Who decides on the type of equilibrium anyway?

Trench warfare is on. Between those who advocate governmental austerity measures and those who insist austerity is all bunk in order to escape from the fears of a double-dip recession.

Yet, to understand this debate is to understand the importance placed in notions of equilibrium in an economic system. Modern economic theory revolves around the notion of equilibrium. This is a by-product of its mathematical origins from the physical sciences in the 19th century.

Viewing economic systems are closed systems. There is a certain lure to the idea of equilibrium wherein all the forces acting upon a complex system are unable to exert undue influence.

This very notion of a unique equilibria, or multiple equilibria, guides economic research often.

While many influential market participants like George Soros, Nassim Taleb and Stanley Druckenmiller have pooh-pooh-ed the idea of equilibrium guiding financial markets. Many investment banks and consulting houses rely on it to make predictions.

It goes without saying that there is an element of truth in both world views. A trading desk focuses on small intervals of time and thus is often forced to readjust its positions on the basis of transient events that in the long run mean little. (Think of the Falkland Wars and value of the pound-sterling in the 1980s).

Academia, however, focuses on larger swathes of time when structural parameters govern more visibly and thus exert greater influence on any predictions from a theoretical paradigm.

While this column has often covered what could be called short term concerns on the fate of the dollar, the intransigence of the yuan, the schizophrenia of the euro, we have rarely commented on the long term factors at play in global trade. Global trade is about exchange of goods.

But, more deeply however, global trade is a result of relative inequality of factors of production in different countries posses, that is the flow and direction of global trade or finance is about the relative differentials between Chinese labour and American labour, between Saudi cost of capital and Pakistani cost of capital.

Today, we have, not withstanding local idiosyncrasies imposed by governments and trade barriers, a single price for commodities, capital and tradable financial instruments.

Gradual transition

This is true, except for labour. Here, true arbitrage exists, as one can just ship the jobs down a fibre-optic cable at virtually no cost and get equal or superior work done.

The result of this macro-phenomena and cheaper access to capital is a gradual transition in the structure of industrial production in the world.

Theoretically, increased exports to the developed world ought to result in rising nominal exchange rates of the emerging market currencies.

And in an equilibrium framework the nominal exchange rates would appreciate till an equalisation of labour costs occurred. (The plethora of protests in the US against China's unfair currency fixing is a public manifestation of this seemingly esoteric idea.)

Complex matters

In absence of gunboat diplomacy, or rampant trade wars, the West has increasingly little options to actively counteract against the structural shifts.

The only release is that the major currencies of the world will have to devalue, if one believes that global economy is governed by a set of equilibrating forces.

To make matters more complex, the commodity market prices are set globally rather than by the arbitrary dictates of a state.

(The recent price increase of fuel in India is evidence that even the state can't support unhinged subsidies forever.)

The result of this global price setting is that emerging markets with their growing productivity levels will need relatively greater amounts than their developed-market counterparts.

As a result, emerging markets end up paying more than they should due to their artificially depreciated currencies, and ironically using lesser than they should given cost constraints.

The developed world ends up paying less than they should and consuming more than necessary. It is, as Lewis Carroll would have said, a topsy-turvy world.

The result of this phenomenon is that globally commodities end up being more volatile than currencies when ideally it should be the other way around since the shock of the exchange rate volatility can be spread across a larger base of consumers.

These are the major conclusions of a doctrine that believes in equilibrium. But there is a great unknown that can upset all equilibrium-chatter: politics!

So, irrespective of whether fears of a double-dip ought to induce greater austerity or not, it is politics and not economics that guides this debate.

That, alas, as many have increasingly noted, is the bane of our times.

The columnist works for a major European investment bank in New York City. You can follow his blog at www.tradingmonsoon.com  via RSS/GoogleReader or Twitter at @tradingmonsoon