Tuesday, June 1, 2010

The dangers of financial liberalization

The WSJ Economics blog recently highlighted a paper written by Ke Tang at Renmin University in China and Wei Xiong at Princeton University about how commodity prices are becoming increasingly more correlated with stock prices. This finding has to do with it becoming easier for investors to move in and out of commodities markets. Greater financial liberalization will mean increased volatility within a market as the prices of commodities will now be based more off of market sentiment, animal spirits and speculation rather than actual supply and demand and mark-up. There are also implications for monetary policy because a spike in investor optimism (pessimism) will cause input prices to increase (decrease) leading to greater uncertainty as to the direction of inflationary expectations. Fluctuations in stock prices have important household and firm wealth effects and similarly fluctuations in commodities may lead to the destruction of many firms balance sheets.

We can see this with a simple example:
“Company A” in Michigan's Upper Peninsula deals with the mining and production of copper and "company B" makes copper tubing. B buys copper from A at a set market price "P". Then say there is an unrelated debt crisis in the euro-zone that shakes up investor confidence in everything from bond markets, stock markets and commodities so that a sudden drop in the price of copper worldwide occurs. Company B who now has to pay the original market price P finds that they also have to charge less for their copper tubing. This is because the tubing price is based off of the current market price per pound plus some service markup. Not only did company B already order this copper from company A at price P but now they have to charge less than it cost them to purchase it thus leading to a potentially crippling loss.

I guess the lesson here is that without stable expectations we may suffer from further bankruptcies.
One of the reasons that the Fed controls the price level so well is that they convince people that the price level will change by a set amount. Unfortunately it is extremely unrealistic to create a Fed for the stock market or commodities markets to ensure slow and rising asset inflation. Instead we have a bunch of profit seeking investors searching for the greatest yield. Goods and services are determined by supply and demand and the rest of the mark-up comes from expected inflation. When something get financially liberalized its price is no longer a function of the market conditions (supply/demand/mark-up) it becomes a function of continuously changing expectations.

A further example may help illustrate my point.
Assume tv's get financially liberalized and people sell and buy tv's based off their expectations about others demand for tv's. We would see drastic changes in tv prices that would not necessarily reflect supply and demand as a dramatic fall or rise in the price of tv's would put electronics stores out of business or in business. Waves of optimism and pessimism might impact their prices while not necessarily reflecting the true cost of production and mark-up.

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