Linking international trade and finance theories

As this crisis started, there was introspection from some economists (though some still did not change their views which was disappointing). The central view that came forward was macro-models did not have finance and finance models did not take into account macro developments. So, both macroeconomists and financial economists did not understand the linkages and underestimated the crisis.

At the centre of criticism were DGSE models which were used by central banks which ignored everything that mattered in this crisis. This was quite strange for two reasons. One, financial crisis have existed for a very long time and impacted economies earlier as well. So why was this linkage ignored in so called modern models? Two, financial markets are critical for monetary policy transmission. So, how can you develop and believe in models which ignore financial markets and its frictions.

Anyways, it seems the story is far from over. In this interesting lecture, Edwin Truman of Peterson Institute for International Economics says large gap exists between international trade and finance as well.

My PhD dissertation topic was trade creation and trade diversion in the European economic community. In that research, completed in 1967, I applied a rudimentary disaggregated,  artialequilibrium methodology focused on trade flows. Today’s approaches exploit computable general equilibrium (CGE) models, but they share an almost exclusive focus on effects on  economic activity, on trade and the real economy rather than on finance and financial markets, and, in particular, not vice versa. The gap between trade and finance is large.

Why do we have this gap? I suggest three reasons: institutional, philosophical, and technical. The institutional reason is that the field of international economics these days has two distinct branches: trade and finance. In the 1960s, they were more integrated. I wrote my trade dissertation under Bob Triffin, a prominent international monetary economist; Dick Cooper, whose field was international finance; and Steve Hymer, whose field was foreign investment and development. (I myself have spent most of my career working on international financial issues.) The philosophical reason is that in most of our models money and finance are neutral. The technical reason is that CGE models and their more sophisticated cousins, dynamic stochastic general equilibrium (DSGE) models have rudimentary financial sectors. In part the reason is because finance as a field has not yet generated useful regularities for macroeconomic models.

Hmmm. Why models increasingly abstracted finance is a puzzle. Economists have tried to list number of factors for the same –

  • It was overconfidence in policymakers that there will not be any crisis; great moderation era was real
  • Complete belief in efficient financial markets
  • Monetary variables mattered no more, True they did not matter in goods inflation but did in asset inflation
  • this time is different etc 

Back to the topic. He then goes on to ask fundamental questions:

Even for those who view economic activity and finance as two sides of the same coin, the question is: Which dominates?

In the domestic context, does the real economy dominate the financial system or vice versa? If a crisis affects both, as has been the case recently, should the real economy be fixed first or the financial system? Can we reform the financial system and its regulation without adversely affecting the performance of the real economy?

In the international context, transactions involve the current account and the financial (formerly capital) account. Again, does the financial account drive the current account, or vice versa? Can we think about the factors affecting the current account (growth rates and exchange rates) preferences)? Can we curb the excesses of the financial account (volatile capital flows) without adversely affecting the current account (global imbalances)?

The general answer to these questions is that both real and financial activities are relevant to the health of our economies and the international economic and financial system. We live in a yin yang world. Yin yang is defined in Wikipedia as “complementary opposites within a greater whole.” It may be that one or the other element is dominant or more important at a particular point in time, but both are equally important over time—like it or not.

He then goes on to say how policies of international trade and finance are developed in separate silos. Countries have both trade and finance ministers and both have separate tasks. There have been cases of them coming together in the past but coordination dropped later. Even within WTO and IMF there is silo mentality thinking about these issues.

In my view, trade, investment, and financial flows are part of an integrated whole. Moreover, governments and governance are also part of the mix. An important illustration of these interactions is sovereign wealth funds (SWFs). These government-controlled pools of assets normally include international assets. The SWFs raise issues of the role of governments and also reveal tensions about the shift in economic and political influence in the global economic and financial system from the North Atlantic to the rest of the world. I have urged the adoption of a set of best practices for SWFs. To this end I devised an SWF scoreboard to provide a benchmark for such a standard.

He concludes saying trade and finance links are stronger that current policy and institutional arrangements suggest. The crisis showed that first trade finance led to decline in trade and then real factors led to decline in trade. So it is all linked. This has to be understood and future steps should be taken accordingly.

Nice speech on trade and finance perspective.

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One Response to “Linking international trade and finance theories”

  1. Prosper Agbobli Says:

    Please l want to know how has been growth in interanational trade been responsible for the importance of studying international finance

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