Saturday, October 20, 2007

Tectonic Shift, Part II

Sivaram Velauthapillai commented on Part I of Tectonic Shift saying:

Globalization, and basically free markets, will equalize the wages (same job will pay same wages within reason) and return on capital (capital can easily flow anywhere nowadays). Wages are downward rigid (due to a whole bunch of reasons) so they won't drop in developed countries. Instead, wages in developing countries will rise.

This idea that wages are downward rigid was best explained by John Maynard Keynes, who thought it was the source of a lot of our economic problems. He stated that individuals did not like to take a cut in their pay to help adjust during recessions. So employers would just fire them instead, and this would magnify the economic problem.

But the part I wanted to talk about was the last statement. It seems plausible that if the developed world would not accept pay cuts that their standard of living would be maintained, while the rest of the world would see a rise in their wages. But that forgets the idea of currency exchange rates. And the US dollar has been hitting record lows, which has a direct effect on our "real earnings". So tonight, I am going to try to show some basic understanding of a recent phenomenon.

It always surprised me that with the rapid increase in globalization, we in the US have not seen a consumer prices in the US decline. Basic economics says that if production costs are declining, competition should at least pass some if not most of this down to the consumer. And then, it has also surprised me that the US could drop interest rates to 1%, or that we could be "awash in liquidity", without seeing an increase in inflation.

Well it turns out the two have actually been balancing each other out. We can see this by looking at two money supply indicators, M1 and M2. M1 is the index tracking all physical currencies and the money in readily available bank accounts. M2 equals M1 plus savings accounts, money market accounts, and other time deposits. Since 2000, M1 has increased from 1123 to 1368. M2 has had a much more significant increase from 4665 to 7372. So there has been a big increase in the money supply, and this is probably what has been offsetting the deflationary forces. Greenspan recently commented that he is afraid of inflation going forward, because a lot of the deflationary benefits of of globalization have already been felt. So, the current pace of increase in the money supply can not continue like it has before. Below is a chart showing some of this historical data.
Now conclusions get rather tricky from here, so for now I'm just going to say that this huge increase in money supply puts a downward pressure on our exchange rate. So, it would be wrong to think our developed world wages and our standards of living are protected by this unwillingness to accept pay cuts. There is a method for real developed world wages to decline, through the much more subtle means of currency exchange rates.

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