Sunday, April 10, 2011

The Fisher Equation in a Changing World: Why Emerging Markets are the Future

Introduction
Irving Fisher was a great economist. One of the greatest actually, according to Chicago Professor and Nobel Prize Laureate Milton Friedman. But although his contributions to academic theory were gigantic in more than just one area, we do especially like the Fisher Equation that states that the money supply (M) multiplied by the velocity of money (V) – i.e. how many times do you use that money during a year to buy goods or services – is by definition equal to the number of transactions (T) multiplied by their average price level (P). Economists started to interpret this in such a way that T would be more or less equal to the real domestic product (Q).

Irving Fisher (1867-1947), one of the greatest according to Friedman

Now, Fisher was an American and the USA is an economy in which international trade and investments are of relatively marginal importance compared to what is going on cross-border. A situation that is totally different from what is going on in most countries. For instance: in LMG’s country of domicile – The Netherlands – about 50 percent (!) of both imports and exports are related to international transactions, with Germany being the most important market for us. At a global scale, a world version of the Fisher Equation

M(w) x V(w) = P(w) x T(w)

would be a neat tautology that is always right. With w indicating the global (‘world’) aspect.
Historically, with Emerging and Frontier Markets being poor, there was not much of a problem The world was basically the US, Canada, developed Europe plus Japan. And whenever we went through a phase where the US would import too much, the ‘Euro’ dollar market (M abroad) would one way or another find its way back to Wall Street as a result of which the US consumers and government could continue their spending – or should we say ‘’borrowing’’ ? – spree. In other words: financial markets were the equilibrating device that kept the whole system stable.

The World has Changed
But the world has changed. The moment we started to buy a growing number of products from countries like China in cheap labor related trade, money was flowing away to China. It is therefore no surprise that China is the world champion when it comes to foreign currency reserves and gold.

Foreign Currency and Gold Reserves: Look at the Emerging Countries (in Grey)

Actually: the Chinese foreign currency and gold reserves alone were 3-4 times bigger than what the US needed to save its banking system in the 2008-09 banking crisis. And a large number of the ‘big pocket’ countries – based on foreign currency and gold reserves – are from Emerging Markets (notice the grey backgrounds). And when we look at External Debt minus Foreign Currency and Gold Reserves as indicator we see all of a sudden that the top-20 consists of Developed Nations alone!

External Debt Burdens? A thing for the so-called rich nations these days!


And one of these days, Obama has to hope for some kind of agreement between his Democrat Party and the Republicans or otherwise the American government runs out of money. Not too surprising with a debt position of about USD 15 trillion!

But it is not just a Cheap Labor thing. True, economic successes in Asia make it look that way. But when we look at the list of the world’s top-25 Sovereign Wealth Funds we see that it is just as much an Energy story.

More than half of the world's Sovereign Wealth is Energy-related!

Renewable Energy will be an important factor in due time, but at the moment Oil, Gas and Coal are far more important (with Nuclear Energy suffering setbacks due to the Japan catastrophe). We actually love the following table from the famous BP Statistical Survey that is every year produced by the oil giant. It shows how many years regions could still survive if they would have to live on local production and reserves of main primary energy resources. Russia and the Middle East are the big winners, holding enormous trump cards and it is therefore no surprise that everyone wants a piece of the action in the Middle East. Post-colonialism in that part of the world is not so much related to Islam, it is related to the West not willing to accept that growing Middle Eastern nationalism is simply about getting a fairer share of what is theirs in the first place.

Available Energy per Region: Russia and the Middle East are here to stay and look at the potential of Africa.

Now, all of this would not really translate into a Global Credit Crisis if the West would allow investors from Asia and the Middle East full access to its markets. Either with the idea that they could acquire stakes in firms and/or to do big portfolio investments. In that case, we would still have some kind of equilibrium. But obviously, the moment you block this ‘return of money’, M is leaking out without translating into a neat PxT in Fisher terms. And that is what is going on in the world right now.

Conclusion
A bet on Emerging and Frontier Markets now, is definitely not a gamble. It is completely in line with structural trends in the world. Does that mean that we are totally pessimistic about the Western financial markets? No! We believe that sooner or later – forced, actually – Western markets will have to open up more to investors from Emerging Markets as a result of which they will become larger and sometimes even dominant shareholders in major Western firms. Something to be scared of? Well, we guess that it is probably just as scary as how scary it was for people from Emerging Nations when being confronted with a huge Western influence in their industries. Bottom-line is that we should start thinking in global terms. Otherwise there won’t be equilibrium. Western nations trying to solve their financial problems together, is actually pathetic. They are all struggling financially. All are faced with disadvantageous demographics. It is like the poor making plans without thinking about asking the rich if they want to invest in what is still a Western trump card: superior knowledge and education. Knowledge transfer is the key. And because that is the fact, interest by big investors from the Middle East, China and elsewhere in buying stakes in big firms or even universities in the Western world is guaranteed. And if you find that scary, you have been a colonialist for all your life. Because if you replace Knowledge by Resources that is what happened with trade between Emerging and Rich nations during the last 100-200 years.

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