May 29 2008
Archive for May, 2008
May 26 2008
It seem that everyone's speculating about the US economy today. Recession or no recession, that is the question. The economy has even surpassed the Iraq War as the number one issue in the US presidential race! John McCain, who has publicly admitted that economics is not his strong suit, may just find himself in trouble in a general election where the most important concern among voters is the economic situation.
So what IS that situation, anyway? Is the US in a recession? In other words, has real gross domestic, or total output in the US economy, actually declined over the last six months? Technically, the answer is no. My fellow blogger, Steve Latter, explains this clearly here. What is true, on the other hand, is that the current situation shares many similarities to the global economic slowdown that did occur in the 1970s.
In 1973 OPEC, the newly formed oil cartel consisting at the time of only Arab states, reduced its output of oil and cut off exports to the United States in response to US support of Israel in the Yom Kippur War, in which the Israelis officially occupied the Palestinian territories of the West Bank and Gaza and seized the Golan Heights from the sovereign nation of Syria. To punish the US for its position on this conflict, OPEC cut off supplies of oil to the west, driving gas and energy prices upwards by 70%, triggering a supply shock characterized by a decline in total output and an increase in both unemployment and inflation, a phenomenon known as stagflation: a macroeconomic policy maker's worst nightmare.
Recently the world has seen a similar (albeit of a different cause) rise in the price of oil and energy prices. Today the rise in energy prices is driven primarily by rising demand, rather than reduced supply (since the 1970s the OPEC cartel has grown to include many non-Arab nations, making it harder to achieve collusion to restrict output and drive up oil prices). Global demand for oil has risen steadily, driven ever higher due to rapid growth in China and other developing nations, and exacerbated by the falling value of the dollar, the currency in which oil prices are denominated.
The supply shocks of today have combined with falling aggregate demand in the US due to weak consumer spending to slow real growth rates to nearlry 0%. So technically, the US has avoided a recession, but the effect on American workers and consumers may be just as painful as the real recession of the 1970s. In order to prevent the “r” word from becoming a reality today, central banks (including the US Fed) have eased money supplies, lowering interest rates, fueling even greater increases in the price level.
…the global weighted average inflation rate will be 5.4 per cent this year, while the global money market interest rate is currently only 4.3 per cent. This means that global short-term real interest rates are negative – at a time when inflation is rapidly accelerating. As monetary policy has been excessively accommodating for more than a decade, inflationary pressures have built up in the global economy.
Central bankers like Ben Bernanke have to make tough decisions sometimes, weighing the trade-off between unemployment and inflation, and determining their monetary policies based on whatever they deem to be the “lesser of two evils”. Rising energy prices have forced firms to cut either cut back their production and raise the price of their products, both actions that result in less overall spending and output in the economy. Falling house prices have led consumers to cut back their own spending, further reducing demand for firms' output. These factors have all pushed the unemployment rate from around 4.8% a year ago to 5.1% today, which combined with an estimated additional 3-5% of American workers having dropped out of the workforce, (referred to by the Department of Labor as “discouraged workers”) paints a pretty ugly picture of the reality for the American worker today.
The harsh reality of the weak labor market has led Mr. Bernanke and the Fed to pursue an expansionary monetary policy aimed at avoiding further increases in the unemployment rate and decreases in the GDP growth rate. Expansionary monetary policy means lower interest rates, with the goal being increased consumption and investment, both factors that could worsen the inflation problem already experienced thanks to the global supply shock. Evidence indicates that the inflation problem, even in the US where slow growth usually leads to lower price levels, is not going away:
In the US, a survey-based measure of inflationary expectations recently showed an increase to more than 5 per cent. I would estimate there are now several hundred basis points of difference between the current Fed funds rate and an interest rate that would be consistent with price stability in the medium term.
…meaning the Fed, in its attempt to avoid recession and rising unemployment, has created a condition where real interest rates are actually negative, a highly inflationary condition. All this wouldn't be so bad if wages in the US were rising along with the price level. This however, does not appear to be happening:
The main difference between the situation in the 1970s and now is today’s absence of wage inflation, which explains why absolute inflation rates are a little more moderate. I guess this is probably because of some combination of deregulated labour markets and globalisation. But the lack of wage-push inflation is not necessarily good news. Falling real wages mean falling disposable income and tighter credit conditions mean less borrowing for consumption.
Rising prices for energy, transportation and food have put American households in a tough situation. In the past, periods of inflation have often been characterized by rising wages, meaning the full brunt of nominal price level increases was not entirely born by the American worker. Today, on the other hand, a recession has thus far been avoided, but the combination of record numbers of “discouraged workers”, rising unemployment and inflation may make the pain of our current economic situation just as real as recessions of the past.
In the words of billionaire investor and economic sage Warren Buffett just today:
“I believe that we are already in a recession… Perhaps not in the sense as defined by economists. … But people are already feeling the effects of a recession.”
“It will be deeper and longer than what many think,” he added.
- What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?
- What impact do rising energy prices have on the behavior of individual firms?
- Why are low interest rates likely to make the inflation problem even worse?
May 22 2008
What do you believe is the most direct cause(s) of the weakening of the dollar? Is it the trade deficit and/or spending deficits along with increased borrowing overseas? Is it offshoring? Tax cuts? And how direct is the causality of this to oil and commodity prices?
Of course I'll give you full credit in the post for educating me more on this subject. Thanks in advance !
Below is my reply. I am posting it here for posterity, and because I think it may include one possible explanation of the weak dollar within the grasp of IB and AP Econ students:
Keep in mind, I'm no expert here, only a high school economics teacher… but let me just share a few thoughts about one cause of the weak dollar.
I think something you've forgotten to mention in your email is the role that the mortgage crisis has had on the dollar. Much of the debt from the sub-prime mortgage market was held by overseas investors. As home foreclosures picked up late last year, confidence in these mortgage-backed securities plummeted and demand for these American assets fell, thus demand for dollars among foreign investors has fallen with it, depreciating the dollar.
I think the housing market is at the core of a lot of our woes right now. In my econ class we talk about the “wealth effect” of falling home prices on consumer spending. Besides disposable income, the main determinant of overall consumption in the economy is the level of “wealth” among households. Of course, Americans' greatest source of wealth is their homes… and the reason home prices have fallen is a simple supply and demand story, which is within the grasps of anyone who knows how supply and demand interact to determine price in a marketplace.
Low interest rates during the late Greenspan era spurred a period of new home sales, which drove prices up, spurring a building frenzy which shifted supply out. As long as demand increased more rapidly than supply, the illusion that house prices would continually rise was believable, thus buyers could be convinced that an adjustable rate mortgage (ARM) was the perfect type of loan for them. But the rising prices were unsustainable, and when the Fed began increasing interest rates a few years ago, demand for new homes declined, right as inventory was at an all time high. Naturally, home prices began to stabilize then fall, and as the “adjustable” part of all those “sub-prime” ARMs kicked in, monthly payments became too much for some Americans to bear. In an attempt to liquidate their now unaffordable houses, millions of Americans put their homes for sale, while thousands began to default on their loans, both which combined to shift supply ever further outward, putting even more downward pressure on home prices.
The story continues from here: falling home prices mean less “wealth” which means less consumer spending which means less total output in the economy which means less demand for workers which means rising unemployment… aka, RECESSION! And that's where we are today.
So, as you can see I think the housing market is at the core of our problems. The weak dollar too, as demand for American homeowners' debt has declined among foreign investors. Now, in the face of a recession, the Fed has lowered interest rates once again to try and stimulate new spending and investment, further exacerbating the dollar's decline, as lower returns in the US bond market divert investors out of dollars and into more secure investments, such as… you guessed it, OIL.
The falling dollar had encouraged investors to look for stable investments, such as commodities like oil, copper, coal, etc, driving demand and prices for these commodities up, contributing to the cost-push inflation that has accompanied America's economics slowdown.
So yes, it's all connected… rising unemployment, sluggish growth, rising price levels and falling real wages. At the core, however, is the housing market and the “irrational exuberance” that led to a speculative building and buying spree over the last six years: a bubble which began bursting late last year and continues to have a ripple effect across the economy.
Bush's tax cuts and deficit spending just made this whole mess even worse. I did a blog post a while back about the trade deficit with China, budget deficits and the value of the dollar, you can read that here: “Excuse me China, could you lend us another billion?”
Okay, that's all I've got for you today… I hope some of these observations are useful!
May 22 2008
I had an email from a good friend of mine who teaches at Shrewsbury International School in Bangkok in my inbox this morning. He had seen the “SAS Responds” fund-raiding website, which I emailed to my friends last week, and wanted to let me know what his own school was doing to bring relief to the cyclone victims in Burma.
Shrewsbury has teamed up with a travel agency in Yangon that has been sending envoys of relief workers south into the delta to deliver supplies. The letter below is from an agency employee who recently returned from the delta:
People living in Town:
I talked to the local people in town and asked them why they could not help the victims. It seems they have lost all heart. The whole town was damage. In down town, beautiful old houses collapsed into pieces. I really don't know how they are going to built it all up again. Everybody seems very poor even before the cyclone they had to try hard even for daily meals. I really have no idea how they are going to make new houses on top of nothing left. I saw people sitting in the half collapsed houses under the heavy rain. Some people’s houses are in good condition and seem good business but it seems they could not give much help to thousands of people. If they give to some the rest of the people will come and they just can't handle this. So they close the doors.
People living in the villages and rice field.
I saw ruins of thatches and old bamboo in the rice fields. No men there as no land left. All was covered by water. Poor villagers were running after our trucks in desperate need of everything. Men, women, children are sitting each side of the road waiting for the donations. When they saw cars coming they just ran to us. Our truck driver had a hard time not to hit them. We had to advise them to line up to receive donations.
I saw sub-human levels of living. If it rains they get wet then when it is sunny again their clothes are dry again. They only have the clothes that they are wearing. We don't have enough clothes to provide for all of them so they have to fight to get one old second hand T shirt. Dogs seem to know what was going on. They were also exciting to accompany their masters when receiving donation. Kids are just kids. They are amazing that they could still laugh. They waved to us, they smiled at us and ran after us with curiosity. When they received something they ran back to their parents full of joy!
We could not hold tears back when victims are praying and wishing best of luck to all the donors. We had to leave them behind with a heavy heart. This is about villagers we saw on our way.
People living in the refugee camp (monasteries, Pagoda, church, school compound):
We saw people living in monasteries, church, pagoda and schools. These people are homeless. Their properties are totally destroyed. Monks and churches provide them with food and shelter for a while. They don't know how to start their life. We neither. The night we went there it was raining. When we met them in the morning we learnt that last night over 3000 people including monks had to stand all night long due heavy rain. If there is no rain they can sleep on the pagoda platform.
We donated rice bags, potatoe bags, bean bags to give them food. We asked all victims to come and sit to get small bags of rice, soap, instant noodles and potatoes to hold on to the situation till international aid comes (hopefully). We donated to more than 5000 people in the refugee camp and 2000 people on the way by hand to hand delivery. So that we make sure that they got it.
We were so glad that we could make it. It was very tiring and a risky trip but we leart more about life and to know how to value our own lives.
Thank you very much for your kindness and help
Kay Zin Tar (Ms.)
Clearly much relief is still needed for the helpless victims of the Burma cyclone. Please visit the SAS Myanmar Relief page to contribute to Shanghai American School's efforts to help International Development Enterprises bring relief to the Irrawaddy Delta cyclone victims!
May 20 2008
The cute little green alien-looking computer that is the XO PC (aka the “$100 computer” that costs $200) is now available with Windows XP. For anyone who's had a chance to play with one of these machines, the Linux based operating system takes some getting used to for those of us used to the familiarity of Windows.
As it would turn out, education ministries in the developing world, the market the “one laptop per child” program targets for its cheap, durable PC, prefer machines with Windows on them over the unfamiliar Linux system as well:
…some countries, such as Egypt, want machines that run Windows, the most common personal computer operating system in the developed world.
“They said we would be in a much better position with a Windows-capable machine,” he said.
Meanwhile, Microsoft was working on a version of its Windows XP operating system that would work on the relatively low-powered XO computer.
“Lo and behold, they finalized [it] and have a very crisp-running machine with XP on it,” Kane said.
A statement from Microsoft said the Windows XP version of the XO will be capable of using hundreds of thousands of Windows-compatible programs and hardware accessories.
My first thought at this news was, “well, there goes any chance at achieving a $100 laptop for poor children in the developing world…” Windows XP, which retails for aroudn $250 in the rich world, would push the price of an XO from $200 to $450, if Microsoft were to charge the retail price for its operating system, that is.
In fact, Microsoft is making its popular operating system available for $3 per XO, which is probably close to the actual marginal cost to Microsoft of producing additional copies of XP. What's the incentive for Microsoft to make this apparently charitable gesture to the OLPC program?
Mike Cherry, lead analyst for Windows at Directions on Microsoft, an independent software-research firm in Kirkland, Wash., said Microsoft doesn't want cheap Linux-based computers to threaten the dominance of Windows.
“Let's say they put Linux on there, and people say, 'Hey this works pretty good,' and they start looking at it for other applications as well,” he said. Getting Windows onto the XO laptop is one way to prevent this.
“I think it's along the lines of not allowing anybody else to get a toehold,” Cherry said.
Sometimes when companies like Microsoft act in the pursuit of their own self-interest, society as a whole benefits. In economics we call this predatory pricing. Two firms, Microsoft and Linux, are competing for a larger foothold in developing countries where more new PC users are expected to emerge in the coming decades than anywhere else.
In the name of competition and its desire to maintain market share, Microsoft has taken a product that it usually charges the full monopolist price of $250 for and reduced its price to the marginal cost of $3. To prevent all PC users from taking advantage of this massive price reduction, however, the company will only make the $3 version of XP available on the XO, assuring that only the poorest, most technologically deprived consumers benefit from the company's price discrimination.
While the price of the XP ready XOs will be about $10 higher, the ability to run thousands of Windows programs will surely give the OLPC program a greater appeal to education ministers and government officials in the developing world. Don't be surprised if in the near future we begin to see more and more of the little green alien machines in the hands of the developing world's school children.
May 19 2008
Two goals recently voiced by the Chinese leadership: increased consumer spending and reduced inflation. These are worthy goals for policymakers to pursue; if accomplished, they will mean increased well-being for the average Chinese household, which will enjoy more goods and services at lower prices.
The problem is, increased consumption usually means rising prices, as can be clearly illustrated in an aggregate demand / aggregate supply diagram. Household spending makes up somewhere around 40% of China's GDP, exports, government spending and investment account for the rest. Whenever one component of total expenditures increase in the economy, all other things equal, the price level will rise.
Only two things could happen to make the Chinese leadership's goal of increased consumer spending and stable prices a reality: either productivity in the economy must increase more rapidly than consumer spending, shifting aggregate supply outward, or another component of aggregate demand must be reduced more rapidly than consumption increases, offsetting the increase in overall expenditures cause by rising consumption.
So what magical combination of fiscal and monetary policy can be employed to both increase consumption and stabilize the price level? The answer may not rest purely in the realm of domestic macroeconomic policy-making, but rather in the foreign exchange markets, where a weak RMB has kept domestic consumption low and net exports (thus the price level) high. Allowing the RMB to appreciate should make “magic” happen and lead to rising domestic consumption and disinflation simultaneously:
A stronger currency, commensurate with China's increased economic strength, would both tamp down inflation and allow Chinese consumers to buy more goods and services. However, for reasons not entirely clear to me, or few others for that matter, China's leaders are resisting this simple and beneficial solution.
The Chinese leadership's stated goal in prodding their citizens to spend more is to decrease their economy's dependence on exports. If the Chinese, who currently save 50 percent of their incomes, saved less, more of their production would be consumed locally. As a result, China would be less vulnerable to economic downturns abroad. Without a vibrant domestic market, over-leveraged Americans will apparently remain China's most important customers.
A strengthened yuan would lower the real costs of goods for domestic consumers and allow the Chinese themselves to compete more evenly with consumers in other nations to whom they currently send the fruits of their labor. As goods become more affordable in China, the Chinese would naturally consume more. A rising yuan would therefore kill two birds with one stone: it would reverse recent consumer price increases and it would induce Chinese consumers to buy their own products.
Some members of the US Congress estimated sometime last year that the Chinese currency was undervalued by 27%, leading certain politicians to call for an across the board tariff on all Chinese imports to the United States. Such protectionist sentiment was not uncommon 12 months ago, but as America faces its own economic slowdown, compounded by rising inflation and the falling value of the dollar, such calls for more taxes on imports have disappeared from Washington.
The sensible action for the Chinese to take in response to its own overheating economy (letting the RMB appreciate in order to relieve inflation and encourage domestic consumption) could spell economic doom for the US. As China adopts a “strong yuan” policy, its demand for US dollar-denominated financial assets, including government debt, will decline, reducing demand in the US bond market, lowering bond prices and driving up interest rates in the US. Higher US rates will discourage investment and consumption, exacerbating the slowdown already underway in America. Furthermore, reduced demand for US assets by China will cause demand for the dollar to slide in foreign exchange markets. Since much of American's household spending is on imports, inflation will rise in America as not only Chinese goods, but all imports, are now more expensive to Americans.
Usually in economics class, we adopt the frame of mind that economics is not a zero-sum game. In other words, through free trade based on comparative advantage and specialization, individuals and nations will benefit due to increased total output, increased productivity, higher incomes, and greater variety of goods and services produced within and among communities and nations. In the case of China and the US today, on the other hand, we appear to be in a situation where increased consumption by Chinese may be achievable only at the expense of American consumers, who because of rising interest rates and a falling dollar, may be forced to live “within their means” for the first time in decades.
- Why is a strong RMB necessary to simultaneously increase consumption and reduce inflation in China?
- Why would interest rates in the US rise if China adopted a “strong RMB” policy?
- Would Americans be better off without trade with China? What about the statement that Americans will be worse off if China is to achieve greater levels of domestic consumption?
May 19 2008
With the official death count at 130,000 and rising, millions more still need help in the Irrawaddy Delta of Myanmar, where Cyclone Nargis swept through on May 2 destroying homes and lives in thousands of villages.
Shanghai American School is responding to the disaster by sponsoring International Development Enterprises, one of the only international NGOs with people on the ground in Burma. 125 of their staff are already in villages, constructing temporary shelters and providing 200 gallon water tanks to provide fresh water. Their resources are running thin, however, and they need our help.
Follow the link to our fundraising page above, or follow our progress towards our goal of 5,000 GBP in the widget to the right. When you're ready to help out, click on the link and make your donation! Every little bit helps!
With thanks, Jason