One question that often comes up in my class discussions of market failure and public goods is “Why can’t we just have a global government that intervenes to correct those market failures with global impacts?” The global market failures my students get so worked up about are those arising from common access resources, such as deforestation, over-fishing and global warming, those resulting from information asymmetry, such the global financial crisis of 2008-2009, and the global inequality in the distribution of income and economic opportunity.

What I haven’t ever really considered or explained to my students (until now) is the history of public goods. In the column below, Martin Wolf of the Financial Times’,  tells the history of public goods, which as it turns out, is intimately tied to the history of the modern state as we know it. This column should become a must read for all economic students studying market failure.

From The World’s Hunger for Pulbic Goods – January 24, 2012, Financial Times

What… is a public good? In the jargon, a public good is “non-excludable” and “non-rivalrous”. Non-excludable means that one cannot prevent non-payers from enjoying benefits. Non-rivalrous means that one person’s enjoyment is not at another person’s expense. National defence is a classic public good. If a country is made safe from attack everybody benefits, including residents who make no contribution. Again, enjoyment of the benefits does not reduce that of others. Similarly, if an economy is stable, everybody has the benefit and nobody can be deprived of it.

Public goods are an example of what economists call “market failure”. The point is generalised in the language of “externalities” – consequences, either good or bad, not taken into account by decision-makers. In such cases, Adam Smith’s invisible hand does not work as one might like. Some way needs to be found to shift behaviour; public goods usually involve some state provision; externalities usually involve a tax, a subsidy or some change in property rights…

The history of civilisation is a history of public goods. The more complex the civilisation the greater the number of public goods that needed to be provided. Ours is far and away the most complex civilisation humanity has ever developed. So its need for public goods – and goods with public goods aspects, such as education and health – is extraordinarily large. The institutions that have historically provided public goods are states. But it is unclear whether today’s states can – or will be allowed to – provide the goods we now demand.

The story of public goods goes back to the very beginning of states, which were the result of the agricultural revolution. The latter made populations vulnerable to… “roving bandits”. The answer was the “stationary bandit” – the state. It was not a perfect answer – answers almost never are. But it worked well enough to permit substantial increases in population. The state provided defence in return for taxation. The empires – Rome or China – enjoyed economies of scale in providing security. When Rome collapsed, security was privatised by local gangsters, at huge social cost: this we now call feudalism.

The industrial revolution expanded the activities of the state in innumerable ways. This was fundamentally because of the needs of the economy itself. Markets could not, on their own, provide an educated population or large-scale infrastructure, defend intellectual property, protect the environment and public health, and so on. Governments felt obliged – or delighted – to intervene, as suppliers and regulators, or subsidisers and taxers. In addition to this, the arrival of democracy increased the demand for redistribution, partly in response to the insecurity of workers. For all these reasons, the modern state, vastly more potent than any that existed before, has exploded in the range and scale of its activities. Will this be reversed? No. Does it work well? That is a good question.

Yet consider where we are now. The impact of humanity is, like the economy, increasingly global. Economic stability is a global public good. So, in the era of nuclear weapons, is security. So, in important respects, are control of organised crime, counterfeiting, piracy and, above all, pollution. So, even, is the supply of education or health. What happens anywhere affects everybody – and increasingly so. Unless there is a global economic collapse, an increasing number of the public goods demanded by our civilisation will be global or have global aspects.

Our states cannot supply them on their own. They need to co-operate. Traditionally, the least bad way of securing such co-operation is through some sort of leadership. The leader acts despite free riders. As a result, some global public goods have been adequately – if imperfectly – supplied. But as we move again into a multipolar era, the ability of any country to supply such leadership will be limited. Even in the unipolar days, it only worked where the hegemon wanted to provide the particular public good in question.

I started with economic stability, because the big surprise of the past few years is just how difficult it has proved to provide even this. The point I finish with is far broader. Ours is an ever more global civilisation that demands the provision of a wide range of public goods. The states on which humanity depends to provide these goods, from security to management of climate, are unpopular, overstretched and at odds. We need to think about how to manage such a world. It is going to take extraordinary creativity.

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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Russell Roberts of George Mason University is a well-known advocate of free trade. This article is one of my favorite and certainly one of the clearest explanations of the mutual benefits resulting from free trade that I have read.

Foreign Policy: Why We Trade – by Russ Roberts

To hear most politicians talk, you’d think that exports are the key to a country’s prosperity and that imports are a threat to its way of life. Trade deficits—importing more than we export—are portrayed as the road to ruin… Politicians are always talking about the necessity of other countries’ opening their markets to American products. They never mention the virtues of opening U.S. markets to foreign products.

This perspective on imports and exports is called mercantilism. It goes back to the 14th century and has about as much intellectual rigor as alchemy, another landmark of the pre-Enlightenment era.

The logic of “exports, good—imports, bad” seems straightforward at first—after all, when a factory closes because of foreign competition, there seem to be fewer jobs than there otherwise would be. Don’t imports cause factories to close? Don’t exports build factories?

But is the logic really so clear? As a thought experiment, take what would seem to be the ideal situation for a mercantilist. Suppose we only export and import nothing. The ultimate trade surplus. So we work and use raw materials and effort and creativity to produce stuff for others without getting anything in return. There’s another name for that. It’s called slavery. How can a country get rich working for others?

Then there’s the mercantilist nightmare: We import from abroad, but foreigners buy nothing from us. What would the world be like if every morning you woke up and found a Japanese car in your driveway, Chinese clothing in your closet, and French wine in your cellar? All at no cost. Does that sound like heaven or hell? The only analogy I can think of is Santa Claus. How can a country get poor from free stuff? Or cheap stuff? How do imports hurt us?

We don’t export to create jobs. We export so we can have money to buy the stuff that’s hard for us to make—or at least hard for us to make as cheaply. We export because that’s the only way to get imports. If people would just give us stuff, then we wouldn’t have to export. But the world doesn’t work that way.

It’s the same in our daily lives. It’s great when people give us presents—a loaf of banana bread or a few tomatoes from the garden. But a new car would be better. Or even just a cheaper car. But the people who bring us cars and clothes and watches and shoes expect something in return. That’s OK. That’s the way the world works. But let’s not fool ourselves into thinking the goal of life is to turn away bargains from outside our house or outside our country because we’d rather make everything ourselves. Self-sufficiency is the road to poverty.

And imports don’t destroy jobs. They destroy jobs in certain industries. But because trade allows us to buy goods more cheaply than we otherwise could, resources are freed up to expand existing opportunities and to create new ones. That’s why we trade—to leverage the skills of others who can produce things more effectively than we can, freeing us to make things we otherwise wouldn’t be able to afford.

Discussion Questions:

1. “Self-sufficiency is the road to poverty” – Discuss…
2. Explain the logical economic fallacy of the mercantilist philosophy of “exports good, imports bad”
3. “…because trade allows us to buy goods more cheaply than we otherwise could, resources are freed up to expand existing opportunities and to create new ones”. What basic economic principle is Professor Roberts alluding to here?

This post was originally published on September 15, 2009. It is being reposted today for my year 2 IB Econ students, who are studying free trade and protectionism as part of Unit 4 of the IB Econ course.

US president Barack Obama made a speech directly to Wall Street today. In his speech, Obama reflected on the many lessons America has learned in the last year since the financial crisis began. He urged his audience of investors, bankers and brokers that

“Normalcy cannot lead to complacency,” Obama said. “Unfortunately, there are some in the financial industry who are misreading this moment. Instead of learning the lessons of Lehman and the crisis from which we are still recovering, they are choosing to ignore them.”

“They do so not just at their own peril, but at our nation’s,” the president added.

In addition to his warnings about the threat posed by overly risky financial markets to the US economy, President Obama expressed his commitment to free trade and “the fight against protectionism”.

Obama says:

…enforcing trade agreements is part and parcel of maintaining an open and free trading system.

The enforcement of existing trade agreements Obama refers to is his way of justifying a decision his administration made over the weekend that actually limits free trade between America and one of its largest trading partners, China.

Trade relations between two of the world’s biggest economies deteriorated after Barack Obama, US president, signed an order late on Friday to impose a new duty of 35 per cent on Chinese tyre imports on top of an existing 4 per cent tariff.

In his first big test on world trade since taking office in January, Mr Obama sided with America’s trade unions, which have complained that a “surge” in imports of Chinese-made tyres had caused 7,000 job losses among US factory workers.

So, in his speech today, Obama decries protectionism and calls for expanded trade and free trade agreements which are “absolutely essential to our economic future”. But only three days ago, he supported a blatantly protectionist measure aimed at keeping foreign produced goods out of America in order to save a few thousand American jobs.

Obama’s decision is a bad one for several reasons. As an economics teacher, I will turn firstly to a diagram for an illustration of the net loss to the American people of higher tariffs on imported tires:

The key point to notice in the above graph is that a tariff on imported tires results in a net loss of welfare in America. The blue area represents the increase in the welfare of tire manufactures (this could be interpreted as the jobs saved in the tire industry and the profits earned due to higher prices); the black areas, on the other hand, are welfare loss. Since all tire consumers in America pay more for their tires due to the 35% tariff, real income is affected negatively for the nation as a whole.

One effect of the protectionist policy the graph does not illustrate, and perhaps the most serious negative impact of the tariff on America, is the response the Chinese are likely to take to what they interpret as a violation of existing free trade agreements between the US and China.

“This is a grave act of trade protectionism,” Mr Chen said in a statement. “Not only does it violate WTO rules, it contravenes commitments the US government made at the [April] G20 financial summit.”

Beijing said it had requested WTO-sanctioned consultations with the US over Washington’s new duties on tyres. Yao Jian, a commerce ministry spokesman, said the duties were in ”violation of WTO rules”.

China said it would now investigate imports of US poultry and vehicles, responding to complaints from domestic companies.

The problems with protectionism are myriad. Clearly American consumers suffer through higher tire prices. In addition, Chinese manufacturers will see sales fall as their product becomes less competitive in the US market. According to the CCTV report below, as many as 9,000 workers in the Chinese tire industry will lose their livelihoods due to declining demand from the US. But the unforseen effects of the US tariff on Chinese tires is the retaliatory measures China will almost certainly take. If China imposes new tariffs on American automobiles and poultry, the scenario in the graph above will be reversed, and Chinese consumers will face higher prices, Chinese car and poultry producers will experience rising sales, while the American auto worker and chicken farmer will suffer.

Free trade tends to result in net benefits for economies that choose to participate in it. American tire manufacturers are certainly harmed by cheap Chinese imports; however, America as a whole benefits through cheaper goods, more consumer surplus, higher incomes in China and therefore greater demand for imports of products made in America. The road to protectionism is a dangerous path to take for the Obama administration. Justifying these new tariffs by claiming that they “enforce existing free trade agreements” is a political maneuver aimed at covering up the truth, which is that the Obama administration has sided with a special interest group to save a few thousand jobs and garner political favor at a time when 700,000 American jobs are being lost each month. By doing so, he is calling into question his own commitment to free trade, and harming America’s image as a global proponent of global economic integration.

Discussion Questions:

1. Why is the Chinese government so upset about a new tax on such an insignificant product as automobile tires?
2. “Self-sufficiency is the road to poverty”: Do you agree?
3. Some would say that it is a small price to pay for Americans to face higher prices for one product like tires in order to “save” 7,000 Americans’ jobs. Would you agree? Why or why not?
4. If 7,000 Americans were to lose their jobs due to free trade with China, what would we call the type of unemployment experienced by these workers? Is this the same type of unemployment experienced by the 700,000 workers who have lost their jobs each month during the last year of recession in the United States?

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.

This article was originally published on June 9, 2008

Asia Sentinel – Malaysia cuts fuel subsidy

One of the recurring themes of this blog is the conflict between good politics and good economics. Most of the time in government, smart economic policy is sacrificed in order to achieve political favor with voters. Whether it’s price ceilings on petrol in China, Zimbabwe’s slashing of food prices, harmful import restrictions to benefit domestic producers, or the proposed suspension of gas taxes in a time when fuel conservation is really what’s needed, politicians often act in economically stupid ways to bolster or hang on to their popularity.

So when a government makes a bold move that is economically sound, it sometimes comes as a surprise, as in the case of the Malaysian government this week. The government in Kuala Lumpur has for years subsidized domestic fuel prices, which at under 2 Malaysian Ringit per liter have been the equivelant of roughly $2.40 US per gallon, far below the average price in the west. Drivers benefited from this subsidy, but were not forced to bear any of the burden of rising oil prices, nor had they any incentive to conserve or switch to more fuel efficient automobiles or alternative forms of transportation. The Malaysian government, on the other hand, has had to allocate more and more of its limited budget towards subsidizing petrol prices.

Well, as of yesterday, all price supports for petrol are cancelled, and the effect will be sweeping in the Malaysian economy:

The government announced Wednesday evening that petrol prices would rise by 78 sen (US24¢) at midnight — a 41 percent jump from RM1.92 per liter to RM2.70. That means those spending RM2,000 per month to fill the tanks of their BMWs will now be paying RM2,820. Regardless of income levels, it is likely most Malaysians will feel the pinch.

The subsidy would have cost the Malaysian government 56 billion ringit (around $17 billion) this year. With the money it will now save by ending the subsidy, the government will begin making public transport cheaper and more convenient for commuters who wish to avoid paying for the more expensive petrol to fuel their personal automobiles:

The government hopes to channel the savings into improving public transportation, as it promised many years and elections ago but with little to show. In Kuala Lumpur, despite having a light rail train service and monorail, public transportation is expensive and inconvenient. Worse, intercity travel is still being serviced by old and slow trains, and accident-prone buses.

Malaysia is not the only country taking measures to end government fuel-price supports:

Indonesia has hiked fuel prices by an average of 29 percent, saving about 34.5 trillion rupiah and kicking off a series of street demonstrations… Similarly, after slashing subsidies, Taiwan will distribute US$659 million to middle and low-income families. The latest to raise oil prices is India, whose government announced Wednesday that gasoline and diesel prices will increase by 10 percent.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Discussion Questions:

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

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

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

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

The $165 M in AIG bonuses that we have heard so much about this past week should have, in my opinion, been paid and then defended by Congress and the President!

As a former CFO, I can say with certainty that I have never paid an employee a bonus for poor performance. To underscore this point, I am 100% against any publicly-traded company ever making any bonus payment to an employee for poor performance regardless of the circumstances. The recently paid AIG bonuses are not an exception to my strong conviction. The true facts surrounding the $165 M in AIG bonus payments have not been made clear to the American public. Moreover, our cowardly American leadership (President, Treasury Secretary, Congress, AIG CEO) refuse to do what is right and defend the bonuses because, in my opinion, of their fear of public opinion.

The $165M in recently paid AIG bonuses, funded with a portion of approximately $170B in taxpayer “bailout” funding, are not PERFORMANCE bonuses being paid to the same AIG executives that got us into this financial mess in the first place. That is what most of America mistakenly believes. In fact, the senior executives, including the CEO, whose decisions caused the company’s collapse, are long gone. Moreover, the top 7 officials currently at AIG have agreed to forego all bonuses. The recent bonus payment outrage also excludes the next 43 highest ranking AIG leaders whose bonus payments are appropriately being linked to restructuring the company and paying back the taxpayers the $170B that has been already sent to bail them out.

So what exactly are these bonus payments for that all of America has gone mad over? The $165 Million in recent bonuses paid to AIG employees were RETENTION or STAY bonuses and not performance bonuses. AIG employees assigned to unravel the mess were offered retention bonuses to stay and work out the problems of AIG’s Financial Products division which has already been announced to be shut down. These retention bonuses were paid to incent remaining and new workers to stay until the billions of dollars of derivatives, still at risk, were unwound. Using basic common sense, which is why retention bonuses have been paid for decades, no reasonable, talented worker would agree to work in a discontinued division receiving hate mail and death threats without receiving a retention bonus. A retention bonus helps keeps top employees working on problems of a division being shut down rather than them resigning and moving on to another company.

As Congress tries to recover these just recently paid bonuses, either through the AIG employees paying them back or having them be taxed close to 100%, the tax payer is already losing as these employees working out the problems that they did not create are already starting to resign. Yes, America and the taxpayer will not save $165 M but rather lose far more than we save as those working the issues are resigning.

So, why didn’t the new AIG CEO, Edward Liddy, defend the $165 M in retention bonuses in front of Congress this past week and explain to Congress that these were not performance bonuses paid to the people that got us into this mess? Why didn’t Tim Gheitner, U.S. Treasury Secretary, defend his decision to allow the retention bonus payments as outlined in the recently passed stimulus bill? Why didn’t Ben Bernanke, Chairman of the FED, defend the retention bonuses that were know by him since last summer? And of course, where was our Harvard-schooled president when we needed his articulation skills the most as he could have clearly explained and defended these payments so we would not have to rehire new employees for all of the AIG employees who are now turning in their resignations for having to repay their contractual retention bonuses?

In summary, our U.S. government has increased the exposure to the American taxpayers by not supporting the AIG retention bonuses being paid to the workers that did not create the problem and who are assigned to fix up the mess. This is cowardly leadership, in my opinion. It is an easy path to for our leaders to keep the AIG bonus discussion at a very surface level and say “bonuses shouldn’t be paid to business leaders that fail”. Well, of course, everyone agrees with that! But that is not what is being paid at AIG.

Milton Friedman: “there is no alternative way so far discovered of improving the lot of ordinary people that can hold a candle to the productive activities that are unleashed by the free enterprise system”

With all the talk of government spending, fiscal stimulus, nationalization of the financial industry, the “new new deal”, infrastructure, education, health, “job creation”, and on and on… I thought it wise to share this bit of wisdom from the greatest advocate of free markets of the last 100 years, Milton Friedman.

AP Economics teacher Michelle Hastings sent the link to this video to the AP Econ email list. Thanks, Michelle.

Discussion Questions:

1. What is Friedman’s view of command economies?
2. Does Friedman imply that “greed is good”? To what extent is greed an important component of free markets?
3. Do you think Milton Friedman would support the current $800 billion fiscal stimulus package being debated in Washington right now? Why or why not?

Does the Economy Self-Correct? – Welker’s Wikinomics Page

The debate in Washington over Obama’s fiscal stimulus package, which has now been re-written by both the House and the Senate, is ultimately one of the validity of orthodox economic theories. By voting for a nearly $1 trillion government spending bill, the Obama administration and Congress are clearly taking the position that an economy in recession will either not be able to correct itself, or will take too long to self-correct, thus the government is needed to accellerate the recovery process.

Washington’s stimulus package presents students and teachers of economics with an all too rare opportunity to put to the test the two competing hypotheses of macroeconomics: the Demand-side Theory versus the Supply-side Theory.

At the core of the long-running macroeconomic debate is the simple question, “Does the economy self-correct in times of recession?” The supply-side theory, attributed to the “classical” economists dating back to Adam Smith and David Ricardo, argues that the answer to this question is YES. The rationale between this laissez faire approach to macroeconomics is the following:

1. Falling demand in an economy means less output by firms, forcing them to lay off workers.
2. As inventories build up due to their inability to sell their output, firms will be forced to lower their prices, putting downward pressure on the price level in the economy (deflation).
3. High unemployment and falling prices eventually lead to workers in the economy being willing to accept lower wages.
4. Weak demand for commodities such as oil and minerals put downward pressure on raw material and energy prices faced by firms.
5. Falling wages and raw material prices mean more potential for profits for firms in various enterprises, even as overall demand in the economy is weak. Firms begin hiring workers at lower wages, and increase production to take advantage of lower input costs. Overall supply of goods and services in the economy begins to increase due to lower costs faced by firms in all sectors.
6. The downward spiral caused by weak aggregate demand, rising unemployment, falling prices for output, falling wages and commodity prices, is eventually reversed and turns into an upward spiral as firms hire more workers, employ more resources, creating more income and spending, moving the economy towards recovery and economic growth.

The supply-side theory of self-correction (so called because recovery results due to an outward shift of aggregate supply) outlined above depends on the downward flexibility of wages. If wages do NOT fall, as some demand-siders propose, then the idea that firms will eventually begin to hire more workers is busted, and unemployment will only continue to increase as overall demand remains weak.

Today, there is some evidence that wages in the United States may in fact be downwardly flexible.

GM Slashing 10,000 White-Collar Jobs, Cutting Pay – washingtonpost.com

…the base pay of higher-level U.S. executives will be lowered by 10 percent, while other salaried employees will face cuts of between 3 and 7 percent.

General Motors employees are beginning to accept lower wages. Rising unemployment, especially in the white collar sector, mean that the number of highly educated and skilled American workers unable to find work will grow as corporate layoffs continue.

A “shovel-ready” stimulus package from Washington may indeed help to “create or save” 3 million jobs, as Obama claims, but it is the self-correcting nature of markets due to flexible commodity prices and wages that will ultimately contribute to a recovery of the US economy. As prices of commodities fall, combined with lower wages for white collar workers and deflation in the overall economy, firms will find it profitable to begin employing resources at their lower costs, putting people back to work, stimulating spending through market forces.

Fiscal stimulus may accellerate the recovery process, but the threat it poses is the same threat posed by all forms of government intervention in the free market: that the nearly trillion dollars will go towards satisfying the priorities of politicians rather than the wants and needs of society as a whole, resulting in a misallocation of the nation’s resources towards goods, services, and infrastructure projects that are chosen by legislators, not the market itself. Stimulus is needed, but only the right kind. The recognition by politicians and the media that markets may also self-correct is also needed. News like GM’s wage cuts may sound dire, but the underlying implication of falling wages may be a sign that the US economy is already on the path to recovery, even before Washington has spent a single dollar on stimlus.