With more than four million Spanish people out of work this week, the eighth largest economy in the world finds itself once more in a perilous position. In the last twelve months the number of unemployed people in Spain has doubled. Spain now has as many unemployed people as France and Italy combined, and the unemployment rate is nearing the historic highs of 1993.

Click here to view the embedded video.

The type of unemployment in an economy can be classified in different ways. The main types are cyclical or demand deficient unemployment but other forms exist such as real-wage unemployment and equilibrium unemployment. Some economists also refer to unemployed people as structural, frictional, seasonally or cyclically unemployed.

From the graph below we can see that unemployment in Spain has been high for at least the last 20 years, compared to other countries within the European Union.

Source: OECD Factbook 2009: Economic, Environmental and Social Statistics

The cause of growing Spanish unemployment in 2008 to 2010 is related to the collapse of the domestic building boom and the wider global recession. In 2006, Spain enjoyed low interest rates and therefore cheap loans, this allowed developers to build new apartment blocks, houses and commercial buildings with a relatively low cost of borrowing. Spanish people could afford mortgages at low interest rates and therefore purchased houses contributing to the building boom. However, when the flow of “cheap money” ran out in mid 2008 the building stopped and the flow on effects of spending dried up. Falling tourism receipts and less foreign investment have also exacerbated the issue leading to unemployment doubling between 2008 – 2010.

We can classify the form of unemployment, illustrated in the Spanish example as demand-deficient unemployment. It is related to a downturn in the economic cycle. This concept is explained below.

Effects and Solutions

The social and economic impacts of 20.7% unemployment are obvious, but the solutions are less so. Climbing unemployment creates two evils; falling tax revenue as workers no longer earn wages and the increased burden of paying benefits to the four million unemployed citizens. In addition, a series of social problems are often intertwined with high unemployment, these include depression; lose of skills, poverty and higher crime rates. Spain therefore has a few problems to solve this summer. Whilst Spanish people may enjoy a summer by the beach, and a glass of sangria, the government will be hitting the books to find a solution to the problem. Here are a few suggests to get the politicians thinking.

• Use fiscal stimulus to boost consumer and government spending, thereby increasing the demand for jobs. Spain could plan for a budget deficit (expansionary fiscal policy) and fund spending increases though increased government borrowing. Spain’s current level of public debt is 67% of GDP, which is well below stricken Greece at 124%. However, Spain now has to borrow money from international bond markets, which are skeptical about Spain’s ability to pay back this debt. This is despite assurances and favourable rates offered from the European Union this week. Increasing government debt in a period of European financial crisis is a risky option.

• Use loose monetary policy (lowering central bank interest rates) to encourage Spanish people to increase their consumer spending through increased borrowing. If you understand the complexities of the European Union, you understand that all 21-member countries use the same currency and follow the lead of one central bank. Despite one country wishing to lower interest rates, other countries may think differently. Europe can be compared to a train rolling along on a set of rails, with 21 separate carriages. Each European country must follow behind the big engine, there is no room to deviate from the central banks interest rates and all of the countries must move together. Many people have wondered how long the European train would run, before one of the carriages derailed.

• Force Spanish firms to employ more people. Firms have no requirement to hire more people. They may choose to employ more people but will logically offer everyone lower wages to maintain profitability.

• Use supply side policies to bring greater efficiencies to firms though increased on the job training and worker education. This is a long-term solution, which will require large structural adjustments, how Spain produces goods and services and exactly what is does produce. A startling statistic is that the average Spanish university graduate will find their first job at the age of 27, long after they have graduated.

Discussion Questions:

1. How do economists measure unemployment?
2. Explain the causes of increased unemployment in Spain?
3. Explain in a few sentences how expansionary fiscal policy could reduce the rate of unemployment?
4. How could supply side policies be used to reduce the level of unemployment in Spain?

Related posts:

1. The business cycle rears its ugly head!
2. Unemployment and inflation: understanding the Fed’s balancing act
3. The Federal Reserve and the tradeoff between unemployment and inflation

The Fed should focus on deflation | The greater of two evils | The Economist

Deflation: a decrease in the general price level of goods and services of an economy. Sounds great, right? Lower prices mean the purchasing power of our income increases, making the “average” person richer! On the surface, it could be concluded that deflation may actually be a good thing. And in some cases, it is!

If prices of goods are falling because of major technological advances (think of the price of cell phones and laptop computers over the last 20 years) or because of massive improvements in the productivity of labor and capital (think of the price of manufactured consumer goods during the Industrial Revolution), then deflation could be considered a sign of healthy economic growth. Put in terms an IB or AP Economics student should understand, a fall in prices caused by an increase in a nation’s aggregate supply is good, since it is accompanied by greater levels of employment and higher real incomes. But if the fall in prices is caused by a decline in spending in the economy (in other words, by a decrease in aggregate demand), the consequences can be catastrophic.

It just so happens that the United States, Great Britain, and my own home of Switzerland are all faced with demand-deficient deflation at this very moment. I’ll allow the Economist to elaborate:

…With unemployment nearing 9% (in the United States), economic output is further below the economy’s potential than at any time since 1982. This gap is likely to widen. House prices are not part of America’s inflation index but their decline is forcing households to reduce debt , which could subdue economic growth for years. As workers compete for scarce jobs and firms underbid each other for sales, wages and prices will come under pressure.

So far, expectations of inflation remain stable: that sentiment is itself a welcome bulwark against deflation. But pay freezes and wage cuts may soon change people’s minds. In one poll, more than a third of respondents said they or someone in their household had suffered a cut in pay or hours…

Does this matter? If prices are falling because of advancing productivity, as at the end of the 19th century, it is a sign of progress, not economic collapse. Today, though, deflation is more likely to resemble the malign 1930s sort than that earlier benign variety, because demand is weak and households and firms are burdened by debt. In deflation the nominal value of debts remains fixed even as nominal wages, prices and profits fall. Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. That undermines the financial system and deepens the recession.

From 1929 to 1933 prices fell by 27%. This time central banks are on the case. In America, Britain, Japan and Switzerland they have pushed short-term interest rates to, or close to, zero…

…inflation is easier to put right than deflation. A central bank can raise interest rates as high as it wants to suppress inflation, but it cannot cut nominal rates below zero… In the worst case, rising debts and defaults depress growth, poisoning the economy by deepening deflation and pressing real interest rates higher….Given the choice, erring on the side of inflation would be less catastrophic than erring on the side of deflation.

Discussion Questions:

1. Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation?
2. The expectation of future deflation can have as equally devastating effect. Why is this?
3. What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?
4. Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

Deflation or Inflation:Watch the video below, see if gives you any clues as to the causes and effects of deflation. What do you think John Maynard Keynes would say in response to the deflationary fears expressed in the Economist article?

Related posts:

1. Doom and gloom in the headlines as US economy teters on edge of recession…
2. Does free trade really mean lower prices? A debate between two economists much smarter than me
3. Stagflation – a blast from the past could mean trouble for US economy

I love this discussion between John Stewart and former director of the National Economics Council Lawrence Lindsey. Stewart pitches his own version of a fiscal stimulus package to the economist, and is surprised when Lindsey agrees with the plan.

I find Lindsey’s suggestion that a stimulus package should include subsidized mortgage rates to home owners fascinating. According to Lindsey, a homeowner with a $200,000 mortgage paying 6% interest on his loan would save $4,000 per year on interest payments if the government accommodated a refinanced rate of 4%. Millions of Americans currently struggling to meet all of their monthly debt obligations while continuing to put food on the table and participate in the consumer economy would benefit from such a scheme. In its current form, Obama’s stimulus package with its $150 billion or so in tax cuts will only put approximately $500 per year for two years into taxpayers’ pockets.

As a homeowner paying a 6% mortgage myself, I can personally say I’d prefer $4,000 in savings on my annual interest payments for the next 23 years (the time remaining on my mortgage) than I would $1000 in cash over the next two years. The mortgage relief plan would result in nearly $100,000 less in interest payments, freeing that income up to be spent on goods and services and contributing to real job creation.

And check out last night’s “moment of Zen”. While Obama’s stimulus package is not quite $1 trillion, it is darn close. Senator Mitch McConnell puts the vast size of the spending bill into perspective for us:

Related posts:

1. Obama’s stimulus is “the first real test of Keynesian economic policy”
2. Fiscal stimulus, the Swiss way
3. Fiscal Stimulus package passes in Congress – here comes $170 billion, America!

Robert Reich’s Blog: A Bottom-Up Bailout Rather Than Trickle-Down

Berkley professor and former Labor Secretary Robert Reich argues that the $300 billion or so of the Treasury’s $700 billion bailout of the financial markets has mostly been squandered, calling it “the worst type of trickle-down economics”. Reich hopes the Treasury will postpone further disbursements of the bailout funds until the new Administration takes office in the hope that it will go into the hands of consumers, not into the pockets of the big banks’ shareholders.

Click the “play” button to listen to Reich’s commentary on NPR’s “Marketplace”:

Discussion Questions:

1. What is wrong with the way the banks have used the funds the Treasury has given them? Why hasn’t the bailout worked so far?
2. What does Reich mean when he calls the bailout “the worst type of trickle-down economics”?
3. Who does Reich think the remainder of the bailout should go towards helping? What does he mean by a “bottom-up bailout”?

Related posts:

1. The Costs of the Bailout, More Government Debt
2. Federal Bailout of The U.S. Economy: Who’s To Blame?
3. U.S. Financial Crisis!! What Is Really Happening?