Two Japanese were detained by Italian financial police last week after trying to enter Switzerland with $134 billion worth of undeclared U.S. bonds, mostly Treasury bonds, an Italian newspaper reported Wednesday.
The Japanese Consulate General in Milan acknowledged that two people had been detained, but it was still trying to confirm with Italian authorities their identities and whether they are Japanese nationals.
According to the report in il Giornale, two unidentified Japanese in their 50s concealed the bonds, including 249 U.S. Treasury bonds worth $500 million each, in a suitcase with a false bottom. The bonds were found June 3 during a search by Italian authorities in Chiasso, on the border with Switzerland about 50 km north of Milan.
The newspaper did not say on what grounds the two were detained, but they may have been held on suspicion of attempting to take a large amount of securities out of Italy without declaring them.
It said the Italian authorities were investigating whether the securities are genuine, given their huge value.
If the bonds are genuine, the two could be fined around 40 percent of their total value, it said.
Harvard Economist Niall Ferguson appeared on CNN’s GPS with Fareed Zakaria over the weekend. Ferguson has stood out among mainstream economists lately in his opposition to the US fiscal stimulus package, an $880 billion experiment in expansionary Keynesian policy. While economists like Paul Krugman argue that Obama’s plan is not big enough to fill America’s “recessionary gap”, Ferguson warns that the long-run effects of current and future US budget deficits could lead the US towards economic collapse. This blog post will attempt to explain Ferguson’s views in a way that high school economics students can understand.
Government spending in the US is projected to exceed tax revenues by $1.9 trillion this year, and trillions more over the next four years. An excess of spending beyond tax revenue is known as a budget deficit, and must be paid for by government borrowing. Where does the government get the funds to finance its deficits? The bond market. The core of Ferguson’s concerns about the future stability of the United States economy is the situation in the market for US government bonds. According to Ferguson:
One consequence of this crisis has been an enormous explosion in government borrowing, and the US federal deficit… is going to be equivelant to 1.9 trillion dollars this year alone, which is equivelant to nearly 13% of GDP… this is an excessively large deficit, it can’t all be attributed to stimulus, and there’s a problem. The problem is that the bond market… is staring at an incoming tidal wave of new issuance… so the price of 10-year treasuries, the standard benchmark government bond… has taken quite a tumble in the past year, so long-term interest rates, as a result, have gone up by quite a lot. That poses a problem, since part of the project in the mind of Federal Reserve Chairman Ben Bernanke is to keep interest rates down“
There’s a lot of information in Ferguson’s statements above. To better understand him, some graphs could come in handy. Below is a graphical representation of the US bond market, which is where the US government supplies bonds, which are purchased by the public, commercial banks, and foreigners. Keep in mind, the demanders of US bonds are the lenders to the US government, which is the borrower. The price of a bond represents the amount the government receives from its lenders from the issuance of a new bond certificate. The yield on a bond represents the interest the lender receives from the government. The lower the price of a bond, the higher the yield, the more attractive bonds are to investors. Additionally, the lower the price of bonds, the greater the yield, thus the greater the amount of interest the US government must pay to attract new lenders.
Ferguson says that the price of US bonds has “taken a tumble”. The increase of supply has lowered bond prices, increasing their attractiveness to investors who earn higher interest on the now cheaper bonds. Below we can see the impact of an increase in the quantity demanded for government bonds on the market for private investment.
Financial crowding-out can occur as a result of deficit financed government spending as the nation’s financial resources are diverted out of the private sector and into the public sector. Granted, during a recession the demand for loanable funds from firms for private investment may be so low that there is no crowding out, as explained by Paul Krugman here.
But crowding out is not Ferguson’s only concern. The increase in interest rates caused by the US government’s issuance of new bonds could lead to a decrease in private investment in the US economy, inhibiting the nation’s long-run growth potential. But the bigger concern is one of America’s long-run economic stability. If the Obama administration does not put forth a viable plan for balancing its budget very soon, the demand for US government bonds could fall, which would further excacerbate the crowding-out effect, and eliminate the country’s ability to finance its government activities. In other words, such a loss of faith could plunge the United States into bankruptcy.
Fareed Zakaria asks Ferguson:
“Is it fair to say that this bad news, the fact that we can’t sell our debt as cheaply as we thought, overshadows all the good news that seems to be coming?”
Ferguson’s reply:
The green shoots that are out there (referring to the phrase economists and politicians have been using to describe the signs of recovery in the US economy) seem like tiny little weeds in the garden, and what’s coming in terms of the fiscal crisis in the United States is a far bigger and far worse story.
Finally Fareed asks the question everyone wants to know:”What the hell do we do?”
Ferguson:
One thing that can be done very quickly is for the president to give a speech to the American people and to the world explaining how the administration proposes to achieve stabilization of American public finance… the administration doesn’t have that long a honeymoon period, it has very little time in which it can introduce the American public to some harsh realities, particularly about entitlements and how much they are going to cost. If a signal could be sent really soon to the effect that the administration is serious about fiscal stabilization and isn’t planning on borrowing another $10 trillion between now and the end of the decade, then just conceivably markets could be reassured.
Ferguson is saying that only if the Obama administration begins taking serious steps towards balancing the US government’s budget can it hope to stave off an eventual loss of faith among America’s creditors (and thus a fall in demand for US bonds). It will be a while before tax revenues are high enough to finance the US budget. But if the country does not begin working towards such an end immediately, it may find itself unable to raise the funds to pay for such public goods as infrastructure, education, health care, national defense, medical research, as well as the wages of the millions of government employees. In other words, the US government could be bankrupt, and its downfall could mean the end of American economic power.
The power of the bond market should not be underestimated. America’s very future depends on continued faith in its financial stability and fiscal responsibility.
Discussion Questions:
Why do you think the US government has such a huge budget deficit this year? ($1.9 trillion) Previously, the largest budget deficit on record was only around $400 billion.
How does the issuance of new bonds by the US government lead to less money being available to private households and firms?
Do you think investors will ever totally lose faith in US government bonds? Why or why not?
In what way is the government’s huge budget deficit a “tax on teenagers”? In other words, how will today’s teenagers end up suffering because of the federal budget deficit?
To learn more about the power of the bond market, watch Niall Ferguson’s documentary, The Ascent of Money. The section on the bond market can be viewed here:
So what kind of teachers could a school get if it paid them $125,000 a year?
An accomplished violist who infuses her music lessons with the neuroscience of why one needs to practice, and creatively worded instructions like, “Pass the melody gently, as if it were a bowl of Jell-O!”
A self-described “explorer” from Arizona who spent three decades honing her craft at public, private, urban and rural schools.
Two with Ivy League degrees. And Joe Carbone, a phys ed teacher, who has the most unusual résumé of the bunch, having worked as Kobe Bryant’s personal trainer.
“Developed Kobe from 185 lbs. to 225 lbs. of pure muscle over eight years,” it reads.
They are members of an eight-teacher dream team, lured to an innovative charter school that will open in Washington Heights in September with salaries that would make most teachers drop their chalk and swoon; $125,000 is nearly twice as much as the average New York City public school teacher earns, and about two and a half times as much as the national average for teacher salaries. They also will be eligible for bonuses, based on schoolwide performance, of up to $25,000 in the second year.
More on the New York City charter school that is experimenting with paying teachers nearly triple the national average salary of public schools.
So what kind of teachers could a school get if it paid them $125,000 a year?
An accomplished violist who infuses her music lessons with the
neuroscience of why one needs to practice, and creatively worded instructions like, “Pass the melody gently, as if it were a bowl of Jell-O!”
A self-described “explorer” from Arizona who spent three decades honing her craft at public, private, urban and rural schools.
Two with Ivy League degrees. And Joe Carbone, a phys ed teacher, who has the most unusual résumé of the bunch, having worked as Kobe Bryant’s personal trainer.
“Developed Kobe from 185 lbs. to 225 lbs. of pure muscle over eight years,” it reads.
They are members of an eight-teacher dream team, lured to an innovative charter school that will open in Washington Heights in September with salaries that would make most teachers drop their chalk and swoon; $125,000 is nearly twice as much as the average New York City public school teacher earns, and about two and a half times as much as the national average for teacher salaries. They also will be eligible for bonuses, based on schoolwide performance, of up to $25,000 in the second year…
The school received 600 applications. Mr. Vanderhoek interviewed 100 in person.
It’s amazing to me that a school in NYC that pays $125,000 a year and expects teachers to work year round gets so much attention, while international schools are paying teachers nearly as much to work a regular school year, yet 99% of American public school teachers seem totally clueless about the career opportunities available at international schools! Teachers can make $100,000+ at at least four international schools I can think of right now… including the one I’m working at currenty!
I am by no means saying that because of what they pay international schools employ more qualified teachers than a typical American public school. On the contrary, it makes me wonder why if excellent pay can attract 600 applicants for 8 positions in a NYC school, why do so many international schools paying more than twice what American public schools pay still find it difficult to recruit teachers?
When are highly skilled American teachers going to realize that they can earn incredibly competitive salaries by teaching overseas? Maybe the best of the best will just wait for another charter school offering $100,000+ to open up so they can compete with hundreds of applicants for a handful of teaching positions. OR they could go to the next ISS international recruiting fair and accept a job in London, Tokyo, Singapore, Hong Kong, Zurich, Dubai or a handful of other cities where international teachers regularly make in the $100,000 range and be lavished with offers from schools in exciting, exotic locales from all corners of the globe!
MY day job is teaching introductory economics to about 700 Harvard undergraduates a year. Lately, when people hear that, they often ask how the economic crisis is changing what’s offered in a freshman course.
They’re usually disappointed with my first answer: not as much as you might think. Events have been changing so quickly that we teachers are having trouble keeping up. Syllabuses are often planned months in advance, and textbooks are revised only every few years.
But there is another, more fundamental reason: Despite the enormity of recent events, the principles of economics are largely unchanged. Students still need to learn about the gains from trade, supply and demand, the efficiency properties of market outcomes, and so on. These topics will remain the bread-and-butter of introductory courses.
Nonetheless, the teaching of basic economics will need to change in some subtle ways in response to recent events. Here are four:
The nation needs to begin planning now to eventually bring taxes and spending in line, Federal Reserve Chairman Ben S. Bernanke said yesterday, arguing that large budget deficits, if sustained, could deepen the financial crisis and choke off the economy.
Bernanke’s testimony to Congress reflected growing concern among economists and investors that the nation’s long-term fiscal imbalances could stand in the way of economic recovery by driving up the interest rates that the government, businesses and consumers pay to borrow money. The rate the government pays has already risen in recent weeks.
On Wednesday last week, yields on 10-year US Treasuries – generally seen as the benchmark for long-term interest rates – rose above 3.73 per cent. Once upon a time that would have been considered rather low. But the financial crisis has changed all that: at the end of last year, the yield on the 10-year fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months. In relative terms, that represents an 81 per cent jump.
Most commentators were unnerved by this development, coinciding as it did with warnings about the fiscal health of the US. For me, however, it was good news. For it settled a rather public argument between me and the Princeton economist Paul Krugman.
It is a brave or foolhardy man who picks a fight with Mr Krugman, the most recent recipient of the Nobel Prize for Economics. Yet a cat may look at a king, and sometimes a historian can challenge an economist.
Is the US (and a number of other high-income countries) on the road to fiscal Armageddon? Are recent jumps in government bond rates proof that investors are worried about fiscal prospects? My answers to these questions are: No and No. This does not mean there is no reason for worry. It is rather that there are powerful arguments against fiscal retrenchment right now and strong reasons for welcoming recent moves in the bond markets.
Last week, the Financial Times carried two columns arguing that the US fiscal path was unsustainable, one by Stanford University’s John Taylor and the other by the Harvard historian Niall Ferguson. The latter, in turn, was a comment on a debate with, among others, the New York Times columnist and Nobel laureate Paul Krugman at the end of April.
On one point all serious analysts agree: public debt cannot rise, relative to gross domestic product, without limit. To embark on fiscal stimulus in the short run, one must be credible in the long run.
So what is the disagreement? Prof Ferguson made three propositions: first, the recent rise in US government bond rates shows that the bond market is “quailing” before the government’s huge issuance; second, huge fiscal deficits are both unnecessary and counterproductive; and, finally, there is reason to fear an inflationary outcome. These are widely held views. Are they right?
As the US government spends an unprecedented amount of money to fix the nation’s economy, there is an equally great need to raise the cash to pay for it. This is accomplished through borrowing, whereby Uncle Sam sells Treasury securities of varying maturity.
For investors, the government bills, notes and bonds are considered a safe financial product because they have a guaranteed rate of return, based on faith in future US tax revenues. The government has been partially funding operations via Treasury securities for decades. This borrowing adds to the national debt, which is now above $11 trillion and is rising every day. Much of that debt is held by private sector, but about 40 percent is held by public entities, including parts of the government. Here’s who owns the most.
Singapore is a flush with different examples of price discrimination. The city’s population is a melting pot of different groups of people who have contrasting spending habits. Many of the local firms have embraced price discrimination to boost profits and a bar called Brewerkz seems to be the best example.
Brewerkz sells mugs, pints and jugs of beer at a desirable location beside the river. At different times of the day tourists and locals are charged different prices for exactly the same product. I arrived last weekend after our school graduation to enjoy a beer with my colleagues at 1pm and was very pleased with the price, $10.00 for a jug of beer. If I had arrived later in the evening at 8pm, I would have parted with $37.00 of hard earned cash for the same privilege. At this price I would have tempted to stick to the water. A sample of prices from the menu is below.
Note: $1 SGD = $0.50 Euro or $0.70 USD
This practice is very common in Singaporean bars and is the extension of the ‘happy hour’ concept. People can also sit and drink the same beer at local hawker food markets for around $6 dollars for a 750ml bottle. Singapore has extreme differences in income levels and high-income inequality. Wealthy investment bankers mingle with poor immigrant helpers and builders living on subsistence wages.
Discussion Questions:
What are the necessary conditions for the practice of price discrimination to occur?
Explain how customers in each different time slot may have different price elasticity’s of demand?
What would occur if the bar could not stop customers from stockpiling and then reselling at a later time (arbitrage) slot to their friends?
Explain how a bar could also use first and second degree price discrimination to maximize profits.
Today’s Wolfram|Alpha is the first step in an ambitious, long-term project to make all systematic knowledge immediately computable by anyone. You enter your question or calculation, and Wolfram|Alpha uses its built-in algorithms and growing collection of data to compute the answer. Based on a new kind of knowledge-based computing… more »
Here in Switzerland I enjoy the luxury of having to pay a relatively small federal income tax of 9.6%. In the US, at my current income level, I would be paying a 25% federal income tax. On the other hand, everything I buy here in Switzerland, from food to clothes to train tickets and bike parts, costs me an additional 7.6% of value added tax. If a product is imported, chances are there is also an additional 20% import tariff. In other words, what I save coming in (because of the low direct tax) I lose going out (through high indirect taxes).
The incentive, therefore, is to save as much of my income as possible. I shop much less than I would in the US where indirect taxes are much lower, but when I do shop prices are much higher. Much of Switzerland’s government revenue comes from the value added tax and other indirect taxes, which means households keep much more of their earned income.
In the United States, where the government has not seen a balanced budget since 2001, there has been much talk about creating a national sales tax to help raise revenue to pay for many of the social plans that the Obama administration wants to pursue, such as national health care. VATs and sales taxes are regressive, which means more of the tax burden is born by low income households compared with high a direct, income tax, which is progressive, meaning the higher a household’s income, the greater percentage it pays. But with budget shortfalls expected to reach $4 trillion over the next four years, new sources of tax revenue are needed.
“Everybody who understands our long-term budget problems understands we’re going to need a new source of revenue, and a VAT is an obvious candidate,” said Leonard Burman, co-director of the Tax Policy Center, a joint project of the Urban Institute and the Brookings Institution, who testified on Capitol Hill this month about his own VAT plan. “It’s common to the rest of the world, and we don’t have it.”
The surge of interest in a VAT is testament to the extraordinary depth of the nation’s money troubles. While some conservatives have long argued that a consumption tax would provide a simpler and more efficient alternative to the byzantine U.S. income tax code, this time it’s all about the money.
To counter claims that a national sales tax is regressive, advocates point out that such a tax would allow the federal government to lower income tax rates for low income Americans, giving them more disposable income to spend on goods and services, which would be more expensive because of the VAT.
Another option the government should consider is a tax on greenhouse gas emissions. Currently, Obama is advocating a carbon permit market, which would be less effective at generating income for the government as permits, once they are issued or auctioned to industry, are bought and sold by firms, creating revenue for companies and not the government. A carbon tax, on the other hand, would create new tax revenue for the federal government and help reduce the negative externalities causing global warming and encourage development of alternative “green” methods of production.
In the short-term, it is unlikely that the US government will legislate any significant new taxes. Carbon taxes have been ignored by the Obama administration and Congress, under the argument that during a recession any new tax on industry might just break the nation’s manufacturing and energy sectors’ backs. A VAT is just as unpopular, for the reason that any policy raising consumer prices puts even greater burden on already strapped household incomes. Tradeable carbon permits are popular for the reason that they appear to be a “market based” approach to reducing greenhouse gas emissions; but Congress is talking about putting a price ceiling on carbon permits of $28 per ton, a price at which the incentives to reduce emissions among firms is minimal.
America’s long period of strong growth, low savings, and deficit financed government spending will necessitate belt-tightening in the near future as ultimately the government will have to start financing its budgets through tax revenues, not the issuing of new debt. Carbon taxes, higher marginal income taxes, or a national sales tax are all options the Obama administration can choose from. For now, it appears it’s choosing none of these, and instead selling more bonds to the public, foreigners, and the Fed, increasing the moneys supply in the hope that households and firms begin spending once more. The path towards fiscal discipline is a hard one to get started on, especially during a recession when no new taxes are politically viable.
Discussion Questions:
What make’s a sales tax regressive if everyone has to pay, say, 10% on top of the regular sales price of a good or service?
How does the US government finance its massive budgets when its revenue from taxes don’t even come close to equaling the amount of spending?
Why is it important for a country, in the long-run, to achieve a balnced budget?
What would you prefer to do: pay a higher income tax or a higher sales tax? What are the pros and cons of direct versus indirect taxes?
A great article outlining the likelihood of “real” versus “financial” crowding-out that may result from the US fiscal stimulus
…the key question is whether government spending that comes into action during recession is likely to crowd out new private spending, dollar for dollar. The answer depends on the extent to which real and financial resources are currently under-utilised.
“Real” crowding out occurs when labour and capital are already fully employed so that further spending exceeds capacity and leads to inflation. The logic of the harm done by inflation is well understood. But the logic of “financial” crowding out is less intuitive and more complex.
Simply put, financial crowding out results from rising interest rates when government deficits put pressure on bond markets. This kind of crowding out is most plausible in the US, which began the recession with the biggest deficit in world history. However, relative to national income, it is not nearly as large as that which Britain ran after the Napoleonic wars. And currently, the biggest as a percentage of national income is Japan’s: almost 200 per cent of its gross domestic product. It doesn’t seem to be crowding out private spending as the Japanese long-term interest rate is still only 1.5 per cent.
Nevertheless, skeptics argue that dramatic doubling of US deficits this year and beyond could leave little room for private sector borrowing. If the US deficit stifles rather than stimulates recovery of its private sector, prolonged worldwide recession is inevitable.
All should read this, it is a powerful exposition of the competing ideologies about the solutions to our global recession:
Following are excerpts from a symposium on the economic crisis presented by The New York Review of Books and PEN World Voices at the Metropolitan Museum of Art on April 30. The participants were former senator Bill Bradley, Niall Ferguson, Paul Krugman, Nouriel Roubini, George Soros, and Robin Wells, with Jeff Madrick as moderator.
—The Editors
Jeff Madrick: It was six months ago now that the Lehman debacle occurred, that AIG was rescued, that Bank of America bought Merrill Lynch; it was about six months ago that the TARP funds started being distributed. The economy was doing fairly poorly in much of 2008, and then fell off a cliff in the last quarter of 2008 and into 2009, shrinking at a 6 percent annual rate—an extraordinary drop in our national income. It is now by some very important measures the worst economic recession in the post–World War II era. Employment has dropped faster than ever before in this space of time.
We have a three-front problem: a housing market that went crazy as the housing bubble burst; a credit crisis, the most severe we’ve known since the early 1930s; and now a sharp drop in demand for goods and services and capital investment, leading to a severe recession. What gives us the jitters is that all of these are related. We have seen some deceleration in the rate of economic decline, and many people are saying that “green shoots” are showing. What is the actual state of the economy, and do we need a serious mid-course correction on the part of the Obama administration?
It’s interesting to me that AP Economics has gotten two major mentions in the mainstream media recently, both asking the same question: Does high school Economics teach kids about the real world anymore?
Both the New York Times and NPR refer to a past AP Macro multiple choice question, this one from the NYT:
Policy makers concerned about fostering long-run growth in an economy that is currently in a recession would most likely recommend which of the following combinations of monetary and fiscal policy actions?
MONETARY POLICY…/…FISCAL POLICY
a. sell bonds…/…reduce taxes
b. sell bonds…/…raise taxes
c. no change…/…raise taxes
d. buy bonds…/…reduce spending
e. buy bonds…/…no change
The correct answer, as readers should know, is e. Buying bonds increases the money supply and lowers interest rates, while choosing not to engage in expansionary fiscal policy means no crowding out of private investment will occur and thus “fostering long-run growth” in the economy.
It’s true, the severity of the current recession has forced the government and Fed to create new monetary and fiscal tricks, but the fundamentals behind a response indicated in answer e. still hold true. Lowering interest rates to encourage private investment is a pro-growth policy for correcting a mild recession.
Anyway, I think it’s worth listening to the podcast from NPR and reading the blog post from the NYT. Definitely read the comments on the blog post too, some interesting points are made by readers.
Are credit markets still “frozen”? Apparently so for small businesses, which account for 80% of America’s economic activity:
Big companies are rushing to issue stocks and bonds to suddenly hungry investors. But credit is still scarce for thousands of mostly smaller companies that rely on bank lending.
U.S. corporations such as Ford Motor Co. and MGM Mirage Inc. raised more than $34 billion by selling stock in the first two weeks of May. At around the same time, Bill Mulrooney, chief financial officer of UniFoil Corp., was setting aside plans to borrow money for new equipment that the company had hoped would boost sales.
“I hear about the credit markets’ freeing, but it’s clearly not the case for small businesses,” Mr. Mulrooney says.
What future threat might the massive US budget deficits pose to America? Here’s what Robert Samuelson has to say…
At best, the rising cost of the debt would intensify pressures to increase taxes, cut spending — or create bigger, unsustainable deficits. By the CBO’s estimates, interest on the debt as a share of federal spending will double between 2008 and 2019, to 16 percent. Huge budget deficits could also weaken economic growth by “crowding out” private investment.
At worst, the burgeoning debt could trigger a future financial crisis. The danger is that “we won’t be able to sell [Treasury debt] at reasonable interest rates,” says economist Rudy Penner, head of the CBO from 1983 to 1987. In today’s anxious climate, this hasn’t happened. American and foreign investors have favored “safe” U.S. Treasurys. But a glut of bonds, fears of inflation — or something else — might one day shatter confidence. Bond prices might fall sharply; interest rates would rise. The consequences could be worldwide because foreigners own half of U.S. Treasury debt.
The Obama budgets flirt with deferred distress, though we can’t know what form it might take or when it might occur. Present gain comes with the risk of future pain. As the present economic crisis shows, imprudent policies ultimately backfire, even if the reversal’s timing and nature are unpredictable.
THE 19th century was dominated by the British Empire, the 20th century by the United States. We may now be entering the Asian century, dominated by a rising China and its currency. While the dollar’s status as the major reserve currency will not vanish overnight, we can no longer take it for granted. Sooner than we think, the dollar may be challenged by other currencies, most likely the Chinese renminbi. This would have serious costs for America, as our ability to finance our budget and trade deficits cheaply would disappear.
Through interactive graphs, ThinkEconomics illustrates basic economic principles that are taught in a college-level introductory economics course. These graphs enable students to develop analytic and deductive reasoning skills by manipulating graphical elements of the economic models. Students also learn how to apply these models to analyze and understand economic phenomena.
Economic models represent causal economic interrelationships that occur in a particular sequence or order. Textbooks offer written explanations accompanied by static illustrations, but they cannot capture or animate the step-by-step dynamics of an economic model. In a classroom, a professor typically draws a graph on the chalkboard, explains its construction, and then uses the graph to analyze the effects of various changes in the model’s parameters or variables. This classroom explanation and graphical manipulations happen only once and the total analysis can be very difficult to replicate in student lecture notes.
With the interactive possibilities of Macromedia Flash and the anytime, anyplace nature of the Web, students can now experience the models as they were meant to be, and in the process, learn to “think economics.” Because of the vector capabilities of Flash, the models do not require a broadband connection for fast downloading and students can easily repeat each model as many times as necessary to understand the economic principle. Animation and interactivity combine to create a greatly improved learning environment.
I thought it might be useful to re-explain why our current predicament can be thought of as a global excess of desired savings — which means that fiscal deficits won’t drive up interest rates unless they also expand the economy.
Here’s what I imagine Niall Ferguson was thinking: he was thinking of the interest rate as determined by the supply and demand for savings. This is the “loanable funds” model of the interest rate, which is in every textbook, mine included. It looks like this:
INSERT DESCRIPTION
where S is savings, I investment spending, and r the interest rate.
What Keynes pointed out was that this picture is incomplete if you allow for the possibility that the economy is not at full employment. Why? Because saving and investment depend on the level of GDP. Suppose GDP rises; some of this increase in income will be saved, pushing the savings schedule to the right. There may also be a rise in investment demand, but ordinarily we’d expect the savings rise to be larger, so that the interest rate falls:
INSERT DESCRIPTION
So supply and demand for funds doesn’t tell you what the interest rate is — not by itself. It tells you what the interest rate would be conditional on the level of GDP; or to put it another way, it defines a relationship between the interest rate and GDP
Below is the loanable funds market at its current equilibrium, according to Krugman (I is investment demand for funds, S is the supply of loanable funds):
In Krugman’s words:
In effect, we have an incipient excess supply of savings even at a zero interest rate. And that’s our problem.
So what does government borrowing do? It gives some of those excess savings a place to go — and in the process expands overall demand, and hence GDP. It does NOT crowd out private spending, at least not until the excess supply of savings has been sopped up, which is the same thing as saying not until the economy has escaped from the liquidity trap.
In AP Macroeconomics, we teach that deficit-financed government expenditure decreases the supply of loanable funds as savers take their money out of commercial banks and invest in the bond market due to the attractive interest rates on government debt. Less funds available for the private sector drives up interest rates and crowds out private investment.
If the economy is producing close to the full-employment level and interest rates are positive, the decrease in supply of loanable funds can indeed drive up equilibrium interest rates and lead to the “crowding-out” of private investment. Krugman points out in this article that when the economy is at the “zero-bound” (i.e. when nominal interest rates are as low as they can go) and the quantity supplied of savings is still greater than the quantity demanded for investment, the government can effectively borrow from the public, decreasing the supply and correcting the surplus of savings without driving up interest rates in the private market. Put another way, the equilibrium interest rate is below zero, but the “zero-bound” acts as a price floor in the loanable funds market, resulting in a surplus of savings.
Government borrowing crowding out private investment is not something we can worry about during a recession, when low confidence and expectations have driven the supply of savings up and the demand for investment down. Public spending will divert funds from the private sector to the public sector, that’s true. But in today’s case, savings are sitting idle in the private sector, so government borrowing is putting those fund to use when the private sector has failed to do so.
Discussion Questions:
Why does the supply of loanable funds (S in the graph above) slope upwards? Why does the demand for loanable funds (I in the graph) slope downwards?
Deficit financed government spending decreases the supply of loanable funds. Why?
Crowding-out is not the only possible down-side of deficit spending by the government. What are some other long-term effects of governments running budget deficits year after year?
Deflation: a decrease in the general price level of goods and services of an economy. Sounds great, right? Lower prices mean the purchasing power of our income increases, making the “average” person richer! On the surface, it could be concluded that deflation may actually be a good thing. And in some cases, it is!
If prices of goods are falling because of major technological advances (think of the price of cell phones and laptop computers over the last 20 years) or because of massive improvements in the productivity of labor and capital (think of the price of manufactured consumer goods during the Industrial Revolution), then deflation could be considered a sign of healthy economic growth. Put in terms an IB or AP Economics student should understand, a fall in prices caused by an increase in a nation’s aggregate supply is good, since it is accompanied by greater levels of employment and higher real incomes. But if the fall in prices is caused by a decline in spending in the economy (in other words, by a decrease in aggregate demand), the consequences can be catastrophic.
It just so happens that the United States, Great Britain, and my own home of Switzerland are all faced with demand-deficient deflation at this very moment. I’ll allow the Economist to elaborate:
…With unemployment nearing 9% (in the United States), economic output is further below the economy’s potential than at any time since 1982. This gap is likely to widen. House prices are not part of America’s inflation index but their decline is forcing households to reduce debt , which could subdue economic growth for years. As workers compete for scarce jobs and firms underbid each other for sales, wages and prices will come under pressure.
So far, expectations of inflation remain stable: that sentiment is itself a welcome bulwark against deflation. But pay freezes and wage cuts may soon change people’s minds. In one poll, more than a third of respondents said they or someone in their household had suffered a cut in pay or hours…
Does this matter? If prices are falling because of advancing productivity, as at the end of the 19th century, it is a sign of progress, not economic collapse. Today, though, deflation is more likely to resemble the malign 1930s sort than that earlier benign variety, because demand is weak and households and firms are burdened by debt. In deflation the nominal value of debts remains fixed even as nominal wages, prices and profits fall. Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. That undermines the financial system and deepens the recession.
From 1929 to 1933 prices fell by 27%. This time central banks are on the case. In America, Britain, Japan and Switzerland they have pushed short-term interest rates to, or close to, zero…
…inflation is easier to put right than deflation. A central bank can raise interest rates as high as it wants to suppress inflation, but it cannot cut nominal rates below zero… In the worst case, rising debts and defaults depress growth, poisoning the economy by deepening deflation and pressing real interest rates higher….Given the choice, erring on the side of inflation would be less catastrophic than erring on the side of deflation.
Discussion Questions:
Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation?
The expectation of future deflation can have as equally devastating effect. Why is this?
What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?
Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?
Deflation or Inflation:Watch the video below, see if gives you any clues as to the causes and effects of deflation. What do you think John Maynard Keynes would say in response to the deflationary fears expressed in the Economist article?
Terms of trade is a term that is often misunderstood by IB Economics students. Simply put, a nation’s terms of trade refers to the relative price of a country’s exports to its imports.
When a country’s imports increase in price, while the value of its exports stays the same, the country’s terms of trade are said to deteriorate. As a nation experiences deteriorating terms of trade, it finds itself moving towards a deficit in its current account, meaning that expenditures on imports are growing more than income from exports, also called a trade deficit.
The United States has run trade deficits for most years since 1970. Since 2004 the US has annually spent over $600 billion MORE on imports than it earned from the sale of its exports. (Balance of trade data going back to 1960 can be found here).
Usually, when a country enters a recession, it would be expected that its balance of trade would improve, since households demand fewer imports and domestic inflation decreases making the country’s products more attractive to foreign households. In fact, in 2008, when the US entered its current recession, its trade deficit actually decreased. Recently, however, due to the weakness of many of its trading partners and a deterioration in terms of trade, America’s recession is accompanied by a deepening trade deficit:
The U.S. trade deficit widened for the first time in eight months during March, as the price and use of imported oil both climbed.
The U.S. deficit in international trade of goods and services increased to $27.58 billion from February’s revised $26.13 billion, the Commerce Department said Tuesday. Originally, the February deficit was estimated at $25.97 billion.
U.S. exports in March slipped by 2.4% to $123.62 billion from $126.63 billion as trading partners bought less consumer goods and cars from the U.S. U.S. imports fell at a lower rate, dropping 1.0% to $151.20 billion from February’s $152.76 billion
Discussion Questions:
How did rising oil prices lead to an increase in America’s trade deficit?
What determines demand for American exports in the rest of the world? Why is demand for American goods and services falling even as their prices decline due to deflation in the US?
Where does America get the money to buy hundreds of dollars more in imports than it sells in exports? What do foreigners do with all the US dollars they earn from their enormous trade surplus with the US?
Why doesn’t the US government simply place tariffs or quotas on imports to try and achieve more balanced trade with the rest of the world? Is this an appropriate response to a trade deficit?
My favorite economics blog, Environmental Economics, points to an article from the Financial times that appears to make a very elementary mistake in its use of basic economics terminology. Read the excerpt and answer the questions that follow.
Shortages stir coffee and sugar prices By Javier Blas and Jenny Wiggins in London Published: May 10 2009
Caffeine addicts face higher prices for their daily fix as the wholesale cost of both coffee and sugar rise sharply because of poor crops and robust demand.
“We are in a dangerous situation,” Andrea Illy, chief executive of Italy’s leading coffee company, told the Financial Times, warning that prices could “explode” due to supply shortages.
Discussion Questions:
Define “shortage”.
Does the rising price of coffee indicate that there are shortages in the market? Why or why not?
Would “poor crops and robust demand” necessarily combine to create a shortage of coffee? Why or why not?
What would lead to a shortage of coffee, based on the economic definition of the term “shortage”.
With appreciation, I re-post his blog here in its entirety. Tim’s “Questions to consider” are perfect for IB and AP Econ students to answer in their Market Failure unit. Read and answer Tim’s discussion questions in the comments:
Today’s Econ 101 topic–actually AED Economics 200 but same diff–the deadweight loss from taxes in otherwise well-functioning markets. In my neverending–futile?–attempt to stay current, I plan to use this example from today’s Wall Street Journal:
Senate leaders are considering new federal taxes on soda and other sugary drinks to help pay for an overhaul of the nation’s health-care system.
The taxes would pay for only a fraction of the cost to expand health-insurance coverage to all Americans and would face strong opposition from the beverage industry. They also could spark a backlash from consumers who would have to pay several cents more for a soft drink.
The Center for Science in the Public Interest, a Washington-based watchdog group that pressures food companies to make healthier products, plans to propose a federal excise tax on soda, certain fruit drinks, energy drinks, sports drinks and ready-to-drink teas. It would not include most diet beverages. Excise taxes are levied on goods and manufacturers typically pass them on to consumers.
…
The Congressional Budget Office, which is providing lawmakers with cost estimates for each potential change in the health overhaul, included the option in a broad report on health-system financing in December. The office estimated that adding a tax of three cents per 12-ounce serving to these types of sweetened drinks would generate $24 billion over the next four years. So far, lawmakers have not indicated how big a tax they are considering.
Proponents of the tax cite research showing that consuming sugar-sweetened drinks can lead to obesity, diabetes and other ailments. They say the tax would lower consumption, reduce health problems and save medical costs. At least a dozen states already have some type of taxes on sugary beverages, said Michael Jacobson, executive director of the Center for Science in the Public Interest.
Questions to consider:
How do you reconcile the seemingly conflicting goals of reducing soda consumption and raising revenues to pay for health care?
Which effect do you expect to dominate: reduction in quantity demanded due to higher prices or increased revenue from higher prices?
Assuming the market for sodas (pop around here) is currently working efficiently, what effect do you expect a new tax to have on consumer well-being, producer well-being, government revenue and total social welfare?
What role do the elasticity of demand and elasticity of supply play in your answers to 1,2 and 3?
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