In the case of Japan and China, isn't there something political as well as economic going on?

I don't think Peter Schiff regards the trade deficit as a problem in and of itself. I think he is only asking the question, why is there a *chronic* and ever increasing trade deficit when in a free market one wouldn't expect this (except under really special conditions.)

I think Schiff is arguing that via America's dominant position in the world and the dollar reserve currency status, America is able to run trade deficits that would not be possible if there were a free market. And further that as this runs against the natural direction the free market would be probably be taking, there will be eventual consequences.

That is, he seems to be suggesting US policy has been to rig the system in its own perceived favor, but that in the long run this won't pan out. Instead it'll have really negative consequences.

In the case of Japan and China, isn't there something political as well as economic going on?

I don't think Peter Schiff regards the trade deficit as a problem in and of itself. I think he is only asking the question, why is there a *chronic* and ever increasing trade deficit when in a free market one wouldn't expect this (except under really special conditions.)

I think Schiff is arguing that via America's dominant position in the world and the dollar reserve currency status, America is able to run trade deficits that would not be possible if there were a free market. And further that as this runs against the natural direction the free market would be probably be taking, there will be eventual consequences.

That he seems to be suggesting US policy has been to rig the system in its own perceived favor, but that in the long run this won't pan out. Instead it'll have really negative consequences.

I think it'd be great to ask the next person who advances that argument if they think that a) the lack of sales is in fact due to trade barriers or b) the Japanese and Korean buyers, correctly or not, don't think much of American cars?

If a) then aren't those countries the real losers, needlessly making a good product more costly?

If b) then haven't you just pointed out the real problem, which isn't going to be changed by any protectionism but only better advertising or manufacturing?

Incidentally, small market makers in extremely liquid securities have been largely pushed out. That's good news as it means the market is extremely efficient and transaction costs are minimal. The new thing is for large market makers (SIG, for example) to provide locked markets for commission. More risky, but worth it for both customer and market maker.

Yes, we're off topic now, but at least it's related.

I have invoked the ceterus paribus clause numerous times because we're assuming nothing else changes other than Mr. Toyota's decisions.

Now, If there are no exogenous shifts in the supply and demand curve of any appreciable amount, we can safely assume (ceterus paribus again) that changing elasticities can change the bid-asked spread, and hence liquidity.

Marketmakers, as you know, absent the presence of other information, can determine the equilibrium which would occur in the Walrasian auction by ensuring appropriate inventory adjustments.

That is, the bid price is on the supply curve and the asked price is on the demand curve, aligned vertically over quantity, such that these spreads cluster near the true equilibrium price.

Now, assuming no change in price variability, changes in elasticites, do in fact change liquidity, all things being equal.

All else aside (I'm getting tired of saying ceterus paribus), typically we assume that supply and demand curves usually become more elastic in the long-run, and with smaller bid-asked spreads and more liquidity, this would tend to put pressure on dealer profitability and some may leave the market as they are earning economic losses.

But anyhow, while we're assuming constant variability in these thought exercises, it seems as though we have all deviated substantially from talking about trade issues.

You missed the point entirely. One need not change elasticity to change liquidity. Smaller bid/ask spreads result from more market participants, therefore an additional market participant adds to liquidity – even in very liquid securities. Large volume does not have to result from individual large orders, it can also result from lots of individuals executing small orders. In fact, the latter is better as it's harder to lean on small orders.

As a market maker, allow me to assure you that market makers are not a textbook example of perfect competition because market makers have advantages other market participants do not. You can thank the regulators for that. But, that's outside the scope of this discussion.

These narrow bid-asked spreads (marketmakers are a textbook example of perfect competition) will occur if the expected volume of transactions is quite large and the expected risk of large equilibrium price change is low.

Large volume (much larger than Mr. Toyota's orders) ensures that an inventory of securities can turn over easily from frequent orders to buy and sell. And low price volatility means the risk exposure to a given inventory is small.

If say, Mr. Toyota were trying to buy in a thin market (a market without depth, breadth and resiliency) then in fact, he ceases to be a pricetaker and could change the equilibrium price. Bid-asked spreads would be quite wide and the market could not be classified as liquid.

Remember, these securities markets are not determined like some Walrasian auction settling at a point where the demand and supply curves cross. Rather, people wish to deal with each other immediately to reduce uncertainty, and the dealers/marketmakers provide this service for a profit.

Their profit, of course, comes from the bid-asked spread. A new dealer could enter the market and simply quote the same bid asked spread which currently prevails. Otherwise, it is inventory changes which provide the crucial signal that some exogenous event has occurred causing the equilibrium to change.

That's very interesting, but being a price taker has absolutely nothing to do with providing liquidity.

If Mr. Toyota buys stock XYZ with some of the money that he acquired by selling his cars to U.S. consumers, he provides liquidity by providing a bid (and, at some point, an offer) for the security. It is the number of ready bids and offers that determines liquidity, not the ability of the market participants to influence price.

My intention was not to contradict but to add to your post on secondary markets. To the extent that Mr. Toyota uses some of his profit from the sale of cars to the U.S. consumer to purchase U.S. securities from the holders of those securities, he provides liquidity and liquidity is often undervalued because it is poorly understood by many people. It doesn't matter if the amount of liquidity provided by these trades is small or large as liquidity provision is a secondary and beneficial effect.

And yes, real estate is illiquid, and if Mr. Toyota would use his $400,000 to buy some real estate, he would still be a pricetaker and would fail to increase the market price of real estate.

Real estate is getting crushed right now because there are millions and millions of pricetakers who have taken mortgages on homes which they simply cannot afford.

So, rather than incomes increasing proportionally to match the previously increasing home values (there are other variables too), home prices have declined, bringing down incomes at a lesser, although very significant rate.

Most people are pricetakers, including Mr. Toyota. If I go to the bank, withdraw money from my demand deposit account, and then proceed to burn it, shred it in the blender or flush it down the toilet, then the reduction in the money supply does have some effect on the economy. But will it be measurable?

No, because I'm a pricetaker. I'm sure that the Fed could care less about what I do to my checking account balance.

Now if all of us do the same thing, well Ben Bernanke might need to buy some new underwear!

I like your post, but you bring up a new point that bears some exploration. The very act of buying securities on the secondary market provides liquidity. Liquidity reduces the risk of investment, lowers transactions costs, aids in price discovery and lowers the cost of capital for companies looking for capital in the public markets. These are also benefits to the primary market because a very liquid secondary market reduces the risk for those who provide initial financing. So, beyond just freeing up the capital of the initial financiers, the liquidity provision is a net gain to the economy.

We can see the negative effects of very illiquid markets in CDOs and Real Estate, as just two examples.

However, if Mr. Toyota buys equity in the primary market, or newly issued debt, that is indeed financing.

Pingry, I agree with your entire comment, but for the sake of clarity, let's make clear that in the case you refer to above, what is being financed is not the "trade deficit" — what is being financed is the activity (whatever it may be) of the firm whose securities Mr. Toyota buys.

[insert non-winking, angry-faced emoticon] – >:( ?

There's a WWII anecdote about packages stamped "USA" being sent to the wrong place. I can't recall the details.

I have thought Mr Toyota and Mr Usa would share the same currency presuming that Mr Toyota is Japanese since Usa is a town in Japan. After all, U.S.A. is an abbreviation not a word.

http://en.wikipedia.org/wiki/Usa,_%C5%8Cita

I agree. It makes no difference to entrepreneur Jones in Jacksonville if the financing comes from Bill Gates in Seattle, Washington or Mr. Toyota in Nagoya, Japan. After all, capital is capital.

But a few observations: If Mr. Toyota uses that $400,000 to buy shares in GE or 3M, this must be in the secondary market for it not to be classified as financing. If these funds are used to buy shares in the primary market, it is in fact financing, as defined by financial economists.

Now, given developed capital markets, no taxes and no agency costs (that is, ignore Jensen and Meckling, 1976) then this proportion of Company X's equity is irrelevant relative to the proportion financed by its issuance of new debt (Modigliani-Miller), but make no mistake about it, it is indeed financing.

In other words, if Mr. Toyota bought already-issued equity or debt, it is not financing, because presumably they bought it from others who already did the initial financing when the firm needed capital. However, if Mr. Toyota buys equity in the primary market, or newly issued debt, that is indeed financing.

While probably not rigorous, one could think of it, as a thought exercise, as indirectly financing if buying securities from someone else (Americans or other foreigners like Mr. Nissan or Mr. Volkswagon) as they already did the initial financing, so that the buying in the secondary market (irrespective of country origin) displaces someone else's purchase of these securities.

Their saving is then allocated to the next best alternative, and somewhere within the incredibly sophisticated economy, new financing does occur, but it's not exactly (direct) financing at the margin if Mr. Toyota directs some else's saving to the next best alternative.

Either way, everyone is better off.