Archive for the 'Classical economics' Category

Mar 03 2009

Recession’s effects on small vs. large companies: some evidence in support of the Classical view of self-correction

Why Are Large Companies Losing More Jobs Than Small Ones? – TIME

This is a fascinating, short article from TIME. Before reading it, see if you can answer the multiple choice question below:

Q: Why do small companies lay off proportionately fewer workers during a recession than large companies?

A) Because small firms are less likely to be in the industries hardest hit by a recession (such as manufacturing)?
B) Because small firms are less focused on maintaining profits to satisfy greedy shareholders?
C) Because small companies are able to hang on to employees and even hire new ones during a recession because of all the talent being laid off by big firms.

Still thinking? Well, it’s likely that all three are true to some extent. But it’s the third one that seems most intriguing as a student of economics. Here’s what the article says:

…small companies hire disproportionately more early on in an economic recovery because it’s easy for these firms to find good workers while unemployment is still high—and easy for workers to come across small companies since there are so many of them. Once the economy is chugging along at full-steam and the labor market is tight, larger companies regain the advantage, since they’re likely able to offer more money—and poach from smaller outfits.

Seems pretty straight forward, right? Sure, but the fact that small firms are likely to hire when unemployment is high supports one side in a long-running economic debate over the economy’s ability to “self-correct” in times of recession.

As any student of Macroeconomics learns early on, there are two dominant theories of macroeconomics, both which are represented in the aggregate demand/aggregate supply diagram that we learn and use in AP and IB Economics.

The two models below represent the two opposing views of macroeconomics. First we see the Keynesian model, which shows that when overall demand in an economy falls, unemployment increases drastically and output tanks, plunging the economy into a deep recession. This is primarily because of the “inflexible” nature of wages, meaning that even when unemployment rises, workers are unwilling to accept lower wages and firms therefore are unwilling to hire more workers.

According to Keynesians, the only way to get the economy out of the recession is by increasing overall demand through heavy doses of government spending (case in point, the $775 billion stimulus in the US).

Next is the Classical AD/AS model with a vertical long-run aggregate supply curve. The implication of the vertical AS curve is that regardless of the level of overall demand in the economy, output will always return to the full-employment level, and thus unemployment will always return to its natural level. The major assumption underlying the Classical model is that wages are in fact flexible in times of recession. As unemployment rises, workers will accept lower wages since they’d rather be making less than making nothing at all. As wages fall firms will begin hiring more workers, increasing overall output and decreasing unemployment until full-employment output is restored.

The implication of the model on the right is that government is NOT needed to get the economy out of a recession, because it will self-correct due to the new hiring and production by firms in response to falling wages in the labor market.

The reason this article stood out to me was that it seems to offer some evidence in support of the flexible-wage, Classical model of macroeconomic self-correction. There has been surprisingly little talk among news anchors, pundits and politicians about the likelihood of the US or ANY economy suffering in the global slowdown “self-correcting” as the Classical model would suggest it should. But the fact that small businesses are less likely to lay off workers in a recession and more likely to begin hiring them due to the large number of workers being laid of by big companies offers at least an inkling of evidence in support of the Classical model of flexible wages and macroeconomic self-correction.

Discussion Questions:

  1. Why is laying off workers the first thing big companies do when faced with falling demand for their products? Why don’t they shut down factories instead?
  2. What pressures does a publicly traded company (one that sells stocks to investors) face in times of recession that a small, privately owned business does not?
  3. When the global recession is finally over, do you think more people or fewer people will be working for small companies (less than 50 people) than before the recession? What would you rather work for, a small firm or a large one? Why?

262 responses so far

Feb 03 2009

What will become of the Chinese worker?

FT.com / China / Economy & Trade – China’s 20m unemployed raise risk of unrest

The days of full-employment in China appear to be over. For decades under communism, the unemployment rate in China stood at an official level of 0%. Of course, being guaranteed work by a state-owned farm or steel factory didn’t exactly mean that all adult Chinese were “working”, rather that they were “employed”. The “iron rice bowl” of communism disappeared in the decades following Mao’s death during the period of “reform and opening” begun under Deng Xiaoping in 1979.

Upon its opening to the world markets, China embarked on three decades of transition from command to market economic principles, characterized by near double digit growth. The demand for workers in its export sector, centered mostly in the Eastern cities from Shenzhen in the south to Shanghai and Beijing in the north, led to the largest rural to urban migration in human history, as nearly 300 million Chinese left the countryside to seek employment in the country’s massive export sector.

Today, the very engine of China’s growth is sputtering to a halt. The demand for Chinese exports is falling as unemployment rises and incomes fall among its trading partners in Asia and the West. Subsequently, the flow of labor from the countryside to the city has reversed, and for the first time in its long history, China is experiencing urban to rural migration:

More than 20m rural migrant workers in China have lost their jobs and returned home as a result of the global economic crisis according to government figures, raising the spectre of widespread unrest in the authoritarian country.

By the start of the Chinese New Year Spring Festival on 25 January, 15.3 per cent of China’s 130m migrant workers had lost their jobs and returned from manufacturing centres in the south and east of the country to their home villages or towns, according to Chen Xiwen, Director of the Office of Central Rural Work Leading Group, who was quoting a survey from the Ministry of Agriculture.

What does the new demographic trend mean for the world’s most populous nation? Bad news, most likely. The hope of work in the city dwindles with demand for Chinese products, but the agricultural sector, which is the main source of employment in the countryside, shows little promise of employment for the millions returning home.

China’s farming industry has become less, not more, labor intensive over the decades since “reform and opening”. The acquisition of capital has supplanted the need for human labor in rural farming, which is one of the “push factors” that led to the massive internal migrations to cities in the first place. The “pull factor” leading the masses to the coastal metropolises, of course, was employment in a factory producing goods to be exported to foreign markets.

Today China’s workers find themselves in the worst possible situation. There is now a “push factor” of 15-20% unemployment, combined with the high cost of living and the struggle of living as an outside in a big city creating an incentive for Chinese workers to return to their familial homes in the countryside. But once they’ve returned home, they find the same lack of opportunity that caused them to leave in the first place. Urban unemployment may shrink as a result of the reverse migration of workers, but rural unemployment will rise.

For the first time in decades, China is faced with a problem that only a year ago (when growth reached 11%!) most would have thought it unlikely to ever face: catastrophic unemployment. Economic theory would suggest, therefore, that China is facing a situation where falling demand for its output has led to rising unemployment due to the downwardly inflexible nature of workers’ wages. According to the Keynesian AD/AS model above, if demand for Chinese output is not restored on its own (which seems unlikely as the West enters deep recession), then the government must take an active approach to stimulating demand through expansionary fiscal and monetary policies.

Keynesian theory, formulated during the Great Depression of the 1930’s, says that in times of recession, spending in the economy is unlikely to increase on its own due to the huge increases in unemployment and corresponding lack in consumer and investor confidence. An active role of government, therefore, is needed to supplant the fall in private spending, and create new income, spending, and economic growth.

In contrast to this “demand-side” theory of macroeconomics, the neo-classical economist would argue that China’s government would do best by letting the economy “self-correct” in times of economic slowdowns. The graph below shows that as demand for China’s output falls in the short-run, unemployment will rise and the price level will fall as firms find it hard to sell their output. Because millions are out of work, and because prices are lower, labor will be willing to accept lower wages, encouraging firms to increase their employment of labor, shifting aggregate supply outward and ultimately restoring full-employment at a new, lower price level than before the downturn began. This classical laissez faire theory of “self-correction” has by most account been proven FALSE, as most major recessions, most notably the Great Depression itself, were ended only after massive intervention by the national government.

The most promising solution to the looming social and economic nightmare it faces is for the Chinese government to push forward massive fiscal stimulus plans aimed at putting the tens of millions recently jobless back to work. This may sound like a return to communism at first, but government money can be spent to create jobs in private enterprise, producing goods, services, and infrastructure that leads to real long-run economic growth fueled by domestic, not foreign, demand for Chinese output.

For too long China has depended on demand from the rest of the world to grow its economy. Faced with the largest economic crisis of the modern era, the Chinese Communist Party should take it upon itself to reduce the nation’s dependency on foreign demand, stimulate growth through new public spending on infrastructure, education, health care and social security for the hundreds of millions of Chinese who are left to fend for themselves once they’ve reached retirement age. Meaningful fiscal stimulus aimed at improving the lives of the common citizen, of whom so many have been adversely affected by China’s over-dependence on export-oriented growth, will may be the best response to the most dire social and economic turmoil the country has faced since the end of the Mao era over 30 years ago.

Discussion questions:

  1. What is China’s most worrying macroeconomic problem currently? Inflation? Recession? Unemployment? Deflation? Trade imbalance? Income distribution? Which of these does falling demand for China’s exports affect most?
  2. What are the social and economic costs of rising unemployment and why is it so important for a government to combat it?
  3. Discuss the differences in the Keynesian and the Classical models in their explanation of what will happen to unemployment after a fall in Aggregate Demand.

271 responses so far

Sep 01 2008

McCain and the Republicans: fiscal conservatives? Think again…

Thanks to my friend Jerry from Shanghai for posting this cartoon to his Facebook profile!

How timely, just as my year 2 IB Economics class is studying the pitfalls of expansionary fiscal policy in times of economic slowdowns. Now, many critics would say that Clinton was the luckiest president of recent decades as he happened to ride a wave of technological innovation fueled by the internet that led to unprecedented grown in income and tax revenue during the 1990s. Sustained 5% growth combined with a period of relative peace on the foreign fronts in between the two Gulf Wars allowed Clinton to balance the budget and begin putting a dent in the country’s $3 trillion deficit during his final years in office.

Along come the “fiscally conservative” Republicans and their faithful leader GWB, just in time to evaporate our budget surplus and add $6 trillion to our national debt over the next eight years. Today, after a long period of “fiscal conservatism” the debt stands at $9.3 trillion, and last year’s budget deficit of $400+ billion broke a record for the largest gap between tax revenue and government spending in US history.

Yeah, you can blame it one the times: a War on Terror costing the US roughly a billion bucks a day, a slowdown in new technology creation, diminishing returns on internet investments, out-sourcing of American industry and jobs, yada yada… but the cartoon does hold some truth. The Democratic Party, long labeled as the “tax and spend liberals”, managed to do what few other administrations have done since the ’60s in balancing the budget, proving that the old stereotype is simply wrong.

Some now consider the Democrats the fiscally conservative party, based only on the simple observation that they tend to spend closer to what they collect in taxes. The Republicans, on the other hand, have had no qualms about spending what they DON’T collect in taxes, in other words, running up huge budget deficits through borrowing from the public and abroad. Are the Republicans the an even worse incarnation of the “tax and spend liberals”? Are they the “DON’T tax and STILL spend Conservatives”?

Discussion questions:

  1. How did the Bush administration’s $160 billion “fiscal stimulus package” that sent $600 checks to every American worker demonstrate the Republican party’s willingness to deficit spend.
  2. What effect will deficit spending by the government have on interest rates and private investment in the economy? What is this effect known as?
  3. In times of weak aggregate demand, as in the US earlier this year, what sort of approach would a “supply-sider” recommend as an alternative to Bush’s deficit-financed expansionary fiscal policy?

Comments Off on McCain and the Republicans: fiscal conservatives? Think again…

Mar 21 2008

Growing pains

OECD Cuts Growth Forecast to Below 2% – Bloomberg.com

The Organization for Economic Cooperation and Development predicts a global slowdown in growth. Among its 30 member nations, the OECD predicts growth of below 2% for 2008.

The [OECD] cut its forecast for expansion this year in its 30 member nations to “less than” 2 percent, the weakest since 2003. This “will be a difficult year of lower growth and some more unpleasant surprises,” OECD Secretary General Angel Gurria said in an interview in Oslo. “We have revised downwards a number of our projections.”

Okay, 2% isn’t that bad, right? I mean, it’s still growth. In fact, the OECD believes the strongest growth will be in emerging economies such as China and India, which it predicts will grow at 6.9%. The US and Europe may not enjoy such comfortable rates of expansion in this time of restricted credit, low consumption and investment and dwindling optimism among households and firms.

Jean-Luc Schneider, deputy director of the OECD’s economics department, said the agency is “not yet completely convinced there will be a recession” in the U.S., though it will be “flirting” with contraction. That will affect other OECD economies, especially those in Europe, said Gurria.

While European growth won’t be as “uncomfortable” as in the U.S., it’ll “probably be worse than we know today…”Keynesian AD/AS

In times of macroeconomic weakness as described above, an active role for government may be required in order to stimulate consumption and investment, increase aggregate demand and restore a healthy rate of economic growth.

Keynesian economists advocate an active role for government and central banks in times of recession. The Keynesian school of economics rests on the theory of downwardly inflexible wages and prices, the implication being that in times of declining demand (low investment and consumption), the economy slides into recession characterized by rising unemployment and slow or negative growth. (as illustrated in the graph here)

The classical view of recession, however, holds that as employment and output decline, the price level will fall due to weak aggregate demand. This “flexible price” theory leads classical economists to argue that if left alone, the economy will self-correct because workers will eventually accept lower wages, leading firms to hire more workers, increase output, and restore full-employment (as shown in the graph on the left). No government intervention is needed in such a scenario.

Classical AD/AS recessionKeynesians argue that “flexible prices” are a myth, that in times of recession prices may remain high or even rise (in the case of a supply-shock as illustrated in the graph below). Due to the “sticky prices”, workers are not willing to work for lower wages, thus firms are not able to increase their employment in a time of weak aggregate demand. Without downwardly flexible wages, aggregate supply will not adjust outwards to restore full employment output.

Keynesian economists therefore support action by the government and central banks in times of slow or negative growth. In America today, the mainstream view adopted by most macroeconomic policy makers is still rooted in Keynesian theory, which explains the government’s recent fiscal stimulus package and expansionary monetary policies undertaken by the Fed.

Expansionary policies like a tax rebate, the Fed’s buying of bonds on the open market, and the lowering of the discount rate are aimed at shifting Aggregate Demand outward to restore full employment. The problem is that in addition to weakextended-as_2.jpeg demand, the world economy is simultaneously experiencing rising costs of production as a result of record energy and food prices.

Cost-push inflation and rising unemployment pose a whole new policy challenge for central bankers and politicians. To combat recession in the face of rising prices is tricky, as the trade-off between unemployment and inflation is tenuous. The Phillips Curve illustrates the inverse relationship between the inflation rate and the unemployment rate. To understand the logic of this model it is useful to examine the current challenge face by the Fed.

Both unemployment and inflation are rising in the US right now. The reason for this is the rising costs faced by firms due to a weak dollar combined with high energy and food prices. Normally, a Keynesian approach to recession alleviation would be in order to restore full employment. Stimulating spending through expansionary policies, however, will only worsen the inflation problem.

The “supply shock” faced by America today has caused both unemployment and inflation to increase, which is illustrated by an outward shift in the Phillips Curve. The best policy action in this scenario may, in fact, be to allow the US to enter aPC recession; in other words, no policy, or laissez faire.

If the US and European economies are allowed to experience a significant slowd0wn or contraction in growth, the global demand for commodities such as fossil fuels, minerals, and other raw materials for production should decline, putting downward pressure on these commodity prices. In addition, rising unemployment should eventually result in workers accepting lower wages. The combination of falling commodity prices and wages should encourage firms to increase output, shifting aggregate supply outward and the Phillips Curve inward, restoring full-employment and price level stability.

In all likelihood we will not see the above scenario transpire. Governments and central bankers are already making moves to maintain growth and low unemployment, even in the face of rising prices. The Keynesian/classical debate, however, will continue. For now, at least, it seems as if the Keynesians are still winning the battle of the hearts and minds of political and economic leaders today.

One response so far

May 30 2007

The Hegemony of Neo-classical Economics

Two heterodox economists respond to an article I blogged about last week, Hip Heterodoxy, published in the Nation, written by Chris Hayes.

Challenging Orthodox Economics – Part I | TPMCafe by Thomas Palley

Economics Outside the Mainstream | TPMCafe by David Ruccio

As our year winds down and we begin getting our materials and lessons in order for our next batch of AP Econ students, it’s unlikely we’ll pause to ask a rather important question: “Is the economics I’m teaching my students the correct and immutable truth?”

After all, isn’t economics still a young science? It’s only been a few generations since Smith, Riccardo and Locke laid the groundwork for what has become the mainstream, neo-classical/neo-Keynesian theory that makes up every major economics text and principles course out there. Who’s to say that in another one hundred years these views, products of the late 20th century themselves, will still be considered the correct solutions for dealing with the economic problem?

As mentioned in a previous post “Keynesian vs. Neo-classical Economics – and what is Heterodox Economics?”, the field loosely described as “heterodox economics” raises difficult questions of human behavior and thinking that challenges the neo-classical view of perfectly rational actors and the efficiency and perfectibility of free markets (the view that we teach in AP Economics). David Ruccio, econ professor at Notre Dame, laments on mainstream economists:

All reasonable arguments are accepted in the marketplace of ideas. Except they (mainstream economists) never read any heterodox economics, and have no idea how the hegemony of their favorite theory shuts out all other ideas…That’s the situation that heterodox economists are trying to change. By using economic theories other than those of the mainstream… By forming journals and associations apart from those of the mainstream (in which their ideas never get aired). And by challenging the mainstream conception of the discipline itself
(including its notions of what science is, and what it means to “think like an economist”).

We do heterodox economics, or what some refer to as political economy—as against economics (which, as Chris correctly argues, has become identified with a tiny number of theoretical approaches). We write about rates of exploitation and the role of power in increasing inequality and the existence of patriarchy and structural racism. Not only do we want to argue that economic actors are sometimes irrational or guided by norms and values; some of us also want to analyze economic institutions and events without even starting from individual actors. Or efficiency. Or constrained optimization.

So, do you feel guilty yet about teaching only the mainstream view in your course? Don’t fret, even Professor Ruccio has to teach his students the neo-classical approach; here’s how he deals with the status quo in his courses:

In all honesty, I mostly prefer not to read maintream economics these days. Either it says nothing of interest, or it gets me very angry. But I teach it, and I teach it in a way that is more rigorous than my mainstream colleagues. Because I teach its basic assumptions (and not as a kind of common sense) and because I present alternative views, heterodox economics. And then I read and do heterodox economics, independently of the mainstream. Because if we spend all our time worrying about mainstream economics, attempting to do mainstream economics (with a tweak here and a changed assumption there), we’ll never get around to developing alternatives.

Professor Ruccio makes an important point here. Before students can become agents of positive change, aware and capable of making the world a better place (and the field of economics a better science) they must first know what needs fixing. I know as much as any AP Econ teacher how rushed this course is, how little time is really left for discussions beyond the basic principles in the syllabus; but in the future, I think I’ll challenge myself and my students to take a little time and find out what alternative approaches to the economic problem are being researched, published, and put into action out there. Technology, the web, blogs: these are the tools that will enable us to easily connect our students to alternative, heterodox economics despite the hectic pace of our AP course. And if your school has access to online journal databases, here’s a few suggestions for economics publications that give a voice to heterodox economists like Professor Ruccio:

The Review of Income and Wealth, the Cambridge Journal of Economics, the European Journal of Comparative Economics, Research in Economic History, Industrial and Corporate Change, CES Ifo Economic Studies, the Eastern Economic Journal, the BNL Quarterly Review and The Economist’s Voice.

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