivity increases are a mid term target, and it requires additional reforms which might take more time than available . Labour market flexibility, is difficult to improve in the short term .
There is one option which can not be left out. Central Banks need to be even more autonomous than they are. The evidence indicates that the more its autonomy, the lower the volatility of inflation and so the volatility of output. Thus, the most serious problem, lies on the political side of the equation. Politicians like to threat Central Bank autonomy ,because it reduce their own influence to manipulates economic growth with more government expenditures pressures.-.