Questions on a Cruel Sea of Capital

Problem Set 1 (due Monday, September 10)

1. Compare the degree of openness of the U.S. economy to another economy of your choice. Provide information on the three types of openness we discussed in class. You should use the World Development Indicators database, which is available through Schaffer Library web site (Databases & Indices, Economics). Once you are in the database choose ‘tree view’ to browse through different indicators. Note that you may not be able to find data on the third kind of openness we talked about. In this case use casual observation to assess openness to the international trade in assets.

2. Read the attached article entitled “A cruel sea of capital” from The Economist and briefly answer the following questions:

a. How is trade in capital different from trade in goods?

b. Why is trade in capital “prone to mistakes”?

c. Why are mistakes in financial markets costly?

d. Are the “anti-globalists on to something”? Would you advocate capital controls or free flow of capital? Questions on “A cruel sea of capital”:

e. How is trade in capital different from trade in goods? a. More prone to mistakes, put a price one price of an asset one day it is 300$ 9 months later it is 30$. Does not happen with goods. Note that they are talking about domestic trade in capital. Where is capital traded domestically? NYSE. DO you think it is prone to mistakes? Hell yes b. Crises are severe and very costly: even in the U.S. many economists attribute current recession to the burst in the dot.com buble, Latin America, the 1980s was a lost decade - direct consequence of the debt crises, East asia ,Argentina, 27 people died, in Indonesia output fell 25% etc. f. Why is trade in capital “prone to mistakes”? a. Stream of payments spread out over times : capital delivers services over long period of time, unlike a chocolate chip cookie which is eaten and done with. Small changes in beliefs can change the value of an asset, capital a lot. Consider an example. b. Beliefs about this stream of payments are subject to crowd mentality or hysteria, herding etc. “behavioral finance” g. Why are the mistakes in financial markets costly? a. Leverage, what is it? Again give an example: b. Banks are very fragile: Only fraction of their assets is in liquid form (they hold long term assets, but their liabilities are short term. As soon as more than usual number of investors come and withdraw their deposits the bank goes bust. They rely on the normal fluctuations in demand for cash. Their buffer is not 100%. If it were then they could not invest it they would simply work as a storage place. h. Are the anti-globalists on to something? a. What does the economist think? “let capital flow where it may is bad policy”. Why does the Economist advocate capital controls? b. We are far from understanding how this should be done.Trade in capital is far more prone to mistakes c. Bottom line is that FDI capital that stays in is good capital that is short term, i.e. “hot money” is bad.

Digression: why are financial markets prone to mistakes? Discounting: a dollar this year is better than dollar next year, why? Can we find out what is this year’s value of a dollar next year?= Present value: