Obamas Efforts To Boost Exports Face Hurdles : NPR

President Obama thinks the key to recovering the millions of American jobs lost during the recession lies in boosting exports to the rest of the world:

The plan sounds great. As we learn in AP and IB Economics, free trade leads to benefits for nations that choose to participate in it. Of course, promoting free trade will harm some industries and workers whose jobs end up being “off-shored” or “out-sourced” to countries with cheaper or more qualified labor; but Obama’s hope is that promoting free trade will result in a net gain of 2 million American jobs.

The goal of doubling US exports in 5 years, however, may be overly ambitious. According to the CIA World Factbook, the US is currently the fourth largest exporter in the world, sending just around $1 trillion worth of goods and services abroad in 2009, behind the EU with $1.9 trillion, China with $1.2 trillion and Germany with $1.18 trillion of exports. Obama’s goal to double US exports would propel the US to the single largest exporting nation in the world, putting it right around where the 27 nations of the European Union are today.

To achieve his goal, Obama proposals include three strategies for boosting demand and supply of US exports.

• On the supply side he suggests continuing recent guarantees for payment by foreign buyers. Essentially such a scheme reduces the risks that often accompany international commerce, reducing the “costs” of exporting firms, which in essence increases the supply of exports from the US.
• On the demand side the US must pressure China to revalue its currency. A stronger RMB (and a weaker dollar) will increase China’s demand for US goods and services.
• Also on the demand side, the US should push through free trade agreements with South Korea, Panama and Columbia, which have encountered obstacles among US lawmakers who fear that more free trade may actually mean a loss of US jobs.

Free trade agreements, export payment guarantees and a weaker US dollar in China will help Obama reach his goal. Chances are, however, that it will ultimately be unattainable. Doubling US exports would propel the US to the top of the list of exporting countries, surpassing even China, today’s current leader, by $700 billion more than the country exported last year. The impact on US GDP would undoubtedly be enormous, adding upwards of  $1 trillion to the US economy.

Creating jobs through trade is controversial, as many Americans still believe trade is partially to blame for the loss of American jobs in recent years.

“The average voter in the U.S. has been pretty on the fence about whether they want more trade coming into the United States,” Slaughter says. “The income pressures that a lot of households have faced in recent years have sort of shifted that balance where more voters now are a lot more wary of globalization than they used to be.”

While his goal is lofty, Obama is on the right track towards growing the US economy and promoting job creation. Trade benefits Americans not just because it will increase demand for our goods and services abroad, but because it will lead to lower prices for many of the things we enjoy consuming at home, ultimately increasing real incomes in America while also creating jobs.

The graph below presents a simple explanation of how the above strategies can result in more jobs in US export industries.

Discussion Questions:

1. How does China manipulate the value of its currency? Why is such manipulation harmful to US exporters?
2. How does a government payment guarantee for exporters actually reduce the costs of doing business for US exporting firms?
3. Do you believe that more free trade agreements with countries like South Korea and Panama will create jobs or destroy jobs in the United States? Explain.

In IB Economics unit 5, Development Economics, several strategies for achieving improvements in the welfare of the world’s poorest people are investigated. Foreign aid has been one of the main focuses of economic development strategies over the last several decades. But is aid in the form of development loans and grants from international organizations and foreign governments always beneficial to those who receive it in the poorest countries (the bottom billion as described by development economist Paul Collier)?

In the discussion that follows, Paul Collier of Oxford and Zambian economist Dambisa Moyo argue that the developed world’s focus on aid to Africa, resulting in a trillion dollars in loans and grants over the last 50 years, has missed the mark and completely failed to achieve meaningful economic development. The focus must therefore shift to opening markets, improving governance, achieving security and creating jobs for the poorest people on the African continent. Watch the two videos below, and respond to the discussion questions that follow. [the time in the video where the question is discussed is in brackets]

Part 1:

Part 2:

Discussion Questions:

Part 1:

1. What factors does Paul Collier point to that contribute to the “poverty traps” many African nations find themselves in? [3:07]
2. What have the two main goals of foreign aid policy been over the last 50 years, according to Dambisa Moyo? [4:45]
3. What are the “four horsemen of the African apocalypse?” How does Moyo think these four obstacles to development can best be overcome? [5:14]
4. What is Paul Collier’s opinion of the role of free trade in promoting human and economic development in Africa? What does he think about Africa’s traditional dependence on primary products and commodities? [7:45]
5. Before economic growth and development can occur, security must be achieved. Why is security, according to Collier, the number one obstacle to achieving meaningful development in Africa? [8:30]
6. In a dissenting view, Dr. Jeffery Sachs argues for more aid to Africa. What types of aid does Sachs believe is absolutely crucial for Africa to continue to receive? [10:39]

Part 2:

1. Collier makes the claim that aid may create “moral hazard” in Africa. What is moral hazard and how could reducing aid to African governments actually “force good governance”? [5:30]
2. Is there any historic record of aid working? What strategies accompanied foreign aid that contributed to its greatest historical success? [8:10]
3. What’s the main difference between Europe’s economic successful development during the second half of the 20th century and Africa’s unsuccessful experience during the same period? [9:00]

A week after the earthquake, the Haitian people now speak of day zero plus seven.  Day zero was the day when an earthquake rumbled and shook the shallow bay near Port-au-Prince and crumpled the many fragile houses, hospitals, churches and hotels. The quake did not discriminate against the rich and the poor, but in the months and years to come the world needs to ensure that the country gets a fair chance to rebuild.

Some consider the day of the quake, as the day a new nation began. As Economists we can offer insights about the path to improved living standards, through our understanding of what has worked, and not worked, in other countries.

Haiti has a history which is more turbulent than most.  In 1697 when Spain ceded control of Haiti to the French, much of the land was deforested and the ecology wrecked as sugar fields were planted. In 1804 the republic was founded, and later the dominant political figure was Dr. François Duvalier, and his son who reined as Presidents of the country from 1957 – 1972 (François) and his son till 1987. In 1990 the ruling military junta gave up power and President Clinton sent in 20,000 troops to a country ravaged by HIV and entrenched poverty. Hurricanes in 2004 and 2008 displace hundreds of thousands of Haitian’s and ruined existing infrastructure. But the recent earthquake might be the biggest challenge yet for most fragile and poorest nation in the Caribbean. On the Human Development Index, Haiti is classified as one of the least developed nations in the world at 149th of 182 countries (HDI Report, UN 2009).

After the mourning and eventual stabilisation, the government will need explain what the future holds for Haiti. This is a window of unfortunate opportunity that the government will never see again and mustn’t squander. The developed world has made promises of aid to support the reconstruction, but health care and education, skills and employment must be offered to the people to help the nation grow from the depths of this disaster in a sustainable way. From our learning about Development Economics we can explain strategies appropriate to Haiti.

Former President Bill Clinton who is the UN’s Special Envoy to Haiti, offered a good insight on the nations challenge in his excellent essay in last weeks Time Magazine.

Time Magazine – Jan 14 2010 – Bill Clinton: The Haiti Earthquake

We’ve got to all work together toward a common goal (for Haiti). We have to relentlessly focus on trying to build a model that will be sustainable, so we don’t plant a bunch of trees and then revert to deforestation, or adopt a program to bring power to the country that can’t be sustained, or adopt an economic strategy that is going to wither away in two years.

What the economic strategy will be for Haiti will likely be influenced by the trade agreement with USA called the Caribbean Initiative. This has recently provided an impetus for the clothing industry in Haiti. Hanes, which sells T-shirts throughout North America, produces part of their stock in Haiti in the factories, which are now being protected from looting. These labour intensive industries are important in a nation with approximately two-thirds of labour force unable to find work. The quake and eventual rebuild also offer opportunities to build on existing plans as Clinton explains,

Haiti isn’t doomed. Let’s not forget, the damage from the earthquake is largely concentrated in the Port-au-Prince area. That has meant a tragic loss of life, but it also means there are opportunities to rebuild in other parts of the island. So all the development projects, the agriculture, the reforestation, the tourism, the airport that needs to be built in the northern part of Haiti — everything else should stay on schedule. Then we should simply redouble our efforts once the emergency passes to do the right sort of construction in Port-au-Prince and use it to continue to build back better.

It is evident that Haiti can use this opportunity to develop the country as Clinton explains. In addition, there are many other ways that the country could improve the living standards of the Haitian people. These development and growth strategies could include;

• The development of Fair Trade schemes to improve Haiti producer’s access to world markets.
• Facilitating the provision of small loans through Micro Finance schemes
• Developing the export sector by investing in the transportation infrastructure to transport products.
• Exploring new trade agreements with nations.
• Promoting foreign direct investment in Haiti by multinational companies.

Nevertheless the task is daunting for Haiti. As a UN staff member recently explained to a New York Times reporter, the immediate recovery is complex. The future reconstruction and redevelopment will be difficult, and the road long.

“You’re talking about a country that pre-earthquake had limited resources and capability, and what resources it did have were concentrated in the capital,” said Kim Bolduc, who is coordinating the relief effort for the United Nations. “This context helps explain why this emergency is probably the most complex in history, more than the tsunami, more than the Pakistan earthquake” of 2005. Link

Here are some interesting facts about Haiti

• 40% of the population is under 14 years of age.
• The nations main exports are coffee, mango and other agricultural products.
• 66% of all Haitian’s work in the agricultural sector on small subsistence farms.
• Before the quake foreign aid made up a large proportion of national income. In 2004 over $1 billion was pledged by USA, World Bank and Canada and France. Partly in loans but also in direct assistance.
• In 2006 Haiti was ranked as the most corrupt nation in the world by Transparency International, followed by Burma and Iraq.

Sources:

http://www.nytimes.com/2004/07/21/world/1-billion-is-pledged-to-help-haiti-rebuild-topping-request.html

http://news.bbc.co.uk/2/hi/business/3522155.stm – Haiti: An economic basket-case.

http://news.bbc.co.uk/2/hi/business/6120522.stm – Transparency International

https://www.cia.gov/library/publications/the-world-factbook/geos/ha.html – Haiti – CIA World Factbook

http://www.flickr.com/photos/un_photo/ – UN Photo stream, Creative Commons

http://topics.nytimes.com/top/news/international/countriesandterritories/haiti/index.html – New York Times, Haiti News.

Discussion Questions:

1. In your opinion, what is Haiti’s most valuable resource endowment? Explain.
2. Choose two development or growth strategies and explain how these could be implemented in Haiti.
3. Evaluate the strengths and weaknesses of each strategy.
4. How could corruption be a barrier to the future development of Haiti?
5. What do you think Haiti will be like in 20 years?

Just a few weeks ago, the U.S. Government’s Commerce Department provided its first estimate of the country’s 3rd quarter (July-September 2009) gross domestic product or GDP, announcing an estimated annualized quarter over quarter growth of 3.5%. GDP reports are of special interest to countries since they provide an important macroeconomic measurement of how much an economy’s goods & services supply and income has grown, or recessed, compared to the last three calendar months.

Let me try and make the concept of GDP easy to understand and why it is considered perhaps the most important, single macroeconomic measurement.

GDP is simply a calculation that measures the market value (final price) of all the final goods and services produced within the borders of our country. Thus, U.S. GDP includes Toyotas produced in Alabama but excludes Cadillac’s made in Canada. GDP includes all U.S. exports but excludes all U.S. imports since imports, by definition, imports are produced in some other country and are a more direct employment benefit of the foreign country’s GDP.

If you think about it, ultimately our country’s economic satisfaction is best measured by the goods and services that are produced and that we have access to, which is why GDP is the measurement that is synonymous with “economic growth” or growth in goods & services for its citizens. In addition, rising GDP (more goods and services) is the ultimate economic goal of any economy which can best be accomplished through the means of the two other key macroeconomic measurements of employment and productivity, which are not the subject of this particular blog.

Let’s describe how the GDP calculation is made. Each quarter, the Government compares the final value of the domestic goods produced and services rendered in the current quarter to the final value of the goods produced and services rendered in the previous quarter. The calculation then takes the percentage gain, current quarter versus previous quarter, and annualizes the percentage. The comparison is always restated for inflation so that the figures are comparable from one period to the next. For purists, we call this “real GDP” which is the only GDP reported by the media, even though the word “real” is almost always dropped to avoid confusion with the average citizen. For example, the third quarter 2009 U.S. GDP report highlighted a 3.5% GDP annualized growth rate. This means that the second quarter final value of goods and services produced was approximately .87% or 3.5%/4.

Now let me get to my favorite point on GDP, which even many economists lose sight of. GDP growth is precisely the same as income growth! For example, in the second quarter of 2009 we can say that incomes for American households and American citizens grew by 3.5% restated for inflation. Said another way, our country’s purchasing power grew by 3.5% which represents the income to produce the increasing supply of goods and services. You probably never thought about it this way but every time you purchase something, every dollar you spend is going to someone as income, whether it is the workers as wages or benefits, the landlords as rent, a bank that has made a loan as interest income, or to the owners of the business as profits. I tell my students that Real GDP = Real Income and the only question is how that real income is dispersed among owners (profits), workers (employee wages and benefits), lenders (interest), and lessors (rent). Many citizens are unaware that the Government calculates GDP both in terms of the final market value of the goods and services PRODUCED (the “expenditure method”, which is the version that the media uses, as well as how that same production value under the “expenditure method” translates to higher incomes in a GDP version called the “income method”.

I find the preceding paragraph, GDP = Income, to be a break through moment for a lot of citizens, or first time economic students, in truly understanding the value of the GDP measurement. It is easier for most to think in terms percentage growth in income in lieu of a fuzzier wording like GDP percentage growth. Most citizens are surprised to find that our national incomes or GDP, restated for inflation, increased by 17.4% from 2000 – 2007, just prior to the onset of this current recession. This 7-year growth rate in GDP or incomes still equates to a below average historical average performance. More specifically, over the last 7 years our average annual GDP or income growth rate was only 2.2% versus our historical average growth rate of 3.2%. However, the final point of caution is that the GDP or income growth rate is a collective average, thus the growth in GDP or incomes does not indicate how those income gains are accruing to the various socioeconomic classes or professions. That is also a topic of a future blog on “income distribution” or equality.

Discussion Questions:

1. Have you ever thought about substituting the word “income” for “GDP” to understand GDP more simply? Why are the concepts of income and GDP inter-changeable?
2. Which four groups earn the income generated by the production of goods and services?
3. Although GDP has still risen this decade, despite the current severe recession, many analyses show that our nation’s middle class has made virtually no real income gains this decade. How could this be so if GDP = Income and our GDP has grown this decade?

World Economic Forum – Latest Press Releases

The World Economic Forum, a group of researchers, leaders, educators, entrepreneurs and others with a vested interest in global economic performance, assembles an annual list of the world’s nations ranked according to “competitiveness”. This year, for the first time ever, the United States does not top this list, instead, Switzerland has been promoted to the status of global competitiveness leader.

What does this ranking really mean?

Competitive economies are those that have in place factors driving the productivity enhancements on which their present and future prosperity is built. A competitiveness-supporting economic environment can help national economies to weather business cycle downturns and ensure that the mechanisms enabling solid economic performance going into the future are in place.”

Competitivness means a nation posesses an evnvironment that leads to improvements in the productivity of its resources, most importantly labor. America, with record budget deficits, in the trillions of dollars, faces a future of tight budgets financed by government borrowing, which eventually means higher taxes and less ability for government to spend on public goods like education and health.

America’s demotion in the rankings is attributable to falling expectations about the country’s future growth potential rather than concerns about its current economic slowdown. Switzerland has also been in a recession for the last year, although due to targeted fiscal policies unemployment has remained low, near its level before the recession begain (around 4%).

The index used to rank countries is based on several factors:

The GCI is based on 12 pillars of competitiveness, providing a comprehensive picture of the competitiveness landscape in countries around the world at all stages of development. The pillars include Institutions, Infrastructure, Macroeconomic Stability, Health and Primary Education, Higher Education and Training, Goods Market Efficiency, Labour Market Efficiency, Financial Market Sophistication, Technological Readiness, Market Size, Business Sophistication, and Innovation.

Discussion Questions:

1. How can a nation’s labor productivity be improved by making policies aimed at improving three of the factors measured by the GCI identified above?
2. How does America’s gigantic budget deficit ($1.8 trillion) threaten its future ability to provide its citizens with the “pillars” identified above?
3. Does economic integration with the global economy improve or limit a country’s ability to achieve economic competitiveness? Explain your answer.

I wonder how many people in countries like Switzerland, Brazil, Canada, Russia, and China, and the United States would be surprised to learn that prices of products and services in their countries have become much less expensive over the years.

Say what? You must be crazy, you say! Prices are rising way too fast!

Yes, most citizens see their purchases as becoming more expensive when, in actuality, things are becoming less expensive. Of course, the paradox is that although nominal prices (the actual price tag) are, in fact, increasing, nominal income (the average wage or salary) has been growing faster. This is a topic that in economics is called “real income” or a measurement that compares a nation’s income growth relative to the growth in prices that the same income buys.

Let’s take some specific facts for the United States:
In the United States real median household income grew from $41,318 to $50,811 from 1970 through 2006 for a total percentage gain of 23% (source: Pew Research Center). Both of the aforementioned median household incomes are stated in 2008 or current dollars which makes the comparison valid. Median household income is an attempt to quantify the progress that the “middle American” family or typical family has made. So, in short, the median household in America can buy 23% more with their income today than they could in 1970. In other words, relative prices are lower to income.

If we look at the same United States income data over the same period for real average household income, there is real income growth of nearly 60%. The higher growth (60%) in real incomes for the average household versus the median (middle) growth rate (23%) is explained by the fact that much of the growth in United States’ real incomes has accrued disproportionately to the college educated & entrepreneurs driving up real income growth rates much faster for the average than the median or middle household. (Hint: continue your education!)

Now let’s get back to the main premise of the title of this blog and the opening assertion that prices are lower than ever. What we are really saying is that you have to benchmark price increases to income increases to really understand whether things are becoming more expensive. The vast majority of products & services are cheaper today in all nations than they have ever been before, which helps explain, excluding the effects of the current recession, why more citizens than ever before can afford to own their own houses, drive more and better cars, and are likely to have cable, cell phones, and computers. The reason we are led to believe differently is because we are victims of our own human nature, which often causes us to focus on the problem areas (rising prices) and not the benefits (incomes that are rising faster). Most citizens’ focus expands out to the last dollar of their incomes and they quickly notice those select products that are rising faster than others like health care, gasoline prices, and education! Hey, even gasoline prices are not at an all relative price high. If gasoline prices in the United States are restated for inflation, or set to comparable 2009 dollars, they are $2.60 per gallon today vs. $3.17 in 1981 and $3.50 in 1918!

Now, you may say to yourself that statistics can lie or mislead and you are sure in your gut that things are getting more expensive relatively. You can try to validate that incorrect “gut feeling” by examining whether your country’s middle class is enjoying less or more products and services. “Real income” really is just a measurement of the quantity and quality of products and services that you have. For example, the average American household has larger homes, more cars, more air conditioning, more gadgets, and better healthcare & prescription drugs than, say, 20 years ago.

But let’s end this blog with a concern. Although everything noted above is accurate, the pace of real income growth has been relatively slow over the last 10 years, especially for the middle class in the United States. Most of that growth in real income mentioned above has occurred up until this current decade. For the last 10 years, median family income growth in the U.S. has been very small and the average income growth has been higher but below the U.S. historical experience. There are many reasons for this slowdown in real income growth, but three big reasons are that

1. the U.S. has now had two recessions this decade (2001 and 2007-current, versus our historical average of only 1 per decade), and
2. energy and health care prices have risen much faster, and
3. foreign labor competition and technology advancement has kept the uneducated/unskilled U.S. workers real income relatively stagnant. More than ever before, a good education is the ticket to your economic future!

Discussion Questions:

1. Inflation is bad, right? Well, what if average prices rise by 2% a year but average incomes rise by 3%. What happens to real income in this situation? Is the average household better or worse off in such a scenario?
2. How have trade and globalization contributed to rising real wages in America and Swizerland?
3. How have trade and globalization contributed to falling nominal wages in America and Switzerland?
4. How do improvments in technology contribute to rising real wages in both developed and developing economies? What about health and education?
5. What types of policies can government pursue to help raise the real wages of the nation’s workers?

Now is that time of year when thousands of high school and college students across the world will be taking their very first economics course. Perhaps it will be a basic, high school introductory economics’ course, or perhaps an even more challenging AP or IB economics’ course. Or perhaps you are a freshman or sophomore in college taking an introductory macroeconomics or microeconomics course.

Whatever your situation, you will soon read that all introductory economic text book authors make the point, usually in their respective text’s first chapter, that a primary benefit of studying economics is that it aims to transform one into a more effective and influential citizen by enabling one to better understand and conclude on the economic positions and promises of those running for public office. The underlying logic is that a citizen or voter that is well-versed in basic economic principles will be a smarter citizen and more likely to vote for the political candidate or referendum that will deliver the greatest economic gain for the citizens of the locality, state, and/or nation. In fact, this “economics for citizenship” reason is why a growing number of states now require completion of a basic economics course as a requirement for high school graduation.

In my classroom, I informally call the study of economics “the 180 degree science” because as the student studies this social science for the very first time they often develop conclusions that are precisely the opposite (hence, the “180 degrees”) of what they had originally believed before taking their first economics course.

For example, here are two “180 degree moments”, which are applicable to the United States’ economy, that you may well learn in your first year economics’ course:

1. Pre-Econ Course or Uninformed View: “We don’t make anything anymore in America. America’s manufacturing prowess is in a state of constant decline. It seems like almost everything bought and used in the U.S. is made in China”

Post-Econ Course and 180 Degree View: Right before the recession hit in 2007, the U.S. was manufacturing approximately 2.5 times more in dollar value than China and is still today the largest manufacturer in the world. The dollar value of manufactured goods in the United States, restated for price level changes so the comparison is accurate, is up over 50% for the last 13 years ending in June of 2007, just prior to the recession! Yes, it is true that the U.S. has lost several million jobs in manufacturing over that same time period, but that is primarily due to rising manufacturing productivity (think machines & technology replacing humans), where the U.S. can now produce more valuable manufactured products than ever before freeing up those displaced manufacturing workers who now have found or must find employment in other more labor-intensive service-related businesses.

Moreover, the US has maintained its percentage share of rising global manufacturing product over that same aforementioned time period, whereas other countries, such as Japan and Germany, have actually decreased their percentage share of global manufactured product. More specifically, in 2006 U.S. manufacturing revenue, profits, exports, and productivity per employee reached their all time peak! Of course, with the current recession and the regression of the U.S. automobile industry, manufacturing levels are now below the levels of 2006. According to government statistics, manufacturing still accounts for slightly over a third of our economic activity and the U.S. will continue to grow in production value, although manufacturing will continue to decline as a percentage of overall economic activity as the United States is growing faster in services than in manufacturing.

2. Pre-Econ Course or Uninformed View: “It is patriotic for U.S. citizens to “buy American” so that we can help our own economy. When we buy foreign products (i.e., exports), in lieu of American products, we hurt our U.S. economy as we lose American jobs and incomes. I hope the recently passed stimulus bill monies will be spent entirely on U.S. products and services.”

Post-Econ Course and 180 Degree View: The U.S. will benefit the most economically if Americans buy what they consider to be the very best product, in terms of price and quality, regardless of whether it is a foreign-produced product or an American-produced product. One of the greatest “ah-ha” moments in all of economics is when an economics’ student or citizen learns for the first time that every time a U.S. buyer purchases a foreign product (i.e., an “import”) that those same U.S. dollars spent on the foreign product circle back to a U.S.- based company, not a foreign company. Yes, I am telling you that when you (or Wal-Mart, for example) buy Chinese shirts, your same U.S. dollars spent quickly end up in the hands of, say, an Apple, Microsoft, IBM, or General Electric to maintain or increase U.S. employment, profits, and stock prices!

Let me try to explain this concept in more detail so that I may actually be able to convince you of this amazing “180 degree” revelation. I always say the more accurate slogan should be “Buying American is Un-American”, since it creates a weaker America!

Let’s say that the United States (we’ll say Wal-Mart) decides to buy some shirts costing $400 from a Chinese shirt manufacturer, in lieu of buying similar shirts from, say, a shirt manufacturer in Elon, North Carolina (USA). The first key point is that when Wal-Mart buys the shirts from China for $400 it can only pay China with US dollars. Why? Because Wal-Mart has only US dollars! It has no Chinese currency (Yuan). It literally drains its bank account of US dollars that are transferred/paid to China! The second key point is that when China receives that same $400 US dollars for the shirts, China cannot, unfortunately, spend any of the $400 in its own economy since only the Yuan is accepted as a medium of exchange in China! China is now forced to either throw the U.S. currency away (not advised!), or immediately spend the money back to the USA (advised!).

In summary, China has initially traded a product (shirts!) for paper (US dollars!), and those US dollars cannot be spent in China. For China to receive any value at all for the shirts it sent to America, China must now spend the $400 back into the US economy for, say, a few i-Pods from Apple (USA). Cutting through to simplicity, in essence, it’s almost as if Wal-Mart (USA) just paid Apple (USA) $400 directly! Yes, the economic “punch line” is that all spending by the domestic nation on foreign products (imports), in turn, are spent immediately back to the domestic nation increasing or maintaining that domestic nation’s employment, income, and standard of living.

And, yes, let’s not forget about that Elon, North Carolina shirt maker that did not get the original $400 from Wal-Mart in our above example! Any good economy promotes competition and I will be excited to see if that North Carolina shirt manufacturer can “raise their game” (increase productivity and/or quality), and hopefully get the next shirt contract from Wal-Mart! If not, well, that North Carolina firm may just have to close down. But remember the key point is that the $400 spent for the Chinese shirts went to Apple, in lieu of the Elon, North Carolina shirt manufacturer. If Wal-Mart would have “bought American” by buying from the Elon shirt manufacturer, even though the Chinese shirts were preferable, Wal-Mart would have prevented the more effective U.S. business (Apple, in this example) from getting your U.S. dollars by giving them to the less efficient Elon manufacturer. In short, you would have contributed to American inefficiency and mediocrity, hurting our country! And that is un-American!

Now, you may be thinking the following if you have a little economics’ background: “But the US has a growing trade deficit with China, so China may not immediately buy those i-Pods from Apple for $400. And, you are correct, but that is also not a problem for either the United States or China. What China is really doing right now is deciding to temporarily save or invest a minority percentage of their US dollars received from U.S. import purchases. Said another way, China is not buying as many US i-Pods as the US is buying Chinese shirts and, of course, we call that situation the US trade deficit which immediately seems to speak “problem”. But it is really not as big a problem as most people think! China is still spending their “saved” US dollars back into the US economy, but in different ways. China is saving and investing some of those US dollars directly into the United States economy by building plants in America, buying US stock to fund American companies’ expansions, and temporarily saving some of their dollars, for future US purchases, by buying US bonds to help the US government pay for other US government initiatives necessitating borrowing. Eventually, China will sell these US bonds and be forced to use those U.S. dollars to buy those i-Pods or build more plants in America to employ more Americans!

I decided to highlight this particular “180 degree moment” because of the fact that the recently passed $800 Billion U.S. stimulus bill has some “buy American” provisions within it. Based on my intuition, I believe that over 95% of adult Americans believe that these “buy American” clauses somehow help our economy more so than if the stimulus bill was silent on “buy American”, thus allowing stimulus money to be spent on foreign-produced products as well. Yes, it is an economic principle that if U.S. citizens “buy American” driven solely by patriotism (and not because they think the product is superior) the American economy actually becomes weaker as the U.S. dollars spent out of patriotism on that American company are, therefore, unintentionally withheld from another more efficient and deserving American company.

In summary, when citizens of any country in the world buy the product that is best for them based on a combination of quality and price, they will be taking the most patriotic action possible to help their own country they love so much! If a domestic citizen sees the foreign product as a better alternative to the domestic product, buy it! Your money spent will immediately find its way back through the “trade loop” to another business within your country!

Of course, this is why all economists from around the world know that international trade, and not protectionism, helps a country’s standard of living and promotes efficiency and rising standard of livings!

Well enough for now. I could go on and on with more 180 degree moments relating to areas such as standard of living, unemployment, the minimum wage, gasoline taxes, and many others. But we’ll discuss some of those in class and I will cover others through this blog site. For now, I just really hope you look forward to and work hard in your economic course so that, you too, will become a more informed and influential citizen as you begin to see your nation’s economy, and our global economy, in a whole new light!

Discussion Questions:

1. Do you believe that politicians will promise and enact policy that seems on the surface to be beneficial to a nation, but are actually harmful to that nation?

2. After reading this blog do you begin to see how the huge declines in manufacturing employment are more driven by leaps in productivity (machines and know-how)? How else could we be producing more manufacturing value each year if employment is decreasing?

3. What would happen to a nation’s “standard of living” if the government passed a law requiring its citizens to only buy their own domestic products? Why?

4. Do you personally believe you will make your own country’s standard of living grow the fastest if you buy the best product available, whether an import (foreign) or a domestic product?

Harvard Economist Niall Ferguson appeared on CNN’s GPS with Fareed Zakaria over the weekend. Ferguson has stood out among mainstream economists lately in his opposition to the US fiscal stimulus package, an $880 billion experiment in expansionary Keynesian policy. While economists like Paul Krugman argue that Obama’s plan is not big enough to fill America’s “recessionary gap”, Ferguson warns that the long-run effects of current and future US budget deficits could lead the US towards economic collapse. This blog post will attempt to explain Ferguson’s views in a way that high school economics students can understand.

Government spending in the US is projected to exceed tax revenues by $1.9 trillion this year, and trillions more over the next four years. An excess of spending beyond tax revenue is known as a budget deficit, and must be paid for by government borrowing. Where does the government get the funds to finance its deficits? The bond market. The core of Ferguson’s concerns about the future stability of the United States economy is the situation in the market for US government bonds. According to Ferguson:

One consequence of this crisis has been an enormous explosion in government borrowing, and the US federal deficit… is going to be equivelant to 1.9 trillion dollars this year alone, which is equivelant to nearly 13% of GDP… this is an excessively large deficit, it can’t all be attributed to stimulus, and there’s a problem. The problem is that the bond market… is staring at an incoming tidal wave of new issuance… so the price of 10-year treasuries, the standard benchmark government bond… has taken quite a tumble in the past year, so long-term interest rates, as a result, have gone up by quite a lot. That poses a problem, since part of the project in the mind of Federal Reserve Chairman Ben Bernanke is to keep interest rates down“

There’s a lot of information in Ferguson’s statements above. To better understand him, some graphs could come in handy. Below is a graphical representation of the US bond market, which is where the US government supplies bonds, which are purchased by the public, commercial banks, and foreigners. Keep in mind, the demanders of US bonds are the lenders to the US government, which is the borrower. The price of a bond represents the amount the government receives from its lenders from the issuance of a new bond certificate. The yield on a bond represents the interest the lender receives from the government. The lower the price of a bond, the higher the yield, the more attractive bonds are to investors. Additionally, the lower the price of bonds, the greater the yield, thus the greater the amount of interest the US government must pay to attract new lenders.

Ferguson says that the price of US bonds has “taken a tumble”. The increase of supply has lowered bond prices, increasing their attractiveness to investors who earn higher interest on the now cheaper bonds. Below we can see the impact of an increase in the quantity demanded for government bonds on the market for private investment.

Financial crowding-out can occur as a result of deficit financed government spending as the nation’s financial resources are diverted out of the private sector and into the public sector. Granted, during a recession the demand for loanable funds from firms for private investment may be so low that there is no crowding out, as explained by Paul Krugman here.

But crowding out is not Ferguson’s only concern. The increase in interest rates caused by the US government’s issuance of new bonds could lead to a decrease in private investment in the US economy, inhibiting the nation’s long-run growth potential. But the bigger concern is one of America’s long-run economic stability. If the Obama administration does not put forth a viable plan for balancing its budget very soon, the demand for US government bonds could fall, which would further excacerbate the crowding-out effect, and eliminate the country’s ability to finance its government activities. In other words, such a loss of faith could plunge the United States into bankruptcy.

Fareed Zakaria asks Ferguson:

“Is it fair to say that this bad news, the fact that we can’t sell our debt as cheaply as we thought, overshadows all the good news that seems to be coming?”

Ferguson’s reply:

The green shoots that are out there (referring to the phrase economists and politicians have been using to describe the signs of recovery in the US economy) seem like tiny little weeds in the garden, and what’s coming in terms of the fiscal crisis in the United States is a far bigger and far worse story.

Finally Fareed asks the question everyone wants to know:”What the hell do we do?”

Ferguson:

One thing that can be done very quickly is for the president to give a speech to the American people and to the world explaining how the administration proposes to achieve stabilization of American public finance… the administration doesn’t have that long a honeymoon period, it has very little time in which it can introduce the American public to some harsh realities, particularly about entitlements and how much they are going to cost. If a signal could be sent really soon to the effect that the administration is serious about fiscal stabilization and isn’t planning on borrowing another $10 trillion between now and the end of the decade, then just conceivably markets could be reassured.

Ferguson is saying that only if the Obama administration begins taking serious steps towards balancing the US government’s budget can it hope to stave off an eventual loss of faith among America’s creditors (and thus a fall in demand for US bonds). It will be a while before tax revenues are high enough to finance the US budget. But if the country does not begin working towards such an end immediately, it may find itself unable to raise the funds to pay for such public goods as infrastructure, education, health care, national defense, medical research, as well as the wages of the millions of government employees. In other words, the US government could be bankrupt, and its downfall could mean the end of American economic power.

The power of the bond market should not be underestimated. America’s very future depends on continued faith in its financial stability and fiscal responsibility.

Discussion Questions:

1. Why do you think the US government has such a huge budget deficit this year? ($1.9 trillion) Previously, the largest budget deficit on record was only around $400 billion.
2. How does the issuance of new bonds by the US government lead to less money being available to private households and firms?
3. Do you think investors will ever totally lose faith in US government bonds? Why or why not?
4. In what way is the government’s huge budget deficit a “tax on teenagers”? In other words, how will today’s teenagers end up suffering because of the federal budget deficit?

To learn more about the power of the bond market, watch Niall Ferguson’s documentary, The Ascent of Money. The section on the bond market can be viewed here:

One of the greatest “ah-ha” moments in all of economics is when an economics’ student or citizen learns for the first time that every time a domestic buyer purchases a foreign product or import that those same U.S. dollars spent on the foreign product go to a U.S.-based company, not a foreign company. Yes, I am telling you that when you (or Wal-Mart) buy Chinese shirts, your same U.S. dollars spent quickly end up in the hands of, say, Apple, Microsoft, Garmin, or General Electric to increase U.S. employment, profits, and U.S. stock prices!

I decided to write this particular blog because of the fact that the recently passed $800 Billion U.S. stimulus bill has some “buy American” provisions within it. Based on an intuitive hunch, I believe that over 99% of adult Americans believe that these “protectionist” clauses somehow help our economy. Yes, the vast majority of U.S. adults believe that it is clearly more advantageous to “buy American” in order to keep the money or wealth within America in order to increase U.S. employment, profits, and U.S. stock prices. In true economic fact, however, if U.S. citizens “buy American” solely out of patriotism (and not because they think it is a superior product) they actually HURT America because the U.S. dollars spent out of patriotism on that American company are, therefore, unintentionally withheld from another more efficient and deserving American country via the “trade loop”.

Let me try to explain this “trade loop” in more detail so that I may actually be able to convince you of this amazing “180 degree” revelation: “Buy American” is Un-American

Let’s say that the United States (we’ll say Wal-Mart) decides to buy many shirts costing $400 from a Chinese shirt manufacturer, in lieu of buying those same shirts from, say, a shirt manufacturer in Elon, North Carolina (USA). The first key point is that when Wal-Mart buys the shirts from China for $400 it can only pay China with US dollars. Why? Because Wal-Mart has only US dollars! It has no Chinese currency (Yuan). It literally drains its bank account of US dollars that are transferred/paid to China! The second key point is that when China receives that same $400 US dollars for the shirts, China cannot, unfortunately, spend any of the $400 in its own economy since only the Yuan is accepted as a medium of exchange in China! China is now forced to either throw the U.S. currency away (not advised!), or immediately spend the money back to the USA (advised!).

In summary, China has initially traded a product (shirts!) for paper (US dollars!), and those US dollars cannot be spent in China. For China to receive any value at all for the shirts it sent to America, China must now spend the $400 back into the US economy for, say, a global positioning system (GPS) from FleetMatics out of Waverly, Massachusetts (USA). Cutting through to simplicity, in essence, it’s almost as if Wal-Mart (USA) just paid FleetMatics (USA) $400 directly!

Yes, the economic “punch line” is that all spending by the domestic nation on foreign products (imports), in turn, are spent immediately back to the domestic nation increasing the domestic nation’s employment, income, and standard of living. (Note; this is also shown and reported in a nation’s balance of payments schedule if you are skeptical about what you are reading!)

And, yes, let’s not forget about that Elon, North Carolina shirt maker that did not get the original $400 from Wal-Mart in our above example! Any good economy promotes competition and I am excited to see if that North Carolina shirt manufacturer can “raise their game” (increase productivity and/or quality), and hopefully get the next shirt contract from Wal-Mart! If not, well, that North Carolina firm may just have to close down. But remember, the key point, the $400 spent for the shirts went to Fleetmatics in Waverly, Massachusetts, in lieu of the Elon, North Carolina shirt manufacturer. If you would have “bought American” even though the Chinese shirts were preferable, you would have prevented the more effective U.S. business in Waverly from getting your U.S. dollars by giving them to the less efficient Elon manufacturer. In short, you would have contributed to American inefficiency and slowing productivity, hurting our country! And that is un-American!

Now, you may be thinking the following if you have a little economics’ background: “But the US has a growing trade deficit with China, so China may not immediately buy that GPS system from FleetMatics for $400. And, you are correct, but that is also not a problem for either the United States or China. What China is really doing right now is deciding to temporarily save or invest a minority percentage of their US dollars received form U.S. import purchases. Said another way, China is not buying as many GPS’ as the US is buying shirts and, of course, we call that phenomenon the US trade deficit which immediately seems to speak “problem”. But it is really not as big a problem as most people think! China is still spending their “saved” US dollars back into the US economy, but in different ways. China is saving and investing some of those US dollars directly into the United States economy by building plants in America, buying US stock to fund American companies’ expansions, and temporarily saving some of their dollars, for future US purchases, by buying US bonds to help the US government pay for other US government initiatives necessitating borrowing. Eventually, China will sell these US bonds and be forced to use those U.S. dollars to buy that GPS system or build more plants to employ more Americans!

In summary, when citizens of any country in the world buy the product that is best for them based on a combination of quality and price, they will be taking the most patriotic action possible to help their own country they love so much! If a domestic citizen sees the foreign product as a better alternative to the domestic product, buy it! Your money spent will immediately find its way back through the “trade loop” to another business within your country!

Of course, this is why all economists from around the world know that international trade, and not protectionism, helps a country’s standard of living and promotes efficiency and rising standard of livings!

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:

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?

At the end of this week, the U.S. Government’s Commerce Department will provide its first estimate of the country’s 3rd quarter (July-September 2008) gross domestic product or GDP. This upcoming GDP report is of particular interest to the world since it will provide an important measurement of how much the U.S. economy has slowed or even recessed over the last several months. Many economists predict that the upcoming GDP report will show either no significant economic growth or, very likely, negative growth.

Let me try and make the concept of GDP easy to understand and explain why it is considered the most important, single macroeconomic measurement.

GDP is simply a calculation that measures the market value (final price) of all the final goods and services produced within the borders of our country. Thus, U.S. GDP includes Toyotas produced in Alabama but excludes Cadillac’s made in Canada. GDP includes all U.S. exports but excludes all U.S. imports since imports, by definition, are produced in some other country and are a part of that country’s GDP.

If you think about it, ultimately our economic satisfaction is better measured by the goods and services that are produced and that we have access to more so than in any other single measurement, which is why GDP is the measurement that is synonymous with “economic growth”. In addition, rising GDP (more goods and services) is the ultimate economic goal of any economy which can best be accomplished through the means of the two other key macroeconomic measurements of employment and productivity.

Let’s describe how the GDP calculation is made. Each quarter, the Government compares the final value of the domestic goods produced and services rendered in the current quarter to the final value of the goods produced and services rendered in the previous quarter. The calculation then takes the percentage gain, current quarter versus previous quarter, and annualizes the percentage. The comparison is always restated for inflation so that the figures are comparable from one period to the next. For purists, we call this “real GDP” which is the only GDP reported by the media, even though the word “real” is almost always dropped to avoid confusion with the average citizen. For example, the second quarter 2008 U.S. GDP report highlighted a 2.8% GDP annualized growth rate. This means that the second quarter final value of goods and services produced was approximately .7% higher than the first quarter final value of goods and services produced. Thus, the quarter over quarter growth of approximately .7% was reported at an official 2.8% annual growth rate for the second quarter.

Now let me get to my favorite point on GDP, which even many economists lose sight of. GDP growth is precisely the same as income growth! For example, in the second quarter of 2008 we can say that incomes for Americans grew by 2.8% restated for inflation. You probably never thought about it this way but every time you purchase something, every dollar you spend is going to someone as income, whether it is the workers as wages, the landlord as rent, a bank that has made a loan as interest income, or to the owners of the business as profits. I tell my students that GDP = Income and we review how the Government calculates GDP both in terms of the final market value of the goods and services as well as how that same production value is reconciled to the incomes of others.

I find the preceding paragraph, GDP = Income, to be a break through moment for a lot of citizens in truly understanding the GDP measurement. It is easier for most citizens to think in terms of income percentage growth in lieu of GDP growth. Most citizens are surprised to find that incomes or GDP, restated for inflation, have increased by 17.4% from 2000 – 2007. This 8-year growth rate in GDP or incomes still equates to a below average historical average performance. More specifically, over the last 8 years our average annual GDP or income growth rate was only 2.2% versus our historical average growth rate of 3.2%. However, the final point of caution is that the GDP or income growth rate is a collective average, thus the growth in GDP or incomes does not indicate how those income gains are accruing to the various socioeconomic classes or professions.

FT.com / Columnists / Wolfgang Munchau – Inflation and the lessons of the 1970s

It seem that everyone’s speculating about the US economy today. Recession or no recession, that is the question. The economy has even surpassed the Iraq War as the number one issue in the US presidential race! John McCain, who has publicly admitted that economics is not his strong suit, may just find himself in trouble in a general election where the most important concern among voters is the economic situation.

So what IS that situation, anyway? Is the US in a recession? In other words, has real gross domestic, or total output in the US economy, actually declined over the last six months? Technically, the answer is no. My fellow blogger, Steve Latter, explains this clearly here. What is true, on the other hand, is that the current situation shares many similarities to the global economic slowdown that did occur in the 1970s.

In 1973 OPEC, the newly formed oil cartel consisting at the time of only Arab states, reduced its output of oil and cut off exports to the United States in response to US support of Israel in the Yom Kippur War, in which the Israelis officially occupied the Palestinian territories of the West Bank and Gaza and seized the Golan Heights from the sovereign nation of Syria. To punish the US for its position on this conflict, OPEC cut off supplies of oil to the west, driving gas and energy prices upwards by 70%, triggering a supply shock characterized by a decline in total output and an increase in both unemployment and inflation, a phenomenon known as stagflation: a macroeconomic policy maker’s worst nightmare.

Recently the world has seen a similar (albeit of a different cause) rise in the price of oil and energy prices. Today the rise in energy prices is driven primarily by rising demand, rather than reduced supply (since the 1970s the OPEC cartel has grown to include many non-Arab nations, making it harder to achieve collusion to restrict output and drive up oil prices). Global demand for oil has risen steadily, driven ever higher due to rapid growth in China and other developing nations, and exacerbated by the falling value of the dollar, the currency in which oil prices are denominated.

The supply shocks of today have combined with falling aggregate demand in the US due to weak consumer spending to slow real growth rates to nearlry 0%. So technically, the US has avoided a recession, but the effect on American workers and consumers may be just as painful as the real recession of the 1970s. In order to prevent the “r” word from becoming a reality today, central banks (including the US Fed) have eased money supplies, lowering interest rates, fueling even greater increases in the price level.

…the global weighted average inflation rate will be 5.4 per cent this year, while the global money market interest rate is currently only 4.3 per cent. This means that global short-term real interest rates are negative – at a time when inflation is rapidly accelerating. As monetary policy has been excessively accommodating for more than a decade, inflationary pressures have built up in the global economy.

Central bankers like Ben Bernanke have to make tough decisions sometimes, weighing the trade-off between unemployment and inflation, and determining their monetary policies based on whatever they deem to be the “lesser of two evils”. Rising energy prices have forced firms to cut either cut back their production and raise the price of their products, both actions that result in less overall spending and output in the economy. Falling house prices have led consumers to cut back their own spending, further reducing demand for firms’ output. These factors have all pushed the unemployment rate from around 4.8% a year ago to 5.1% today, which combined with an estimated additional 3-5% of American workers having dropped out of the workforce, (referred to by the Department of Labor as “discouraged workers”) paints a pretty ugly picture of the reality for the American worker today.

The harsh reality of the weak labor market has led Mr. Bernanke and the Fed to pursue an expansionary monetary policy aimed at avoiding further increases in the unemployment rate and decreases in the GDP growth rate. Expansionary monetary policy means lower interest rates, with the goal being increased consumption and investment, both factors that could worsen the inflation problem already experienced thanks to the global supply shock. Evidence indicates that the inflation problem, even in the US where slow growth usually leads to lower price levels, is not going away:

In the US, a survey-based measure of inflationary expectations recently showed an increase to more than 5 per cent. I would estimate there are now several hundred basis points of difference between the current Fed funds rate and an interest rate that would be consistent with price stability in the medium term.

…meaning the Fed, in its attempt to avoid recession and rising unemployment, has created a condition where real interest rates are actually negative, a highly inflationary condition. All this wouldn’t be so bad if wages in the US were rising along with the price level. This however, does not appear to be happening:

The main difference between the situation in the 1970s and now is today’s absence of wage inflation, which explains why absolute inflation rates are a little more moderate. I guess this is probably because of some combination of deregulated labour markets and globalisation. But the lack of wage-push inflation is not necessarily good news. Falling real wages mean falling disposable income and tighter credit conditions mean less borrowing for consumption.

Rising prices for energy, transportation and food have put American households in a tough situation. In the past, periods of inflation have often been characterized by rising wages, meaning the full brunt of nominal price level increases was not entirely born by the American worker. Today, on the other hand, a recession has thus far been avoided, but the combination of record numbers of “discouraged workers”, rising unemployment and inflation may make the pain of our current economic situation just as real as recessions of the past.

In the words of billionaire investor and economic sage Warren Buffett just today:

“I believe that we are already in a recession… Perhaps not in the sense as defined by economists. … But people are already feeling the effects of a recession.”

“It will be deeper and longer than what many think,” he added.

Discussion Questions:

1. What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?
2. What impact do rising energy prices have on the behavior of individual firms?
3. Why are low interest rates likely to make the inflation problem even worse?

One of the many reasons that I find the study of economics so fascinating is that what so often appears to be a negative situation to the average citizen is actually a positive one. In other words: “down is often up” and “black is often white”. One of my favorite examples of this “180 degree moment”, and why I love to teach AP Macroeconomics, relates to the study of unemployment.

FT.com / World / Americas – US economy threatens Dominican Republic

Trade based on comparative advantage… the theory originally articulated by Adam Smith, later fine-tuned by David Ricardo, the theory that suggests that if each nation specializes its economic activity on the products for which it faces the lowest opportunity cost, then trades with its neighbors, total world output and efficiency can be maximized: today this theory represents the philosophical underpinning of all free trade agreements signed between and among the nations of the world.

Through trade, countries can exchange their extra output with other nations for the goods specialized in by others, enabling all nations to enjoy a level of consumption beyond what they’d be able to achieve if they tried to produce all goods domestically.

For many developing countries, with their abundance of either land or labor, comparative advantages tend to lie in either agricultural goods or low-skilled manufactured goods. Since global prices for food are highly unstable and dependency on healthy harvests, good weather, and stable rainfall are all highly risky endeavors for a poor country, developing nations prefer to foster the growth of manufacturing sectors in their path towards economic development.

Strategies for economic growth available to developing nations include export-oriented and inward-oriented growth. A country like the Dominican Republic, the largest economy in the Caribbean, has pursued a predominantly export-oriented growth strategy, promoting through “free zones” the growth of a textile industry aimed at producing goods for consumers in developed countries, primarily the US.

To the Domincans, producing textiles for export to America has successfully given the people of this poor nation a grip on a rung of the ladder towards economic development. The import of capital has taken previously unproductive workers out of agriculture and put them into an industry where productivity, thus income, has risen, leading to improvements in living standards. Export-led growth, however, runs some serious risks of its own, as is being realized by the people of the Dominican Republic today.

It had been clear for some time that Luis Caraballo’s textile factory, in one of the Dominican Republic’s largest “free zones”, was struggling.

Finally, last December, he closed the factory gates for the last time: cut-throat competition from China and Vietnam, a weakening US dollar and unsustainable costs had become too much.

Once a hot destination for American companies looking for a cheap place to “off-shore” production of labor intensive textiles, the Dominican Republic today faces new competition, and is finding its comparative advantage slip slowly away from textiles…

The Dominican Republic depends heavily on the US, which is the destination of more than 85 per cent of exports. But textile exports – these days accounting for less than a third of total exports – fell by 32 per cent over 2007.

Although other countries in the Caribbean are also suffering from Asian competition – with Chinese textile exports to the US tripling between 2000 and 2005, while Vietnam’s multiplied almost 117 times – the Dominican Republic has been worst hit.

Here’s the thing: a nation’s comparative advantage may shift over time (from land to labor to capital intensive goods) as the structure of the global economy evolves. Once an economy like the Dominican Republic’s has undergone a period of structural adjustment, away from agriculture and towards industry, the flow of low wage workers from farm to factory begins to slow to a trickle, leading to rising wages and increased competition from countries with more abundant supplies of cheap labor.

The challenge for policy makers is to manage the structural changes as they come, minimizing the deleterious impact such global shifts of productive resources has on the citizens of a country like the D.R. Clearly, it is in the country’s interest to prepare its citizens for a “new economy”, one in which skilled labor will play a larger role. The problem is, this requires a solid education system, which the D.R., it turns out, does not yet have:

There is widespread acceptance of the need to develop a better-educated workforce, but so far education spending has been inadequate.

“The government simply doesn’t have enough resources,” said Mr Montás. About 40 per cent of its budget goes on debt obligations and another 15 per cent is dished out through subsidies. Just 1.5 per cent goes towards education.

It also turns out that this is a balance of payments story:

Mr Montás calculated that for every percentage point the US economy contracted, the Dominican Republic’s GDP would shrink by 0.4 per cent.

Not only will exporters be hit, but also the huge tourism sector and remittance flows…

One possible result of the decline in exports and flows of remittances from the US will be a depreciation of the D.R. peso, as demand for pesos by Americans falls. A weaker peso might make the country’s exports attractive once again, assuming the exchange rate is allowed to adjust on foreign exchange markets. A weaker peso should help slow the decline in the D.R.’s exports to the US, at least until new competition emerges, perhaps elsewhere in Asia, maybe even from Africa or other Latin American countries.

In all likelihood, given the increased competition from Asian textile manufacturers, continued economic growth in the Dominican Republic will depend on the country’s ability to educate and train its workforce to adapt to a more capital, technology and information-based economy, which, if successful, will eventually lead to rising incomes and higher standards of living for the people of the this rising Caribbean nation.

Comparative advantages evolve with the emergence of new competition among developing and developed countries. The negative impacts this evolution has on a particular economy can be managed if wise policy actions are taken to assure a country’s workforce is educated and trained to participate in tomorrow’s economy, rather than yesterday’s or today’s.

*Click on the graphs to see full-size versions

The following message was submitted through the AP/IB Econ Help Desk:

Jason,

An AP Macro Question: Comes from the recently published AP Practice Exam

An increase in which of the following is most likely to promote economic growth?

A. Consumption Spending
B. Investment Tax Credits
C The natural rate of unemployment
D The trade deficit
E Real Interest Rates.

The answer is B, and I understand the economic principles of why that would promote economic growth, but what I can’t answer for my students is why A, Consumption Spending wouldn’t work. I know that consumption spending makes up part of the demand in aggregate demand, but I can’t help but think that an increase in it, would promote economic growth.

Thanks, “Econ Teacher”

For what it’s worth, here is my reply:

Hello “Econ Teacher”,

That’s a good question. I would explain to my students that in the short-run, an increase in AD alone will lead to some growth, but would be accompanied by inflation, since AS does not shift out when consumption increases. However, an investment tax credit will result in REAL long-run economic growth (by real I mean nominal GDP will increase while the price level remains stable), since it encourages investment. Investment is a determinant of AD, just like consumption, so AD will shift out, but it is also a determinant of AS, since firms are investing in capital. Increase the quantity or the quality of capital, and labor becomes more productive. Greater productivity shifts out AS, leading to growth AND stable prices.

Economic growth is defined, in terms of the AD/AS model, as an outward shift of both AD and AS. Increases in consumption will increase AD, but this will lead to inflation, and in the long run, workers will demand higher wages, increasing the costs of production and shifting AS leftward, returning the economy to the full employment level of output at an even higher price level, i.e. no economic growth occurs (see graph to the right). Investment, however, encouraged through a tax credit, will have positive demand and supply side effects, resulting in real economic growth and stable prices (see graph below)

Hope that helps!

Jason Welker

FT.com / Asia-Pacific / China – Weak dollar troubles Beijing

Inflation, with its erosive effects on wealth and income, has plagued China at increasing rates since mid-2007. In February it reached an annualized rate of 8.7%, threatening to undermine China’s GDP growth rate, which has been predicted in the 8% range for this year.

As we have discussed in our our AP Econ class here in Shanghai, China’s inflation is caused by a combination of demand and supply-side factors. On the demand-side, a growing middle class has driven consumer spending to record levels recently, surpassing investment as the largest component of China’s GDP in 2007. Of course, as always, high inflation (thus low real interest rates), optimism about rising consumption in the future, and a comparative advantage in labor-intensive manufacturing (albeit a diminishing one as wages continue to rise) all combine to keep investment extremely high. Furthermore, cheap exports have helped keep demand for China’s output from abroad strong. The combination of increasing consumption, strong investment, and its trade surplus have resulted in demand-pull inflation.

On the supply-side, China has encountered additional inflationary pressures of late. Rising energy prices (mostly due to coal and oil shortages) combined with record rises in food prices (24% increase in the last year), have driven costs to firms up, shifting the aggregate supply curve leftward, further fueling inflation.

Knowing the damaging effects inflation has on income and wealth, it might be assumed that Beijing would place the utmost emphasis on taming the country’s rising prices. This, however,is not at the top of the government’s macroeconomic goals, according to premier Wen Jiabao:

On the issue of whether he would sacrifice economic output to bring down inflation, at the risk of increasing unemployment, Mr Wen indicated that growth re­mained the overarching priority. “We must ensure that our economy will grow…in order to ensure employment,” he said. “China is a developing country with 1.3bn people. We have to maintain a certain degree of fast economic growth to provide enough jobs.

”He said China needed to add about 10m jobs a year for the next five years, a lower figure than in the past when the aim was growth of 15m-20m jobs a year.

The tradeoff between inflation and unemployment to which Mr. Wen refers is a text book example of the challenges faced by macroeconomic policymakers everywhere. This trade-off is illustrated in the Phillips Curve model, which shows that in the short-run, there exists an inverse relationship between the price level and the unemployment rate.

In his words above, Mr. Wen demonstrates Beijing’s preference in the trade-off between inflation and unemployment: He’ll take inflation… Here’s why.

In case you haven’t heard, China is not a democracy. Nor is it a, ehem, “free” country. According to Alan Greenspan in his book “The Age of Turbulence”, democracy and freedom of speech act as “safety valves” in Western countries; in other words, in times of economic or political unrest, the right to gather in the streets, the right to vent frustrations through a free press and the opportunity to advocate political and economic change through the various media, all combine to prevent violent and revolutionary uprisings when times get tough economically.

Take the US for example. Times are certainly tough right now. Inflation’s approaching 4-5%, while nominal growth has nearly stagnated. Unemployment, while it has technically fallen recently, in reality has risen as hundreds of thousands of workers have given up searching for work. The bursting of the housing bubble represents one of the most massive losses of wealth in recent history. A weak dollar has meant that even cheap imports don’t seem so cheap anymore. Throw in the desperate war in Iraq, the nuclear threat from Iran, rising food prices, $110 oil and an incredibly unpopular national leader, and by some measures the country would appear ripe for revolution. However, a revolution is about the least likely thing to occur in America, because it enjoys the “safety valve” of democracy. Rather than overthrowing their government, Americans have the right to go to the pole and vote for a new one, which in all likelihood will occur this November when it seems either Barrack or Hillary stand the greatest chance and winning the White House.

Now let’s look at China. The picture’s not quite so gloomy for the Chinese right now. Yes, inflation is high, as in the US. But unlike America, China is still growing at a very healthy pace, unemployment is probably still below its natural level, the real estate markets in China’s cities are still booming, meaning the middle class residents there are experiencing leaps and bounds in terms of personal wealth. Demand for its exports remains strong, and ever more poor Chinese are finding jobs in high paying factories across the country. Investments in capital, infrastructure and education point towards a bright future of continued growth for the foreseeable future.

But wait, 8.4% is something to worry about, especially when we take into account the 24% increase in food prices. Shouldn’t Wen and Beijing be taking drastic steps to reign in this high rate of inflation? In short, NO, they shouldn’t. Because as can be seen in the Phillips Curve, to reduce inflation could result in another, far more serious problem for Beijing; rising unemployment.

It appears that Beijing’s greatest fear is a population out of work. Its goal of creating 10 million new jobs is ambitious, but in the eye’s of the government, necessary. The Chinese people do not enjoy the “safety valve” of democracy through which economic frustrations and hardships can be channeled were the country to experience a slowdown in growth and an increase in unemployment. The last time the economy faced high inflation AND high unemployment, students, workers, soldiers and tanks all gathered for an afternoon of urban warfare under Mao’s somber gaze in Beijing. To avoid such massive revolutionary movements in the future, Beijing must do all it can to insure job creation continues and growth remains strong, even if the trade-off is record high inflation.

This one passage spoken by Wen Jiabao, China’s premier, tells a vivid story about the reality of Communist dictatorship in China. Sound economic policy may go on the back burner in times of political uncertainty. Price controls, such as those on petrol in Shanghai (speaking of, the long lines at gas stations are back!), were a microeconomic example of bad economics; Beijings hesitance to seriously tackle inflation is a macroeconomic example. Holding on to power seems to be more important than stabilizing prices, at least for now.

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Job losses worst in five years – Mar. 7, 2008

The news late last week out of Washington was not what the White House was hoping for only a couple of weeks after the passing of a fiscal stimulus package meant to achieve exactly the opposite of what has happened. The US Labor Department released its latest numbers on employment on Friday:

There was a net loss of 63,000 jobs, which is the biggest decline since March 2003 and weaker than the revised 22,000 jobs lost in January. Economists had forecast a gain of 25,000 jobs…

“Based on today’s Employment Report, if we are not in a recession, it is a darned good imitation of one,” said Kevin Giddis, managing director of fixed income at Morgan Keegan.

So with a net loss of jobs, it may seem weird to hear that unemployment has actually fallen from 4.9% to 4.8%. How is this possible? In this case lower unemployment may indicate an even worse reality for the American economy:

The unemployment rate fell because of an increase of 450,000 people whom the government no longer counts as being part of the labor force for a variety of factors, such as that they are not currently looking for work. That drop in the size of the labor force allowed for the modest decline in unemployment, even as the household survey showed 255,000 fewer Americans with jobs than in January.

Discouraged workers point to a deep pessimism underlying households and workers in America, indicating that if we’re not already in a recession, it is only a matter of time. With the apparent failure of fiscal policy at achieving any immediate turnaround in consumer confidence, all eye’s are now on the Fed, America’s central bank, to see how Ben Bernanke will respond to the latest round of bad news.

“Even the silver lining of a falling unemployment rate has a little rust,” said Rich Yamarone, director of economic research at Argus Research. He predicted that the central bank will cut rates by a half percentage point at both its March meeting and again on April 30.

But Yamarone and some other experts questioned whether additional Fed cuts would do much to improve the employment outlook.

“We’re not in a crisis because the cost of borrowing is too high, it’s because people are afraid of lending,” said Dan Alpert, managing director of Westwood Capital, referring to the ongoing credit crunch. “At the end of the day, the Fed cuts don’t really solve the problems. They’ve already cut allot; if jobs continue to decline in face of further interest rate cuts, it’s prima facie evidence cuts aren’t effective.”

But few experts were ready to suggest the Fed would stop cutting rates at this point, given the problems in the economy and financial markets.

“The Fed has to do what it can to provide remedy and not scare the market as well,” said Mike Materasso, a senior portfolio manager at Franklin Templeton.

Central bankers face difficult decisions in times like these. While unemployment and falling growth rates pose significant problems to the American economy, the third macroeconomic evil is certainly in the minds of policymakers when deciding how to deal with the first two: inflation.

In order to lower interest rates, the Fed first has to implement expansionary monetary policy. In other words, the central bank must increase America’s money supply. How does it do this, exactly? Most commonly, the Fed uses open market operations, which is a fancy way of saying the Fed buys and sells government securities (treasury notes, bonds, etc…) on the bond market. When the Fed wishes to lower interest rates, it must inject new money into the economy, which it does by buying government bonds from the holders of those securities; namely, the public.

American banks, households, and firms, as well as foreigners all hold government debt. When the Fed wants to expand the money supply, it simply starts buying these debt securities back from the public. The increase in demand for securities drives up their prices, encouraging holders of the debt to sell their securities to the Fed, for which they receive money in exchange. In effect, the public exchanges illiquid (unspendable) debt certificates for liquid money. Now consumers have more money in their pockets to spend, firms have more to invest, and banks have more to loan out to borrowers who want to spend and invest. How do banks get rid of their new liquidity? Yep, they lower their interest rates.

In a nutshell, that’s how monetary policy works. To combat a recession and rising unemployment, the Fed simply buys bonds on the open market, injecting liquidity into the economy, which should result in more borrowing and more spending, shifting aggregate demand out, leading to growth and rising employment.

But what about that third evil, inflation? Won’t more spending lead to demand pull inflation? Usually this is not a major concern in times of a slowdown, since rising unemployment indicates the economy is producing below its full employment level of output. Expanding aggregate demand should result in increased output and stable prices. Today, however, Americans are facing other inflationary pressures, including a historically weak dollar (meaning imported goods and raw materials are more expensive than ever), and skyrocketing food and energy prices due to rising global demand for such commodities.

This all makes the job of monetary policy exceptionally challenging for Mr. Bernanke and his colleagues at the Fed. Expand the money supply too much (i.e. lower interest rates too much) and you risk accellerating inflation. Keep rates too high, and we can expect even worse employment and output numbers in the next few months.

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Economics focus | From Mao to the mall | Economist.com

China, long acknowledged as the world’s factory, could suffer if falling demand for its exports in the US results in a decline in aggregate demand and GDP here as some economists believe it will. But not all economists agree on the importance of exports to China’s domestic economy:

The increase in net exports (exports minus imports) has never been the main source of China’s growth. It contributed two to three percentage points to annual GDP growth between 2005 and 2007, whereas domestic demand (consumption and investment) added eight to nine percentage points.

But the latest figures show that exports have become even less important as a driver of growth. The World Bank’s latest China Quarterly Update suggests that net exports contributed only 0.4 percentage points to GDP growth in the year to the fourth quarter of 2007 (see left-hand chart). Overall GDP growth slowed only modestly (to 11.2%) because of faster growth in domestic demand, which contributed an impressive 10.8 percentage points.

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As we study economic development in year 2 IB Economics, we examine different models for economic growth. Growth in GDP is not the only determinant of economic development, which in order to be measured effectively must account for human welfare determinants such as life expectancy, literacy rates, child mortality rates, distribution of income, and so on. However, it has been shown throughout history that economic growth, or the increase in real output and income, correlates directly with improvements in development factors like those above.

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