December 09, 2006
Intergenerational Accounting and Long-Term Policy Problems
Ok, this one is a bit misclassified in the article as a "remedy" or "solution" or fix for a long-term policy problem. Intergenerational accounting as a practice simply computes the total cost to a government of addressing a problem over time. In the case of public pensions, like Social Security, this would involve computing the total amount the government would have to pay out under current law and reasonable projections about how long people will live, and computing how much income it will have in Social Security taxes (involving assumptions about how many people will be working and how fast the economy will grow, etc.). Then you compare the two numbers. To be a long-term policy problem, almost by definition the costs have to be greater than the expected income. (If we were expecting enough money to pay for it, then it wouldn't really be a problem, would it?) In some cases, it's a really big gap - some countries have pensions obligations that are more than 2 times their annual GDP, which is an enormous number of times more than their annual pensions tax income.
For a case like pollution abatement or stopping global warming, the "intergenerational accountants" would compute the expected amount of pollution they'll have to clean up over time (and how much it would cost to do the clean up and fix anything else that goes wrong as a result), and the expected income of any pollution taxes or government funding. Again, it shows about how much the projected value of current efforts falls short of what will be needed to fix the problem.
Posted by lpowner at 08:03 PM | Comments (0)
What Is Speculation? How Do You Do It?
Entries may be shorter than most previous ones; I want to try to get as many of them done as I can before the exam.
Speculation is a specific form of arbitrage (the process of buying something where/when it's cheap and selling when/where it's costly). In our context, it refers pretty exclusively to efforts by international currency traders to make money off of changes in exchange rates (especially fixed rates).
To recap, fixed exchange rates are set by a government or central bank and declare a set rate at which foreign currency will be exchanged for local currency. To make this concrete, let's use a real example: China has pegged its currency, the yuan, at 5Y to US$1. (1Y = $0.20). Anyone who does business with China and exchanges currency at the central bank (the only legal place to change currency; banks use it on behalf of their clients) will get that rate, any day or any time or anyone.
The 'speculation' part comes from currency traders. Experts estimate, based on lots of math, that if it were allowed to float freely, the Chinese yuan would probably end up being worth 9Y = $1 (or 1Y = $0.11). According to these calculations, the yuan is clearly overvalued - the government says it's worth a lot more ($0.09, or almost half its declared value) than 'the market' thinks it's really worth.
Let's say now that currency traders think that there is something wrong or out of balance in the Chinese economy to the point where they feel the long-term ability of the Chinese central bank to uphold that 5Y=$1 rate is doubtful. Perhaps the pattern of global trade shifts drastically as a result of labor unrest in major Chinese cities, or cheaper production venues become available, or consumer tastes shift away from the kinds of things China produces for export. If currency traders begin to have private doubts about these kinds of things, they may begin to sell off their holdings of yuan. Every trader wants to sell his/her yuan back to the central bank before the central bank runs out of dollars; the dollar doesn't go through major shifts so it's a safe currency to hold. When one trader sees others selling yuan, they may investigate and perhaps start selling their yuan too. Currency traders who are convinced that the central bank will be unable to sustain the high rate for long may also try to buy yuan from other investors or traders at current market prices and then sell them back to the Chinese central bank to get their hands on even more dollars. As one trader sees others selling off yuan, he too will sell in fear of having the central bank run out of devalue the currency before he got rid of his holdings. The result is a "herd effect" or "stampede."
The net result of all of this is that the market is flooded with a large supply of the currency - and, in the case of a speculative attack, demand goes down because no other market actors are willing to buy it. As we all know, when supply goes up, and demand goes down, pries will fall. (Graph it out if you're not clear on why that relationship holds: do a starting supply and demand, then S2 (higher) and D2 (lower) and see what happens to price.)
For a currency with a floating exchange rate, this is somewhat problematic but not fatal, so long as the value of the currency doesn't drop tooooo far. A central bank that is committed to a fixed exchange rate, though, faces a much more serioius challenge. To keep the price of its currency (its exchange rate) from dropping, it must personally intervene in currency markets to create demand for the currency. The Chinese central bank must buy all available yuan - pay dollars for all the yuan that actors are trying to sell, at the established rate - to keep the price of its currency at the target level. This gets incredibly expensive, and can only continue as long as the central bank doesn't run out of reserves.
Currency traders command much greater amounts of money than the central bank does, though, so the real issue is not "if" but "when."
When the central bank nears the end of its reserves, it has two choices: devalue the currency (require more yuan for each dollar it dispenses) or stop exchanging currency. Both are effectively admissions that the market is right and the policy is "wrong" - even if later research suggests the opposite, and so doing either destroys the market's confidence in the currency's value. (This is probably the biggest impediment to recovering from a currency crisis, this lack of confidence - not the loss of reserves or the need to rebuild reserves.)
Posted by lpowner at 07:28 PM | Comments (0)