Thursday, June 15, 2006

Legal Arbitrage & Global Macro

"Legal arbitrage" is a trading strategy which exploits regulatory differences between two economies and front-runs capital flow based on anticipated behavioral consequences of arbitrarily differing laws. An easy example of "legal arbitrage" would be purchasing property in Reno, expecting an increased tax burden on neighboring California real estate. A more sophisticated example of legal arbitrage would be to invest in an industry that is likely to provide tax havens for people in a neighboring country, or an industry on the cusp of legally creating barriers to entry. Insofar as different governments regulate economies in different ways, there will be opportunities for legal arbitrage.

Classical market theory says that trade over frictionless borders will efficiently allocate resources, but once there are regulatory differences between different economies, legal arbitrage is often a better way to model capital flow, particularly in cases where there are regulatory and social disparities between two countries. In other words, trade will naturally flow from countries that lack the political consensus to allow unions and that do not enforce environmental regulations to countries that accept worker's rights and care about the the environment. Structurally, wage differentials are just spice: trade would still flow from China if with wages the same, though probably not at the same rate.

A country willing to pollute their environment and keep their population in slavery will naturally attract capital flow, and this is a form of "legal arbitage". The punch line, of course, is that much pollution floats back across international borders to the very places that are trying to protect themselves from that pollution. And, of course, jealously guarding worker's rights in one country while benefiting from their ruthless exploitation in another, is like salving one's conscience by watching documentaries on Theresienstadt.

Smart people on both the right and left want to remove the structural differences between the US and China. People on the right want their models to be both prescriptive and descriptive -- growth is maximized when reality is aligned with their models. Thinking people on the left know that structural differences create arbitrary groups that benefit from unjust situations, and as people benefit from things, it becomes progressively easier to find excuses for them. In the long run, both groups expect the Chinese economy and the United States economy to ultimately converge.

The Chinese elites are clearly not planning for the long term. They are keeping people in near-slavery, preventing the socially disrupting consequences of repatriating wealth by keeping it in the United States (see, for example, this post), poisoning the landscape and population with pollution, and, most tellingly, discouraging population replacement, to the point where their population's productive versus retired ratio will be wildly imbalanced in less than twenty years. The Kelp-eating crowd hopes that if Chinese could just sit down and study the most recent science, they might be motivated to change their environmental policies. The problem, of course, is that the Chinese elites are destroying their environment in ways that were clearly understood half a century ago, so it is hard to imagine that their behavior would change once they assimilate the latest research. It is much more likely that they are creating international stockpiles of capital with the plan to abandon a polluted and angry country once it becomes ungovernable. They are accelerating global warming, but they are also setting aside enough money to buy an awful lot of air conditioners.

So my hedge fund buddies, with their ears to the ground, poised to front-run the giant sucking sound when the Chinese repatriate their capital, may be waiting for a long time. The Chinese elites will probably come to the United States long before their capital goes back to China. If this is true, then the net economic effect of the trade deficit is less dire than commonly supposed: shifting production to china reduces industrial employment in the United States and increases world pollution, but it supports our economy in ways that create higher paying jobs, and lower Chinese wages mean that more money stays in the United States. Further, the very structural differences that create the incentives to shift industry to China also make America an attractive haven for Chinese capitalists.


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