Once again, my IB Economics students are working on yet another Internal Assessment Commentary, this time on syllabus section 3, Macroeconomics. Since they found my sample Microeconomics commentary so helpful, I thought I’d punch out a quick sample of a macro commentary for them and for anyone else who is working on their IB Economcis Internal Assessment.

The commentary below (not including the selection from the article) is 749 words in length. This does NOT include words in the graphs, so let’s not have that debate in the comment section. The new IB economics internal assessment model (first examinations 2013) will not count words on graphs, so this sample commentary is perfectly suited for the new assessment model. If you’re a 2012 student, you would be wise to count words in graphs as part of your word count.

If you like what you see, or have any quesitons, please leave your comments below the post.

Article highlights:

An Impeccable Disaster – NYTimes.com

Paul Krugman clearly explains the problems faced by two or Europe’s largest economies today:

So why is Spain — along with Italy, which has higher debt but smaller deficits — in so much trouble? The answer is that these countries are facing something very much like a bank run, except that the run is on their governments rather than, or more accurately as well as, their financial institutions.

Here’s how such a run works: Investors, for whatever reason, fear that a country will default on its debt. This makes them unwilling to buy the country’s bonds, or at least not unless offered a very high interest rate. And the fact that the country must roll its debt over at high interest rates worsens its fiscal prospects, making default more likely, so that the crisis of confidence becomes a self-fulfilling prophecy. And as it does, it becomes a banking crisis as well, since a country’s banks are normally heavily invested in government debt.

Now, a country with its own currency, like Britain, can short-circuit this process: if necessary, the Bank of England can step in to buy government debt with newly created money. This might lead to inflation (although even that is doubtful when the economy is depressed), but inflation poses a much smaller threat to investors than outright default. Spain and Italy, however, have adopted the euro and no longer have their own currencies. As a result, the threat of a self-fulfilling crisis is very real — and interest rates on Spanish and Italian debt are more than twice the rate on British debt.

Commentary:

The European Central Bank (ECB) is engaging in a new form of monetary policy in which it buys government bonds directly from the Spanish and Italian governments. Essentially, the goal is to bring down the interest rates on Italian and Spanish government bonds, which should reassure private investors that Italy and Spain will be able to pay them back and thus reduce the upward pressure on interest rates in the Eurozone, a situation which threatens to reverse the already sluggish recovery from the recessions of 2008 and 2009.

Monetary policy refers to a central bank’s manipulation of the money supply and interest rates, aimed at either increasing interest rates (contractionary monetary policy) or reducing interest rates (expansionary monetary policy). The ECB is currently buying government bonds from European governments, effectively increasing the supply of money in Europe with the hope that more government and private sector spending will move the Eurozone economy closer to its full employment level of output, at which workers, land and capital resources are fully employed towards the production of goods and services.

If successful, the ECB’s “quantitative easing”, as the new type of monetary policy is known, should bring down interest rates on government bonds and thereby reallocate loanable funds towards Italy and Spain’s public and private sectors.  The increase in supply of loanable funds should bring down the private interest rates available to borrows (businesses and households), making private investment more attractive.

The ECB’s bond purchases make it cheaper for Italy and Spain to borrow, lowering the interest rates on their bonds, restoring confidence among international investors, who may be more willing to save their money in Italy in Spain. The inflow of loanable funds into these economies (seen as an increase in the supply of loanable funds from S1 to S2) should bring down private borrowing costs (the real interest rate), encouraging more firms to invest in capital and more households to finance the consumption of durable goods, increasing aggregate demand and moving the Eurozone economy back towards its full employment level of output, from AD1 to AD2 in the graph on the right.

In certain circumstances, monetary easing like this could be inflationary, but in reality inflation is unlikely to occur given the large output gap in Europe at present (represented above as the distance between Y1 and the dotted line, signifying the full employment level of output). Any increase in aggregate demand will lead to economic growth (an increase in output), but little or no inflation due to the excess capacity of unemployed labor, land and capital resources in the European economy today.

With private sector borrowing costs increasing due to growing uncertainty over their deficits and debts, the Italian and Spanish governments will find expansionary fiscal policies (tax cuts and increased government expenditures) are unrealistic options for achieving the goal of full employment. The ECB, however, as Krugman argues, should continue to play an increasing role in the expansion of credit to cash strapped European governments, with the aim of keeping interest rates low to prevent the crowding-out of private spending that often occurs in the face of large budget deficits. Inflation, always a concern for central bankers, should be a low priority in Europe’s current recessionary environment. Only when consumer and investor confidence is restored, a condition that requires low borrowing costs, will private sector spending resume and the Euro economies can begin creating jobs and increasing their output again.

In the short-term, Italy and Spain should take advantage of the ECB’s bond-buying initiative, and make meaningful, productivity-enhancing investments in infrastructure, education and job training. If their economies are to grow in the future, Eurozone countries must become more competitive with the rapidly expanding economies of Asia, Eastern Europe, and elsewhere in the developing world.

In the medium-term, the Eurozone countries must demonstrate a commitment to fiscal restraint and more balanced budgets. Eliminating loopholes that allow businesses and wealthy individuals to avoid paying taxes, for example, is of utmost importance. Also, increasing the retirement age, downsizing some of the more generous social welfare programs and increasing marginal tax rates on the highest income earners would all send the message to investors that these countries are commited to fiscal discipline. Then, in time, their dependence on ECB lending will decline and private lenders will once again be willing to buy Eurozone government bonds at lower interest rates, allowing for continued growth in the private sector.

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

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

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

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

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

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

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

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

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

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

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

Discussion questions: 

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

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

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

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

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

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

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

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

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

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

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

Summary of Krugman’s argument:

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

Summary of Rogoff’s argument:

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

Discussion Question:

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

This post is an introduction to the Academy Award winning documentary, ‘Inside Job’ for introductory Economics students

What do Wall Street investment bankers and used car salesmen have in common? Sometimes, the less their customers know about the products they’re selling, the more profits they both stand to earn. Imperfect information in markets can lead to market failure, and at its core, the failures of global financial markets during 2008 – 2009 was a result of imperfect information.

Last night, the film ‘Inside Job’ won the Academy Award for Best Documentary of 2010. The film focuses on the changes in the financial industry in between 2000 and 2007 that led to an overall increase in the level of risk undertaken by home mortgage lenders, investment banks, and ultimately the broader investment community the banking system serves.

The mis-aligned incentives motivating Wall Street banks and the asymmetry of information between the buyers and sellers of financial products, as well as the creation of new, complex derivative markets that allowed investment banks to bet against the very assets they were assembling and selling off to investors, contributed to the collapse of credit markets in 2007 and 2008 and ultimately a contraction of the level of economic activity worldwide during the “Great Recession” of 2008 and 2009.

The article below is an attempt to introduce the seemingly incomprehensible nature of global financial markets and understand what occurred in them between 2000 and 2007 in the context of an introductory Economics unit on Market Failure.

Imperfect Information as a Market Failure:

Imagine this. You’re in the market for a used car. You go to the used car dealership, speak with a salesman, and he takes you through rows of automobiles, telling you the features of each one and assuring you that each of his cars has been inspected by a third party garage for reliability. You find this re-assuring; after all you wouldn’t want to buy a car that hasn’t passed a basic inspection, since you don’t want it to break down once you’ve driven it off the lot.

After an hour or so of poking around the lot, you pick out the perfect car. A silver 2006 Audi, a great year for Audis, says the dealer. You have his word that it has been closely inspected and is in top notch shape. So you hand over $20,000 for the Audi and drive it off the lot, satisfied with your purchase.

What would you say, however, if you knew that soon after driving off the lot, the very salesman who convinced you to buy that Audi purchased an insurance policy that would pay the salesman $20,000  in the case that it broke down. Would that knowledge have made you question your purchase?

What would you say if you found out that the “third party garage” the salesman used to inspect the car actually followed orders from the dealer himself, and was 100% dependent on that dealer’s business. Therefore, the mechanic was under significant pressure to give each of the cars sent to him a high mark in its inspection. By doing so, the garage mechanic assures that the dealer is able to easily sell cars to the buyers who trust that the mechanic has given an honest appraisal of the car’s mechanical reliability. Since the dealer can sell cars given high inspection marks  for higher prices, the dealer is then able take out insurance policies that pay a greater amount when the car ultimately breaks down.

Would all of this knowledge have made you questions your purchase and the price you paid for your Audi? Chances are, if there had been perfect information in the market for used cars, you, and countless other people, would not have been willing to pay the price you paid for your Audi. Fewer used cars would have been sold, and they would have sold for lower prices. The existence of asymmetric information results in an over allocation of resources towards the market for mechanically unsound used cars.

So what does the story above have to do with the global financial crisis? Believe it or not, the fundamental cause of the near collapse of the global financial system in recent years is almost identical to our story about the used-car salesman, the corrupt garage mechanic, the dubious insurance policies and the sucker buyer, who was stuck driving a crappy car that broke down within days of driving it off the lot.

Financial Market Failure:

Between 2000 and 2007, financial innovation led to unprecedented increases in the availability of low interest loans to millions of low income American households for whom home mortgages traditionally would have been unobtainable. Banks which issued these “sub-prime” loans to households with very poor credit were able to sell them to Wall Street investment banks, which were re-packaging individual home mortgages with  thousands of similar loans from all over the United States into asset-backed securities, a form of bond that could then be sold to an investor to whom the interest payments made by the homeowners would accrue over the lifespans of the mortgages included in the bond.

Investment banks turned to the big credit rating agencies (Standard and Poors, Moody’s), who inspected the make-up of these asset backed securities, declared them investment grade and gave them AAA ratings, essentially giving a thumbs up to the institutional investors who ultimately bought these bonds from the investment banks. An AAA rating assured investors who bought the bonds that they were very safe investments, in essence that they were in “good mechanical order”, just like the Audi you drove off the lot after being told it was in good mechanical order.

The investors who ultimately bought these bonds were not small time investors like you and me, rather they were institutions, such as state pension funds, hedge funds, money market funds, sovereign wealth funds, and so on, who often times used taxpayers money to buy bonds from big investment banks on Wall Street (such as Morgan Stanley, Goldman Sachs and Bear Stearns). These investors were assured by the banks that the bonds were of the highest quality and would therefore earn the investors interest payments for years, even decades. In addition, because of the high ratings given to these bonds by the rating agencies, the investors believed they would always be able to sell the bond if they needed the money back they had originally used to buy it.

The information given to investors was not always correct, however, it turned out that many of Wall Street banks assembling and selling these bonds were also betting against them in a parallel market for derivatives known as credit default swaps.

Here’s the catch… the Wall Street banks that bought millions of low-income Americans’ mortgages (the “sub-prime” type) were just like that used car salesman. They knew the bonds of their creation were of poor quality, but just had to get the investors to believe they were in good mechanical order to “get them off the lot” into the hands of an investor.

And just like the sleazy car salesman, as soon as the banks started selling these bonds to investors, they began taking out insurance policies against them in the case that they should lose their value. An insurance policy that pays out when the value of a bond collapses is called a “credit default swap” (CDS), and the market for these  became a multi-billion dollar industry in which big Wall Street banks bought insurance on the very bonds they created and sold to institutional investors, essentially betting that their own bonds would collapse in value. Of course, none of the investors knew the banks were betting against their own bonds, because this knowledge would have surely wiped out demand for them and led to collapse in business for the Wall Street banks.

The rating agencies inspecting the asset backed securities assembled from bad mortgages were just like the corrupt garage mechanic giving all the 2006 Audis a “thumbs up” to make them easier for the car dealership to sell. By giving sub-prime mortgage backed securities “investment grade” AAA ratings, the rating agencies made it easier for investment banks to sell them to sucker investors for high prices, which in turn enabled investment banks to take out insurance policies (CDSs) against them. And since the rating agencies knew the banks wanted AAA ratings for bonds that should have been given “junk bond” status, the agencies continued to give them the highest rating, since they were dependent on the Wall Street banks for their business.

In the end, just like the 2006 Audi you drove off the lot was of poor mechanical integrity and broke down just days after you dropped $20,000 on it, most of the bonds assembled and sold on to investors by Wall Street banks were themselves of very poor quality. The underlying assets, the sub-prime mortgages themselves, were made to American households who could not possibly pay them back, Americans whose incomes were so low that the monthly payment for the home loan often exceeded the income of the borrower himself.

Ultimately, when sub-prime mortgage borrowers began defaulting on their loans, the Wall Street investment banks that had assembled them into asset backed securities and the institutional investors who bought these bonds found themselves holding trillions of dollars worth of loans that were no longer being repaid. For the banks, however, things weren’t all that bad, because just like the corrupt car salesman, they had taken out hundreds of billions of dollars in insurance on the bonds, which assured that when they finally went bad, the banks, which had passed on most of the bonds to investors, could simply collect the insurance payouts from the issuers of credit default swaps.

Who were the insurance companies stupid enough to insure crappy bonds, you ask? You may have heard of AIG (American Insurance Group). This was the insurance company insuring most of the sub-prime mortgage backed bonds. When all the bonds started to go bad AIG quickly ran out of money as it paid the investment banks out the insurance they owed. When AIG ran out of cash, the US government stepped in and gave AIG $85 billion of taxpayer money in September 0f 2008, assuring that the Wall Street banks with insurance through AIG collected 100% of their insurance money.

Show Me the Market Failure:

So what makes this a “market failure” in the economic sense of the term? Well, the existence of imperfect information in the automobile market led to an over allocation of resources towards the market for used cars. Because the buyers were being duped by the sellers and the corrupt garage mechanics, demand for used cars was too high and the price they were being sold for was too high. With more perfect information, consumers would have demanded fewer cars and they would have been sold for a lower price.

With more perfect information in the financial markets, far fewer investors would have been willing to pay the prices they did for the bonds the Wall Street banks assembled from sub-prime mortgages. Far less credit would have been made available to low income American home buyers. Far fewer sub-prime mortgage loans would have been made, and fewer Americans would have purchased homes that they could not afford in the first place.

In addition, if the institutional investors who were ultimately stuck holding these bonds had known that the investment banks selling them were simultaneously buying insurance policies against them, the investors would have been much more wary about investing in them. Also, if the investors had known that the rating agencies giving the bonds AAA, investment grade ratings were essentially following orders from the investment banks, giving the bonds the high ratings the Wall Street bosses wanted them to get, then the investors would have  been less willing to buy the bonds and less credit would have ended up in the hands of low-income American home buyers.

The market for financial services failed because too many resources were allocated towards the provision of loans to low-income American households. With more perfect information about the value of the under-lying assets included in the bonds being sold by Wall Street banks (the sub-prime mortgages), and with the knowledge that the banks themselves were betting against the bonds they assembled and sold, far fewer investors would have been willing to buy the bonds and far less credit would have been made available to American home buyers.

A market failure exists anytime the free market produces at a level of output greater or less than that which is deemed socially optimal. Given the huge surplus of unsold homes in the United States right now, and the collapse of many institutional investors’ portfolios on whose financial strength hundreds of millions of real people around the world depend for their very livelihoods, it can be safely argued that the imperfect information in the market for mortgage-backed securities (bonds) led to an over allocation of resources towards homes for low income Americans.

Discussion Questions:

1. Why is perfect information needed for a market to be perfectly efficient? How does imperfect information lead to a mis-allocation of resources in a market?
2. In the case of financial markets, what information, if known by those who invested in sub-prime mortgage-backed securities, would have helped correct the market failure and prevented the global financial crisis?
3. Another type of market failure we study in Microeconomics is negative externalities. Did the over-allocation of resources towards home loans for low income households create any negative externalities when the assets backed by the loans ultimately lost their value? What are some of the social costs of too many loans being made to low income borrowers in the early 2000′s?
4. Some argue that the financial crisis was not a market failure, but a regulatory failure, meaning the government failed to notice the actions of Wall Street banks and stop them before they caused a financial crisis? To what extent should the government intervene in the functioning of free markets to assure that information asymmetry does not lead to similar crises in the future?
5. Suggest one regulation the government could have enacted to prevent the over-allocation of capital towards the sub-prime mortgage market?

BACKGROUND & FRAMING OF THE ISSUES
One of the most widely discussed and often misunderstood areas of the U.S. economy is the current amount of the United States’ national debt, which currently totals $14.1T. Yes, currently the U.S. Government owes a collective $14.1T to both American & foreign households & institutions. This borrowing was necessary since the U.S. government has spent in excess of its tax revenue over the years, which, in economic speak, is called “deficit spending”. In short, the U.S. government must borrow when its spending exceeds its tax revenue. Over the past 10 years especially, government spending has well exceeded tax revenue almost tripling during that period. A combination of two wars, two recessions, and two political parties that have not yet made deficit fighting an urgent priority accounts for this surge in debt over the past 10 years.

The shear magnitude of the U.S. national debt ($14.1T), coupled with alarmist comments by the U.S. Congress and the American press lead most Americans to conclude that our country is in a very precarious position and is perhaps on the verge of bankruptcy. Moreover, many Americans are aware that future Federal payouts for social security and Medicare alone, assuming no benefit changes, will rise at a much faster rate than the current tax revenues for those same social programs further increasing the national debt.

THE IMPORTANCE OF DEBT TO A COUNTRY
Contrary to what many Americans believe to be conventional wisdom, debt is actually a beneficial and recommended pursuit, if used correctly, since it enables a nation or an individual to equalize income and expenditures over time, and improve standards of living earlier than what would otherwise be attainable. It is easier to accept this premise on the personal front as millions of Americans have been able to improve their standard of living currently by pulling their future incomes forward via borrowing to purchase homes, cars, and education. Of course, we all know that debt, like a car, can cause damage if it is not used and managed wisely, and that is where many alarmists focus and even some go so far as saying that all debt is bad and should be avoided. Many nations, with Russia being a prime example, have been criticized by economists for not utilizing enough national debt to improve their economy and their citizens’ standards of living. Thus, hopefully, with a conclusion that debt is actually a “good thing”, if used for productive purposes, one can then proceed to the next section as to what are acceptable levels of national debt.

$14.1T: AN AFFORDABLE LEVEL OF NATIONAL DEBT?
The United States’ current level of national debt is still affordable and consistent with several other nations. The problem, however, is that with the continued rate of growth in the debt experienced over the last 10 years it will not be affordable forever. National accounting statistics show clearly that the U.S.’s 96% national debt/GDP percentage is, in fact, above average compared with most other modern economies, but it is certainly not the highest as economies like Japan and Italy currently have debt/GDP levels at 204% and 130%, respectively. Moreover, the level of U.S. national debt as a percentage of GDP (96%) is relatively close to where it was back in 1950 after having financed World War II. Our nation’s highest level of debt relative to GDP was 121% back in 1945. The key point is that debt must be benchmarked to our nation’s income which is GDP. I find it interesting that if I tell someone that Bill Gates owes someone $10M they quickly can figure out that he’s probably fine, but if I tell the guy at Starbucks that the U.S. owes $14.1T they think the country must be ready to go bankrupt. Big numbers really scare people, so one needs a perspective.

WHO IS THE NATIONAL DEBT OWED TO?
Much has also been made of the fact that $4.3T of the U.S. national debt, or 30%, is owed to foreigners. The fact that a good chunk of the debt is owed to foreigners is not nearly as much of a concern as the growth of the national debt in general. Foreign debt is nothing more than foreigners temporarily saving their U.S. dollars, the same dollars sent to them for their products imported into our country. Some foreigners elect to temporarily save these dollars and earn interest by lending them back to the U.S. Government by purchasing bonds. I don’t consider the fact that debt is “foreign” to be a problem, as these dollars will eventually be paid back to the foreigners with interest and these same dollars will, in turn, be spent back into our U.S. economy. Debt held by foreigners is “dollar savings” just like debt held by American citizens is “dollar savings”, so, in other words, it is really not that important whether the debt is held by foreigners or US citizens since eventually those dollars will be spent back into the U.S. economy since they can’t be spent in another economy!

SO IT MIGHT BE AN AFFORDABLE LEVEL OF U.S. NATIONAL DEBT NOW, BUT WHAT ABOUT THE FUTURE?
Many have argued that the U.S. aging population coupled with the flood of “baby boomers” moving into their retirement years will cause social security and Medicare alone to “shoot through the roof” and cause the U.S. national debt to reach unacceptable and unmanageable levels, potentially, some say, even bankrupting the U.S. Government. Many use extrapolations of future social security and Medicare payments out into varying distant futures based on the number of retiring baby boomers and increasing life spans concluding that there are trillions of unfunded government obligations ($10T, $25T, $80T, etc.) which are insurmountable. The problem with most all of these analyses are that they fail to address how simple and relatively small adjustments make these problems disappear. For example, on social security, an increase in the social security tax rate from its current rate of 12.4% (6.2% for employees matched by employer) to 15.9% is deemed by one source to fully fund social security at today’s benefit structure out into perpetuity (i.e., forever). Similar analyses are out there for other actions such as updating social security retirement ages to be more consistent with longer life spans. Now granted, few would be happy with a 28% increase in their social security taxes paid or later retirement ages, but what will likely happen will be a combination of different types of changes including reduced benefits, higher taxes, later retirement ages, and reallocations of the overall federal budget.

CONCLUSION
Today’s $14.1T U.S. national debt, although currently affordable, is rising at too fast a rate. In just 10 years, the U.S. debt level has gone from 58% of GDP in 2000 to 96% today. At current rates of spending and tax revenues, our country will exceed 100% of GDP by the end 2011.

The U.S. economy has some sizable challenges ahead in terms of keeping our increasing national debt in line with increases in our economic growth. Most notably, our demographic trends of fewer births and increased retirees with longer life spans will put additional strains on our country’s debt/income relationship.

Am I optimistic? Very much so! Our Government has shown before that we can pare our debt down. Our nation restored fiscal soundness after World War II when national debt reached an all time high of 121% of GDP and again in the 1990’s as our Government made significant changes in government spending and taxation policies to curb our debt from 67% of GDP to 58% of GDP.

What should be the goal? I say a debt level of 67% of GDP should be the goal, which is a very average and affordable level of debt. It’s OK for debt to grow as long as it does not become too high relative to the size of our economy or GDP.

The next 5 years will be very important years to establish the fiscal discipline to restore our debt to very manageable levels. If not…well….has anybody heard about Greece?

Discussion Questions:

1. How do economists gain a perspective of just how high a country’s national debt is? Can you think of any other ways to gain a perspective on how high a country’s debt levels are?
2. Respond to the comment: “Reponsible governments should balance their budget (spending = tax revenue)”
3. If Japan’s debt to GDP ratio is over twice that of the U.S. can we conclude that the U.S. has a lot of “breathing room” and can continue to carry large annual deficits out into the future?

Argentina’s reserves and its debts: Central Bank robbery | The Economist

I received the following email from an Econ teacher who wonders if I had any insight on a question posed by one of his students:

The email reads: “I have alittle query i was hoping you could help clear up for me..a year 13 student has asked a question relating to Argentina’s prime minister, Cristina Fernandezde De Kirchner’s, decision to sell the central bank’s dollar reserves to fund part of the country’s decifit against the advice of the director of the central bank who resigned.”

The student’s question is on the following passage from the Economist article above:

Fernández (Argentina’s president”) justified her raid on the reserves by saying that the Central Bank had more than it needed, because they exceeded the size of the monetary base. Economists disagree about what is an appropriate target for the reserves, but Mr Redrado’s view is that a highly dollarised emerging economy like Argentina’s needs an abundance of Treasury bonds (the form in which most reserves are held) as insurance. Even if Ms Fernández might find support from some economists for her argument, her plan to swap the dollar reserves for a non-transferable government bond would not.

The student’s question is: “I do not know what a monetary base is, nor why Argetina needs treasury bonds.”

This article really caught me off guard at first as well. One thing I love about the Economist newspaper is its use of economic jargon that requires a real understanding of the subject to be able to interpret. The first time I read the article, I will be honest I was completely confused as to what the Argentinean president was up to. But after some reflection and rough sketches of graphs on scrap paper, I think I have “translated” the article’s jargon into plain English.

Below is my reply to the teacher and his student:

Hello,

The president of Argentina wants to sell the country’s US dollar reserves, which are held in the form of US treasury bonds, and then use the US dollars she receives to buy Argentinean government bonds in order to finance her own government’s budget deficit. In essence she wants to swap Argentina’s central bank reserves of US debt (considered a very stable and safe asset due to America’s low inflation rate and relative solvency of the US government) for Argentinean government debt (less stable and safe, especially in the wake of the country’s 2002 default on its debt). Argentina’s central bank would then hold fewer transferable, stable US bonds and more “non-transferable”, Argentinean government bonds. And since the bonds represent Argentina’s government debt, the country as a whole reduces its assets and increases its liabilities.

It is important for a developing country like Argentina to keep large reserves of US dollar-denominated assets (i.e. US treasury bonds) in reserve in order to assure foreign investors that the country would be able to stabilize its currency’s value in the face of a currency crisis such as that which Argentina experienced in 2001-2002. If the value of the peso began to decline on foreign exchange markets (due, for instance, to a decline in international investor confidence in the government’s ability to pay the interest on its foreign debt or inflation fears caused by excessive monetary growth or government spending) then the central bank could use its large dollar reserves to intervene in the forex market and stabilize the value of the peso, reestablishing investor confidence and maintaining the government’s ability to attract foreign creditors in the Argentinean bond market. A collapse of the peso would have ripple effects throughout Argentina, driving up imported products and raw materials and causing spiraling inflation, forcing the government to print more money to finance its budget in the face of falling demand for its debt in domestic and international bond markets.

Argentina must be sure to keep its balance sheet (i.e. its liability to asset ratio) in check. Its assets are US government bonds, its liabilities are the Argentinean bonds it issues to finance its budget deficits. If this ratio become too heavy on the liability side, foreign investors and speculators will lose confidence in the both peso and the Argentinean government’s solvency and dump their holdings of Argentinean currency, assets, and bonds, driving interest rates through the roof and the exchange rate through the floor, grinding the economy to a halt.

The article says,

Argentina’s economy is on course to rebound this year and grow at 3-5%. But the government is spending money so fast that this growth will not finance current spending on its own, says Daniel Marx, a former finance minister. Ordinarily, a government faced with a shortfall would turn to domestic and international bond markets. But this has been difficult since Argentina defaulted in 2002.

The country cannot count on private creditors to make up its budget shortfall, so the president is planning to finance her country’s deficit by buying Argentinean bonds with the country’s own US dollar reserves. Such behavior concerns economists because it could send a message to international investors that the country is on the path towards another unsustainable build-up of debt that could culminate in another default and economic collapse. The article is a word of caution to the president that all leaders should heed: balanced budgets are a good idea, and debt is dangerous!

Homo Economicus, the “Economic Man” is the concept underlying most economic theories. It holds that all humans are purely self-interested, rational actors who have the ability to make judgments that fulfill their subjectively defined ends. In modern economic theory, the end man seeks is generally accepted to be increasing monetary well-being and material wealth.

Philosophical foundations of “homo economicus“:

Aristotle (350 BC):

Again, how immeasurably greater is the pleasure, when a man feels a thing to be his own; for surely the love of self is a feeling implanted by nature and not given in vain, although selfishness is rightly censured; this, however, is not the mere love of self, but the love of self in excess, like the miser’s love of money; for all, or almost all, men love money and other such objects in a measure. And further, there is the greatest pleasure in doing a kindness or service to friends or guests or companions, which can only be rendered when a man has private property. These advantages are lost by excessive unification of the state.

• What does Aristotle think about the interference of government in the private property rights of man?
  

Adam Smith (1776):

In almost every other race of animals, each individual, when it is grown up to maturity, is entirely independent, and in its natural state has occasion for the assistance of no other living creature. But man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love of them. Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer: and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher the brewer or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages.

• How does Smith believe the pursuit of individual self-interest can lead to benefits for society as a whole?

John Stuart Mill (1836)

What is now commonly understood by the term “economics” is not the science of speculative politics, but a branch of that science. It does not treat of the whole of man’s nature as modified by the social state, nor of the whole conduct of man in society. It is concerned with him solely as a being who desires to possess wealth, and who is capable of judging of the comparative efficacy of means for obtaining that end. It predicts only such of the phenomena of the social state as take place in consequence of the pursuit of wealth. It makes entire abstraction of every other human passion or motive; except those which may be regarded as perpetually antagonizing principles to the desire of wealth, namely, aversion to labor, and desire of the present enjoyment of costly indulgences. These it takes, to a certain extent, into its calculations, because these do not merely, like our other desires, occasionally conflict with the pursuit of wealth, but accompany it always as a drag, or impediment, and are therefore inseparably mixed up in the consideration of it.

• According to Mill, labor is not something humans value for its own sake, but only because it allows us to do what?

Fredrick von Hayek (1930s):

We will benefit our fellow man most if we are guided solely by the striving for gain. For this purpose we have to return to an automatic system which brings this about, a self-directing automatic system which alone can restore liberty and prosperity.

• How would Hayek respond to those who argue that the government’s role in society and the economy is to promote fairness and equality?

Are you a “homo economicus“? - The Golden Balls Game

The prize: $1 million

How to play:

• Find an opponent from among your classmates.
• You and your opponent have never met before today, never spoken to one another, and will never see nor speak to one another again after the game ends.
• Since you do not know or care about your opponent, you must play this game with your own self-interest in mind, and assume that your opponent will play it with his or her self-interest in mind.
• You have in front of you two folded pieces of paper. One says “SPLIT” and one says “STEAL”
• You must decide which piece of paper to select, based on the following possible outcomes

The payoffs:

• If both players decide to “split”, each player will take home $500,000.
• If one player chooses to “split” and the other chooses to “steal” then the one who chooses to steel will take home $1 million, and the one who chose to split will get nothing
• If both players choose to “steel”, both players go home empty handed.

Let’s play!

• You only have one chance to play this game. Remember, you care only about yourself and should do what is best for you.
  
• On the teacher’s command, reveal your decision to your opponent.
  
• Take note of your payoff and report it to the teacher
  

Discussion:

• What was the outcome of your game?
  
• Was the outcome rational? Was it predictable?
  
• Did the outcome reflect the concept of “homo economicus“? Were you and your opponents’ decisions purely self-interested and coldly rational, intended to maximize your OWN payoff?
  
• Are you a homo economicus? What would homo economicus have done? Why?
  

Videos:

Golden Balls – the real gameshow: http://www.youtube.com/watch?v=p3Uos2fzIJ0&feature=player_embedded

• Which player was more like homo economicus? Sarah or Steve?
• Which player acts rationally? What makes it rational?
• Which player acts irrationally? What makes it irrational?

“The Trap”: Intro to game theory and rational self-interest in politics and economics: http://www.youtube.com/watch?v=qzNcY-gZdiA&feature=related

• John Nash’s Game Theory proved that “a system driven by selfishness did not have to lead to chaos”, that “there could always be a point of equilibrium in which everyone’s self-interest is perfectly balanced against each other”? How does such a theory support the concept of homo economicus?
• What is the Prisoner’s Dilemma? “The rational choice is always to betray the other person.” What does this say about humans in society? Is government regulation needed to prevent constant betrayal by greedy, self-interested individuals? Or are constant betrayal and self-interest themselves capable of achieving a socially optimal outcome?

Noam Chomsky on the inefficiency of markets and the threat posed by de-regulation: http://www.youtube.com/watch?v=QPl27BO7fHE&feature=related

• What is the “externality” of financial market failure that Chomsky identifies?
• Why is the failure of a financial market more worrisome than the failure of a market like that for used automobiles?
• How does Chomsky feel about the de-regulation of financial markets? Does he think markets are always rational and efficient?

Modern applications of the concept of Homo Economicus:

• Rational Expectations Theory (RET): This economic theory assumes that humans acting generally in their own self-interest will make rational decision based on the best available information. Therefore, it assumes that people (and therefore, markets, which are made up of rational people) do not make systematic errors when predicting the future.
• Efficient Markets Hypothesis (EMH): Rooted in Rational Expectations Theory, which itself is rooted in the concept of homo economicus, EMH says that prices in markets, particularly financial markets (whose collapse has caused the today’s global economic crisis) represent the best possible estimates of the risks attached to the ownership of various financial assets (stocks, shares, bonds, etc…) Asset bubbles are therefore impossible, since “bubble” implies an irrational and unsustainable increase in the value of an asset which will ultimately “burst”. Markets are “self-correcting”, and the most effective tool for assuring economic stability is free markets, rather than government regulation or oversight.
  

Connecting the dots – from Homo Economicus to today’s Economic downturn:

The general acceptance of theories rooted in the concept of homo economicus led to the de-regulation of financial markets, which allowed money and resources to go whichever way the “market” (rational or not) determined.

• During the last decade, the market decided that more and more money and resources should go towards particular assets, specifically the United States mortgage market (the market for new homes in the US).
• As money flooded the US home mortgage market, it became cheaper and easier for Americans to get loans to build a home. GREAT, RIGHT?! Well, only until it came time to pay back those loans.
• Trillions of dollars worldwide became tangled up in the US mortgage market, representing households’ savings from around the globe.
• When Americans suddenly found their loans coming due, they found it hard to repay them due to adjustable interest rates and falling home price (supply had grown more rapidly than demand).
• American and many Europeans began defaulting on their mortgages, meaning all that money that had been lent to home buyers literally disappeared.
• Banks and financial markets faced a “liquidity crisis”, meaning they had no money.
• Lending stopped to households, firms, and other banks , meaning spending on goods and services decreased, meaning jobs were lost and economies entered recession.
• How could any of this have happened if the concept homo economicus and the economic theories based on the concept are correct? Are humans always rational, calculating, perfectly informed, self-interested beings acting purely in their own self-interest?

Conclusion: The concept of homo economicus has formed the basis for economic theories for centuries and for major macroeconomic policies over the last 30 years. Policies of “market liberalization” (freeing the market from the guiding, regulatory hands of government) have led to great prosperity, but even greater risk and volatility as irrational exuberance over asset prices has led to inefficient market outcomes, bubbles, and financial shocks plunging the “real” economies of the world into recession.

Perhaps a more complete understanding of humans is needed as the human science of economics enters a new era. The human as a cold, rational, calculating creature interested in only his own gain is an over-simplification, and forming theories and policies on such an assumption is dangerous. The future of economics must incorporate a more complete and complex understanding of human behavior if the economic crises of the last two years are to be avoided down the road.

Economic Growth Yet to Hit Job Market – washingtonpost.com

In AP and IB Economics, we understand the importance of macroeconomics to policymakers, whose primary macroeconomic goal is growth. Economic Growth, defined as an increase in a nation’s total output of goods and service (and therefore the national income), is desidred not only for the sake of growth itself (producing more stuff requires more resources, and may not necessarily make the average citizen better off), rather growth is needed in order to achieve full-employment of a nation’s labor force.

Growth is good. This tenet of economics is rooted in two basic observations: 1. Growth leads to an improvement in the average standard living of a nation’s people, and 2. Growth is needed to employ the growing workforce of a nation experiencing population growth and immigration.

America’s work force is a diverse group of people of all skill levels. 150 million strong, the nation’s workforce requires a healthy national economy with strong investment and consumption to maintain enough jobs to keep unemployment low.   In the last two years, however, the prospect of employment in America has diminished as the number of people out of work has grown to nearly 15 million.

Involuntary unemployment is perhaps the most serious cost of an economic slowdown. A willing and able worker (or 15 million of them!), skilled in mind and body, unable to find prouductive work, represents a monumental failure of a nation’s economy. Policies aimed at promoting growth are in fact aimed at creating employment.

The costs of unemployment affect not only the unlucky  individuals who have have lost their job. Social costs include increased crime and poverty, psychological costs include stress, anxiety, loss of self-image and depression. The economic costs are myriad. Unemployed workers become dependent on the rest of society for support, in one way or another. Benefits for the unemployed payed by the government require greater budget deficits or increased tax burden on the employed. The large pool of jobless citizens seeking work puts downward pressure on the wages of those still working, as employers find it difficult to keep paying high wages while demand for their products has fallen and millions of job seekers are willing to work for less.

The families and friends to whom unemployed workers turn for help find their already stretched incomes spread even thinner. Without steady incomes, the unemployed consume less, putting further strain on an already depressed economy. Deflation can result from unemployment, which can lead to futher layoffs by pessimistic firms, excacerbating the situation and plunging the economy into what’s known as a deflationary spiral.

For all the reasons above, policymakers strive to promote growth. When monetary policy fails to incite spending, the government must pick up the slack, hence the stimulus package so discussed in America today. China’s stimulus of over $500 billion (twice that of the US, as a percentage of its GDP) has had a positive effect on both GDP and the job market.

Employment levels in China began to recover over the past three months in the latest evidence of the rapid rebound in the economy from the international financial crisis as a result of heavy public investment.

Yin Weimin, China’s labour minister, said there had been a modest increase in the number of jobs in the economy during June, July and August, reversing the sharp slump in employment which began last October.

America’s stimlus has also begun to restore growth, but the rise in employment has so far not occured:

Despite an emerging economic expansion, businesses were sufficiently skittish about the future that the job market continued its long, steep decline in August, according to a new government report Friday. The unemployment rate rose to 9.7 percent, from 9.4 percent, as employers shed jobs for the 20th straight month, the Labor Department said.

“Our clients tell us they will not hire in anticipation

of a recovery, but will wait until they see it,” said Jonas Prising, an executive vice president at Manpower, the giant employment services firm. “In a normal recession, people would now start to feel more comfortable and start hiring, but nobody is doing that today. They’ll do it when they see real orders and real business.”

The “silver lining” of the latest unemployment figures is hardly encouraging. The rise in unemployment is not as sharp as over most of the last year. In other words, workers are definitely worse off, but not as badly as they could have been if things were as dismal as they were earlier this year.

While the unemployment rate, as seen on the graph to the right, has risen almost every month since August of 2008, the rate at which the rate has increased has begun to slow. In other words, the economy is probably close to “bottoming out”.

The tally of lost jobs now stands at 6.9 million since the beginning of the recession in December 2007. But the rate of job losses has been declining, if haltingly, since winter. The 216,000 jobs eliminated in August is down from 276,000 cut in July and a peak of 741,000 lost in January.

Here’s what I find most interesting from in the current data. The unemployment rate’s recent rise may actually be a sign that the economy is beginning to recover. Recovery means growth in output, which should mean less unemployment. However, if workers who have been unemployed for a long time, and have therefore stop seeking employment suddenly feel more optimistic about the prospects of getting a job and begin seeking work again, then the nation’s unemployment rate actually rises! How’s that for “silver lining”? The 216,000 additional people added to the list of unemployed may have already been out of work but since they were notactively seeking employment they were not included in last month’s data.

The tricky thing about macroeconomic policy is this:  Monetary and fiscal policies can put billions of dollars into the nation’s banks and households’ and firms’ pockets through tax breaks, government bailouts, subsidies, infrastructure spending and “troubled asset swaps”… but all the money and income in the world will not lead the nation towards full-employment unless the nation’s consumers and producers feel confident. I teach my students that national income is made up of the sum of wages, interest, rent and profit; its spending consists of consumption, investment, government spending and net exports… but without the “big C” of confidence, expansionary policies aimed at increasing employment will come to nought. Confidence, according to John Maynard Keynes, is an animal spirit, a trait of humans beyond the assumption of rational behavior. Until confidence is restored, America’s output and employment levels will remain low.

Fidelity Investments – Inflation: A Threat or Not? by Dirk Hofschire

I was surprised to receive an email from the company that manages my personal investments directing me to an article that I would be able to use in class. But this analysis by a vice president of Fidelity Investments offers and excellent, concise examination of the threat posed by inflation in America today. I will use excerpts from the article and present the ideas in a graphical form to help students better understand the situation faced by the US as it struggles to emerge from its deep recession.

Hofschire sets out to answer four questions about inflation:

1. Is inflation accelerating?
2. Why is higher inflation expected?
3. Why hasn’t inflation occurred yet?
4. When will inflation return?
5. How high will inflation go?

1. Is in flation accellerating:

In short, NO.

In June, the U.S. consumer price index (CPI) declined 1.2% (on a year-over-year basis), representing the biggest fall in prices since 1950.1 Much of the decline is attributable to the steep drop in energy prices over the past year, which may reverse itself in the second half of 2009 if crude-oil prices remain near current levels. However, core CPI—which excludes food and energy—was less than 1.8% in June, demonstrating little inflationary pressure in general

A combination of weak aggregate demand and low resource costs for firms has kept price levels down.  While total spending has falling (leftward shift of AD), firms’ costs of production have fallen (rightward shift of AS). Since total output fell we can see that national income (Y) is less in 2009 than in 2008. Since price level has fallen, we can see deflation.

Diagram 1:

2. Why is higher inflation expected?

With little evidence of economic strength or cost-push inflation today, the concern now is that the monetarist economic view of the world sees inflation clouds on the horizon. The godfather of modern monetarist economic thought, Milton Friedman, once stated, “Inflation is always and everywhere a monetary phenomenon.” What Friedman meant was that money—specifically changes in the supply and use of currency—was the primary driver for changes to price levels in an economy. Friedman informally defined inflation as “too much money chasing too few goods and services.” As a result, an excessive increase in the amount or use of money relative to economic output is the textbook prescription for inflation.

The inflation described above, and feared by Friedman and today’s monetarists is not of the cost-push type, rather the demand-pull variety. As the vast quantities of money injected by the US Fed work their way through the banking system and into the pockets of consumers and the hands of firm managers, eventually demand for America’s goods and services will rise. But in the current recession, the production of those goods and services has stagnated, meaning that once all this money starts getting spent, the competition among buyers for the limited output of producers will drive prices up.

Diagram 2:

3. Why hasn’t inflation occurred yet?

…there remains considerable downward pressure on prices still in place, due to growing slack in the economy (i.e. underutilized resources, such as labor) and continued deleveraging by consumers and financial firms with heavy debt loads. With the unemployment rate at its highest level in 26 years and consumers saving more and spending less, there is little upward pressure on wages or prices for consumer goods.

Yes, the money supply has increased, which according to our answer to number 2 should lead to inflation. But not if the new money isn’t being spent! Banks with money from the Fed are holding onto their excess reserves instead of loaning them out, due to a prevailing lack of confidence in borrowers ability to repay loans during these hard economic times. If all the money the Central Bank is injecting in the economy is sitting idle, and resources such as labor, land and capital are under-employed, then there is little fear of cost-push nor demand-pull inflation.  Diagram 1 illustrates why inflation hasn’t occured yet.

The excess bank reserves thus represent both the potential for future inflation as well as the explanation for why rapid money growth has yet to create current inflation.

In short, money must be spent to drive inflation up. When households prefer savings to consumption and banks prefer liquidity to risk, inflation is only a distant fear.

4. When will inflation return?

Interestingly, the answer to this question can be summed up as: “hopefully sooner rather than later”. Despite popular belief, some inflation is considered a positive sign of economic growth. Just as deflation is the purveyor of doom and gloom (unemployment, uncertainty, low consumer and investor confidence, credit crunch, etc) inflation is a sign of health returning to the economy (improved confidence, rising employment, looser credit markets, expectations of future growth). Central Bankers like Bernanke will surely be showered with praise, while congressman will be quick to give credit to the fiscal stimulus package.

Whether the pick-up in money velocity leads to significantly higher inflation depends on how quickly the Fed pulls the reins back on the extraordinary credit it is currently providing. In theory, the Fed can take actions to reduce the size of its balance sheet and move back to a more appropriate level of money. In practice, due to the unprecedented expansion in the Fed’s balance sheet, this will be a challenge.

Just as it was the Fed”s and government’s job to get the party started through expansionary monetary and fiscal policies, it is equally important for policymakers to calm the party down should the level of inflation begin to rise.

Diagram 3:

5. How high will inflation go?

Given the high level of slack (i.e. underutilized resources) likely to remain in the economy during the next two years, there also could be offsetting deflationary pressures lingering in the system. For example, the unemployment rate is expected to rise above 10% and not peak until sometime in 2010. Industrial capacity utilization rates are at their lowest level on record, which means a lot of unused capacity in the manufacturing sector. This slack must tighten considerably before upward pressure is placed on wages and other prices.

As a result of this downward pressure on wages, which remain the largest expense for corporations, it would appear a 1970s-style, double-digit inflation outburst remains unlikely in the short to medium term. Average weekly earnings for U.S. workers rose more than 7% annually during the period from 1975-1981 in which consumer price inflation averaged more than 9% and peaked at 14% in 1980.5 It is hard to foresee wage gains of that magnitude reinforcing inflation pressures during the next couple of years.

The 1970′s was a period of high inflation in the US, caused primarily by higher costs for firms rather than increasing demand for output. This “cost-push” inflation is unlikely to occur in today’s climate due to the high levels of unemployment and under-employment of labor, land and capital resources. This does not mean inflation won’t happen, just that it’s unlikely to look like the cost-push variety of the 1970′s.

Diagram 4: