Last Friday my favorite podcast, NPR’s Planet Money, did a feature story called “Switzerland’s too Strong for it’s own Good”. The gist of the story is that the uncertainty over budget deficits and the national debt in the US and Eurozone at this time are causing international investors to put their money into the Swiss franc and Swiss franc denominated assets. Switzerland’s reputation for financial discipline and fiscal responsibility makes it a safe-haven for international investors feeling jittery over the large budget deficits in Euro countries and in the United States.

The Planet Money team discusses why the rising value of the franc poses a threat to the Swiss economy. To understand just how much the franc (CHF) has strengthened against the currencies of its trading partners, examine the graph below, which shows the rise (and recent decline) in the value of the CHF against the currency of Switzerland’s neighbors, the Euro.

As can be seen, earlier this year on CHF was worth only around 0.76 euros, but as recently as August 10 one CHF could buy nearly 0.95 worth of goods from Euro countries. Of course, cheaper imports is a benefit to Swiss households, but what we need to realize is that this upward trend in the value of the CHF also means that all Swiss goods are becoming more expensive to European consumers. And here’s the problem with the stronger franc. Over 50% of Switzerland’s output is exported to the rest of the world (meaning a large proportion of Switzerland’s workers depend on strong exports), and the more expensive the country’s currency, the more expensive the goods produced by Swiss businesses become in the countries with which Switzerland trades.

A simple example would help: A Swiss chocolate bar that sells for two CHF would have cost a European consumer only 1.50 euros in February of this year (when one CHF = 0.75 Euro). But in early August the same bar of chocolate would have cost the European consumer 1.90 Euro, an increase in price of nearly 30%. This may not seem like much to a casual observer, but when you realize that Switzerland’s biggest exports are capital goods and financial services, which cost far more than 2 CHF, a 30% price hike placed on foreign consumers is much more noticeable. If a train engine that sold for 1 million Euros suddenly costs a European transport agency 1.3 million Euros, you can imagine such a transaction would become much less appealing, and demand for Swiss rail engines will begin to fall, putting Swiss jobs at risk.

Here on the ground in Switzerland, the effects of the strong franc have definitely not gone unnoticed. One point of discussion in the podcast is the fact that Swiss retailers have strangely not begun lowering the prices for their imported products. For example, one would expect that a bike shop selling bikes made by American companies in Taiwan would be able to lower its price for those bikes as one franc now buys about 30% more US goods than it could earlier this year. Logically, a $1000 bike that used to cost 1,100 CHF for a Swiss bike shop to import now only costs that shop around 800 CHF to import. The Swiss consumer should begin to see lower retail prices reflecting the lower costs to Swiss importers. Strangely, however, this has not materialized, and most retailers have kept their prices at the same level they were before the rise of franc’s value.

Perhaps retailers are unwilling to lower their prices because they are uncertain whether or not the franc will remain strong, and they would not want to have to be in a situation in which the franc suddenly weakens and their costs rise once again. Perhaps retailers are simply enjoying the greater profits resulting from falling costs and the same high prices. However, as a consumer myself living in Switzerland, I would guess that this is not the case, because I and many other people I know here have reduced the quantity of goods we buy from Swiss retailers. In the age of online shopping, it is now cheaper than ever to order goods like bicycles, clothing and electronics from foreign retailers through the internet.

For example, I recently ordered a bicycle from the United States that sells for $1,100 there. At current exchange rates, I was able to order this bike for only 800 CHF from the US. The same bike in Switzerland has a retail price on it reflecting the US dollar/CHF exchange rate of several years ago, and sells for 1,500 CHF. Of course, any imported product is charged a duty by customs, but even after paying around 160 CHF in duties, I still am saving nearly 500 CHF on this bike. The result is Swiss bike shops selling foreign brands have experienced a decline in sales as consumers like myself have chosen to order their good from foreign retailers, whose prices are much lower due to the stronger franc.

As an American working in Switzerland, I also benefit from the strong franc in that all of my debts are in dollars. I own a house in the States, and still have about four years left on my student loans from grad school. The strong franc reduces the burden of these debts and allow me to keep more of my income in Switzerland, sending home less and less money each month to cover the same expenses back home.

The big question on everyone in Switzerland’s minds right now is whether the rise of the franc will continue, or whether it will return to an equilibrium exchange rate against the euro and the dollar closer to levels seen earlier this year. Swiss exporters (chocolate companies, watch makers and train engine manufacturers) are hoping the franc will fall again. Households, on the other hand, will continue to enjoy the cheap online shopping opportunities, and may eventually enjoy cheaper retail products in Switzerland if importers become more comfortable lowering their prices to reflect the lower costs of their imports.

I predict that the rise in the franc is over, but that in the next few months it will reach an equilibrium against the dollar and the euro somewhere well above its historic level (around 1.5 francs per Euro and around 1.1 francs per dollar). I believe the franc will settle around 1.1 CHF per Euro and around 0.85 CHF per dollar. Once these exchange rates have settled and the wild fluctuations of the last month come to an end, Swiss exporters and importers alike will begin adjusting their costs and prices to reflect the more stable equilibrium to which we will become accustomed.

Living and working in one of Europe’s and the world’s strongest, most fiscally sound economies has its advantages. But in a world of free trade and floating exchange rates, panic among investors abroad has the potential to fire a devastating blast into the ship that is a healthy economy like Switzerland’s. But over time, just like in any speculative bubble, the rise in the value of the franc will stop, it will begin to fall once again, and everyone will come to their senses as import and export prices once again begin to reflect the true exchange rates between the franc and the currencies of its trading partners.

Discussion questions: 

1. Strong is always better, right? A strong army, a strong economy, a strong leader. But when it comes to currencies, strong is often not better. Why is a strong currency potentially harmful to a nation’s economy?
2. How would an increase in online shopping among Swiss households affect the prices Swiss retailers are able to charge for their imported products?
3. How would a Swiss exporting firm, such as Rolex (a watch manufacturer) be affected by the rising value of the Swiss franc? What would such a firm have to do to keep its products at a competitive price in foreign markets?

Other Media Download (15)

• “Economics is the study of money flow between either countries or individual companies.”
• “My definition of Economics is the control of money by a person, organization or nation.”
• “Economics is a complex system that determines and justifies global prices, currency values, and ultimately the success of a nation.”
• “I’d say Economics is the study of how humans use resources including income, investments, taxes and the economy.”
• “I think economics is the study of investments and money. Especially income and outcome, and taxes in the government.”
• “The study of the distribution of wealth and how human beings tend to handle wealth.”
• “A bunch of old men moaning about all of the potentially free lunch oppurtunities they had missed in their youth, passed off as the behaviour of markets.”

As you can see, most students do not yet have a clear definition of the subject in their heads when they start the course, which is perfectly understandable! So I thought I’d start the year off by sharing my definition of economics. Please read the following introduction to Economics then answer the discussion question that follows.

So what IS Economics, anyway? Well, look around you. What do you see? From here in my classroom at Zurich International School, I see five new condominium buildings being built. I can count eight yellow cranes swinging their arms hauling construction materials around their respective sites. Beyond the cranes I see a beautiful forest stretching up a hillside with green sheep pastures and quaint farm houses scattered here and there. I see a church steeple and the rooftops of the businesses down in the village below school. I can just see the tops of cars racing along the A3 highway to and from Zurich and the other cities of central and eastern Switzerland.

Now ask yourself, how did things get to be this way? Why are new condos going up in the midst of Europe’s deepest recession in decades? Why are farmers still able to graze sheep on hillsides when 100 square meter condos are selling for a million francs just below their fields? Why are the ancient forests of the Sihlwald still standing even as development has encroached into most of the region’s  forests and natural ecosystems? How do normal people make enough money to live comfortably in this expensive country? Where do the things we buy come from? Who built this computer I’m typing on and what will I be doing for a living in twenty years?

One of my favorite quotes that to me sums up what economics is all about comes not from an economist, but from the civil rights leader Martin Luther King. In 1967 King wrote:

Did you ever stop to think that you can’t leave for your job in the morning without being dependent on most of the world? You get up in the morning and go to the bathroom and reach over for the sponge, and that’s handed to you by a Pacific islander. You reach for a bar of soap, and that’s given to you at the hands of a Frenchman. And then you go into the kitchen to drink your coffee for the morning, and that’s poured into your cup by a South American. And maybe you want tea: that’s poured into your cup by a Chinese. Or maybe you’re desirous of having cocoa for breakfast, and that’s poured into your cup by a West African. And then you reach over for your toast, and that’s given to you at the hands of an English-speaking farmer, not to mention the baker. And before you finish eating breakfast in the morning, you’ve depended on more than half the world. This is the way our universe is structured, this is its interrelated quality.

Economics is about all the questions I posed above and it’s about all the interactions King describes. Economics is about solving one major problem faced by all human societies going back thousands of years. Economics is about the problem of scarcity. Scarcity is the natural phenomenon arising from the fact that all the world’s resources are physically limited in quantity.

Limited resources alone would not pose a problem if it were not for one characteristics of human beings that makes us truly unique in the animal kingdom. The fact that we have desires and wants beyond our basic physical needs. In the face of humans’ practically unlimited desires and wants, the limited nature of the earth’s limited natural resources gives rise to conflicts regarding the allocation of those resources. Economics is the social science that deals with the allocation of earth’s scarce resources among the competing wants and needs of society. Economists provides society with various tools and techniques for efficiently allocating our scarce resources.

Discussion question:

1. Scarcity of resources has given rise to countless conflicts among and between societies throughout history. Identify one conflict from the past or present that you think the problem of scarcity gave rise to.
2. Some say that many of the environmental problems our world faces to day can be solved by economics. If that’s the case, then they must have to do with scarcity. Identify one environmental problem and explain how it relates to scarcity.
3. Time is one of the scarcest resources. Explain how the decisions you make regarding your limited time in and out of school can be considered economic decisions.

As yet another school year begins, we once again find ourselves returning to an atmosphere of economic uncertainty, sluggish growth, and heated debate over how to return the economies of the United States and Europe back onto a growth trajectory. In the last couple of weeks alone the US government has barely avoided a default on its national debt, ratings agencies have downgraded US government bonds, global stock markets have tumbled, confidence in the Eurozone has been pummeled over fears of larger than expected deficits in Italy and Greece, and the US dollar has reached historic lows against currencies such as the Swiss Franc and the Japanese Yen.

What are we to make of all this turmoil? I will not pretend I can offer a clear explanation to all this chaos, but I can offer here a little summary of the big debate over one of the issues above: the debate over the US national debt and what the US should be doing right now to assure future economic and financial stability.

There are basically two sides to this debate, one we will refer to as the “demand-side” and one we will call the “supply-side”. On the demand-side you have economists like Paul Krugman, and in Washington the left wing of the Democratic party, who believe that America’s biggest problem is a lack of aggregate demand.

Supply-siders, on the other hand, are worried more about the US national debt, which currently stands around 98% of US GDP, and the budget deficit, which this year is around $1.5 trillion, or 10% of GDP. Every dollar spent by the US government beyond what it collects in taxes, argue the supply-siders, must be borrowed, and the cost of borrowing is the interest the government (i.e. taxpayers) have to pay to those buying government bonds. The larger the deficit, the larger the debt burden and the more that must be paid in interest on this debt. Furthermore, increased debt leads to greater uncertainty about the future and the expectation that taxes will have to be raised sometime down the road, thus creating an environment in which firms and households will postpone spending, prolonging the period of economic slump.

The demand-siders, however, believe that debt is only a problem if it grows more rapidly than national income, and in the US right now income growth is almost zero, meaning that the growing debt will pose a greater threat over time due to the slow growth in income. Think of it this way, if I owe you $98 and I only earn $100, then that $98 is a BIG DEAL. But if my income increases to $110 and my debt grows to $100, that is not as big a deal. Yes, I owe you more money, but I am also earning more money, so the debt burden has actually decreased.

In order to get US income to grow, say the demand-siders, continued fiscal and monetary stimulus are needed. With the debt deal struck two weeks ago, however, the US government has vowed to slash future spending by $2.4 trillion, effectively doing the opposite of what the demand-siders would like to see happen, pursuing fiscal contraction rather than expansion. As government spending grows less in the future than it otherwise would have, employment will fall and incomes will grow more slowly, or worse, the US will enter a second recession, meaning even lower incomes in the future, causing a the debt burden to grow.

Now let’s consider the supply-side argument. The supply-siders argue that America’s biggest problem is not the lack of demand, rather it is the debt itself. Every borrowed dollar spent by the goverment, say the supply-siders, is a dollar taken out of the private sector’s pocket. As government spending continues to grow faster than tax receipts, the government must borrow more and more from the private sector, and in order to attract lenders, interest on government bonds must be raised. Higher interest paid on government debt leads to a flow of funds into the public sector and away from the private sector, causing borrowing costs to rise for everyone else. In IB and AP Economics, this phenomenon is known as  the crowding-out effect: Public sector borrowing crowds out private sector investment, slowing growth and leading to less overall demand in the economy.

Additionally, argue the supply-siders, the increase in debt required for further stimulus will only lead to the expectation among households and firms of future increases in tax rates, which will be necessary to pay down the higher level of debt sometime in the future. The expectation of future tax hikes will be enough to discourage current consumption and investment, so despite the increase in government spending now, the fall in private sector confidence will mean less investment and consumption, so aggregate demand may not even grow if we do borrow and spend today!

This debate is not a new one. The demand-side / supply-side battle has raged for nearly a century, going back to the Great Depression when the prevailing economic view was that the cause of the global economic crisis was unbalanced budgets and too much foreign competition. In the early 30′s governments around the world cut spending, raised taxes and erected new barriers to trade in order to try and fix their economic woes. The result was a deepening of the depression and a lost decade of economic activity, culminating in a World War that led to a massive increase in demand and a return to full employment. Let’s hope that this time around the same won’t be necessary to end our global economic woes.

Recently, CNN’s Fareed Zakaria had two of the leading voices in this economic debate on his show to share their views on what is needed to bring the US and the world out of its economic slump. Princeton’s Paul Krugman, a proud Keynesian, spoke for the demand-side, while Harvard’s Kenneth Rogoff represented the supply-side. Watch the interview below (up to 24:40), read my notes summarizing the two side’s arguments, and answer the questions that follow.

Summary of Krugman’s argument:

• Despite the downgrade by Standard & Poor’s (a ratings agency) there appears to be strong demand for US government bonds right now, meaning really low borrowing costs (interest rates) for the US government.
• This means investors are not afraid of what S&P is telling them to be afraid of, and are more than happy to lend money to the US government at low interest rates.
• Investors are fleeing from equities (stocks in companies), and buying US bonds because US debt is the safest asset out there. The market is saying that the downgrade may lead to more contractionary policies, hurting the real economy. Investors are afraid of contractionary fiscal policy, so are sending a message to Washington that it should spend more now.
• The really scary thing is the prospect of another Great Depression.
• Can fiscal stimulus succeed in an environment of large amounts of debt held by the private sector? YES, says Krugman, the government can sustain spending to maintain employment and output, which leads to income growth and makes it easier for the private sector to pay down their debt.
• With 9% unemployment and historically high levels of long-term unemployment, we should be addressing the employment problem first. We should throw everything we can at increasing employment and incomes.
• Is there some upper limit to the national debt? Krugman says the deficit and debt are high, but we must consider costs versus benefits: The US can borrow money and repay in constant dollars (inflation adjusted) less than it borrowed. There must be projects the federal government could undertake with at least a constant rate of return that could get workers employed. If the world wants to buy US bonds, let’s borrow now and invest for the future!
• If we discovered that space aliens were about to attack and we needed a massive military buildup to protect ourselves from invasion, inflation and budget deficits would be a secondary concern to that and the recession would be over in 18 months.
• We have so many hypothetical risks (inflation, bond market panic, crowding out, etc…) that we are afraid to tackle the actual challenge that is happening (unemployment, deflation, etc..) and we are destroying a lot of lives to protect ourselves from these “phantom threats”.
• The thing that’s holding us back right now in the US is private sector debt. Yes we won’t have a self-sustaining recovery until private sector debt comes down, at least relative to incomes. Therefore we need policies that make income grow, which will reduce the burden of private debt.
• The idea that we cannot do anything to grow until private debt comes down on its own is flawed… increase income, decrease debt burden!
• Things that we have no evidence for that are supposed to be dangerous are not a good reason not to pursue income growth policies.
• When it comes down to it, there just isn’t enough spending in the economy!

Summary of Rogoff’s argument:

• The downgrade was well justified, and the reason for the demand for treasuries is that they look good compared to the other options right now.
• There is a panic going on as investors adjust to lower growth expectations, due to lack of leadership in the US and Europe.
• This is not a classical recession, rather a “Great Contraction”: Recessions are periodic, but a financial crisis like this is unusual, this is the 2nd Great Contraction since the Depresssion. It’s not output and employment, but credit and housing which are contracting, due to the “debt overhang”.
• If you look at a contraction, it can take up to 4 or 5 years just to get back where you started.
• This is not a double dip recession, because we never left the first one.
• Rogoff thinks continued fiscal stimulus would worsen the debt overhang because it leads to the expectation of future tax increases, thus causing firms and households increased uncertainty and reduces future growth.
• If we used our credit to help facilitate a plan to bring down the mortgage debt (debt held by the private sector), Rogoff would consider that a better option than spending on employment and output. Fix the debt problem, and spending will resume.
• Rogoff thinks we should not assume that interest rates of US debt will last indefinitely. Infrastructure spending, if well spent, is great, but he is suspicious whether the government is able to target its spending so efficiently to make borrowing the money worthwhile.
• Rogoff thinks if government invests in productive projects, stimulus is a good idea, but “digging ditches” will not fix the economy.
• Until we get the debt levels down, we cannot get back to robust growth.
• It’s because of the government’s debt that the private sector is worried about where the country’s going. If we increase the debt to finance more stimulus, there will be more uncertainty, higher interest rates, possibly inflation, and prolonged stagnation in output and incomes.
• When it comes down to it, there is just too much debt in the economy!

Discussion Question:

1. What is the fundamental difference between the two arguments being debated above? Both agree that the national debt is a problem, but where do the two economists differ on how to deal with the debt?
2. The issues of “digging ditches and filling them in” comes up in the discussion. What is the context of this metaphor? What are the two economists views on the effectiveness of such projects?
3. Following the debate, Fareed Zakaria talks about the reaction in China to S&P’s downgrade of US debt. What does he think about the popular demands in China for the government to pull out of the market for US government bonds?
4. Explain what Zakaria means when he describes the relationship between the US and China as “Mutually Assured Destruction (MAD)”.
5. Should the US government pursue a second stimulus and directly try to stimulate employment and income? Or should it continue down the path to austerity, cutting government programs to try and balance its budget?

The following lesson is a great way to start an IB or AP Economics class for the year. I just tried it this morning for the first time and it went great!

Instructions:

• Before your Econ students arrive for their first full class meeting, remove chairs until there are only half as many as you will have students. I stuck mine in the library, well out of view of the students coming to my class.
• Tell students that the custodian removed the chairs for repairs, or they were taken to another room for a presentation or something. Anyway, you don’t know when they’ll come back and it may be a couple of weeks.
• For now, we are stuck with this many chairs, and we have to figure out a way to resolve this problem!
• Tell the students it’s up to them to decide how our limited number of chairs will be allocated. Have them brainstorm solutions out loud while you write their suggestions on the board.
• Try to come up with 6-10 possible solutions, then have the students vote on the one they would like to see enacted. They can only vote once! Write the tallies next to each option on the board.
• If there is a tie for #1, have the whole class vote between the two or three options you’ve narrowed it down to until there is one clear winner.

Scarcity exists:

• When something is limited in supply and in demand, it is scarce.
• Everyone wants to sit, but the chairs were missing… chairs were scarce.
• Scarcity is a function of both demand and supply. The greater the demand relative to supply, the more scarce something is.

Choices must be made:

• Because scarcity exists, we must make choices about how to allocate our scarce resources
• We had to choose between competing systems for allocating the chairs

Rationing systems:

• When faced with scarcity, a system must be decided upon to ration the scarce items.
• The systems we decided upon ranged from a lottery to first come first serve to a merit-based system.

Something that is scarce has value:

• Everyone wanted a chair, yet they were limited. Because the chairs provide us with benefit, we value them, and are therefore willing to pay to have one.
• Value is a function of scarcity. The scarcer something is, the more valuable it becomes (gold), while less scarce items are less valuable (drinking water).

Consumer surplus:

• Consumer surplus is the difference between what you are willing to pay and what the price is.
• Sofia would have had lots of consumer surplus if she only had to pay $2 , because she was willing to pay up to $10.

Equity versus Efficiency:

• Equity means fairness, while efficiency requires that resources go towards their most socially optimal use, so that those who value something most end up getting that which they value. 
• The tradeoff between equity and efficiency is a major theme of the IB Economics course.
• What is most efficient (an auction to determine who is willing to pay the most for the chairs) may not be equitable (or fair).
• When the richest students end up in the chairs, those with lesser ability to pay feel that they’ve been treated unfairly.
• A lottery in which names would be drawn from a hat to determine who gets a chair is certainly more equitable, but is actually less efficient, since those who get the chairs may not be those who place the greatest value on having a chair.
• Auctioning the chairs assures that those who value them the most will end up getting them, therefore resources are allocated most efficiently.

The Economist – Sticking it to China