Note: This post was originally published in August of 2010. It is being reposted today to support a lesson on fiscal policy in my year 2 IB Economics class.
In the seemingly endless and currently ongoing debate over the role of the government in the macroeconomy, there are two main camps: Those who think the governments of the developed economies have not done enough to get their economies out of recession, and those who think they have already done too much, and therefore need to start rolling back stimulus and reducing deficits.
At the heart of this debate are the two macroeconomic schools of thought, the Keynesian demand-side theories and the classical, supply-side theories. Two intellectuals have emerged in the last several years representing the two sides of the macroeconomic debate. On the demand-side, representing the Keynesian school of thought, is 2008 Nobel Prize winning economist Paul Krugman. Representing the classical, supply-side school of thought is Harvard economic historian Niall Ferguson. These two have squared off in many forums over the last three years, Krugman arguing for more and continued fiscal stimulus to prop up and increase demand in the economy, Ferguson arguing for smaller deficits, lower taxes and less government spending to increase private sector confidence and thereby supply in the economy.
During our long summer break the two squared off once again in the aftermath of a G20 meeting in which the governments of several major economies from Europe and North America announced plans to begin rolling back the stimulus spending they embarked on throughout 2008 and 2009. The reason for increased “austerity measures” (policies that reduce the budget deficit and slow the growth of national debt), argue global leaders, is to reduce the chances of more countries experiencing debt crises like that experienced in Greece this spring.
International investors realized earlier this year that Greece’s budget deficits were a much larger percentage of its GDP than previously thought, and very quickly decided that Greek government bonds were an unsafe investment. Almost overnight the cost of borrowing in Greece shot up above 20%, bringing investment in the economy to a halt and forcing the government to cut its budget, leading to higher unemployment and reduced social benefits for the people of Greece. If investors were to look at the growing budget deficits in other developed countries and then suddenly lose faith in other government’s ability to pay back their debts, then a similar crisis could occur in much larger economies, including the UK, Germany and the United States. Hence these country’s apparent desire to begin reducing deficits and rolling back stimulus spending; measures that may just plunge these economies into an even deeper recession than that which they have experienced over the last two years.
The videos below show the leading intellectuals on both sides of the stimulus/austerity debate presenting their arguments. Below each video are discussion questions to help guide your understanding of their views. Watch the videos and respond to the discussion questions in the comment section below.
On February 6 my IB year 2 Economics classes welcomed Dr. Irene Forichi, former Research Officer for Zimbabwe’s Ministry of Agriculture, and former Regional Emergency Agronomist for the Food and Agriculture Organization for Southern Africa. Dr. Forichi spoke with our classes about the role of agricultural productivity in contributing to human development and economic growth in Southern Africa.
For students or teachers who are interested, she delivered an excellent presentation about the agriculture-related obstacles to and strategies for economic development in the Southern Africa Development Community (SADC). Her presentation can be viewed here, or the PowerPoint she presented can be viewed below.
As we study economic development in year 2 IB Economics, we examine different models for economic growth. Growth in GDP is not the only determinant of economic development, which in order to be measured effectively must account for human welfare determinants such as life expectancy, literacy rates, child mortality rates, distribution of income, and so on. However, it has been shown throughout history that economic growth, or the increase in real output and income, correlates directly with improvements in development factors like those above.
The reason? Increases in national income usually mean at least some levels of improvement in access to basic necessities for the average citizen in a developing country. Also, higher incomes mean more savings, which means greater access to capital for investment by entrepreneurs. More investment leads to greater productivity and rising incomes for those who join the emerging industrial and service sectors that usually accompany economic growth. Furthermore, rising incomes mean more tax revenue for governments, whose spending on public goods like education, health care, and infrastructure result in real improvements in standard of living for not just the emerging upper and middle classes, but the poor as well.
Of course, the following models can be observed to varying degrees among the world’s developing economies today. Some of these models will fail to play out if the institutional and political environment fails to create a stable atmosphere for savings and investment. What you should notice, however, is the underlying importance of savings in all three models. Poor countries suffering from low savings and, even worse, capital flight, are doomed to a cycle of poverty, where funds for investment leading to productivity increases are never made available due to instable institutions like banking and politics. To put a poor country on a path towards economic growth and development, a strategy is needed. Such strategies will be covered in a later post. For now, let’s look at the models:
Harrod-Domar Growth Model:
The model suggests that the economy’s rate of growth depends on:
the level of saving
the productivity of investment i.e. the capital output ratio
The Harrod-Domar model was developed to help analyse the business cycle. However, it was later adapted to ‘explain’ economic growth. It concluded that:
Economic growth depends on the amount of labour and capital.
As LDCs often have an abundant supply of labour it is a lack of physical capital that holds back economic growth and development.
More physical capital generates economic growth.
Net investment leads to more capital accumulation, which generates higher output and income.
Higher income allows higher levels of saving.
Lewis Structural Change (dual-sector) Model:
Many LDCs have dual economies:
The traditional agricultural sector was assumed to be of a subsistence nature characterised by low productivity, low incomes, low savings and considerable underemployment.
The industrial sector was assumed to be technologically advanced with high levels of investment operating in an urban environment.
Lewis suggested that the modern industrial sector would attract workers from the rural areas.
Industrial firms, whether private or publicly owned could offer wages that would guarantee a higher quality of life than remaining in the rural areas could provide.
Furthermore, as the level of labour productivity was so low in traditional agricultural areas people leaving the rural areas would have virtually no impact on output.
Indeed, the amount of food available to the remaining villagers would increase as the same amount of food could be shared amongst fewer people. This might generate a surplus which could them be sold generating income.
Those people that moved away from the villages to the towns would earn increased incomes:
Higher incomes generate more savings.
Increased savings meant more fund available for investment.
Increased investment meant more capital and increased productivity in the industrial sector, higher wages, more incentive to move from low productivity agriculture to high productivity industry, the circle continues…
Rostow’s Model – the 5 Stages of Economic Development:
In 1960, the American Economic Historian, WW Rostow suggested that countries passed through five stages of economic development.
According to Rostow development requires substantial investment in capital. For the economies of LDCs to grow the right conditions for such investment would have to be created. If aid is given or foreign direct investment occurs at stage 3 the economy needs to have reached stage 2. If the stage 2 has been reached then injections of investment may lead to rapid growth.
The most important graph used in Macroeconomics today is almost certainly the Aggregate Demand / Aggregate Supply (AD/AS) model. This graph can be used to illustrate most macroeconomic indicators, including those objectives that policymakers are most interested in achieving:
Price level stability
Full employment, and
The AD/AS model, on its surface, is a very simple diagram, showing the total, or aggregate demand for a nation’s output and the total, or aggregate supply of goods and services produces in a nation. It is very similar to the microeconomics supply and demand diagram, except that instead of comparing the quantity of a particular good to the price in the market, the AD/AS model plots the national output (Y) against the average price level (PL). The model shows an inverse relationship between aggregate and price level, and a direct relationship between aggregate supply and price levels.
What makes this seemingly simple model so interesting, however, is that there are two wildly different opinions among economists on one of the its two primary components. Some economists, whom we shall refer to as Keynesians, believe that the AS curve is horizontal whenever aggregate demand decreases, and vertical whenever AD increases beyond the full employment level of output. On the other side of this debate is whom we shall refer to as the Hayekians who believe that AS is vertical, regardless of the level of demand in the nation. The two views of AS can be illustrated as follows.
Underlying the two models above are very different ideas about a nation’s economy. The Keynesian AS curve implies that anything that leads to a fall in a nation’s aggregate demand (either household consumption, investment by firms, government spending or net exports) will cause a relatively mild fall in prices in the economy but a significant decline in the real GDP (or the total output and employment in the nation). The neo-classical AS curve, on the other hand, being vertical (or perfectly inelastic), implies that no matter what happens to AD, the nation’s output and employment will always remain at the full employment level (Yfe).
Behind these two models of AS are two schools of economic thought, one rooted in Keynesian theories and one rooted in the theories of an intellectual rival and contemporary of John Maynard Keynes’, Friedrich Hayek. Keynes and Hayek were the most pre-eminent economists of their era. Both lived in the first half of the 20th century, and rose to prominence in between the two World Wars. Both economists saw the world fall into the Great Depression, but each of them formulated their own distinct theory on the best way to deal with the Depression. The episode of Planet Money below goes into some detail about the lives and the theories of these to most influential economists.
Keynes believed in what we today call demand-management. The idea that through well planned economic policies, governments and central banks could intervene in a nation’s economy during periods of economic downturn to return the economy to its full-employment level, or the level of output the nation would be producing at if everyone who was willing and able to work was actually working. Keynes believed that aggregate demand was the most vital measure of economic activity in a nation, and that through its use of fiscal and monetary policies (changes in the tax rates, the levels of government spending, and the interest rates in the economy), the government and central bank could provide stimulus to a depressed economy and create demand for the nation’s resources that would help move a depressed economy back towards full employment.
Hayek and his disciples, on the other hand (sometimes referred to today as the supply-siders) had a different interpretation of the macroeconomy. Hayek was what many today refer to as a libertarian. He believed that the government’s best strategy for handling an economic downturn was to get out of the way. Any attempt by the government to influence the allocation of resources through “stimulus projects” would only reduce the private sector’s ability to quickly and efficienty correct itself. The free market, argued Hayek, was always superior to the government when it came to allocating resources towards the production of the goods and services consumers demanded, so why allow government to intervene in the economy at all. All a government should do, argued Hayek, was provide a few basic guidelines to allow the economy to function. A legal system of property rights, for instance. The government need not provide anything else. The free market would take care of health care, education, defense, security, infrastructure, and anything else the market demanded.
During depressions, Hayek believed that government could only make things worse by trying to intervene to restore full employment. At any and all times, government’s best action would be to lower taxes, reduce its spending on goods and services, and thereby encourage private entrepreneurs to provide the nation’s households with the output they demand. Any regulation of the private sector, including minimum wages, environmental regulations, workplace safety laws, government pensions, unemployment benefits, welfare payments, or any other measures by government to redistribute wealth or promote equality or social welfare would reduce incentives for individuals in society to achieve their full productivity and strive to maximize their potential output. By minimizing the government’s role in the economy, argued Hayek, a nation would be likely to recover swiftly from a 1930’s style Depression, and output can be maintained at a level that corresponds with full employment of the nation’s resources.
The graphs below show how the two competing ideologies view the effects of a fall in aggregate demand in the economy.
On the left we see the Keynesian model, which shows output (real GDP) falling with a fall in AD. The fall in output corresponds with a fall in employment, and therefore a recession (or Depression). To return to full employment, aggregate demand must move back to the right (or increase). To facilitate this, Keynes and his contemporaries believed that government should increase its spending, decrease taxes (to encourage households and firms to spend) and lower interest rates (to make saving less appealing). All that is needed, say the Keynesians, is a dose of stimulus to get back to full employment (Yfe).
In the Hayekian model, no government intervention is needed at all when aggregate demand falls. In fact, in an economy with very limited government, a fall in AD will have little or no effect on output and employment. Without minimum wages or laws making it difficult or expensive for firms to reduce wages or fire and hire workers, firms faced with falling demand will simply lower their employees’ wages and reduce the prices of their products to maintain their output. If there is no more demand for some products, those firms will shut down and their workers will go to work for firms whose products are still in demand, at whatever wage rate the market is offering. Wages and prices are perfectly flexible in the Hayekian view, because there is no government interfering, demanding workers for big government projects, competing wages up, enforcing a minimum wage, or paying unemployment benefits to those out of work: all policies that make it difficult for wages to adjust downwards during a recession. Without government intervention, wages and prices rise and fall with the level of demand in the economy, but output remains constant at its full employment level.
The two models could not be more different. In one (Keynes’) recessions will occur anytime demand falls below the level needed to maintain full employment. In the other (Hayek’s), recessions are impossible as long as government gets out (and stays out) of the way.
Which models is the right model? For most of the last 100 years, most Western economies have demonstrated more of the characteristics of the Keynesian model. As the last several years show, recessions certainly are possible. Wages and prices have NOT fallen as much as Hayek’s model suggest they should, and economic output has declined in many Western nations and remains below the levels achieved in 2007 in many places. Most economists would argue that this prolonged recession is likely due to a weak level of aggregate demand. And the economic policies of many Western nations have reflected the Keynesian belief that government can “fix the problem” through stimulus plans involving tax cuts, spending increases, and low interest rates.
But two years of Keynesian policies are now being reversed. US President Obama’s latest attempt at a Keynesian-style stimulus (his $447 billion “American Jobs Act”) has been rejected by the US Congress. Across Europe, government spending is being slashed and taxes are being raised, both policies that threaten to further reduce aggregate demand. Deregulation is the battle cry of the Republican Party in the United States one year before the next presidential election. Presidential candidates are promising to “cut taxes, cut spending and cut government”, which sounds like a Hayekian battle cry. Less government will lead to more competition, greater efficiency, more employment and a stronger economy, goes the thinking. Government cannot solve our problems, government is our problem.
This debate is not a new one. It has been going on since the 1930s when two scholars, one an Englishman from Cambridge, the other an Austrian at the London School of Economics, went toe to toe on the role of government in a nation’s economy. The two models of aggregate supply above survive to this day, and 80 years later, in the midst of what may be the second Great Depression, economists and politicians still haven’t figured out which theory is correct. Part of our problem is that in our Western democracies in which economic policies are determined by politicians who are often only in office for two to four years, we have not had the opportunity to truly put either economic theory to the test. Less than three years ago Barack Obama, freshly elected, embarked on the greatest experiment in Keynesianism since Franklin Roosevelt’s “New Deal”, which was widely credited with getting the US out of the Depression. Now, with another election looming, we have politicians promising to bring America back to economic prosperity in a truly Hayekian fashion, by “cutting, cutting and cutting”.
Sometimes when I read the news, I wonder what it would be like to NOT understand basic economics, and then I realize how much of what goes on around us can be explained by two simple concepts: demand and supply. The NPR story below talks about how the construction of two proposed coal exporting facilities on America’s west coast could, indirectly, lead to a greener future for America. Listen to the story then read on for more analysis:
China, already the world’s largest coal consumer, continues to build new coal burning electricity plants at an alarming rate. Its appetite for the “black gold” has driven the world price up to $100 per ton, as it has demanded increasing quantities from its own coal producers, but also those in other coal rich areas like Australia and the United States.
However, because of America’s lack of coal transporting and shipping infrastructure, US coal producers have been unable to sell their abundant coal to the Chinese, who are willing to pay 500% the equilibrium price in the US. The US market has remained isolated from the world market, not due to any explicit, government-imposed barriers to trade, rather due to fact that they simply can’t get their coal to the Chinese energy producers who demand it most.
Graphically, this situation can be illustrated as follows:
If the export facilities on the West coast of the US are not constructed, it will remain difficult for US coal producers to sell their output to China at the high price of $100, and the domestic quantity (Q2) will continue to be produced and sold for $20 per ton. But with the new port facilities, US energy producers will now have to compete with Chinese energy producers for American coal, and the US price will be driven up to the world price, since demand now includes thousands of Chinese coal-fired power plants. As the price rises from $20 to $100, the domestic quantity demanded in the US will fall to Q1, as domestic energy producers seek alternative sources of energy, switching instead gas, solar, or wind power.
The irony is that through increasing the ease with which American coal producers can sell their product to China, the US may reduce its own consumption of coal and its emissions of greenhouse gasses. Overall coal production in the US will rise with increased trade, but overall consumption within the US will fall.
Now, this may sound great if you’re the kind of person who thinks only locally. Air pollution will be reduced in the US, health will be improved, our electricity production will be greener and more sustainable. But globally, by making its coal available to China, the US market will contribute to the continued dependence on carbon-intensive energy production, and delay any progress among Chinese energy producers towards a transisttion to greener fuel sources.
The podcast also points out the fact that if the US did undertake the construction of the new coal-exporting facilities, it could be that the current high price of coal will have led to the entrence of several other large coal prodcuing countries into the world market, reducing China’s demand for US coal, reducing the price at which American producers can sell to China and thereby off-setting any domestic environmental benefit that may have resulted from the large decrease in quantity demanded among US producers at the current price of $100 per ton.
The whole conversation about the coal industry is somewhat depressing when the environmental costs of the industry are considered. Another NPR show, Planet Money, ran a story this week about the “gross external damages” caused by the production of coal-powered electricity.
They cited a study which found that the damages caused by coal to human health and the environment outweight the benefits enjoyed by society from the generation of cheap electricity by around $10 billion in the United States alone. This means that if the US shut down every coal-powered energy plant in the country immediately, total welfare in the US would increase by $10 billion. There’s no doubt that energy prices would rise, but the gains in human and environmental health would outweight the added costs of electricity generation by $10 billion. If a similar analysis were undertakein in China, I would guess the potential welfare gain of transitioning to alternative energies would be far greater for the Chinese people.
Here’s the chart from Planet Money’s blog showing the net welfare loss of coal-generated electricity and other economic activities in the United States.
*GED = Gross external damages from pollution
Notice that although generating electricity by burning coal adds nearly $25 billion of value to America’s economy, its negative environmental externalities create nearly $35 billion in damage to the US economy. The net effect of using coal to make electricity, therefore, is around -$10 billion. America would be better off without coal-generated electricity, if we include environmental and health factors in our measure of well-being. Unfortunately, the negative environmental and health costs of coal-electricity generation are currently externalized by the industry, indicating that this industry may be experiencing a market failure.
How would the construction of two coal-exporting facilities on America’s West coast ultimately lead to a cleaner environment in the United States? Do you think this prediction is realistic?
Who stands to gain the most if the coal-exporting facilities are constructed? Who would suffer? In your opinion, should the facilities be constructed? Why or why not?
Interpret the colorful diagram above. What do the green bars represent? What do the yellow and red bars represent? According to the graphic, which type of activity is most harmful to American society? How do you know?
True, false, or uncertain. Explain your reasoning. “The burning of coal to make electricity should be completely banned in China, since China is the world’s largest greenhouse gas emitter.”