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.
The reason? Increases in national income usually mean at least some levels of improvement in access to basic necessities for the average citizen in a developing country. Also, higher incomes mean more savings, which means greater access to capital for investment by entrepreneurs. More investment leads to greater productivity and rising incomes for those who join the emerging industrial and service sectors that usually accompany economic growth. Furthermore, rising incomes mean more tax revenue for governments, whose spending on public goods like education, health care, and infrastructure result in real improvements in standard of living for not just the emerging upper and middle classes, but the poor as well.
Of course, the following models can be observed to varying degrees among the world’s developing economies today. Some of these models will fail to play out if the institutional and political environment fails to create a stable atmosphere for savings and investment. What you should notice, however, is the underlying importance of savings in all three models. Poor countries suffering from low savings and, even worse, capital flight, are doomed to a cycle of poverty, where funds for investment leading to productivity increases are never made available due to instable institutions like banking and politics. To put a poor country on a path towards economic growth and development, a strategy is needed. Such strategies will be covered in a later post. For now, let’s look at the models:
Harrod-Domar Growth Model:
The model suggests that the economy’s rate of growth depends on:
the level of saving
the productivity of investment i.e. the capital output ratio
The Harrod-Domar model was developed to help analyse the business cycle. However, it was later adapted to ‘explain’ economic growth. It concluded that:
Economic growth depends on the amount of labour and capital.
As LDCs often have an abundant supply of labour it is a lack of physical capital that holds back economic growth and development.
More physical capital generates economic growth.
Net investment leads to more capital accumulation, which generates higher output and income.
Higher income allows higher levels of saving.
Lewis Structural Change (dual-sector) Model:
Many LDCs have dual economies:
The traditional agricultural sector was assumed to be of a subsistence nature characterised by low productivity, low incomes, low savings and considerable underemployment.
The industrial sector was assumed to be technologically advanced with high levels of investment operating in an urban environment.
Lewis suggested that the modern industrial sector would attract workers from the rural areas.
Industrial firms, whether private or publicly owned could offer wages that would guarantee a higher quality of life than remaining in the rural areas could provide.
Furthermore, as the level of labour productivity was so low in traditional agricultural areas people leaving the rural areas would have virtually no impact on output.
Indeed, the amount of food available to the remaining villagers would increase as the same amount of food could be shared amongst fewer people. This might generate a surplus which could them be sold generating income.
Those people that moved away from the villages to the towns would earn increased incomes:
Higher incomes generate more savings.
Increased savings meant more fund available for investment.
Increased investment meant more capital and increased productivity in the industrial sector, higher wages, more incentive to move from low productivity agriculture to high productivity industry, the circle continues…
Rostow’s Model – the 5 Stages of Economic Development:
In 1960, the American Economic Historian, WW Rostow suggested that countries passed through five stages of economic development.
According to Rostow development requires substantial investment in capital. For the economies of LDCs to grow the right conditions for such investment would have to be created. If aid is given or foreign direct investment occurs at stage 3 the economy needs to have reached stage 2. If the stage 2 has been reached then injections of investment may lead to rapid growth.
The prevalence of income inequality in free market economies indicates that inequality may be the result of a market failure. Those who are born rich are more likely to become rich, while individuals who are born poor are more likely to live a life of relative poverty. In a “free” market, it is believed, all individuals possess an equal opportunity to succeed, but due to a mis-allocation of resources in a purely market economy, this may not always be the case.
The resources I refer to here are those required for an individual to escape poverty and earn a higher income. These include public and merit goods that those with high incomes can afford to consume, while those in poverty depend on the provision of from the state, including:
Good education
Dependable health care
Access to professional networks and the employment opportunities they provide
Whenever a market failure exists, it can be argued that there is a role for government in regulating the market to achieve a more optimal distribution of resources. When it comes to income inequality, government intervention typically comes in the form of a tax system that places a larger burden on the rich, and a system of government programs that transfer income from the rich to poor, including welfare benefits, unemployment benefits, healthcare for low income households, public schools and support for economic development in poor communities.
Many politicians and some economists like to argue that income inequality is not as evil as many people make it out to be, and that greater income inequality can actually increase the incentive for poorer households to work harder to get rich, contributing to the economic growth of the nation as a whole. Allowing the rich to keep more of their income, in this way, leads more people to want to work hard to get rich, as they will be able to enjoy the rewards of their hard work.
Another common argument is that higher income inequality leads to social and economic disruptions that can slow economic growth and bring an economy into a recession or a depression, since the middle and lower income groups in the nation will not benefit from a relatively equal share of the nation’s output, and over time will see their living standards drop and their overal productivity and contribution to national output decline.
Some believe that increase inequality leads to more growth, others argue that it leads to less growth.
A more interesting question is whether rising income inequality leads to a higher standard of living for everyone in society, or whether standards of living decline for those in the middle as the percentage of total income earned by the top 10% increases.
The study found that the higher the percentage of income earned by the top 10%, the incomes of those in the middle and bottom of the income distribution actually decreases. Not just the percentage of total income, but the actual incomes of these groups falls as the rich get richer.
The popular belief is that reducing taxes on the rich increases the amount of investment in the economy, creating more jobs and helping increase incomes of the middle and lower income households. This theory is sometimes referred to as “trickle down” economics, as the increased incomes and wealth at the top will “trickle down” and raise the incomes of the rest of society as well.
However, actual data shows that a 10% increase in the share of total income earned by the top 10% of income earners leads to a 2% decline in the incomes of households in the middle of the income distribution (based on data for the period between 1979 and 2005).
It’s not just that the rich get richer and the poor get poorer, rather that the rich getting richer makes the poor (and the middle income earners) poorer. This is a breakthrough discovery.
Possible explanations:
The rich contribute to growth abroad, rather than at home: Rich households’ higher incomes allow them to consume more domestic output and imported goods and services, but it also allows them to save more, which sometimes translates into more investment. But more investment does not always translate into domestic economic growth, since investment is now global. A rich American saving more does not mean American firms will have access to cheaper capital, as domestic savings may fuel investment in emerging markets or elsewhere abroad. Foreign investment resulting from savings among rich Americans counts as a leakage from America’s circular flow of income, leaving less income within America for the middle and low income earners. Essentially, much of the income earned by the rich is saved abroad, contributing to employment and growth overseas, reducing incomes of the middle class at home.
Reduced support for the provision of public goods: When examining living standards, more than just income must be considered, but also access to education, provision of health care and other public goods such as public safety and security. Richer households are less interested in things like public schools and social welfare programs, as they do not rely on these for their own well-being. Therefore, the richer the top 10% become, the greater their incentive to work against efforts to fund public education, public health and public safety. The underprovision of these social welfare enhancing goods by govenrment further widens the gap between the living standards of the richest and the middle class. Economist Robert Reich refers to this phenomenon as “the secession of the successful”.
Wage competition reduces incomes in the middle: Business owners, who make up a large percentage of the richest households in America, increase their own incomes to the extent that they can drive down the wages they pay their employees. In this way a higher share of national income is enjoyed by a smaller proportoin of society. The minimum wage has barely increased over time, and workers have less bargaining power as fewer workers than ever are members of labor unions; this has allowed business owners to pay lower wages over time, concentrating an increasing share of national income in business profits, and less and less in wages for workers.
In the video below, the study’s author shares some of the findings discussed above. Watch the video and respond to the discussion questions that follow.
Discussion Questions:
Summarize the argument against a government taking measures to redistribute its nation’s income to reduce the level of inequality between the rich and the poor.
Summarize the argument for a government reducing inequality.
Popular belief holds that “a rising tide lifts all boats”. In other words, if the total income of a nation is increasing, it does not matter if the rich are enjoying a larger percentage of the higher income than the poor and middle, because everyone is likely to be better off than if total income were not growing at all. Does the study discussed above support this popular view? Why or why not?
What measures can a government take to assure that higher national income leads to higher standards of living for everyone in society, including the middle class and the poor? Why might the highest income earners be opposed to such attempts by government?
Should government intervene to reduce the level of income inequality in society?
The activity below is to introduce Economics students to the three primary Macroeconomic objectives of any government or policy making body. These are :
Full employment of the nations work force: This means that nearly everyone who wants to work in the country is able to find a job. It does not mean that there is no unemployment, rather that the unemployment that does prevail in the economy is voluntary, i.e. it exists because workers are simply not willing to work at the prevailing wage rate. If there is involuntary unemployment in the economy, then the country is not meeting its macroeconomic objective, and there is likely a recession caused by a lack of overall demand (aggregate demand) for the nation’s goods and services.
Resources for learning about Full Employment:
Textbook (Welker’s IB Economics for the IB Diploma) pages 286 – 288, 295-299.
Price level stability: Changes in the average price level of goods and services in the nation are measured by calculating inflation, commonly using a consumer price index to do so. Low and stable inflation is one of the macroeconomic objectives since price level volatility (high inflation or deflation) has several harmful effects on a nation’s households and business firms. Keeping inflation low and stable promotes a healthy environment for achieving business investment, full employment and economic growth
Resources for learning about Price level stability:
Economic growth: The third macroeconomic objective is to increase the output of the nation’s goods and services year after year. Economic growth refers to the increase in real Gross Domestic Product (GDP) and can be measured by finding the total value of a nation’s output one year, comparing it to the previous year, and adjusting it for any changes in the price level between the years. Economic growth is a desirable goal because it generally means that incomes are rising and people’s lives are getting better. Of course, GDP only measures the physical output of goods and services, and does not include many non-economic variables that also should be considered when measuring people’s well-being. But rising incomes and output are deemed worthy goals since they are associated with rising living standards.
Assignment: Complete the readings and online activities above. Then use the data in the table linked below to answer the quesitons that follow.
Questions:
Calculate the unemployment rates for each of the years in the table. Describe what happened to unemployment over the years displayed.
Calculate the inflation rates between each of the years in the table. Describe what happened to inflation over the years displayed.
Calculate the Real GDP for each of the years in the table.
Calculate the Real GDP growth rates between each of the years in the table. Describe what happened to real GDP from one year to the next in the years displayed.
Describe the relationship between the inflation and unemployment rates you calculated for each of the years. Is there any correlation in how the figures change from year to year?
Based on your analysis of the data above, to what extent has the United States succeeded in achieving its three macroeconomic objectives of:
As yet another school year begins, we once again find ourselves returning to an atmosphere of economic uncertainty, sluggish growth, and heated debate over how to return the economies of the United States and Europe back onto a growth trajectory. In the last couple of weeks alone the US government has barely avoided a default on its national debt, ratings agencies have downgraded US government bonds, global stock markets have tumbled, confidence in the Eurozone has been pummeled over fears of larger than expected deficits in Italy and Greece, and the US dollar has reached historic lows against currencies such as the Swiss Franc and the Japanese Yen.
What are we to make of all this turmoil? I will not pretend I can offer a clear explanation to all this chaos, but I can offer here a little summary of the big debate over one of the issues above: the debate over the US national debt and what the US should be doing right now to assure future economic and financial stability.
There are basically two sides to this debate, one we will refer to as the “demand-side” and one we will call the “supply-side”. On the demand-side you have economists like Paul Krugman, and in Washington the left wing of the Democratic party, who believe that America’s biggest problem is a lack of aggregate demand.
Supply-siders, on the other hand, are worried more about the US national debt, which currently stands around 98% of US GDP, and the budget deficit, which this year is around $1.5 trillion, or 10% of GDP. Every dollar spent by the US government beyond what it collects in taxes, argue the supply-siders, must be borrowed, and the cost of borrowing is the interest the government (i.e. taxpayers) have to pay to those buying government bonds. The larger the deficit, the larger the debt burden and the more that must be paid in interest on this debt. Furthermore, increased debt leads to greater uncertainty about the future and the expectation that taxes will have to be raised sometime down the road, thus creating an environment in which firms and households will postpone spending, prolonging the period of economic slump.
The demand-siders, however, believe that debt is only a problem if it grows more rapidly than national income, and in the US right now income growth is almost zero, meaning that the growing debt will pose a greater threat over time due to the slow growth in income. Think of it this way, if I owe you $98 and I only earn $100, then that $98 is a BIG DEAL. But if my income increases to $110 and my debt grows to $100, that is not as big a deal. Yes, I owe you more money, but I am also earning more money, so the debt burden has actually decreased.
In order to get US income to grow, say the demand-siders, continued fiscal and monetary stimulus are needed. With the debt deal struck two weeks ago, however, the US government has vowed to slash future spending by $2.4 trillion, effectively doing the opposite of what the demand-siders would like to see happen, pursuing fiscal contraction rather than expansion. As government spending grows less in the future than it otherwise would have, employment will fall and incomes will grow more slowly, or worse, the US will enter a second recession, meaning even lower incomes in the future, causing a the debt burden to grow.
Now let’s consider the supply-side argument. The supply-siders argue that America’s biggest problem is not the lack of demand, rather it is the debt itself. Every borrowed dollar spent by the goverment, say the supply-siders, is a dollar taken out of the private sector’s pocket. As government spending continues to grow faster than tax receipts, the government must borrow more and more from the private sector, and in order to attract lenders, interest on government bonds must be raised. Higher interest paid on government debt leads to a flow of funds into the public sector and away from the private sector, causing borrowing costs to rise for everyone else. In IB and AP Economics, this phenomenon is known as the crowding-out effect: Public sector borrowing crowds out private sector investment, slowing growth and leading to less overall demand in the economy.
Additionally, argue the supply-siders, the increase in debt required for further stimulus will only lead to the expectation among households and firms of future increases in tax rates, which will be necessary to pay down the higher level of debt sometime in the future. The expectation of future tax hikes will be enough to discourage current consumption and investment, so despite the increase in government spending now, the fall in private sector confidence will mean less investment and consumption, so aggregate demand may not even grow if we do borrow and spend today!
This debate is not a new one. The demand-side / supply-side battle has raged for nearly a century, going back to the Great Depression when the prevailing economic view was that the cause of the global economic crisis was unbalanced budgets and too much foreign competition. In the early 30′s governments around the world cut spending, raised taxes and erected new barriers to trade in order to try and fix their economic woes. The result was a deepening of the depression and a lost decade of economic activity, culminating in a World War that led to a massive increase in demand and a return to full employment. Let’s hope that this time around the same won’t be necessary to end our global economic woes.
Recently, CNN’s Fareed Zakaria had two of the leading voices in this economic debate on his show to share their views on what is needed to bring the US and the world out of its economic slump. Princeton’s Paul Krugman, a proud Keynesian, spoke for the demand-side, while Harvard’s Kenneth Rogoff represented the supply-side. Watch the interview below (up to 24:40), read my notes summarizing the two side’s arguments, and answer the questions that follow.
Summary of Krugman’s argument:
Despite the downgrade by Standard & Poor’s (a ratings agency) there appears to be strong demand for US government bonds right now, meaning really low borrowing costs (interest rates) for the US government.
This means investors are not afraid of what S&P is telling them to be afraid of, and are more than happy to lend money to the US government at low interest rates.
Investors are fleeing from equities (stocks in companies), and buying US bonds because US debt is the safest asset out there. The market is saying that the downgrade may lead to more contractionary policies, hurting the real economy. Investors are afraid of contractionary fiscal policy, so are sending a message to Washington that it should spend more now.
The really scary thing is the prospect of another Great Depression.
Can fiscal stimulus succeed in an environment of large amounts of debt held by the private sector? YES, says Krugman, the government can sustain spending to maintain employment and output, which leads to income growth and makes it easier for the private sector to pay down their debt.
With 9% unemployment and historically high levels of long-term unemployment, we should be addressing the employment problem first. We should throw everything we can at increasing employment and incomes.
Is there some upper limit to the national debt? Krugman says the deficit and debt are high, but we must consider costs versus benefits: The US can borrow money and repay in constant dollars (inflation adjusted) less than it borrowed. There must be projects the federal government could undertake with at least a constant rate of return that could get workers employed. If the world wants to buy US bonds, let’s borrow now and invest for the future!
If we discovered that space aliens were about to attack and we needed a massive military buildup to protect ourselves from invasion, inflation and budget deficits would be a secondary concern to that and the recession would be over in 18 months.
We have so many hypothetical risks (inflation, bond market panic, crowding out, etc…) that we are afraid to tackle the actual challenge that is happening (unemployment, deflation, etc..) and we are destroying a lot of lives to protect ourselves from these “phantom threats”.
The thing that’s holding us back right now in the US is private sector debt. Yes we won’t have a self-sustaining recovery until private sector debt comes down, at least relative to incomes. Therefore we need policies that make income grow, which will reduce the burden of private debt.
The idea that we cannot do anything to grow until private debt comes down on its own is flawed… increase income, decrease debt burden!
Things that we have no evidence for that are supposed to be dangerous are not a good reason not to pursue income growth policies.
When it comes down to it, there just isn’t enough spending in the economy!
Summary of Rogoff’s argument:
The downgrade was well justified, and the reason for the demand for treasuries is that they look good compared to the other options right now.
There is a panic going on as investors adjust to lower growth expectations, due to lack of leadership in the US and Europe.
This is not a classical recession, rather a “Great Contraction”: Recessions are periodic, but a financial crisis like this is unusual, this is the 2nd Great Contraction since the Depresssion. It’s not output and employment, but credit and housing which are contracting, due to the “debt overhang”.
If you look at a contraction, it can take up to 4 or 5 years just to get back where you started.
This is not a double dip recession, because we never left the first one.
Rogoff thinks continued fiscal stimulus would worsen the debt overhang because it leads to the expectation of future tax increases, thus causing firms and households increased uncertainty and reduces future growth.
If we used our credit to help facilitate a plan to bring down the mortgage debt (debt held by the private sector), Rogoff would consider that a better option than spending on employment and output. Fix the debt problem, and spending will resume.
Rogoff thinks we should not assume that interest rates of US debt will last indefinitely. Infrastructure spending, if well spent, is great, but he is suspicious whether the government is able to target its spending so efficiently to make borrowing the money worthwhile.
Rogoff thinks if government invests in productive projects, stimulus is a good idea, but “digging ditches” will not fix the economy.
Until we get the debt levels down, we cannot get back to robust growth.
It’s because of the government’s debt that the private sector is worried about where the country’s going. If we increase the debt to finance more stimulus, there will be more uncertainty, higher interest rates, possibly inflation, and prolonged stagnation in output and incomes.
When it comes down to it, there is just too much debt in the economy!
Discussion Question:
What is the fundamental difference between the two arguments being debated above? Both agree that the national debt is a problem, but where do the two economists differ on how to deal with the debt?
The issues of “digging ditches and filling them in” comes up in the discussion. What is the context of this metaphor? What are the two economists views on the effectiveness of such projects?
Following the debate, Fareed Zakaria talks about the reaction in China to S&P’s downgrade of US debt. What does he think about the popular demands in China for the government to pull out of the market for US government bonds?
Explain what Zakaria means when he describes the relationship between the US and China as “Mutually Assured Destruction (MAD)”.
Should the US government pursue a second stimulus and directly try to stimulate employment and income? Or should it continue down the path to austerity, cutting government programs to try and balance its budget?
I have lived in Singapore for two years now and am always interested in the nuances of the city state’s economy. In some measures Singapore has the one of the highest levels of Gross Domestic Product per capita in the world. As measured using Purchasing Power Parity, Singapore is ranked 7th in the world with $53,900 GDP per capita
Marina Bay Sands – Singapore – World’s Most Expensive Standalone Casino at SG $8 Billion – credit (me)
Singapore also has a high, and growing level of income inequality which has been associated with the form of rapid economic growth. In 2009 Singapore was ranked as having the second highest level of income inequality in developed countries, with a Gini Coefficient score of 0.425. Hong Kong was 1st and USA 3rd. In most rapidly developing economies (China, Brazil, India) strong economic growth is leading to growing income inequality. The gains from growth are not being shared equally between all citizens and the rich continue to get richer at the expense of the poor. Here are some economic indicators from Singapore.
During 2010 Singapore’s Gross Domestic Product expanded by 14.7%. This is the fastest rate of economic growth in the world.
Since 1989 it’s GDP per capita has risen from $16,000 to $48,000.
Total Gross Domestic Product in Singapore Dollars has increased from $56 Billion in 1989 to $265 Billion.
The bottom 10% of the population now account for only 5% of the national income, compared to the top 10% of people who account for 49% of the income.
Each of the above statistics support the economic goals of Singapore except for the last bullet point. Singapore believes in inclusive growth and attaches a high degree of importance on the ideals of social cohesion. These statistics are a challenge to the goals of the country, which aims to allow all families to live in dignity and with material self sufficiency.
Therefore one possible way to increase the income of the lowest people is to introduce the concept of a minimum wage. Currently the free market determines the market wage. For some occupations such as cleaners, constructions workers and domestic helpers the market is awash which cheap labour from neighbouring countries such as the Philippines, Indonesia, India and Bangladesh. This drives down the market wage. The average domestic live in helper in Singapore would make $120 a week and construction workers slightly more. These workers also have the lowest bargaining power and are often unable to negotiate for higher wages. Thus free market wage seems to disadvantage low income workers in Singapore.
Introducing a Minimum Wage:
The minimum wage is a wage floor. In Singapore, employers would not be allowed to pay their employees a rate below the minimum wage and this presumes the minimum wage was binding and set above the prevailing market rates. Some would call this a living wage and would be set to enable citizens to enjoy a basic standard of life and subsistence.
The negative aspects of the minimum wage legislation would be an increase in unemployment. After the introduction of the minimum wage the market demand for workers would fall to LD. At a higher wage firms have less incentive to hire workers. The other important feature is that Labour Supply would increase at the level of the new minimum wage. More workers would be attracted into the workforce. This therefore creates a disequilibrium where Labour Demand does not equal Labour Supply. In the Labour Market this is known as unemployment. In Singapore potential foreign investors could be less willing to invest in a country with higher labour costs and the nations competitiveness with other economies could fall. After the introduction of minimum wages in Japan (1959), South Korea (1988) and Taiwan (1956) researches found no evidence of a fall in foreign investment or economic competitiveness.
Positive aspects of introducing a minimum wage?
To reduce poverty: To help reduce poverty for the bottom 20% of households in Singapore, a binding minimum wage set above the market wage would lift incomes. The lifting of incomes should also reduce the level of income inequality for low income households.
Taxes and Benefits: If workers begin to earn higher wages then tax receipts should increase. At the same time the level of financial support for such families will likely fall as they become more self sufficient. This could also help reduce government spending. Both of these effect will likely have a positive impact on the government budget.
The effect on worker productivity:Some economists believe that the increased wage might improve labour productivity. Workers may respond to their higher wage rate by working harder, possibly as a result of worrying about losing their job now that the increased wage rate has made it a more ‘sought after’ job. Employers may force through productivity improvements. Some workers will work shorter hours and achieve a greater work life balance and hopefully be more productive during these hours at work.
Workers…. (count 7) fixing the road outside my street this week – Credit (me)
Market interventions are obvouisly not the only way to improve the incomes of low income households. Singapore currently does many small things to improve the quality of life for low income households. In my opinion in the long run the economy needs to think of other ways to increase incomes of low income households so that Singapore holds the value of social cohesion and does not become a infamous country of unequal incomes and extremes of wealth and poverty.
Subsidized Housing and Grants for first home buyers – HDB Scheme
Free education from Kindergarten to Secondary School.
In my last post, I outlined the consequences of a nation running a persistent deficit in its current account. In the post below, I will share some thoughts on how a nations can reduce its trade deficit by promoting increased competitiveness in the global economy through the use of expansionary supply-side policies. Earlier in the chapter from which this post is taken, I outlined other deficit reduction strategies, including the use of protectionism, currency devaluation and contractionary demand-side fiscal and monetary policies. In my opinion, each of these methods creates more harm than good for a nation, resulting in a misallocation of society’s scarce resources (in the case of protectionism) and negative effects on output and employment (in the case of contractionary demand-side policies)
Therefore, the following presents the “supply-side” strategies for reducing a deficit in a nation’s current account.
From Chapter 22 of my upcoming textbook: Pearson Baccalaureate Economics
Contractionary fiscal and monetary policies will surely reduce overall demand in an economy and thereby help reduce a current account deficit. But the costs of such policies most likely outweigh the benefits, as domestic employment, output and economic growth suffer due to reduced spending on the nation’s goods and services. A better option for governments worried about their trade deficit is to pursue supply-side policies that increase the competitiveness of domestic producers in the global economy.
In the long-run, the best way for a nation to reduce a current account deficit is to allocate its scarce resources towards the economic activities in which it can most effectively compete in the global economy. In an environment of increasingly free trade between nations, countries like the United States and those of Western Europe will inevitably continue to confront structural shifts in their economies that at first seem devastating, but upon closer inspection will prove to be inexorable.
The auto industry in the United States has been forever changed due to competition from Japan. The textile industry in Europe has long passed its apex of production experienced decades past, and the UK consumer will never again buy a television or computer monitor made in the British Isles. The reality is, much of the world’s manufactured goods can be and should be made more cheaply and efficiently in Asia and Latin America than they could ever be produced in the US or Europe.
The question Europe and the United States should be asking, therefore, is not “how can we get back what we have lost and restore balance in our current account”, but, “what can we provide the world with that no one else can?” By focusing their resources towards providing the goods and services that no Asian or Latin American competitor is capable of providing, the deficit countries of the world should be able to reduce their current account deficits and at the same time stimulate aggregate demand at home, while increasing the productivity of the nation’s resources and promoting long-run economic growth.
Sure, you say, that all sounds great, but how can they achieve this? This is where supply-side policies come in. Smart supply-side policies mean more than tax cuts for corporations and subsidies to domestic producers. Smart supply-side policies that will promote more balanced global trade and long-run economic growth include:
Investments in education and health care: Nothing makes a nation more competitive in the global economy than a highly educated and healthy work force. Exports from Europe and the US will lie ever increasingly in the high skilled service sector and less and less in the manufacturing sector; therefore, highly educated and skilled workers are needed for future economic growth and global competitiveness, particularly in scientific fields such as engineering, medicine, finance, economics and business.
Public funding for scientific research and development: Exports from the US and Europe have increasingly depended on scientific innovation new technologies. Copyright and patent protection assure that scientific breakthroughs achieved in one country will allow for a period of time over which only that country will enjoy the sales of exports in the new field. Green energy, nano-technology, bio-medical research; these are the field that require sustained commitments from the government sector for dependable funding.
Investments in modern transportation and communication infrastructure: To remain competitive in the global economy, the countries of Europe and North America must assure that domestic firms have at their disposal the most modern and efficient transportation and communication infrastructure available. High speed rail, well-maintained inter-state or international highways, modern port facilities, high-speed internet and telecommunications; these investments allow for lower costs of production and more productive capital and labor, making countries goods more competitive in the global marketplace.
Reducing a current account deficit will have many benefits for a nation like the United States, Spain, the UK or Australia. A stronger currency will assure price stability, low interest rates will allow for economic growth, and perhaps most importantly, less taxpayer money will have to be paid in interest to foreign creditors. Governments and central banks may go about reducing a current account deficit in many ways: exchange rate controls, protectionism, contractionary monetary and fiscal policies, or supply-side policies may all be implemented to restore balance in the current account. Only one of these options will promote long-run economic growth and increase the efficiency with which a nation employs its scarce factors of production.
Supply-side policies are clearly the most efficient and economically justifiable method for correcting a current account deficit. Unfortunately, they are also the least politically popular, since the benefits of such policies are not realized in the short-run, but take years, maybe decades, to accrue. For this reason, we see time and time again governments turning to protectionism in response to rising trade deficits.
Over a year has gone by since the 2009 American Recovery and Reinvestment Act (ARRA) was passed and put into action by the Obama Administration. Supporters of the program say that it has been successful, arguing that the economy would be in much worse shape if no stimulus had been introduced at all. In fact, some are arguing that government spending has not been sufficient for a full economic recovery and that more direct government spending is necessary. Economists on the other side argue that the stimulus package has done little for the economy except to delay the inevitable, self correcting forces of the economy needed to pave the road back to recovery. Some actually say that we are in a worse situation now due to the massive increase in government debt which will eventually have to be paid back.
So the question is, are we better off as an economy a year after the stimulus package was introduced? With growth still sluggish and unemployment at 9.5%, many people have begun to question the success of the ARRA. Again, some say the $784 billion was insufficient while others say less regulation and more tax cuts should have been utilized.
In a recent Washington Post article, Neil Irwin argues that the obstacles towards economic growth may not be solved by more stimulus, lower interest rates or tax cuts for corporations. The problem, he claims, is not a lack of funds for investment, but in the uncertainty businesses have in future conditions. He writes:
Corporate profits are soaring. Companies are sitting on billions of dollars of cash. And still, they’ve yet to amp up hiring or make major investments — the missing ingredients for a strong economic recovery. Many Democrats say the economy needs more stimulus. Business lobbyists and their Republican allies say it needs less regulation and lower taxes. But here in the heartland of America, senior executives say neither side’s assessment fits.
They blame their profound caution on their view that U.S. consumers are destined to disappoint for many years. As a result, they say, the economy is unlikely to see the kind of almost unbroken prosperity of the quarter-century that preceded the financial crisis.
With consumers choosing to save or pay off their debts now rather than spend, many businesses find it in their interest to hold off on investments into new capital until consumers begin spending again. With no planned investment and no incentive to hire workers, unemployment stays high and economic growth remains stagnant. With inflation rates low and economists predicting deflation, it makes more sense to hold onto money as it is not losing its value.
So is there a solution? In this situation, expansionary monetary policy through lower interest rates will not have the desired effect as demand for loanable funds is low. As stated in the article:
For large companies such as Illinois Tool Works, the price of borrowed money isn’t the problem. The company had $1.3 billion in cash on its balance sheet at the end of June, up from $743 million at the end of 2008. Lower interest rates wouldn’t make much of a difference, either.
“I could borrow $2 billion tomorrow for 3 1/2 percent,” said Speer. “But what am I going to do with it?””
Other executives claim that an increase in government spending would only provide a temporary fix but have no effect on long term consumer spending.
David Speer is chief executive of the company, which has 60,000 employees worldwide in more than 800 business units and $14 billion in sales. He said an additional burst of fiscal stimulus from Washington might help boost economic growth for a period of months. But that is unlikely to affect his decisions about hiring and expansion, which Speer said are based on expectations for sales over years to come, not just the immediate future. As long as U.S. consumers remain deeply strained, he is unlikely to undertake aggressive expansion.
More fiscal stimulus “might help make things a little better for a couple of quarters, but I’m not sure it would get at the underlying economic issue,” Speer said. “The core question is: How do you get consumers back on their feet. We need growth in a sustainable way, not another Band-Aid.”
Another solution would be for the government to implement supply side measures such as less market regulation and lower corporate taxes. Again, without the much needed consumer spending and confidence, its difficult to say whether or not this will materialize into increased investment and employment.
The rest of the Washington Post article can be read here. Once you’ve read the article, answer discuss the questions below and share your thoughts in a comment on this post.
Discussion Questions:
Why is consumer spending and confidence so important for businesses?
What role does business investment into capital play in the economy and why is it so important in leading the economy towards recovery?
Is there any benefit in the economy for consumers to save and pay off their debts now? Is this a rational decision given the current economic conditions?
If fiscal and monetary policies along with lower taxes for corporations are not the answer, then what is? What other possibilities are available for the government to implement?
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:
How does China manipulate the value of its currency? Why is such manipulation harmful to US exporters?
How does a government payment guarantee for exporters actually reduce the costs of doing business for US exporting firms?
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:
What factors does Paul Collier point to that contribute to the “poverty traps” many African nations find themselves in? [3:07]
What have the two main goals of foreign aid policy been over the last 50 years, according to Dambisa Moyo? [4:45]
What are the “four horsemen of the African apocalypse?” How does Moyo think these four obstacles to development can best be overcome? [5:14]
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]
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]
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:
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]
Is there any historic record of aid working? What strategies accompanied foreign aid that contributed to its greatest historical success? [8:10]
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.
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.
