FT.com | The Economists’ Forum | Will Americans demand the cars that Congress wants the big three to build?

It’s been driving me nuts, this whole bailout debate. My frustrations are definitely appartent to my students, who have had to put up with my occasional rants about the insanity of the whole affair since the issue came to the media forefront over a month ago. Here are some of the issues that just don’t add up from the perspective of a high school economics teacher:

The three companies asking for a bridge-loan supposedly want the money so that hundreds of thousands (some reports say as many as 2.6 million) jobs can be saved. But how could Ford, Chrystler and GM possibly maintain their labor force in a time of a recession when nobody is buying new cars in the first place? In the parlance of AP or IB Economics, automobiles are normal goods, ones for which demand falls as incomes fall. By definition, a recession in the United States means falling incomes. A government loan may allow the Big Three to keep making cars for the time being, but WHY WOULD THEY KEEP MAKING CARS when falling incomes point to falling demand in the immediate future? Making cars that nobody will buy represents a gross misallocation of the nation’s productive resources, not to mention taxpayers’ money. What is required of these industries is precisely what the government loan will prevent them from doing, DOWNSIZING, meaning the shrinking of their labor force as well as the number of plants in operation.

The US recession can not be avoided by allocating the nation’s scarce resources towards a bailout of the auto industry. In fact, it will be worsened because the capacity of any nation to emerge from a cyclical downturn requires the flexibility of the country’s labor force to adapt to the structural changes the country is experiencing in the era of globalization and free trade. America’s future does not reside in labor-intensive manufactured goods, especially in the production of a very expensive durable good for which demand falls drastically during recessions; specifically, automobiles.

The Finanacial Times Economists Forum approaches the issue of long-term falling demand for automobiles from another perspective. One of the conditions of the Big Three accepting a loan from the federal government is the mandate that Detroit will begin producing more fuel efficient automobiles to assure Americans more affordable, more environmentally friendly alternatives to the gas-guzzling SUVs that have dominated the industry for the last two decades. But here’s the problem, gasoline has fallen to a price as low as it was when SUVs were at their peak popularity back in the early 2000s! As any high school economics student knows, gasoline and SUVs are what we call complementary goods, or two goods for which demand and price are inversely related. As gas prices fall to their 2000 levels, demand for SUVs promises to rise once again, while demand for fuel-efficient automobiles will likely decline, creating market pressures for the Big Three to make not more fuel-efficient cars, but more SUVs instead! From the Financial Times:

The basic problem is that Americans like to drive sport-utility vehicles, minivans and small trucks when gasoline costs $1.50 a gallon…

Consumers may have regretted their behaviour when gasoline prices soared above $4 a gallon, but as gas prices descend, there is no reason to believe that left unchecked they will not return to their gas-guzzling ways.

Indeed, there is a distinct possibility that if they really do increase their small car production, in a few years the big three will be back asking for more help, on the grounds that they are losing money by doing exactly what Congress asked.

The only reasonable solution to this dilemma? If Congress DOES begin mandating that Detroit increase its production of fuel-efficient cars and phase out its manufacture of SUVs, any such requirement should be accompanied by a government-set price floor on gasoline. Several months ago, my colleague and fellow blogger Steve Latter blogged about a proposed price floor of $4 per gallon on gasoline. Such a scheme would likely prove nearly impossible to initiate politcally, but may be exactly what’s necessary to add legitimacy to any government requiremens of Detroit to manufacture fuel efficient automobiles. The FT appears to support such a scheme:

Congress should put their mouths where their money is. They should make binding commitments to ensure higher US oil prices and thereby sufficient demand for fuel-efficient cars and trucks in the future.

Discussion Questions:

1. What message does falling demand in the auto market send from buyers to sellers, and what contradictory message does a subsidy from the government send to auto makers?
2. If the auto makers receive a low-interest bridge loan (subsidy) from the government, how will this actually undermine the efficient functioning of markets in America?
3. Why would a price floor on gasoline be needed to accompany a government requirement that the Big Three make more fuel efficient automobiles after receiving a government loan?

Alternative Currencies Grow in Popularity – TIME

Most of us take for granted that those rectangular green slips of paper we keep in our wallets are inviolable: the physical embodiment of value. But alternative forms of money have a long history, and appear to be growing in popularity. It’s not merely barter, or primitive means of exchange like, say, seashells or beads. Beneath the financial radar, in hip U.S. towns or South African townships, in shops, markets, and even banks, throughout the world people are exchanging goods and services via thousands of currency types that look nothing like official tender

• tags: economics

Posted from Diigo. The rest of my favorite links are here.

This post was originally published in November of 2007. While the analysis is still relevant, data is out of date.

Managing Globalization » Business Blog » International Herald Tribune » Blog Archive » Here’s that silver lining, finally

In IB Economics we’ve been studying concepts relating to balance of trade and exchange rates. The Marshall-Lerner Condition and the J-curve are two concepts that explain the relationship between a the exchange rate for a nation’s currency and the country’s balance of trade. (click on the graph to see a larger version)

Common sense might indicate that if a country’s currency (let’s say the US dollar) depreciates relative to other currencies, then this should lead to an improvement in the country’s balance of trade (economists call this the current account). The reasoning goes as such: a weaker dollar means foreigners will have to give up less of their money in order to get one dollar’s worth of American output. At the same time, since the dollar is worth less in foreign currency, imports become more expensive, as Americans have to fork over more dollars for a certain amount of another country’s output; hence, imports should decrease.

Fewer imports and more exports means an improvement in the country’s balance of trade, right? Well, not necessarily. What matters is not whether a country is importing less and exporting more, rather, whether the increase in income from exports exceeds the decrease in expenditures on imports. Here is where the Marshall-Lerner Condition can be applied.

The M-L condition examines the price elasticities of demand for exports and imports of a particular country. Say the US experiences a depreciation of its currency (as it has over the last year or so). If foreigners’ demand for exports from America is relatively elastic, then a slightly weaker dollar should cause a dramatic increase in foreign demand for American output, causing export income in the US to rise dramatically. On the other hand, if American’s demand for imports is highly price elastic, then a slightly weaker dollar should likewise cause Americans’ demand for imports to decrease drastically, reducing greatly American’s expenditures on imports. If the combined elasticities of demand for exports and imports is elastic (i.e. the coefficient is greater than 1), then a depreciation of a nations currency will shift its current account towards surplus. This is the Marshall-Lerner Condition.

Marshall-Lerner Condition: If PEDx + PEDm > 1, then a depreciation or a devaluation of a nation’s currency will shift the the balance on its current account towards surplus.

So what if the Marshall Lerner Condition is not met? Demand for exports and imports may not always be so responsive to changes in exchange rates. Imagine a scenario where a weaker dollar does little to change foreign demand for America’s output. In this case income from exports may actually decline (in real terms, since the dollar is weaker) as the dollar depreciates. Likewise, if Americans’ demand for imports is highly inelastic, then more expensive imports will only minimally affect Americans’ demand for imported goods, in which case expenditures on imports may actually rise as they become more expensive. In this case, where the elasticities of demand for exports and imports are highly inelastic, a depreciation of the currency will actually worsen a trade deficit. Americans’ import expenditures will go up while export income from abroad will decline shifting the current account further into deficit.

In the article above, some data is presented that points to evidence that in the US today, the Marshall-Lerner Condition is in fact being met:

“Exports in the year through September are up by 12 percent from 2006, while the dollar’s trade-weighted exchange rate dropped by only 6 percent. That means foreigners may actually be spending more – even in their own currencies – on American products. It’s a support that the American economy, and in turn the global economy, can really use right now.

Of course, this process isn’t helping the trade deficit too much, No one, it seems, can change Americans’ taste for foreign products. But it does show, for all to see, that the risks of an open economy are at least somewhat balanced by the benefits.”

An increase in exports of 12% in response to a 6% weakening of the dollar indicates a price elasticity of demand coefficient for America’s exports of 2, meaning foreigners are highly responsive to cheaper US goods.

We can assume that Americans’ demand for imports is highly inelastic, as the article hints at when it says, “imports to the United States, including oil, are still rising in volume and value.” If a 6% weaker dollar leads to an increase in expenditures on imports, then demand must be less than one. In order for M-L Condition to be met, PEDx+PEDm must be greater than 1. Clearly, with a PEDx of 2, the condition is met, and a weaker dollar in leading to an improvement in America’s balance of trade with the rest of the world.

Discussion Questions:

1. What is the J-curve effect? Based on the evidence from the article, where on the J-curve is the US right now?
2. Is America experiencing an improvement in or a worsening of its current account deficit?
3. What determinants of demand are fueling America’s ever-increasing expenditures on imports?
4. What should happen to the elasticity of demand for imports if the dollar remains weak in the long-run? How will this affect America’s position on the J-curve?

How high is China’s jobless rate? | The great wall of unemployed | The Economist

China Faces Unemployment Woes

Unemployment in China is a big deal. The legitimacy of the Chinese Communist Party hinges on its ability to assure  stable jobs and income growth for the 300 million “middle class” Chinese who live in the country’s cities. When the urbanites are unhappy, trouble ensues.

So a dip in economic growth rate into single digits, while we in the West may think of it as silly to fret about, is a major deal for China. Interestingly, according to the Economist newspaper, unemployment data in China is notoriously unreliable; in fact analysts have no clear idea of just how much unemployment there is:

Until the 1990s, the government more or less guaranteed full employment by providing every worker with an “iron rice bowl”—a job for life. But when soaring losses at state-owned firms forced the government to lay off about one-third of all state employees between 1996 and 2002, the official unemployment rate rose only slightly. Today it is 4% in urban areas, up from 3% in the mid-1990s.

But the official rate excludes workers laid off by state-owned firms. Thus at the start of this decade, when lay-offs peaked, it hugely understated true unemployment. Over time, as laid-off workers have found jobs or left the labour force, the distortion will have shrunk. Another flaw is that the official unemployment statistics cover only people who are registered as urban dwellers. An estimated 130m migrant workers have moved from the country to the cities, but there is no formal record that they live there, so they are ignored by the statisticians. After adjusting the official figures for these two factors, several studies earlier this decade concluded that the true unemployment rate was above 10%—and might be even as high as 20%.

The textbook definition of unemployment is the percentage of the labor force actively seeking but unable to find a job. In China, however, the “labor force” only includes the 25% of the country’s population that lives in cities, and the massive number of workers who were fired from state-owned enterprises over the last decade are mysteriously excluded from official figures. 4% unemployment, the official number, puts most developed countries to shame, as it represents extremely low levels of unemployment.

Despite the fuzziness in the figures, one thing is for sure, slower economic growth, even though it is still expected to be between 8-9% this year, means fewer new jobs in China, hence the government’s recent slashing of interest rates to re-invigorate investment and spending in the economy.

…on November 26th the People’s Bank of China slashed rates by more than a percentage point—the most in 11 years—to boost growth. The slowing economy has led factories to cut jobs, and there are mounting fears that the swelling ranks of the unemployed might one day take to the streets and disrupt China’s economic miracle.

An interesting point made in this article is that even continued economic growth in China does not guarantee continued job growth. Basic economic theory holds that when a nation’s output is increasing, employment is also increasing, since growth in output implies increase demand for labor. China, however, is experiencing a different type of growth today than that of years past:

China is creating fewer new jobs than it used to. In the 1980s, each 1% increase in GDP led to a 0.3% rise in employment. Over the past decade, 1% GDP growth has yielded, on average, only a 0.1% gain in jobs. Growth has become less job-intensive, so the economy needs to grow faster to hold down unemployment.

One reason for this is that the government has favoured capital-intensive industries, such as steel and machinery, rather than services which create more jobs… China needs to shift the mix of its growth from industry, investment and exports to services and consumption. To adjust the structure of production requires a further strengthening of the yuan, raising the price of energy, scrapping distortions in the tax system which favour manufacturing, and removing various shackles on the services sector.

More labour-intensive growth would also boost incomes and consumption and so help to reduce China’s embarrassingly large trade surplus. But most important, by allowing more workers to enjoy the rewards of rapid growth, it could help to prevent future social unrest.

Discussion Questions:

1. How does China’s current account surplus result in fewer new jobs than a growth strategy based on domestic consumption would?
2. Why would a stronger RMB contribute to greater domestic job creation?
3. “More labour-intensive growth would boost incomes and consumption and so help to reduce China’s embarrassingly large trade surplus” Discuss this statement.
4. Philosophically speaking, why is there more pressure on the Chinese Communist Party to maintain high growth and low unemployment than there might be on a democratically elected party such as the Republicans in the United States?

• Economics Social Network – Economics Forum, Blogs, Resources and Videos

  Economics Forum, Blogs, Resources and Videos

  tags: economics

Posted from Diigo. The rest of my favorite links are here.

• Flash econ animations

  This is an excellent tool for teaching microeconomics concepts using flash animations. Lessons include short-run production and costs, comparative advantage, profit maximization, and regulating natural monopolies. Great resource for AP and IB Economics teachers!

  tags: economics

• The Journal of Economic Education

  The Journal of Economic Education offers original articles on innovations in and evaluations of teaching techniques, materials, and programs in economics. Articles, tailored to the needs of instructors of introductory through graduate-level economics, cover content and pedagogy in a variety of mediums. Editorial decisions are directed from the Executive Editor’s offices, in the Department of Economics, College of Arts and Sciences, at Indiana University. The JEE is published quarterly by Heldref Publications in cooperation with the National Council on Economic Education and the Advisory Committee on Economic Education of the American Economic Association.

  tags: economics

• Advanced Placement economics | Social Education | Find Articles at BNET

  Here’s a study on the state of AP Economcis written a few years ago… interesting stuff!

  “Who Teaches AP Economics?

  Who is the typical AP economics teacher? According a survey conducted by Edward Scahill and Claire Melican. (2) the average AP economics teacher is a white male with 18.2 years of total teaching experience and 11.2 years of experience teaching economics. The macroeconomics teacher has taught AP macroeconomics for about 5.1 years, while the microeconomics teacher has taught AP microeconomics for about 3.6 years. Both are most likely to have been using the college-level principles of economics textbook written by McConnell and Brue. Less than seven percent of survey respondents indicated that they had not had a single economics class in college, while 22.6 percent indicated they had had three or fewer undergraduate or graduate level economics courses. Only 18.7 percent had majored in economics or economic education.”

  tags: economics

• Financial crisis drives up interest in economics – Nation AP – MiamiHerald.com

  The financial crisis has made “the dismal science” more relevant and immediate to many high school and college students, and they are suddenly paying closer attention in class.

  “Now we can actually see the examples while they happen, instead of relying on history. It’s been the most engaging class ever,” said New York University junior George Schwartz, who dropped macroeconomics the first time he took it, but is so fascinated this time that he has decided to major in economics.

  tags: Economics

Posted from Diigo. The rest of my favorite links are here.

• Greg Mankiw’s Blog: AS, AD, and the New Deal

  Paul Krugman has posted a nice note analyzing New Deal wage policies using the model of aggregate supply and aggregate demand familiar to teachers of undergraduate macroeconomics. The essence of Paul’s argument is that the economy of the Great Depression was in a liquidity trap, which implies that the AD curve is vertical, which in turn implies that policies that adversely shift the AS curve do not affect equilibrium output in the short run. Thus, a policy that under normal circumstances would be bad, such as cartelizing the supply of labor, is not bad under the extraordinary circumstances of the 1930s.

  tags: Economics

Posted from Diigo. The rest of my favorite links are here.

xkcd – A Webcomic – Alternate Currency

Automakers turnaround plans sent to Congress – Dec. 2, 2008

…and hopefully every other American with a functioning cerebral cortex. Ford Motor Company announced today its ambitious plan to cut costs and restore its profitability as it appeals once again to Washington for a $25 billion “low-interest bridge loan” (aka bailout).

The company announced that the salary of Ford CEO Alan Mulally would be cut to $1 a year if Ford actually borrowed money from the government. When Mulally appeared before the House Financial Services Committee last month, he did not agree to the suggestion of such a paycut…

Ford and GM also announced plans to get rid of corporate jets. Mulally, Wagoner and Nardelli were all roundly criticized at a House hearing last month when they admitted they had each flown their corporate jets to Washington to ask for help…

Mulally and Wagoner will be driving to Washington in hybrid vehicles made by their companies when they return to Capitol Hill later this week to make their case for loans. Nardelli is also not planning to fly to Washington but Chrysler has not disclosed any more specifics of his travel plans.

So the CEOs of the three largest auto companies are agreeing to be exploited for one year by accepting a salary of one dollar. The combined savings from the salary cuts of the three companies’ CEOs  equal roughly $6 million, or about 0.024% of the sum the companies are asking for from the government. Selling corporate jets during a recession when demand for such frivolous luxuries is at a record low will also do little to cut the costs of the incredibly inefficient US automakers.

As for any serious cost cutting plans, Ford had little to report:

…the Ford plan is perhaps most notable for what it did not include. The company did not mention that it would be dropping any brand or unprofitable models…

There was also no announcement of additional plants being closed or capacity being eliminated. Ford said it continues to work with its unions and dealers to achieve additional savings, but it did not set any cost savings targets for those discussions.

Ford highlighted many of the cuts it has already made, including closing 14 plants and reducing salaried personnel by 36% over the past three years. The company also touted labor cost savings that would bring the cost of factory workers’ pay and benefits close to those of the nonunion U.S. plants operated by Asian automakers

Real cost savings will only be achieved by the further closing of plants. With the economy in a deep recession and auto sales at their lowest in decades, the demand for new cars is just not there. Until Ford and its American competitors begin adjusting their plant capacities to the realities of market demand, the chances of achieving profitibility seem slim.

Allow me to make a connection between the situation faced by American auto makers and a basic economic concept we are currently studying in Microeconomics class. Firms, as any first year econ student knows, are profit maximizers. In fact, all companies are trying to make the same thing as all other companies, profits. When a firm experiences negative profits, or losses, as American auto makers are today, it can do one of two things to restore profitability: 1) Increase its revenues or 2) Lower its costs. Since demand for new cars is so low, the revenue increasing option is just not there, so American auto makers must reduce costs to restore profits.

There are two main types of costs we study in microeconomics. Short-run and long-run costs. In the short-run, which in the case of the auto industry we can consider the last few months since the financial crisis began, firms can do one thing to lower their costs: reduce the use of labor. Workers can be asked to take unpaid vacations, jobs can be eliminated, work hours can be cut back. In the short-run, plant size is fixed, meaning firms cannot add nor eliminate capital and land resources. The only variable resource is labor. By “reducing salaried personnel by 36% over the past three years” Ford has taken steps to lower its short-run costs of production.

Long-run costs must also be considered when firms are faced with negative profits. The long-run in the automobile industry is considered the period of time over which auto makers can either add new plant facilities or shut down existing facilities, lowering the costs of capital and land to firms. Long-run cost reductions have also been undertaken by Ford, including “closing 14 plants… over the past three years”.

Clearly, Ford has made an effort to reduce short-run labor costs and long-run capital costs by eliminating some of its work force and closing some of its factories in recent years. But today, as the US officially enters what is likely to be a deep, long recession, the announcement by Ford and its competitors that its new strategy for further cutting costs hinges on paying its CEOs one dollar and making them travel across the country in hybrid cars represents a laughable insult to the intelligence of high school Econ students.

Discussion Questions:

1. What is the “variable resource” that firms can use less of in the short-run if cost reductions are needed?
2. In Microeconomics, we sometimes refer to the long-run as the “variable plant period”. Explain the meaning of this concept.
3. The law of diminishing marginal returns would indicate that if Ford were to close additional factories, it would almost certainly have to simultaneously lay off thousands of additional workers. What is the law of diminishing marginal returns and why does it require firms to lay off workers as plants are closed?

BBC NEWS | Business | Sterling rebounds from sharp fall

Americans, are you planning a vacation anytime soon? If so, why not visit LOVELY Great Britain! Why, you ask, would ANYONE want to visit the UK in during this wet, cold season? Well, here’s why I’m buying British this year:

I recently booked a Himalayan ski tour in Indian Kashmir organized by a British company. The price? 1400 GBP, which only three months ago was the equivalent of $2800 US! Today, with the newly weak British Pound, my ski trip to India will only cost me $2100*. In the span of just a few months, the dollar price of this amazing Himalayan ski adventure has fallen by $700! Naturally, Americans like myself now have an incentive to buy British!

What has caused the slide of the Pound in recent months? Here’s the complicated answer:

“The environment of very weak sentiment regarding the domestic economic picture and potential rate cuts alongside equity volatility is keeping sterling very much on the defensive,” said Jeremy Stretch, strategist at Rabobank.

Strategists get paid lots of money to say stuff that 99% of people don’t understand the first time they read it. I get paid very little money to help those people better understand it, specifically, my students. Here’s what Mr. Stretch is trying to say:

A weak economy in Great Britain leads foreign investors to believe that the Bank of England may lower interest rates in the near future. Why would Britain’s central bank lower interest rates? Because lower interest rates create an incentive for consumers and businesses to take out loans from banks and spend money in the economy, which should create new jobs and help prevent a recession in the UK.

If the bank does lower interest rates, this puts “the sterling on the defensive”, in other words, leads to a weakening of the British Pound, as foreign investors looking to put their money where they can earn a decent return on it will be less likely to save in the UK when interest rates fall. “Equity volatility” is a fancy way of saying British stocks have been performing poorly, decreasing their attraction to foreign investors. When saving in British banks becomes less attractive due to expected interest rate cuts, and buying British stocks becomes risky due to their volatility, investors turn to the safest investment in the world, which is… can you guess? United States government bonds!

So how’s this all relate to exchange rates, you ask? Let’s leave this question for readers to answer and discuss in the comments:

Discussion Questions:

1. How does the expected drop in British interest rates affect the demand for British pounds on foreign exchange markets? What does this do to the value of the pound?
2. Why does the stability and safety of US government bonds lead to a strengthening of the dollar in times of global economic slowdowns?
3. How has the recession in the United States further contributed to the weakening of the British pound?

*In fact, I’m too poor to take a ski trip to India this year, I will have to settle for the puny peaks here in the Swiss Alps!