World Crises Can Lead To Stock Market Crash

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Alex Christensen of Global Risk Insights offers a warning to global investors dealing with the global turmoil and U.S. stock markets.  Developments in Ukraine and the Middle East can prove harmful to the U.S. stock market.  With the unfortunate Malaysian Airlines crash being a result of actions of Russian-tied rebel factions, there is increased pressure on the European Union to impose economic sanctions on Russia.  Even though the U.S. will likely press for crippling actions on the Kremlin, Europe had a lower appetite for this move because their economic prosperity is tied to access to plentiful Russian energy sources.  Now with this distasteful event, Europe will face more outward pressure to respond to their neighboring menace even if it contributes to a recession for them.

Then there are rising tensions in the Middle East where ISIS are gaining ground in Syria and Iraq, while Israel is expanding operations in rooting out Hamas in Gaza.  This is also spooking global investors that are concerned about about free flowing oil.  If access to oil is compromised by these developments, then that can dampen economic growth because businesses and consumers rely on crude oil to keep their energy prices low.  If crude oil becomes scarce, then that will drive up the cost of gasoline and causes both consumers and businesses to downsize.

Global investors are aware of the risks associated with Eastern Europe and the Middle East and have sent their funds to safe U.S. Treasury securities.  Even though Standard and Poor’s have reaffirmed the U.S. credit rating at AA+ due to high budget deficits and Congressional gridlock, they still remain a safe haven for investors seeking safety.  When investors start buying bonds, this drives down their yields and thus bring down other interest rates associated with it, such as the prime interest rate and the mortgage rate.

With interest rates remaining low, there is enhanced risk of asset bubbles. As implied by Christensen, the Fed has been trying to normalize interest rates, which have been artificially lowered by Fed policy aimed at boosting employment.  Even though the Fed actions have undoubtedly improved labor markets with U.S. unemployment rate on the decline, it has roiled foreign markets, who are struggling to tamp down inflation and prevent asset bubbles themselves.  Eventually, these same symptoms could be felt in the U.S., especially if signs of a more robust recovery becomes more consistent.  Stronger labor markets will provide U.S. consumers with more security and income, thus resulting in more savings.  If U.S. consumers decide to shift their increased savings to the U.S. stock market, then there is concerned that this could push equity prices to unsustainable levels and cause a market crash.

All of these events can compromise Fed policy and end up swallowing wealth in the long-run.


Engines of Growth and Prosperity

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When doing international comparisons of wealth and prosperity, one can distinguish rich from poor countries based on the following four factors:  physical capital, human capital, natural resources, and technological knowledge.  Countries that score high in all four factors are usually more productive and grow faster than countries that rate low in those same factors.

Physical capital per worker measures spending on infrastructure, equipment, and machinery in relation for each worker.  Despite the relative small size of the U.S., their investment in physical capital far outnumbers any other country in the world.  When you look at the level of automation and technology present in all aspects of American life, one can see how it makes our life much simpler.  For instance, imagine doing complex calculus problems by hand, rather than computer.  Instead of using Microsoft Word, imagine doing business reports with a pencil and paper.  Imagine how hard it would be for a Proctor and Gamble factory worker to produce paper towels with their hands, rather than heavy machinery.  The computer, Microsoft Word, and heavy machinery at Proctor and Gamble are all examples of physical capital.  Acquiring physical capital requires a strong financial system in order for firms to make significant investments in expensive technology and equipment.  The U.S. sophisticated financial system provides an edge over other countries.  While China and India remain relatively poor countries, their investment in infrastructure and technology has fueled their rapid growth over the last couple of decades.

Human capital per worker refers to the knowledge and skill accumulated by the typical worker.  When an individual increases their human capital, they are more productive and in demand by businesses.  Typically, examples include earning a college degree, but it also includes attaining specialty certifications and hands-on training.  As we shift from an industrial economy to a service-based economy, attaining certain skills can set you apart from others.  That is why earning a college degree, particularly in a math or science discipline, will earn you much more money than a high school diploma.  Countries that have more college graduates will yield higher salaries over those with less.  Developing countries, such as China, Brazil, and India, have started to close the economic gap, particularly in their urban areas with improvements in educational outcomes

Natural resources per worker is the accumulation of resources for each worker.  This includes land, energy, and water resources.  Countries, such as the United States, that have an abundant source of natural resources have an edge on countries that have less natural resources, such as China.  Unlike China that must pay high sums to the Middle East and Africa in order to meet their energy needs, the U.S. is able to offset those costs by boosting their domestic oil production.  Also, Norway has a wealth of natural resources, which plays a role in their very high Gross Domestic Product (PPP) per capita of $53,471.

Technological knowledge is society’s understanding of the best way to produce goods and services.  While similar to human capital, there is an important distinction.  With technological knowledge, you are doing the teaching.  However with human capital, you are trying to increase your knowledge base or skill level.  For instance, a teacher developing curriculum is an example of technological knowledge.  A student completing their junior year in high school is an example of boosting their human capital.  The U.S. has a well-respected higher educational system that is the envy of many countries and its presence makes coming the U.S. very valuable to people across the world.  Our free market system, which encourages individuals to pursue their career goals, encourage innovation and leads to high technological knowledge.  Conversely, China’s economic model might not be sustainable in the long run because their system discourages innovation with inadequate protections of property rights.

When crafting policies to spur growth, it is essential that our various global leaders emphasize these four drivers of productivity.

How To Achieve Growth and Prosperity

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For my Principles of Macroeconomic students, they are currently learning how living standards vary across the globe in the Production and Growth chapter of Mankiw’s Principles of Economics.  While the U.S. and Canada enjoy “rich” country status with GDP Purchasing Power Parity (PPP) per capita figures of 48,387 and 40,541, respectively, there are other countries, such as Ukraine and Indonesia, whose GDP (PPP) per capita figures are fractions of that at 7,233 and 4,666.

That might lead to this question:  What is GDP (PPP) per capita?  This measures living standards and is a proxy on how much each individual contributes to their economy.  Global comparisons are difficult to make because currency valuations differ.  For instance, a Zimbabwean could make 1 million Zimbabwe dollars, while a German makes twenty thousand Euros.  One would assume that the Zimbabwean is better off, but that is far from the case because Zimbabwe has a very weak currency relative to the Euro.  In fact, 1 million Zimbawean dollars would only be approximately 2,122 Euros.

Therefore, purchasing power parity is used to take out the bias of currency exchange rates and allows for more accurate global comparisons.  Referring back to the U.S. and Ukraine, we can make a rough estimate that the typical American contributes $48,387 to economic output, which is must higher than the typical Ukrainian, who only produces $7,233 to their economy.

What accounts for these vast differences?  One can point to these four factors to explain the wealth differences across the globe:  physical capital per worker, human capital per worker, natural resources per worker, and technological knowledge.  Typically, countries, who score high in economic freedom, also rate high in most if not all of those four factors.

In particular, a country’s score in the following four areas from the Index of Economic Freedom are drivers to high U.S. productivity and prosperity:  Rule of Law, Limited Government, Regulatory Efficiency, and Open Markets.

When comparing and contrasting countries across the world, there is a distinct relationship between economically free countries than those that are repressed.  That is because economically free countries respect private property rights, which encourages individuals to take more risk and build wealth.  In repressed economies, most decisions on producing goods and services are determined by state government officials, who lack the dynamism and expertise to adjust sufficiently to rapidly changing market forces.  Also, state-run economies have less competition and result in more corruption that erode wealth accumulation.

Though it should be pointed out that the U.S. ranking in economic freedom has declined over time as rising budget deficits and an expanding role for government to deal with the financial market crisis and rising health costs have taken its toll.  We still rank in the top 10 and are only behind Canada among advanced economies.   When looking at advanced economies, which include the U.S., Canada, Germany, Italy, United Kingdom, France, and Japan, most have economic freedom scores that rank as mostly free with the two exceptions being France and Italy, which are still considered moderately free.  It may not be a coincidence that France and Italy also has experienced more economic turmoil in Europe than Germany or the United Kingdom.

While some would dismiss these rankings and point to historical colonialism of Europe and the U.S. over much of Central America, South America, and Africa, that does not explain how developing countries in those three parts of the world who embrace economic freedom mostly enjoy greater living standards than those with lower scores.

It is noteworthy to point out that pursuit of growth often comes at the expense of equality.  That speaks to the tradeoff between equality and efficiency.  However, Canada has been able to achieve a high economic freedom score and still provide a substantive safety net, including universal health care.  Though, it is difficult to achieve both.