THE FIRST DEGREE VIEW



The free traders dirty little secret PLUS what happens when the Fed starts selling?

Stephen Fisher - Thursday, April 06, 2017
Free traders' dirty little secret

It all started with Adam Smith and David Ricardo who together formulated the theory of absolute and comparative advantage. Basically, they opined that the reason countries experience rapid growth is because they get to specialise in the industries which have the lowest resource cost to themselves, and then trade with other countries for the goods and services that they cannot produce efficiently. Specialisation and trade are the cornerstone of classical economic theory.

 

But just how much does trade contribute to economic growth? This is an age-old question and, it turns out, very difficult to estimate. The best estimates we have for the US are that a 1% increase in trade generates the 0.75% increase in GDP per capita. Trade, in and of itself, does not imply accelerated rates of growth-there is no multiplier effect as some economists believe. Only about 10% of US GDP is trade related, so increasing this contribution by 1% is no mean feat.

 

This "dirty little secret" is important in the current debate as to whether Donald Trump can either (a) restrict international trade to increase domestic jobs in the US, or (b) threaten large trading partners such as China with trade sanctions in order to obtain a bargaining advantage for US interests. Trumps opponents argue that the economic costs of trade restrictions will be substantial. The numbers, on the other hand, suggest that there will be little impact of trade restrictions on US GDP or, indeed, the World.

 

Put simply, the cost  of a trade war to the US is negligible.  Trump will therefore fail to create jobs with trade sanctions, though they may lead to an increase in wages for low skilled workers.  Trump's China threats, on the other hand, may be more effective since the cost to the US of a trade war is much less than for trade dependent China.  Of course the Chinese know this (they can read this blog!), so they may well counter with an offer to 'do something' about North Korea, leaving the Donald with a diplomatic coup and a Nobel Peace Prize.

 

What happens when the Fed starts selling?

I have said it before and I will say it again. Transactions volumes are rarely associated with directional movements in prices.  If every investor agrees that the price of a security is $100, then the price will be $100 irrespective of whether nothing trades or a $trillion goes through the market.  This is a feature of an informationally efficient market.

 

Yesterday's Fed minutes were released and they indicated a desire for the Fed to reduce their US Treasury holdings.  There was no price impact of this announcement indicating that the market has fully anticipated these sales.

 

So what will be the effect on prices when the Fed starts selling? ABSOLUTELY NOTHING!

Comments
Colin King commented on 06-Apr-2017 03:55 PM
Very good points. Bonds still the most misunderstood asset class.

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