Tuesday, December 4, 2007

[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -31.2%]

In April 2001, in the midst of the worst deflation episode in half-a-century, Argentina granted "special powers" to economic czar Domingo Cavallo. Mr. Cavallo promptly issued a decree to put an end to the dollar-based currency board, widely seen as an aggravating factor in terms of deflation. Many in Argentina were encouraged by the move: people thought that the euro would continue to fall, and that Mr. Cavallo's new scheme —a currency basket with both the dollar and the euro— would offer some relief to battered Argentine exporters. In early May, a local pension fund kindly requested my opinion on the matter. My answer was straightforward: "I can't predict what will happen to the euro, but I can predict one thing — Mr. Cavallo's scheme will collapse".

My Argentinean forecast turned out to be one my few 2001 winners. The way I saw it, the matter clearly transcended the economics of exchange-rate determination. Mr. Cavallo's so-called "super-powers" were at the root of the problem. If one individual has the power to arbitrarily modify the currency, then property rights are ... gone. Interest rates have to go up, because the supply of loanable resources in the credit market will shrink fast — very fast. Sadly, this is what happened in Argentina in 2001. I bring up this issue because I have just found an academic paper in which the authors contend that high inventory-to-sales ratios may be caused by ... weak judiciaries! [1]. Now, inventory-to-sales ratios provide one of the best ways to analyze the volatility of the business cycle, a key component of ... endogenous liquidity.

Thus, the general principle can be stated like this: the lack of political checks and balances leads to weak property rights, to smaller credit markets, and to a higher cost of capital. As the great James Madison said: "Where an excess of power prevails, property of no sort is duly respected. No man is safe in his opinions, his person, his faculties, or his possessions" [2]. I recently took the trouble to put together an "Index of Checks & Balances", made up by Fraser Institute's grades on judicial independence, Freedon House's grades on freedom of the press and the WEF's grades on network readiness. The ten top-countries are to ones in which one would expect to find the lowest cost of capital: New Zealand, The Netherlands, Norway, Denmark, Germany, Iceland, Australia, Finland, Switzerland and Sweden. Now get ready for the ten bottom countries: Russia, Armenia, Georgia, Cameroon, Nicaragua, Paraguay, Tchad, Zimbabwe, Venezuela and Haiti.

[1] Angara V. Raja, Hans-Bernd Schaefer: "Are Inventories a Buffer Against Weak Legal Systems?", Kyklos, Vol. 60, No. 3, 2007, 415-441.

[2] James Madison: "Property", 29 Mar. 1792, Papers 14: 266--68.


akhondofswat said...

How come China doesn't figure in list 2?

Agustin said...

China is an interesting case. On its owm, it ranks very low -- just as one would expect. But wait a minute. Add Hong Kong, and the picture changes completely. Hong Kong is one of the best-governed countries. I´ll publish the data tomorrow.

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