Natural Value Theory

NATURAL VALUE THEORY: EMPIRICAL EVIDENCES OF THE LONG TERM WORLD FINANCIAL MARKET FUNCTION

NATURAL VALUE THEORY:

EMPIRICAL EVIDENCES OF THE LONG TERM WORLD FINANCIAL MARKET FUNCTION

GONZALO PÉREZ-SEOANE

ABSTRACT This paper introduces a new value theory, the natural value theory. The theoretical background for the natural value theory may be found in the writings of Adam Smith. The hypotheses of this theory include the assertion that, for nations in a completely free market economy, all macroeconomic variables are interconnected in a natural manner. Moreover, the behaviour of the macroeconomic variables is harmonic, rational and empirically demonstrable over time. This paper gives important empirical evidences of the economic validity of the natural value theory for the World Financial Market.

1. - The Natural Value Theory The natural value theory states that every good or service has two distinct values. The first value, which is visible, is the market price. The second value, which is permanently hidden, is the natural value or natural price, (just as Smith defined it). The difference between the natural value and the market price of every good and service is inflation, leading to a generalisation of the Fisher effect in the economy. In other words, defining this effect in terms of the proposed hypothesis: any market price existing in the economy is composed of its natural value plus a certain level of inflation. This effect is universal, constant and may be empirically verified in the long run. Thus, in the long run the principal variations observed in any market price are the result of the mood of inflation over time. It would seem that, to date, the generalisation of the Fisher effect has not been proposed in the terms described, thus, this effect will be termed universal Fisher effect.

NaturalValue

Inflation

M a r k e t P r i c e

UniversalF i s h e r E f f e

Figure 1

1

GONZALO PEREZ-SEOANE

The central principle of the natural value theory (and model) is that the natural value of every good and service is derived from the quantity and grade of productive capacities and skills incorporated by unit of time. This gives a new perspective on the theory known as the labour value theory. This theory, with different emphases and various levels of development has been maintained by an important number of economists throughout economic history. This has given rise to two great schools of economic thought. The first school advocates a labour value theory that is subjective in its nature. This theory was initiated by some members of the Scholastic school and nowadays constitutes an important branch of the Austrian school. The second school was begun by Smith and proposes a labour value theory which is objective in its nature. Ricardo and his followers subsequently sustained this line of thought. The natural value theory is a continuation of Smith’s thesis, although there are some important deviations. a) Smith’s labour value theory may be interpreted as an absolute standard of

value of a static nature that is constant over time. The natural value theory suggests that the changes in the natural values will occur in accordance with modifications in the quantity and grade of the existing human productive capacities and skills. Thus the labour standard of value presented here is fully dynamic, adapting itself over time, to the variations in the existing human productive capacities and skills.

b) The natural value theory maintains that the natural value of any productive

activity is fixed in terms relative to the value of other existing productive activities (capacities and skills). Thus, as Walras suggested – in a different theoretical context- all prices in the economy are interconnected.

At present, Marshall's law is the main paradigm of economic science. The natural value theory fully upholds the economic validity of Marshall's law; nevertheless, there are important differences with respect to the mechanism of market adjustment. Thus, when the markets are in disequilibrium, Marshall's law assumes that the adjustment variable is quantity, which implies that the equilibrium price depends on the quantity supplied and demanded of the good. Contrary to one of the basic principles of Marshall's law, the natural value theory, convinced of the existence of a natural or original value in each and every good or service in the economy -a value derived from the hidden but real functioning of the labour value standard- suggests that: the quantity supplied and demanded of any good or service will tend to adjust (in the long run) to the natural value of every good or service. Hence, as suggested by Walras in his general equilibrium model, the price would be the adjustment variable. Marshall: Dpx = ƒ(qx); Spx = ƒ(qx) (Partial Equilibrium Model) Walras: Qdx = ƒ(px); Qdx = ƒ(px) (General Equilibrium Model) Natural Value Qdx = ƒ(px) Qsx = ƒ(px) ⇒ px = ƒ(Vtx) (Natural Model) Theory

Vt= value of labour deployed in production / quantity and grade of productive capacities and skills incorporated by unit of time

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Thus, the natural value theory may be summarised in the following diagram.

UniversalFisher Effect

Natural Price TheoryEquilibrium point

Qd = QsQd,Qs = f (P)P = f (inflation,

relative value of labourincorporated)

Value of labour

incorporated

Price

Qua

ntity

po

Qo

Inflation

Demand(d) Supply (s)

Marketprice

Naturalvalue

Market Price: price derived from the relative value of the labour incorporated in a good; this value is altered over time by inflation and by the supply and demand

Natural Value: price derived from the relative value of the labour incorporated in the good; this value is altered over time by the supply and demand

Figure 2

The natural value theory tackles the problem of the functioning of any price (market) using an approach different to that of Marshall. While accepting the existence of supply, demand and price for any market (good or service), as well as the possible interrelationships of one market with another by reason of the existence of complementary and substitutive products or services or as a consequence of the income effect, the natural value theory views all these relationships as transitory or circumstantial when the effects are considered in the short run. Smith said: “the natural price, therefore, is, as it were, the central price, to which the prices of all commodities are continually gravitating. Different accidents may sometimes keep them suspended a good deal above it, and sometimes force them down even somewhat below it. But whatever may be the obstacles which hinder them from settling in this centre of repose and continuance, they are constantly tending towards it.... But though the market price of every particular commodity is in this manner continually gravitating, if one may say so, towards the natural price, yet sometimes particular accidents, sometimes natural causes, and sometimes particular regulations of police, may, in many commodities, keep up the market price, for a long time together, a good deal above the natural price” . 1 All prices in the economy perform and vary over time in accordance with the natural value theory, except the price of money. Returning to the initial hypothesis regarding the universal Fisher effect, an aspect relevant to the origin of inflation may well be mentioned. Since this is not the main focus of this article, it is sufficient to point out that the natural value theory maintains the thesis commonly shared by current economic theory that the principal origin of inflation is monetary. It should be pointed out that the monetary cause is not the only factor that affects prices in a general and constant manner, however, it is the most important, constant and demonstrable among the factors that affect the general behaviour of prices from the long run perspective. _____________________ 1 Adam Smith, “The Wealth of Nations”, Alianza Editorial 1996, pp. 100, 102, 103.

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If we accept as possible the monetary origin of inflation - which presupposes that the functioning in time of each monetary standard gives rise to distinct inflations – then the real economic transcendence of the universal Fisher effect would not be in this effect itself or indeed in its domestic effect, but rather in this effect in relative terms among the nations. The universal Fisher effect in relative terms among the nations leads to the national inflation differential. The means for calculating the national inflation differential (NID) of one nation as against the other interconnected nations may be formulated by means of the following equation, (as index = IDI)

( ) ⎥⎦

⎤⎢⎣

⎡⎟⎠⎞

⎜⎝⎛−∑

=

n

i

ii EMx

EMyxy1

.ππ

πy = Inflation of foreign country (y) πx = National inflation (x) EMy = Exports to foreign country (y)

EMx = Total national exports (x)

š x

š y1

š y2š y3

š y4

š y5

š y6

š y7

š y8š y9

š y10

š y11š y12

š y13

š y14

š y15š x= Inflación domésticaš y= Inflación otros países

š y17

š y18

š y19š y20

š y21

š y22

š y23

š y24

Figure 3

The calculation of the national inflation differential may be expressed graphically as shown in figure 3. The final result of the national inflation differential may be positive, negative or zero. If the result is positive then the variation in prices (inflation) of the nation(x) is less than the weighted sum of the existing variation in prices of the group of nations which trade with the nation x. .If the result is negative then the variation in prices (inflation) of the nation(x) is greater than the weighted sum of the existing variation in prices of the group of nations which trade with the nation x. If the result is zero then the variation in prices (inflation) of the nation(x) is equal to the weighted sum of the existing variation in prices of the group of nations which trade with the nation x.

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It is customary in macroeconomics –international finance- to calculate the inflation differential on the basis of the existence of bilateral relations in economics. Thus the inflation differential of one country is always calculated against another specific nation. The inflation differential equation proposed here, while recognising the existence of bilateral relations in the economy, nevertheless, goes a step further by considering and resolving the effect of the variation of prices of each nation in a globalised multilateral context, a context where, in particular the price changes of each nation are not inconsequential in the economic relations maintained with the group of connected nations. This method of calculating the inflation differential based on multilateral economic functioning is certainly much closer to economic reality than the normal simple bilateral calculation. It is interesting to call attention to the fact that from the theoretical perspective, in current economic theory, there exist a number of theories that tackle the effect of the variation in prices among the nations. Thus for the Neoclassical School (Monetarist and Keynesians) the answer would be connected with the theory of the non-cooperative equilibrium of Nash, which states that the relative variation of prices would be insignificant at world level. This is so since prices always reach equilibrium. For other currents of economic thought, such as the Austrian School, the relative variation of prices does affect the economic process. Summing up, the suggested validity of the labour standard of value in the economy would imply that all prices are interrelated. However, prices are affected a) as a consequence of the behaviour of supply and demand and b) by the functioning of monetary system. While supply and demand affect any price in a circumstantial way or in the short run, the functioning of the monetary system leads to what is termed inflation or the generalised and constant increase in prices. This effect of the accumulation of the monetary value of prices coupled with the existence of intrinsic or natural values has been labelled the universal Fisher effect. While the universal Fisher effect is appealing for the intellectual explanation of part of the process of mutation that prices experience over time, nevertheless, its real significance is to be found in relative terms among the nations, in other words, the national inflation differential. However, if we accept the hypothesis that all prices in the economy are interrelated and that the only enduring long run cause for alteration of prices is inflation then the national inflation differential would be decisive in the verification of the harmonic functioning of the totality of macroeconomics at the global level. Hence if we eliminate the inflation differential from any variable then this variable should display a completely rational economic behaviour, consistent with the other variables and subject to the principles of the functioning of the labour standard of value. In the case of variables of a monetary/cuasimonetary nature (exchange rate-bond yieds, interest rates, stock market) the variations over time should be directly related to the national inflation differential.

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2.- Objective and methodology of the research Objective. The Natural value theory claims that the prices of all goods and all services of the nations are interconnected through the labour standard of value, except the price of money. If this is correct, then the exchange rate market and the stock market should reflect the fact that they constitute an organised system of rational markets with a precise and demonstrable relationship between each other. Methodology. It is generally accepted that economic theory consists of a collection of definitions and assumptions about the behaviour of people and things. In general, economic theory is based on relationships between different measures (functional relationships). The concept that one thing depends on an other is one of the fundamental notions on which all science is based. Thus, dispersion diagrams were used in order to check for the existence of an economic relationship between the dependent variables and the independent variables. These diagrams are a reliable means of quickly establishing the existence or not of a relationship between variables. It is well known that the relationship between variables in a dispersion diagram can adopt different shapes giving rise to simple or complex mathematical functions. Linear and polynomial functions will be used throughout this empirical demonstration. With a view to determining the percentage variation in the dependent variable (y) accounted for by variation in the independent variable (x), the coefficient of determination R2 has been chosen. The strength of association between the dependent and independent variables or correlation -R- is also given. This simple methodology will be followed throughout the empirical analysis. 3.- Functional relationships empirically established Some results obtained from the empirical analysis: * Significant direct empirical evidence was found which showed a relationship

between the variation in the exchange rates over time and the variation, over time, of the national inflation differential. The world exchange rate market displays rational economic behaviour, a behaviour that, moreover, is not random.

* Empirical proof was found that confirms the direct relationship between the

variation in the bond market yields / and short term interest rates over time and the variation, over time, of the national inflation differential. Again, the world bond market yields display rational economic behaviour.

* Empirical proof was found that confirms the direct relationship between the

variation in the stock market indices over time and the variation, over time, of the national inflation differential. The NID/IDI provides a significant

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explanation for the variation over time of the stock market indices. Again, the stock market indices display rational economic behaviour, a behaviour which, moreover, is not random. Also, empirical evidence was found that confirms the direct relationship between the stock market indices and the economic growth.

Dependentvariable

R2Number ofMarkets /countries

Exchange rate 39 96,64%Yield to maturity 21 97,43%Interest Rates 19 98,71%Stock Index 49 71,84%

World FinancialMarket 128 91.15%

(average)(31 December 2002

4.- Final consideration The empirical results obtained on the World Financial Market are consistent with the principles of functioning maintained by the Natural Value Theory.

National Inflation Differential 1995-2002

World Exchange Rate Market Long Term Function

R2 = 0,9664

-50%

0%

50%

100%

150%

200%

250%

300%

350%

400%

450%

500%

550%

600%

650%

700%

-120% -100% -80% -60% -40% -20% 0% 20% 40% 60%

R = 0,9861

Russian Ruble

BahrainDinar

Colombian Peso

Icelandic Krona

Bolivar

1 EMU2 Australian Dollar3 Bahrain Dinar4 Bolivia Boliviano5 Brazil Real6 Canadian Dollar7 Chilean peso8 Chinese Yuan9 Colombian Peso

10 Croatian Kuna11 Czech R Koruna12 Danish Krone13 Egyptian Pound14 El Salvador Colon15 Hong Kong Dollar16 Hungarian Forint17 Icelandic Krona18 Indian Rupee19 Ind.Rupiah20 Israeli New Shegel

21 Japanese Yen22 Korean Won23 Macao Pataca24 Malaysian Ringgit25 NZ Dollar26 Norwegian Krone27 Peruvian New Sol28 Philippine peso29 Polish Zloty30 Russian Ruble31 Singapore Dollar32 Slovak Koruna33 Slovenian Tolar34 Swedish Krona35 Swiss Franc36 Thai Bart37 Pound Sterling38 US Dollar39 Bolivar

39 C

urre

ncie

s / S

DR

sA

ccum

ulat

e m

onth

ly v

aria

tion

from

Janu

ary

1995

to D

ecem

ber

2002

7


Bon

d Y

iels

22

Cou

ntri

es 1

995-

2002

R2 = 0,9743

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

-40% -30% -20% -10% 0% 10% 20% 30% 40% 50%

1 Australia2 Belg.-Luxbg3 Canada4 Denmark5 EMU6 France7 Germany8 Iceland9 Italy

10 Japan11 Korea12 Netherlands13 New Zealand14 Norway15 Philippines16 South Africa17 Spain18 Switzerland19 Thailand20 UK21 United States22 Venezuela

World Bond Market Function


Inte

rest

Rat

es P

ublic

Deb

t (Sh

ort T

erm

)30

Cou

ntri

es /

1995

-200

2

R2 = 0,9871

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

-40% -30% -20% -10% 0% 10% 20% 30% 40%

1 EMU2 Argentina3 Australia4 Bahrain5 Bolivia6 Brazil7 Canada8 Colombia9 Croatia

10 Czech Republic11 Denmark12 Hong Kong13 Iceland14 Indonesia15 Japan16 Korea17 Macao18 Mexico19 New Zealand20 Norway21 Philippines22 Poland23 Russia24 Singapore25 Slovenia26 South Africa27 Switzerland28 Thailand29 UK30 United States


World Public Debt Market Function

8


World Stock Market FunctionA

ccum

ulat

e V

aria

tion

49 S

tock

Indi

ces

From

199

5-20

02 (4

9 na

tions

)N

atur

al v

alue

s = N

omin

al /

Infla

tion)

x N

ID

R2 = 0,7184

-320%

-280%

-240%

-200%

-160%

-120%

-80%

-40%

0%

40%

80%

120%

160%

200%

240%

-120% -100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100%

Madrid SEIBEX-35


1 Austria ATX Prime 40 Index 26 Mumbai (Bombay) SE2 Belgium CBB Bel-20 Index 27 Jakarta SE Composite Index3 Finland HEX All-Share Composite 28 Israel All-Share Index4 Paris CAC-40 Index 29 Japan Nikkei 2255 Germany CDAX Composite Price Index 30 Korea SE (KOSPI)6 Athens SE General Index 31 Taiwan SE C.Weighted7 Ireland ISEQ General Price Index 32 Malaysia KLSE Composite8 Milan SE MIB-30 33 Mˇxico SE Indice9 Amsterdam AEX Stock Index 34 New Zealand SE 40 SI

10 Oporto PSI-20 Index 35 Oslo SE All-Share Index11 Madrid SE IBEX-35 36 Lima SE General Index12 Europe Dow Jones Stoxx Price Index 37 Manila SE Composite Index13 Buenos Aires SE Merval Index 38 Warsaw SE 20-14 Australia ASX All-Ordinaries 39 Moscow Times Ruble Index15 Bahrain SE General Index 40 Singapore Straits-Times Index16 Brazil Bolsa de Valores de Sao Paulo (Bovespa) 41 Bratislava SE SAX Index17 Canada S&P/TSX 300 Composite Index 42 Slovenia Bourse Index (SBI-20)18 Santiago SE IPSA Index 43 FTSE/JSE All-Share Index19 Shanghai SE Composite 44 Stockholm SX All-Share Price Index20 Colombia IGBC General Index 45 Swiss Market Index21 Prague SE PX-50 Index 46 Thailand SET General Index22 Cairo Capital Market Authority General Index 47 UK Financial Times-SE 100 Index23 Hong Kong Hang Seng Composite Index 48 S&P 500 Composite24 Budapest SE Central European Stock Index 49 Caracas SE General Index25 Reykjavik All-Share Index (ICEX)

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Relation between Economic Growth (GDP) and Stock Market Growth

R2 = 0,7198

-400,00%

-300,00%

-200,00%

-100,00%

0,00%

100,00%

200,00%

300,00%

-350,0% -300,0% -250,0% -200,0% -150,0% -100,0% -50,0% 0,0% 50,0% 100,0%

Natural GDP (Economic Growth)Accumulate Rate 1995-2002

(Nominal GDP / Inflation) x NID

Spain Economic GrowthMadrid SE IBEX-35

Acc

umul

ate

Var

iatio

n 49

Sto

ck In

dice

sFr

om 1

995-

2002

(49

natio

ns)

Nat

ural

val

ues =

Nom

inal

/ In

flatio

n) x

NID

1 Austria ATX Prime 40 Index 26 Mumbai (Bombay) SE2 Belgium CBB Bel-20 Index 27 Jakarta SE Composite Index3 Finland HEX All-Share Composite 28 Israel All-Share Index4 Paris CAC-40 Index 29 Japan Nikkei 2255 Germany CDAX Composite Price Index 30 Korea SE (KOSPI)6 Athens SE General Index 31 Taiwan SE C.Weighted7 Ireland ISEQ General Price Index 32 Malaysia KLSE Composite8 Milan SE MIB-30 33 Mˇxico SE Indice9 Amsterdam AEX Stock Index 34 New Zealand SE 40 SI

10 Oporto PSI-20 Index 35 Oslo SE All-Share Index11 Madrid SE IBEX-35 36 Lima SE General Index12 Europe Dow Jones Stoxx Price Index 37 Manila SE Composite Index13 Buenos Aires SE Merval Index 38 Warsaw SE 20-14 Australia ASX All-Ordinaries 39 Moscow Times Ruble Index15 Bahrain SE General Index 40 Singapore Straits-Times Index16 Brazil Bolsa de Valores de Sao Paulo (Bovespa) 41 Bratislava SE SAX Index17 Canada S&P/TSX 300 Composite Index 42 Slovenia Bourse Index (SBI-20)18 Santiago SE IPSA Index 43 FTSE/JSE All-Share Index19 Shanghai SE Composite 44 Stockholm SX All-Share Price Index20 Colombia IGBC General Index 45 Swiss Market Index21 Prague SE PX-50 Index 46 Thailand SET General Index22 Cairo Capital Market Authority General Index 47 UK Financial Times-SE 100 Index23 Hong Kong Hang Seng Composite Index 48 S&P 500 Composite24 Budapest SE Central European Stock Index 49 Caracas SE General Index25 Reykjavik All-Share Index (ICEX)

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Natural Value Theory