The table at the right summarizes the percent change between January 6 and November 11 in the cash prices of 19 commodities reported in the Wall Street Journal (downloaded via Webstract). The average commodity in this list has appreciated 37% since the start of the year.

A recent paper by Ke Tang and Wei Xiong documents an increasing tendency for commodity prices to move together over the last few years. A decade ago, what happened to oil prices was largely unrelated to movements in most other commodity prices. The graphs below show how the correlations between oil prices and the prices of four representative commodities have increased significantly over time.

Correlation (using a rolling sample beginning one year before indicated date) between returns on oil and specified commodity. Source: Tang and Xiong (2009).

One explanation I often see in the popular press is that movements in commodity prices are driven by changes in the value of the dollar relative to other currencies. However, the magnitude of movements in commodity prices greatly exceeds the size of changes in the exchange rate. For example, the table above shows that since the start of this year oil prices have increased five times as much as the dollar price of a euro; see also Steve Gordon's graphs. While the depreciation of the dollar is part of the story, most of the explanation must be found elsewhere.

Another important factor is resurging real economic growth outside the United States, which produces pressures for both the dollar to depreciate and the real price of commodities to appreciate. According to this theory, the increasing correlations between commodity prices results from the fact that countries like China are so much more important for the world economy today than they were a decade ago.

A third explanation is that investors are making increasing use of commodities as an investment class. Although Treasury Inflation Protected Securities offer a hedge against an increase in the U.S. consumer price index, they don't offer protection for foreign investors against depreciation of the dollar. Insofar as increases in the prices of commodities like oil may depress real economic activity, holding commodities as an investment also offers useful diversification against risks to equities. Particularly when interest rates are low, there is an incentive to hoard physical commodities as an investment vehicle.

The paper by Tang and Xiong proposes that the increased use of commodities as a financial investment accounts for the increasing correlation among commodity price changes over time. In support of that claim, they note the growing popularity of investment strategies based on the Goldman Sachs Commodity Index or the Dow Jones Commodity Index. Tang and Xiong document that correlations among commodities included in the indexes have increased faster than those not included. For example, one of the regressions they estimate relates the return on commodity i to equity returns, bond yields, the value of the dollar, and oil prices, where the coefficients are allowed to grow with time at different rates before and after 2004, and with different trends on these coefficients estimated for commodities included in indexes as for those excluded. The figure below shows their estimated time path for the coefficient on oil prices comparing the indexed and non-indexed groups.

Coefficient relating return on average commodity to return on oil as a function of time for commodities included in the GS or DJ indexes (top curve) and those excluded (bottom curve). Source: Tang and Xiong (2009).

For any of the explanations in this third class, one of the important challenges is to reconcile the story of commodity speculation with supply and demand for the underlying physical commodity. If we propose that speculators have driven the price of the commodity up, the physical quantity demanded should decline as a result. In order to be sustained, a coherent speculation-based theory of commodity price appreciation requires increased physical storage of the commodity.

The solid black curve in the figure below plots the typical U.S. crude oil stocks (excluding those held in the Strategic Petroleum Reserve) for each week of the year, based on the average over 1990-2007. The red line gives the actual values for 2008, which were significantly below the historical average, particularly in the spring of 2008 when oil prices were rising so dramatically. Those below-normal inventories were one reason I focused on what was going on to the fundamentals of supply and demand in trying to understand the behavior of oil markets in the first half of 2008.

Weekly U.S. crude oil ending stocks, excluding SPR, in thousands of barrels, from EIA. Black line: average over 1990-2007. Red: 2008. Green: 2009.

On the other hand, inventories of crude oil this year, shown in green above, have been substantially above normal, meaning that in the absence of that oil going into storage, we would have expected to see lower oil prices than we currently have.

Moreover, much of the current stockpiling may be taking place outside the United States. For example, Yves Smith noted this story from Bloomberg last August:

Copper, nickel and other base metals stockpiled by speculative Chinese investors including pig farmers may be sold when "market sentiment turns," said Scotia Capital Inc.

A price surge and easy bank credit this year encouraged pig farmers, stock brokers and businessmen to buy copper and nickel for speculation, Liu Na, an analyst with Scotia Capital, wrote in a note dated Aug. 17, citing reports from the state-owned China Central Television....

"These stockpiles are in 'weak hands' as speculators have no real use for base metals," Liu wrote. "When the market sentiment turns, they are very likely to turn into quick sellers, especially when the bank's money is involved."

I also found this November 3 story from the Financial Times of interest:

Gold prices continued to rise on Wednesday extending the all-time highs which followed India's central bank bought 200 tonnes of the precious metal, swapping dollars for bullion as the country's finance minister warned the economies of the US and Europe had "collapsed".

India's decision to exchange $6.7bn for gold equivalent to 8 per cent of world annual mine production sent the strongest signal yet that Asian countries were moving away from the US currency.

Policy-makers in the Federal Reserve have traditionally thought of inflation as a broad movement in all wages and prices, which to some extent is under their control, and viewed changes in relative commodity prices as outside their control. I believe that this is not the correct understanding of the current situation. Concerns about inflation, particularly on the part of foreign dollar-holders, are likely to show up first in the relative prices of internationally traded commodities. Insofar as these relative price changes can be destabilizing in themselves, it cannot be wise for U.S. policy-makers to ignore them.

Today, we're fortunate to have David Papell, Professor of Economics at University of Houston, as a guest contributor.

The Federal Open Market Committee voted last Wednesday to keep the federal funds target rate at a record low of between zero and 0.25 percent. If it was not constrained by the zero lower bound, should the federal funds rate be negative? If the answer is yes, this suggests that the rate should remain at its record low for a considerable period and provides a justification for continued increases in the Fed's balance sheet. If the answer is no, then the Fed may need to raise its interest rate target sooner rather than later.

There has been a lively debate on this topic in the context of the Taylor rule for monetary policy. The debate started with an article in the Financial Times, which cites a confidential Fed staff study that placed the implied Taylor rule rate at negative 5 percent. John Taylor, speaking at the Atlanta Fed, counters that the Fed got both the sign and the decimal point wrong and calculates the rate at 0.5 percent. Glenn Rudebusch, writing in the San Francisco Fed's Economic Letter, argues for negative 5 percent. Most recently, Taylor writes in a Bloomberg.com commentary that the rate should be zero.

In its original form, the Taylor rule states that the Fed's interest rate target should be one plus 1.5 times the inflation rate plus 0.5 times the output gap. According to the most recent Congressional Budget Office (CBO) projections, "core" CPI inflation, excluding food and energy, was 2.0 percent in 2008 but is expected to fall to 1.6 percent in 2009. The output gap is expected to be negative 7 percent in the second half of 2009 and the first half of 2010. Using 2.0 percent for inflation, the implied rate is 0.5 percent while, with 1.6 percent inflation, the rate is -0.1 percent, both around the Fed's current target.

The implied interest rate target can change if the Taylor rule is modified. It is often argued that, because monetary policy is forward-looking, policy evaluation with Taylor rules should be conducted using forecasts rather than actual data. The CBO forecasts that core inflation will fall further to 1.1 percent in 2010. Using this forecast, the implied rate falls to -0.85 percent. More dramatically, Rudebusch and others argue that the coefficient on the output gap in the Taylor rule should be 1.0 instead of 0.5. With inflation forecasts and the larger output gap coefficient, the implied Taylor rule interest rate falls to -4.35 percent.

In "Taylor Rules and the Great Inflation: Lessons from the 1970s for the Road Ahead for the Fed," written with Alex Nikolsko-Rzhevskyy of the University of Memphis, we use research on the natural rate of unemployment published in the 1970s to construct real-time output gap measures for the periods of peak unemployment in 1971 and 1975, and argue that real-time linear and quadratic detrended output gaps provide the best measure of what policymakers perceived the output gap to be at the time. Using these gaps to estimate Taylor rules, we conclude that:

• The Fed did not follow a stabilizing Taylor rule in the 1970s. In order for policy to be stabilizing, the federal funds rate needs to be raised more than point-for-point when inflation increases, so that the real interest rate rises. Our estimates never produce a coefficient on inflation that is significantly greater than one.
• The Fed did follow a stabilizing Taylor rule if inflation forecasts, rather than inflation rates, are used. These forecasts, however, systematically under-predicted inflation following the 1970s recessions and this does not constitute evidence of stabilizing policy.
• The Fed responded too strongly to negative output gaps, with estimated coefficients between 0.7 and 1.0.

In the 1970s, the Fed "stabilized" overly optimistic inflation forecasts and responded too strongly to output gaps, lowering interest rates too much -- especially during and following the 1970-1971 and 1974-1975 recessions, resulting in frequent recessions and the Great Inflation. What are the lessons from the 1970s for Fed policy today?

• The Fed should respond to inflation, not inflation forecasts, especially in an environment where large negative output gaps are causing forecasted inflation to fall.
• The Fed should not tinker with Taylor's output gap coefficient of 0.5.

Using the rule with Taylor's original coefficients, the experience of the 1970s suggests that, even if it could, the Fed should not lower its interest rate target below zero. If the incipient recovery takes hold and inflation stays the same or rises, it may need to raise rates sooner than many people think.

This post written by David Papell.

Standard & Poor's will consider creating a commodity futures index that excludes commodities listed in the United States, according to a new report in the Financial Times. Michael McGlone, head of the S&P GSCI, says the firm has been flooded with requests from clients concerned about the impact of the expected regulatory crackdown on commodity investors by the Commodity Futures Trading Commission.

The CFTC is widely expected to enact new rules this fall that would severely limit the size of positions that investors can take in the commodity futures market.

Many have predicted that such a crackdown would only serve to move commodity investors overseas, and the announcement by S&P is the latest sign that such a migration may in fact take place.

The S&P GSCI is the world's most popular commodity index. Approximately $60 billion is currently benchmarked against the index.

Read the full story here.

The European Central Bank has made up to €1bn in extra profits from crisis-related emergency lending, but its caution on unconventional policy measures has curbed potential earnings, analysts estimate. Extra liquidity pumped into the eurozone banking system since the collapse of Lehman Brothers last year has probably generated an extra €900m ($1.5bn, £780m) in profits so far, according to calculations by Goldman Sachs.

Some €300m of the total has been generated since June, when the ECB provided €442bn in one-year loans in its biggest liquidity providing operation. The extra profits are on top of the sums that the ECB normally makes on its market operations. Although the interest rate currently charged by the ECB – 1 per cent – was the lowest in its 11-year history, revenues “remain juicy because of the quantity of liquidity that banks keep hoarding”, said Natacha Valla, European economist at Goldman Sachs in Paris.

From last October the ECB has been meeting, in full, eurozone banks’ demand for liquidity. Ms Valla argued, however, that by sticking largely to using policy instruments already in its armoury the ECB had forgone potentially far higher margins.

Profits on the ECB’s programme to buy €60bn in covered bonds – low risk assets issued by banks and backed by public sector loans and mortgages – could be dwarfed by those on schemes launched by other central banks, which have involved higher risk. The Financial Times reported last month that the US Federal Reserve had made a $14bn profit on its crisis loan programmes, with its purchases of commercial paper among its most lucrative operations.

Instead, the ECB has created arbitrage opportunities for eurozone banks, which have used liquidity provided by the central bank to buy large amounts of government bonds, including from some of the smaller eurozone countries and riskier assets. These, in turn, can be used as collateral to raise fresh funds from the ECB. Eurozone banks’ holdings of euro-denominated government bonds have increased by more than €200bn since last year.

Chicago, IL – August 25, 2009 – Zacks.com announces the list of stocks featured in the Analyst Blog. Every day the Zacks Equity Research analysts discuss the latest news and events impacting stocks and the financial markets. Stocks recently featured in the blog include: News Corp. (NWS), McGraw-Hill (MHP), NYSE Euronext (NYX), Thomson Reuters (TRIN) and Novartis (NVS).

Get the most recent insight from Zacks Equity Research with the free Profit from the Pros newsletter: http://at.zacks.com/?id=5513

Here are highlights from Monday’s Analyst Blog:

Dow Jones to Change Hands

Dow Jones & Co., owned by News Corp. (NWS), has started seeking potential buyers for its stock market index business, including the renowned benchmark Dow Jones Industrial Average.

Goldman Sachs has been appointed to explore strategic options for the business. News Corp. bought Dow Jones & Co. in 2007 for $5.7 billion, and has never released any financials for the unit since its acquisition. As an independent company, Dow Jones last reported results for the first nine months of 2007, when its revenue increased 18% year over year to $101.3 million.

Market analysts believe that competitors, like McGraw-Hill’s (MHP) Standard & Poor’s, FTSE, a joint venture between the Financial Times and the London Stock Exchange, MSCI Barra, Russell Indexes, NYSE Euronext (NYX), Bloomberg and Thomson Reuters (TRIN), will be interested in Dow’s index business.

Xolair Label Expanded in EU

This morning, Novartis (NVS) announced that it has received approval from the European Commission (EC) for the use of Xolair (omalizumab) as an add-on therapy for severe persistent allergic asthma in children in the age group of 6 to 11 years.

The approval is positive news for the company and should expand the patient base for the drug. Asthma is a chronic lung disease which is estimated to affect about 10% of children in Europe. It is also the most common cause of school absenteeism and children often use oral corticosteroids to deal with the disease. However, despite conventional therapy, severe asthma remains uncontrolled in more than 50% of children with this condition.

Xolair is a humanized monoclonal antibody aimed at treating the underlying mechanism of allergic asthma. The product works by blocking the action of immunoglobulin E (IgE). This helps in preventing the onset of debilitating symptoms, such as shortness of breath and wheezing, in severely affected patients.

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I should stress immediately that this is not a virtue but rather a vice, but I do think that exploring  conventional economic theory (and moving beyond?) is an important part of the process. In the end, the argument should be amendable to plain English and, as it were, plain common sense and intuition as well as, of course, empirical falsification. One thing which I can promise though is that there will be no mathematical models; at least there, I should have provided some comfort. If you want the math, you will have to wait for the thesis.

The best way to frame the following argument is perhaps to insert it in the chronology of the thesis where it appears, in the end, as a perspectivation on aggregate global capital flows. What precedes this is thus an, hopefully convincing, account of the fact that Germany and Japan are effectively dependent on exports to grow as a result of their demographic profiles.

Some Thoughts on Export Dependency

First it would be worthwhile taking a look at the following sketch (click to enlarge) which captures a lot of the issues that will be discussed below. Essentially, it attempts to show, as nastily and brutishly short as possible, what export dependency means in the context of what we could call conventional economic theory.

For non-econ wonks it is likely to be quite difficult to read, but in fact; it is fairly simple. The X-axis  represents the age of an economy here exemplified in the phases of the age transition derived from a study by Malmberg and Sommestad that discusses the demographic transition as a transition in age structure (and not population growth). But really, it could just as well be median age where a median age of 40-50 would the limit to the right and, let us say, about 20-25 to the left. The Y-axis is adopted directly from Higgins (1998,  e.g. table 1, p. 350) who uses empirical estimations to model the effect from age on, in this case, the current account. As I, Higgins also use age on the x-axis (age distributions) and on the y-axis he has age coefficients. This basically means that a negative value signifies that the age structure in the economy influences the current account negatively (i.e. pushing the CA towards a deficit) while the reverse is true for a positive value. Essentially, we need not, initially, bother with the numerical value of such age coefficients here, but merely note whether it is positive or negative and then secondarily we may look at the level effect (i.e. whether the effect is numerically large).

I should immediately point out that there are no direct empirical basis for the curves. The line which is labeled trajectory of export dependency is basically a cubed function designed to show a more less linear association between export dependency and ageing with the added and important feature (hence the cubed functional form) that export dependency tends to increase exponentially when you move into very old age. The blue line naturally do contain some empirical foundation in that it originates from an empirical study Higgins (1998) where it is constructed based on empirical estimations. I shall not go into Higgin's empirical framework here since it would take us into the dark world of time series econometrics but merely point out that Higgins manages to come up with what we could call the textbook representation of the effect of ageing on the current account and it is worth pointing out that he is not the only one. Also Supan et al. (2007), Bryant (2006), Henriksen (2002) and Summers et al. (1990) (among a myriad of other studies) postulate either through theoretical elaborations or empirical estimations a relationship which may be approximated by the chart above.

In theoretical terms, the basis for this "hump-shaped" relationship between ageing and the current account is derived in the context of the simple, yet crucial, intuition derived from Modigliani's life cycle hypothesis which states that consumers spend their working age years saving for retirement where they will dissave those accumulated assets. Then, at some point during working age there is a "peak" which is characterised by the time when the saving rate is highest and thus also, indirectly, where the effect on the current account should be largest. Following convention, this is modeled in economics through the idea of overlapping generations and often in the form of a neo-classical growth theory framework or simply a general equlibrium representative agent framework. I shall not open pandora's box and discuss the merit of these methods here but merely point out that I think it is very difficult to argue against the the basic intution which lies behind these models and thus, as it were, the intuition from the life cycle hypothesis.

In essence of course, the real issue is one of calibration and thus one of empirical analysis to see just how this postulated hump may materialise as well as of course realizing that ageing is not the only variable which influences the current account. It is also here that the fun begins and where things very quickly become very complicated. 

In this respect, it is worthwhile focusing the attention on the so-called dissaving phase which should be a natural result of the move towards an ever higher share of the elderly in the population. The basic mechanism here is simply that in standard economic models "old" economic agents will dissave their entire asset and thus as the old cohorts increasingly will outnumber the young cohorts the dissaving of the former will trumph the saving of the latter and lead to dissaving on an aggregate level. All sorts of ill prophecies have been proposed in the context of this dissaving hypothesis, not least that we are facing an asset meltdown scenario in 2050 because there will be far too many elderly wanting to offload their assets to a much smaller base of younger cohorts who cannot support a satisfactory price (yield) level.

Now, the problem here is that empirical studies have shown that the idea of dissaving, while intuitively strong, is difficult to verify to the extent that theoretical models suggest. This is not difficult to imagine I think. By very nature of the uncertainty of the mortality schedule people do not (cannot) dissave to 0 and beyond this there are may be bequest motives. In an open economy context this further creates the rather dubious situation in which economies well into their old age will have to run persistent external deficits because, presumably, savings will have decline far faster than domestic investment demands. I say dubious here because this is exactly where I have chosen to take my stab at trying to amend the theoretical framework.

Consequently, I am not so sure that this is a plausible end point in the context of continuing population ageing. Specifically, I would like to ask the simple question of whether it is actually optimal for any society to dissave as the theory postulates. I don't think it is and while it is certainly not unlikely that economies may actually dissave (defacto) they will still be dependent on exports to grow and thus the difference between the two curves into the latter age transitions represents an externality. This is also why I think that economies, in stead of responding with dissaving, will fight the point at which they reach this stage since when they do it is effectively game over. Imagine for example how the likes of Germany and Japan would ever be able to finance an external deficit brought about solely on the basis of the fact that savings has declined so fast as to not even be able to meet domestic investment demand which in itself will be declining. In this situation, wouldn't it be much smarter to maintain savings persistently higher than domestic investment demand which can of course only be materialized in an external surplus. I think it will and it is this point which you need to keep in mind as we move forward.

Implications for Global Capital Flows

With these considerations in mind, the key question then becomes; what happens when more and more economies grow to become increasingly like Germany and Japan? (As we know they will, at least in the context of the OECD). Naturally, not everyone can maintain excess exports over imports at the same time so something, as they say, has got to give and it is this something, as it were, which is the topic of this entry.

The focus on the implication of ageing on aggregate global capital flows is not new and is, in fact, an integral part of the analysis in Supan et al. (2007), Higgins (1998) and Bryant (2006) which were also mentioned above. However, in the following we are going to relax the condition of dissaving normally assumed in e.g. OLG models and accept that the propensity to run an external surplus will increase as an economy ages.

If we do this, it should not require too much imagination to see the issues that may rise. For starters, I want to reiterate yet again the trivial fact that not all economies can run an external surplus at one and the same time. This means, quite naturally, that what might be optimal from the point of view of a single economy (i.e. maintaining a surplus as it ages) may not be viable or optimal from the point of view of the global economy.

In order to frame the discussion it is natural to take our point of departure in the discourse on global macroeconomic imbalances.

As so many other things, the financial crisis has completely dislocated this system but it still worthwhile to ponder the nature of the global financial system in a post Asian crisis perspective and up until now. Consequently, the global macroeconomic landscape has long been characterized by what many has termed Bretton Woods II in which a large batch of especially Asian and oil exporting economies have been pegging their currencies to the US dollar who in turn have been running a large current account deficit to match the savings surplus in emerging markets such as China, South Korea, the Petroexporters, Brazil and Russia. In fact, if we cut a lateral line through this argument we could say that the world has hitherto been characterized by the Anglo-Saxon economies running external deficits to match surpluses in big emerging markets as well as Japan and Germany.[1] That however changed abruptly with the advent of the financial crisis and it is interesting to note the initial response by market participants and many scholars in their interpretation. Consequently, as it became clear that the US economy had been mortally wounded on the back of the subprime mortgage debacle the US Fed slashed nominal interest rates significantly. As a result the USD plummeted which led many commentators to hail the US economy’s fall from grace and specifically coined the notion of decoupling in which the Eurozone economy and Japan were pinned as the ones taking up the slack in steering forward global demand. Initial versions of the decoupling thesis thus centered on the shift in emerging market exports from the US to Japan and, especially, the Eurozone and thus in the process also a shift from the US dollar to the Euro as a global reserve currency. As it turned out this was nothing but a mirage masked by the fact that US policy makers essentially acted preemptively to a crisis which turned global during the summer 2007 and now most major central banks in the OECD have slowly bitten the bullet and followed Bernanke into quantitative easing to combat the risk of deflation which would be devastating in the context of the debt overhangs some economies face. Moreover, and as a general point, the global economy already decoupled from the US, and indeed OECD, economy a long time ago. Consequently, it is an irrefutable fact that the global economy is undergoing a fundamental change in which emerging economies such as India, Turkey, Brazil, China; Chile etc will ascend to account for an ever larger share of global GDP and growth. The crucial question is then; how will this process and the process of global ageing be transmitted to the global economy through capital flows?

As a starting point to answer this question I would like to draw the attention to comments made by two of the most prominent members of the global financial punditry in the form of US economist Paul Krugman (PK) and the Financial Times’ chief economics commentator Martin Wolf (MW).

Starting with the former[2] he recently pointed to the fact, in the context of Japan, that external demand was instrumental in ending the slump and providing a relative bounce between 2003 and 2007. As PK further goes to argue, this may present a rather ominous outlook since the extent to which we are all, in the OECD, currently stuck in a “Japan-style” liquidity trap the way out may constitute a rather crowded route. As PK poignantly points out at the end of his small piece;

(...) needless to say, we can’t all export ourselves out of a global slump. So, how does this end?

Krugman 2009

This is indeed a good question and MW makes a similar argument in a recent column[3] where he points towards the fact that the global imbalances themselves may prove to be an impediment to a swift global recovery.

 In short, if the world economy is to get through this crisis in reasonable shape, creditworthy surplus countries must expand domestic demand relative to potential output. How they achieve this outcome is up to them. But only in this way can the deficit countries realistically hope to avoid spending themselves into bankruptcy.

Martin Wolf (2008)

This is of course a very appealing proposition and also goes to heart of idea that, at least, one part of the solution of the current global crisis lies in the resolution of global macroeconomic imbalances. But prey tell, how are these surplus countries going to revert towards a growth path characterized by a more balanced external account and perhaps even an external deficit?

It is in this context that the argument presented in this thesis becomes important. Consequently, there is a big risk that these surplus economies (e.g. Japan and Germany) simply will not be able to heed the call of MW. The main reason for this inability is then, in part, exactly to be found in the economic profile of a rapidly ageing economy with a median age pushing 40 year mark and beyond. Japan and Germany as well as the economies next in line to reach their age bracket cannot achieve growth based on domestic demand in a way which would allow them to suck up excess global capacity through an external deficit.

This is a very important point to stress in the context of the global economy and must be stressed with great emphasis.

Some Charts to Go With This

In order to try to make sense of all this consider the supply/demand chart below which plots the supply and demand for savings in the global economy. Following convention, the X-axis represents quantity and the Y-axis represents price. In this specific case, the X-axis can be seen as the total demand (from deficit nations) for excess investment beyond the level which can be achieved through domestic savings. The Y-axis then becomes the price[4] (interest rate) which equates this demand with the level (supply) of excess savings provided by the surplus nations beyond the level which can be absorbed by domestic investment demand

(click to enlarge)

As a natural consequence of the intuition underlying this small model, equilibrium is a forced (and always binding) condition since, by definition, the sum of external deficits must equal the sum of external surpluses in the global economy. 

If we accept the idea behind the theoretical framework presented in this thesis it is very easy to see the implications of a sustained global process of ageing. As is shown in the diagram the supply of excess savings (external surpluses) will increase with ageing [S(1) to S(2)]. But this is not the only effect. Following the simple intuition of a closed system an increase in supply must be meet by a decrease in demand too since we assume that economies are moving from a position as external deficit nations to a position of external surplus nations. In this sense, the constant level of output (quantity) is largely a simplifying trick in the sense that we let the entire adjustment process occur on the return of the excess savings of surplus nations rather than the quantity of excess widgets they can produce to sell abroad.[5] This produces an effect whereby ageing reduces the price of excess savings in equilibrium.

In order to move forward from here we need to mentally relax, as it were, the idea that deficits need to equal surpluses in equilibrium. In concrete terms, we need to understand the idea of equilibrium does not capture the notion of dependency on exports/foreign asset income to grow.

This is amended in the following graph; (click to enlarge).

The key here is the notion of the critical price level [6]. This should be seen as the level needed to sustain an acceptable level of growth in ageing economies and is thus a direct proxy for export dependency. As the global economy ages and assuming that equilibrium must hold at all times, the supply of excess savings and the demand for these savings decrease both lowering the equilibrium price and quantity. However, the critical price level remains. One key implications of this is a systematic oversupply of savings, or glut if you will, produced by the process of ageing and it is very important to understand that this oversupply is very tangible. It represents the value of external surpluses which would be enough for the likes of Germany, Japan etc to maintain a growth rate consistent with expectations and essentially the maintenance of their market economies. In the jargon of the theory, it represents the point at which ageing economies are optimally smoothing consumption and saving as a function of their intertemporal preference for the latter over the former. Of course, it cannot exist as a real entity but it may still have real implications.

The first obvious effect is to make the variation of ageing economies’ output very sensitive to the variation in out of deficit nations and thus global output. In its strictest form, this is how export dependency emerges. Another notable effect would be that it drives down the return in ageing economies to such an extent that it may fuel so called carry trade flows in which traders borrow in low interest rates currencies and invest in high interest rate currencies. Another example would be how these savings may be used to fund temporary and unsustainable build up of credit expansion in economies running external deficits. This is to say that if the equilibrium depicted above essentially is binding in the long run the implied existence of this excess pool of savings may lead to sudden outward jumps of the demand curve and thus the creation of credit bubbles. The main key to take away from this small economic model is thus the idea of an externality of ageing on a global level. This externality arises as a direct function of the implied existence of an excess of savings over demand as the global economy ages. In the context of the theoretical framework above the externality should be seen as function of the crowding of economies in one end of the spectrum on intertemporal preferences for consumption and saving. Crucially, it also means that what we might find to be optimal in the context of a single economy is not optimal on a global level a point which is certain to make standard economic modeling of aggregation from the representative economy level to the global economy very difficult. In empirical terms it means that what one might find to be the optimal path in a time series perspective of one economy may turn out to have radically different implications in the cross section when more or all global economies are involved.  

Further studies should attempt to develop this idea further since it provides a useful venue of analysis as an alternative to the traditional idea drafted from life cycle theory that global ageing will entail dis-saving on an aggregate level.

List of References

David M. Cutler & James M. Poterba & Louise M. Sheiner & Lawrence H. Summers (1990)
"An Aging Society: Opportunity or Challenge?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 21(1990-1), pages 1-74.

Henriksen, Esben (2002) – A Demographic Explanation of U.S. and Japanese Current Account Behavior, Graduate School of Industrial Administration, Carnegie Mellon University

Higgins, Matthew (1998) – Demography, National Savings, and International Capital Flows, International Economic Review, Volume 39 (1998) Issue (Month): 2 (May) pp 343-69

  Borsch-Supan, Axel H; Alexander, Ludwig; and Krüger Dirk (2007) – Demographic Change, Relative Factor Prices, International Capital Flows and their Differential Effects on the Welfare of Generations, NBER Working Paper No W13185

[1] With the German surplus mainly materializing itself in an intra-European imbalance.

[2] Paul Krugman (2009) – The Eschatology of Lost Decades, NYT blog post

[3] Martin Wolf (2008) – Global Imbalances Threatens the Survival of Free Trade

[4] Which is assumed to be exogenously determined for all involved economies through the equilibrium in this system.

[5] Remember that I am assuming that quantity is fixed and that the entire adjustment takes place on the price. In a more realistic representation the adjustment would of course take place on both the price and quantity.

Goldman Sachs has been appointed to explore strategic options for the business. News Corp. bought Dow Jones & Co. in 2007 for $5.7 billion, and has never released any financials for the unit since its acquisition. As an independent company, Dow Jones last reported results for the first nine months of 2007, when its revenue increased 18% year over year to $101.3 million.

Market analysts believe that competitors, like McGraw-Hill’s (MHP) Standard & Poor’s, FTSE, a joint venture between the Financial Times and the London Stock Exchange, MSCI Barra, Russell Indexes, NYSE Euronext (NYX), Bloomberg and Thomson Reuters (TRIN), will be interested in Dow’s index business.

The company’s stock market index business consists of 130,000 equity indices and earns revenue by licensing them for use as benchmarks for investment in hedge fund, real estate and commodity markets. Its best known index is the Dow Jones Industrial Average, which was introduced in 1884 by Charles Dow and Edward Jones comprising 11 stocks. Currently, the basket comprises 30 stocks.

Law Firms Threatening Action Against Leveraged ETF Providers

At least two law firms say they're talking to clients who use leveraged exchange-traded funds about potential lawsuits against the funds' providers.

The list is large and includes ETFs sponsored by ProShares, PowerShares, Direxion and ETF Securities, which recently entered the U.S. (see story here.)

How do we know this? The law firms, of course, put out a press release. You can read it here.

Two Deutsche Bank Funds Hit By CTFC Ruling

A pair of PowerShares-DB commodity ETFs will be curtailed in how much they can buy in soybeans, wheat and corn due to a decision by the Commodity Futures Trading Commission.

You can read this Bloomberg News report for more details. Also, check Matt Hougan's blog here.

SSgA's Hoguet: Sovereign Wealth Funds To Buy SDRs

Special drawing rights, or SDRs, are what the International Monetary Fund uses internally as currency markers to traverse its global reach. China has nominated SDRs as a natural new world currency, replacing—or complementing—the de facto U.S. dollar.

When the suggestion was made, critics voiced their displeasure at the notion. But now, according to this interesting Reuters report, several big sovereign wealth funds are considering buying SDRs.

The report is based on information supplied by George Hoguet, a State Street Global Advisors emerging markets expert. (His work has been profiled at IndexUniverse.com several times in the past few years, including a Q&A earlier this year.)

You can read the Reuters story here.

Fidelity President Looking For Successor

Rodger Lawson, who took over as president of Fidelity Investments in 2007, tells Bloomberg News he's looking for a replacement. The position has been a bit of a revolving door at the mutual funds giant in recent years.

The story addresses that issue and also includes Lawson's rebuttal of Morningstar data showing the company is lagging its peers in performance, particularly compared with arch rival Vanguard. (For more about the battle between Vanguard and its competitors, see related story here.)

You can read the Bloomberg interview with Lawson here.

In related news, Fidelity says its assets rose to $2.8 trillion. See a Wall Street Journal story on the firm's finances here.

Hedge Fund Bets Big On Natural Gas Prices

It might be interesting to note that with all of the furor going on over UNG and commodities markets, a hedge fund has apparently made a rather large bet that natural gas prices will triple by winter.

The Financial Times story also gets into the most recent forecasts for the market from analysts and their reaction to the unusual play.

You can read the story here.

• Honeywell (NYSE:HON) reported in-line second quarter earnings of 60 cents a share, as revenues increased 22% to $7.6 billion versus estimates of $7.73 billion.  The firm cautioned "Economic conditions, however, remain challenging and we are not planning for any recovery in 2009." It expects second quarter earnings of $2.85 a share, up from the consensus estimates of $2.82

• Verizon (NYSE:VZ) reported in-line quarterly numbers at 63 cents a share, on revenues of $26.9 billion versus projections of $26.85 billion

• Tellabs (NASDAQ:TLAB) posted second quarter at 7 cents, 1 penny above estimates, as revenues fell 11% to $385 million

• Aetna (NYSE:AET) disappointed with its second quarter posting of 68 cents, a dime under expectations, as revenues increased 10.3% to $8.7 billion, versus estimates of $8.56 billion. The company also provided downside guidance for 2009 of $2.75-$2.90, versus Street consensus of $3.53

• Goldman Sachs (NYSE:GS) added Energizer (NYSE:ENR) shares to its Conviction Buy List

• Morgan Stanley (NYSE:MS) upped its price target on Credit Suisse (NYSE:CS) shares, noting "Low rates and policy response are starting to suppress non-performing loans formation in Western markets, and alongside strong wholesale earnings, this is driving up book value expectations"

• According to the Financial Times, Apple (NASDAQ:AAPL) is working on a tablet-sized device with a planned holiday release

The report by the Financial Times on Sunday also said that French marketing company Publicis Groupe SA could emerge as a possible bidder.

The FT stated that an analyst has valued the agency at $600 million to $700 million based on last-year's revenue of $400 million and profit margins for similar businesses of 12% to 13%.

Microsoft acquired Razorfish in 2007 as part of its $6 billion takeover of aQuantive.

The Seattle-based digital agency has more than 2,000 employees and boasts of a client list, which includes AT&T Inc. (T), McDonald's Corp. (MCD) and NIKE Inc. (NKE).

MSFT, a Zacks #3 Rank ("Hold") stock, have gained nearly 2% on lower-than-usual volume of approximately 40 million, against the average daily volume of about 64.1 million.

Institutional Investors Shifting To Index Funds

In an article titled: "Active Managers Get Cold Shoulder," Craig Karmin writes in Monday's Wall Street Journal that big institutional managers are increasingly shifting to index funds.

It quotes a director of the $9 billion Illinois State Board of Investment as saying that "active managers have not given us the added performance in a down market that we hoped for."

You can read the story here.

SEC Investigating Dark Pools

In an interesting story from the Financial Times, the Securities and Exchange Commission is reportedly looking into so-called "dark pools." In an interview with Mary Schapiro, the SEC's chairwoman, the paper is reporting that the trading systems set up for large investors to block trade with little outside transparency is a source of real concern for U.S. regulators.

You can read the story here.

Hedge Funds Redux?

In a look at the growth in exchange-traded funds using hedging strategies, MarketWatch's John Spence notes an ironic twist; namely the fact that even though hedge funds are falling in popularity, ETF providers are rushing to come out with their own versions.

The difference, of course, is that the ETF industry is able to provide similar products without taking 2% off the top and charges much more reasonable annual expense ratios.

You can read the story here.

ETFs Turn More Active

As the markets continue to show signs of volatility, this Boston Globe piece looks at the evolution of ETFs and notes developments in how they're inching toward more actively managed products.

You can read the story here.

The deal is significant for Honeywell as it will be the only US-based firm with a major role in a consortium dominated by European companies.

A substantial portion of the contract will be executed by the company's employees based in Europe, which forms around 10% of its worldwide aerospace workforce.

Meanwhile, Honeywell's chief executive Dave Cote said in an interview to the Financial Times that although the diversified conglomerate was looking for acquisitions, it still considered valuations expensive in comparison to market reality.

"It is a very easy time to overpay right now because you have to remind everybody that it's not last year anymore, it is this year," said Mr. Cote, who is a member of President Obama's stimulus task force.

HON, a Zacks #3 Rank ("Hold") stock, is down nearly 1.5% on lower-than-usual volume of approximately 2.5 million, against the average daily volume of about 5.1 million.

New reports put BlackRock's deal for BGI at $13 billion.

During the weekend, several new articles appeared in British papers reporting that BlackRock Inc. is closing in on a deal to acquire Barclays Global Investors, the parent company of iShares, in a transaction worth up to US$13 billion.

But not all the reports were as definitive as the one coming out of the US late last week. Pensions & Investments magazine, on its Web site, broke the news late Friday afternoon after markets had closed in the US. It quoted unnamed sources as saying that the groundwork for a deal was in place and that an announcement would be forthcoming.

The story also had estimates that a BlackRock purchase of BGI would surpass $10 billion. (See related story here.)

However, in a story over the weekend, a report out of London by the Financial Times said that Barclays isn't expected to reach a decision until early this week on who will purchase its asset management division.

Also, more details are leaking out about the complexity of such a transaction.

Barclays is expected to acquire a stake of 20% in BlackRock. Meanwhile, BlackRock is likely to rely on financing from Middle Eastern sovereign wealth funds. And Barclays’ president, Bob Diamond, is supposedly rumoured to be considering joining the board of the US-based BGI.

Larry Fink, BlackRock’s founder and chief executive, met the Kuwait and Qatar Investment Authorities last week to seek funding, according to the Financial Times.

The deal, if confirmed, would set a record for the acquisition of an asset management company, dwarfing the US$ 8.5 billion paid by BlackRock for Merrill Lynch’s fund arm in 2006.

It would also trigger a payout of US$ 585 million for the 200 employees of BGI with stakes in the company, with Diamond set to receive around US$ 30 million.

Although weekend press reports suggested that a new deal is close to being reached, Barclays has another 10 days until the June 18 deadline for seeking further bids for iShares and other related businesses.

This was set as part of the US$ 4.2 billion May agreement to sell iShares to CVC Capital Partners. CVC will receive a US$ 175 million break fee if Barclays concludes a transaction with a third party, as now seems likely.

A BlackRock acquisition of BGI would mean intensifying competition in the fixed-income ETF market, according to some observers. Last week Pimco, BlackRock’s biggest riva,l initiated its ETF range with a 1- to 3 -ear US Treasury bond tracker, undercutting the equivalent iShares fund with a 9 basis point annual fee.

-- IndexUniverse.eu's Paul Amery submitted this report. IU.com's Murray Coleman also contributed.

Surely, the pressure has only piled on since I last wrote about this only a few days ago (see links above). The Financial Times' blog Alphaville in this case personified by Izabella Kaminska has steadily been supplying us with the latest on the unravelling in Latvia. A particularly good piece hammers down the point that it is not only freelance bloggers such as yours truly who are questioning the Baltic (Latvian) currency peg but also, now, most professional analysts close to the situation. This is a called a market discourse and although the commitment to maintain status quo may be there one cannot make the waters go back.

However and to be fair to all parties it does seem as if the Latvian authorities got the best of the discourse this week if, that is, being the last one to shout constitutes an upper hand in this case. Consequently, both the central bank and the premier minister Valdis Dombrovkis issued strong statements to suggest that the peg will hold simply because Latvia is committed to seeing this correction through.

Latvian Prime Minister Valdis Dombrovkis pledged to push through budget cuts and ensure the inflow of international loan payments as speculation grows the Baltic state may devalue, threatening the economy of Sweden. “These rumors and speculations should finally be stopped” about the devaluation of the lats, Dombrovskis, 37, said in an interview with Latvian Independent Television today. The currency will not be devalued, he said, and the country will pass budget cuts needed to get the next tranche of money.

This is of course all well and good, but one has the distinct feeling that all this merely constitutes the inevitable last launches before the opponent finally lands the kidney blow to send you crushing into the canvas.

In terms of a more thorough look at the Latvian situation which goes beyond the immediate plethora of market jitter you could do a lot worse than visit Edward's latest post on this issue. As he sets out pointing towards, overnight interbank rates rose to a record of 20% this week and it suggest more than anything the stress being levied on the system.

Another particular issue Edward deals with is the risk of contagion and essentially fallout from a devaluation in Latvia. Certainly, this is an important question in itself but I also agree with Edward [1] in the sense that the immediate plunge in other CEE currencies not to mention the Swedish Krona following a Latvian devaluation is not really the main issue here.

For the record, I see no decoupling and a Latvian devaluation would clearly force others to do the same, most notably I would think Lithuania and Estonia. As for the ripple effects towards the entire CEE edifice, they are likely to be substantial although not necessarily catastrophic. The real issue we need to understand I think is that that IMF program has problems and that this will become clearer and clearer as we move forward. Edward points to one very important data point in the form of a real effective exchange rate where numbers have just been published in 2008 format.

This gives a very clear image of the amount of down scaling the Baltics, and indeed many of the Eastern European Economies, need. It is important to understand that there is a level effect and relative effect here in the sense that one thing is to correct relative to one's own past level, and quite another to correct relative to others. Consequently, this is a chronic problem all across Eastern Europe and thus everybody has to correct. In this sense, the IMF are submitting those with pegged exchange rates to a dose of "medicine" which is simply too strong and which the domestic "system" cannot muster.

So, my feeling is that all this goes beyond whatever effect currency speculation would have in the wake of a Latvian devaluation/default. There are clear signs that the "exit strategy" from this crisis is not working and it is next to scandalous that the IMF/EU do not realize that while these countries certainly need a strong dose of "stick" to get themselves on the right track we need to ensure that they are not obliterated over the course of the next year. I mean, this talk about Euro adoption in 2012 is just so silly and counterproductive since who the heck knows where we are in 2012. Who knows, for example, where the Eurozone itself is in 2012. Really, I cannot stress enough how these road maps of convergence need to be rethought since there has been a structural break. We need a new plan and one which factors in the change in environment.

Moreover, I think we have established by now that the Eurozone is no magic potion and in fact faces a series of very severe tests on Spain, Italy not to mention the mental crush it will be when Germany does not recover because I can tell you; in terms of domestic demand she won't.  Basically as I see it, the option has always been to "let the CEE in", but that would also take a much stronger coordination on the fiscal side and essentially joint European financing through Euro bonds. At the moment, this is far to big a step for the gents in Frankfurt and Brussels to consider.

So, no decoupling in an immediate devaluation context, but more importantly, I tend to look at this more structurally than a simple question of how much the e.g. Forint and Leu will fall in the context of a Latvian devaluation.

At the end of day, this is a question of swallowing those camels and accepting the idea that the current solution being applied is out of touch with reality. Essentially, I don't think the parties involved quite understand the structural damage many of the CEE, and Latvia in particular, have suffered. As per usual I am implicitly referring to the importance of factoring in demographics but then again; it is absolutely amazing that none of the presumed experts here have not added this variable to the equation yet. As Edward says towards the end in his entry ...

That is, the simple fact of the matter is that there is no exit strategy. The programme simply doesn't work. It is "over determined", since whichever way you look at it, there is always one more problem than there is solution. Gentlemen. I think its time to give up. Honourably, but to give up. Come on out of the bunker, white flags and hands in the air will not be called for. There's a world out here waiting for you, it's on your side, and there will be a tomorrow.

I couldn't have put it much better myself, I really couldn't.

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[1] - There is a surprise :)