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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 PREZ-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.


Natural
Value
Inflation
Ma r ke t Pr i c e
Universal
F i s h e r Ef f e

Figure 1

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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 Smiths thesis, although there are some
important deviations.

a) Smiths 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 = (qx); Spx = (qx) (Partial Equilibrium Model)
Walras: Qdx = (px); Qdx = (px) (General Equilibrium Model)
Natural Value Qdx = (px) Qsx = (px) px = (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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NATURAL VALUE THEORY:
EMPIRICAL EVIDENCES OF THE LONG TERM WORLD FINANCIAL MARKET FUNCTION
Thus, the natural value theory may be summarised in the following diagram.

Universal
Fisher Effect
Natural Price Theory
Equilibrium point
Qd =Qs
Qd,Qs = f (P)
P =f (inflation,
relative value of labour
incorporated)
Value
of labour
incorporated
Price
Q
u
a
n
t
i
t
y
po
Qo
Inflation
D
e
m
a
n
d
(
d
)

S
u
p
p
l
y

(
s
)
Market
price
Natural
value
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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GONZALO PEREZ-SEOANE


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
i
i
EMx
EMy
x y
1
.

y = Inflation of foreign country (y)
x = National inflation (x)
EMy = Exports to foreign country (y)
EMx = Total national exports (x)

x
y
1
y
2
y
3
y
4
y
5
y
6
y
7
y
8
y
9
y
10
y
11
y
12
y
13
y
14
y
15
x=Inflacin domstica
y=Inflacin otros pases
y
17
y
18
y
19
y
20
y
21
y
22
y
23
y
24

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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NATURAL VALUE THEORY:
EMPIRICAL EVIDENCES OF THE LONG TERM WORLD FINANCIAL MARKET FUNCTION
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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GONZALO PEREZ-SEOANE


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 R
2
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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NATURAL VALUE THEORY:
EMPIRICAL EVIDENCES OF THE LONG TERM WORLD FINANCIAL MARKET FUNCTION
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.

Dependent
variable
R
2
Number of
Markets /
countries
Exchange rate 39 96,64%
Yield to maturity 21 97,43%
Interest Rates 19 98,71%
Stock Index 49 71,84%
World Financial
Market
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
R
2
= 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
Bahrain
Dinar
Colombian Peso
Icelandic Krona
Bolivar
1 EMU
2 Australian Dollar
3 Bahrain Dinar
4 Bolivia Boliviano
5 Brazil Real
6 Canadian Dollar
7 Chilean peso
8 Chinese Yuan
9 Colombian Peso
10 Croatian Kuna
11 Czech R Koruna
12 Danish Krone
13 Egyptian Pound
14 El Salvador Colon
15 Hong Kong Dollar
16 Hungarian Forint
17 Icelandic Krona
18 Indian Rupee
19 Ind.Rupiah
20 Israeli New Shegel
21Japanese Yen
22Korean Won
23Macao Pataca
24Malaysian Ringgit
25NZ Dollar
26Norwegian Krone
27Peruvian New Sol
28Philippine peso
29Polish Zloty
30Russian Ruble
31Singapore Dollar
32Slovak Koruna
33Slovenian Tolar
34Swedish Krona
35Swiss Franc
36Thai Bart
37Pound Sterling
38US Dollar
39Bolivar
3
9

C
u
r
r
e
n
c
i
e
s

/

S
D
R
s
A
c
c
u
m
u
l
a
t
e

m
o
n
t
h
l
y

v
a
r
i
a
t
i
o
n


f
r
o
m
J
a
n
u
a
r
y

1
9
9
5

t
o

D
e
c
e
m
b
e
r

2
0
0
2

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GONZALO PEREZ-SEOANE

B
o
n
d

Y
i
e
l
s

2
2

C
o
u
n
t
r
i
e
s

1
9
9
5
-
2
0
0
2
R
2
=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 Australia
2 Belg.-Luxbg
3 Canada
4 Denmark
5 EMU
6 France
7 Germany
8 Iceland
9 Italy
10 Japan
11 Korea
12 Netherlands
13 New Zealand
14 Norway
15 Philippines
16 South Africa
17 Spain
18 Switzerland
19 Thailand
20 UK
21 United States
22 Venezuela
World Bond Market Function
National Inflation Differential 1995-2002





I
n
t
e
r
e
s
t

R
a
t
e
s

P
u
b
l
i
c

D
e
b
t

(
S
h
o
r
t

T
e
r
m
)
3
0

C
o
u
n
t
r
i
e
s

/

1
9
9
5
-
2
0
0
2
R
2
=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 EMU
2 Argentina
3 Australia
4 Bahrain
5 Bolivia
6 Brazil
7 Canada
8 Colombia
9 Croatia
10 Czech Republic
11 Denmark
12 Hong Kong
13 Iceland
14 Indonesia
15 Japan
16 Korea
17 Macao
18 Mexico
19 New Zealand
20 Norway
21 Philippines
22 Poland
23 Russia
24 Singapore
25 Slovenia
26 South Africa
27 Switzerland
28 Thailand
29 UK
30 United States
National Inflation Differential 1995-2002
World Public Debt Market Function

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


World Stock Market Function
A
c
c
u
m
u
l
a
t
e

V
a
r
i
a
t
i
o
n

4
9

S
t
o
c
k

I
n
d
i
c
e
s
F
r
o
m

1
9
9
5
-
2
0
0
2

(
4
9

n
a
t
i
o
n
s
)
N
a
t
u
r
a
l

v
a
l
u
e
s

=

N
o
m
i
n
a
l

/

I
n
f
l
a
t
i
o
n
)

x

N
I
D
R
2
=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 SE
IBEX-35
National Inflation Differential 1995-2002


1 Austria ATX Prime 40 Index 26 Mumbai (Bombay) SE
2 Belgium CBB Bel-20 Index 27 Jakarta SE Composite Index
3 Finland HEX All-Share Composite 28 Israel All-Share Index
4 Paris CAC-40 Index 29 Japan Nikkei 225
5 Germany CDAX Composite Price Index 30 Korea SE (KOSPI)
6 Athens SE General Index 31 Taiwan SE C.Weighted
7 Ireland ISEQ General Price Index 32 Malaysia KLSE Composite
8 Milan SE MIB-30 33 M xico SE Indice
9 Amsterdam AEX Stock Index 34 New Zealand SE 40 SI
10 Oporto PSI-20 Index 35 Oslo SE All-Share Index
11 Madrid SE IBEX-35 36 Lima SE General Index
12 Europe Dow Jones Stoxx Price Index 37 Manila SE Composite Index
13 Buenos Aires SE Merval Index 38 Warsaw SE 20-
14 Australia ASX All-Ordinaries 39 Moscow Times Ruble Index
15 Bahrain SE General Index 40 Singapore Straits-Times Index
16 Brazil Bolsa de Valores de Sao Paulo (Bovespa) 41 Bratislava SE SAX Index
17 Canada S&P/TSX 300 Composite Index 42 Slovenia Bourse Index (SBI-20)
18 Santiago SE IPSA Index 43 FTSE/JSE All-Share Index
19 Shanghai SE Composite 44 Stockholm SX All-Share Price Index
20 Colombia IGBC General Index 45 Swiss Market Index
21 Prague SE PX-50 Index 46 Thailand SET General Index
22 Cairo Capital Market Authority General Index 47 UK Financial Times-SE 100 Index
23 Hong Kong Hang Seng Composite Index 48 S&P 500 Composite
24 Budapest SE Central European Stock Index 49 Caracas SE General Index
25 Reykjavik All-Share Index (ICEX)


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GONZALO PEREZ-SEOANE


Relation between Economic Growth (GDP) and Stock Market Growth
R
2
=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 Growth
Madrid SE IBEX-35
A
c
c
u
m
u
l
a
t
e

V
a
r
i
a
t
i
o
n

4
9

S
t
o
c
k

I
n
d
i
c
e
s
F
r
o
m

1
9
9
5
-
2
0
0
2

(
4
9

n
a
t
i
o
n
s
)
N
a
t
u
r
a
l

v
a
l
u
e
s

=

N
o
m
i
n
a
l

/

I
n
f
l
a
t
i
o
n
)

x

N
I
D

1 Austria ATX Prime 40 Index 26 Mumbai (Bombay) SE
2 Belgium CBB Bel-20 Index 27 Jakarta SE Composite Index
3 Finland HEX All-Share Composite 28 Israel All-Share Index
4 Paris CAC-40 Index 29 Japan Nikkei 225
5 Germany CDAX Composite Price Index 30 Korea SE (KOSPI)
6 Athens SE General Index 31 Taiwan SE C.Weighted
7 Ireland ISEQ General Price Index 32 Malaysia KLSE Composite
8 Milan SE MIB-30 33 Mxico SE Indice
9 Amsterdam AEX Stock Index 34 New Zealand SE 40 SI
10 Oporto PSI-20 Index 35 Oslo SE All-Share Index
11 Madrid SE IBEX-35 36 Lima SE General Index
12 Europe Dow Jones Stoxx Price Index 37 Manila SE Composite Index
13 Buenos Aires SE Merval Index 38 Warsaw SE 20-
14 Australia ASX All-Ordinaries 39 Moscow Times Ruble Index
15 Bahrain SE General Index 40 Singapore Straits-Times Index
16 Brazil Bolsa de Valores de Sao Paulo (Bovespa) 41 Bratislava SE SAX Index
17 Canada S&P/TSX 300 Composite Index 42 Slovenia Bourse Index (SBI-20)
18 Santiago SE IPSA Index 43 FTSE/JSE All-Share Index
19 Shanghai SE Composite 44 Stockholm SX All-Share Price Index
20 Colombia IGBC General Index 45 Swiss Market Index
21 Prague SE PX-50 Index 46 Thailand SET General Index
22 Cairo Capital Market Authority General Index 47 UK Financial Times-SE 100 Index
23 Hong Kong Hang Seng Composite Index 48 S&P 500 Composite
24 Budapest SE Central European Stock Index 49 Caracas SE General Index
25 Reykjavik All-Share Index (ICEX)


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